Episode #384: Robert Cantwell, Upholdings – The Man Behind The First Hedge Fund to ETF Conversion
Guest: Robert Cantwell is Founder of Upholdings, the first hedge fund in the U.S. to convert into an ETF.
Date Recorded: 1/5/2022 | Run-Time: 56:58
Summary: In today’s episode, we’re talking to the first person to convert a hedge fund into an ETF and invest in a private company through an ETF. Robert shares why he chose to do the conversion and some benefits of the ETF structure, including transparency, taxes and even short lending to generate income.
Then we get into his ETF, ticker K-N-G-S. We talk about Robert’s philosophy for running a concentrated portfolio of companies that he defines as compounders. We hear his thought process for analyzing a company and he uses Facebook as an example.
As we wind down, we touch on the Chinese Internet stocks and how investors should think about geopolitical risk when investing abroad.
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Links from the Episode:
- 0:40 – Sponsor: The Idea Farm
- 1:10 – Intro
- 2:00 – Welcome to our guest, Robert Cantwell
- 2:44 – Hedge fund to ETF conversion
- 5:38 – Why the ETF structure is beneficial compared to mutual funds
- 10:55 – How hard it was to launch an ETF and onboarding investors
- 13:18 – Robert’s investing philosophy
- 16:44 – Meta (Facebook) as an example of an investment
- 20:13 – Robert’s framework for position sizing
- 20:47 – #373: Tim Maloney, Roundhill Investments; META ETF
- 23:42 – Distinguishing between growth investing and what they do
- 25:37 – Investing in a private company in an ETF
- 33:45 – Robert’s investment letters
- 39:14 – Other tools and resources he uses for running the fund
- 43:21 – Some of the less held names in their portfolio
- 46:57 – How much global exposure does Robert’s portfolio have?
- 49:06 – What has him worried and excited about 2022
- 52:31 – His favourite spots to hangout at in Nashville; Exit/In and Mercy Lounge
- 53:33 – Learn more about Robert; Twitter @upholdings; kngsetf.com
Transcript of Episode 384:
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Meb: Welcome, friends. We’ve got a great show today. Our guest is the founder and chief investment officer of Upholdings and serves as the portfolio manager of the Compound Kings ETF. In today’s episode, we’re talking to one of the first people ever to convert a hedge fund into an ETF and invest in a private company through the ETF. He shares why he chose to do the conversion and some of the benefits of the ETF structure including transparency, taxes, and even short lending to generate income. Then we get into his ETF ticker KNGS. We talk about his philosophy for running a concentrated portfolio of companies that he defines as Compounding Kings. We hear his thought process for analyzing a company and uses Facebook as a good case study. As we wind down, we touch on the Chinese Internet stocks and how investors should think about geopolitical risk when investing abroad. Please enjoy this episode with Upholdings’ Robert Cantwell. Robert, welcome to the show.
Robert: Hey, Meb.
Meb: Where do we find you today?
Robert: Nashville, Tennessee.
Meb: NashVegas. I mean, every time I go there it’s cranes everywhere. Is it still booming? This would be, like, the top three corona relocate spot, I think, up there with Austin and Miami. Does that feel about right? How long you’ve been there?
Robert: It’s a hot one. We came late 2020 so we were part of the first wave but it keeps coming. What’s nice…I mean, there’s enough land out here that there’s a lot of building going on, a ton of residential. And we had our first new celebrity come to town, Dennis Quaid. He came out. He said, “These are all my favorite restaurants.” And now all of a sudden, you can’t get into those restaurants anymore. So, we’ve got our own little celebrity thing happening here.
Meb: Nice. I need to get back there. I love it. Got a lot of friends there. All right, well, we’re going to get into all things ETFs, compounding. You guys got a great new fund out. Really cool ticker. But what we have to start with is I don’t know how to describe your past. A retail fashion exec/VC/I don’t know what. And hedge fund manager. I guess that’s the progression. Give me the right progression. What was the timeline lead-in to you guys launching this new ETF?
Robert: I swear it’s a cleaner story than the title suggests. To skip the beginning of it but back in 2010, I was a research analyst at a hedge fund. And a good friend of mine started a company called Everlane. And the general premise was why don’t we just have a website, no stores, build a brand online and sell product direct to customers? We’ll do low markups and own the customer relationships ourselves. And Everlane was doing this in lifestyle fashion. Rory Parker, Harry’s, Glossier, Away, Bonobos, there was a huge number of brands that sprouted up around this time and a lot of it had to do with the technology and infrastructure being there to allow us to build a brand without a store.
And Michael and the team, it was just a few people, they sold a million dollars of product in their first year and I thought, “Well, gosh, this is a way cooler opportunity to actually build a new business like this as opposed to keep peddling around a hedge fund for a number of years.” My wife and I moved from New York to San Francisco when I joined the team. A year later, Instagram launches and in the move from social on desktop to social on mobile, Instagram turned out to be total rocket fuel for all these brands that had started up building themselves directly online without these physical presences. And the other thing that was very strongly in our favor was that the legacy retailers were being so slow to move their businesses online because they were so beholden to their physical store infrastructures. So, in about seven years, we were able to take Everlane from a million to a couple hundred million in sales and ironically, once we got that big, we actually started opening physical stores and competing there.
So, I stepped away around that time. I started managing my own small hedge fund then. But given the experience that I had on the retail side at Everlane, I was very curious to learn a lot more about the retail investment management industry. And I’m going to say things that everyone here already knows but ETFs started about 30 years ago. And it’s been a total boon for index funds and passive strategies but it wasn’t until the 2019 ETF rule change that the game for active managers just totally changed because starting with that rule, now the active managers had the ability to use the custom baskets to move between securities and get the tax efficiency benefit when we’re changing positions. So, in the history books, as far as I’m concerned, starting in October of 2019, there is now zero reasons remaining why an actively managed equity strategy should still sit inside of a mutual fund.
Meb: What you’re hitting upon right here…and I think to interrupt you just because this is extremely significant, for those listening who don’t know this background, just a quick refresher. The ETF structure basically allows the end investor to only pay taxes. They buy the fund and then when they sell it regardless of turnover. So, index funds were always great because they didn’t have 5%, 10% turnovers in a lot of trading. You’re not going to see a lot of taxes in the mutual fund structure. ETFs, because of this custom basket, think of it refreshing, even if the fund has 100% turnover, what would normally be capital gains each year, the end investor only sees it when you buy it and you sell it and that’s the way it should be. That’s a great product hack. And I have the belief that it probably should be that way across all funds but that’s not the way the tax code’s structured.
So, ETFs are clearly, clearly superior in what…the insight you’ve arrived at that is the flows of the past decade you’re seeing used to all be index ETFs because of a wonky ruling structure by the powers that be. But when that changed, the world is slowly waking up to this fact that you probably have, on average, about a 70 basis points, almost a 1% tax advantage of the ETF versus a mutual fund or hedge fund, which is enormous. Sorry. Not to ruin your whole story but this is something…
Robert: But to amplify it.
Meb: …we live through.
Robert: Here we are. It’s 2022 now and 98% of actively managed equity capital is still inside of mutual funds. So, looking at this as the entrepreneur, there’s some similarities to Everlane all over again here where the really large legacy players, Capital Group, T. Rowe, even Vanguard, they are still stuck with their active equity strategies inside of mutual funds. And there’s a long list of reasons for that. A lot of it has to do with protecting historical cash flows.
Meb: When you talk about the incumbents…and I was ranting on Twitter about this the other day. I said, “A good example…” I said, “is it iShares that has EEM,” which is the emerging market. It’s an index fund and they charge, like, 70 or 80 basis points for it. And there’s a bunch of competitors that are, like, 10 basis points but this is one of the largest funds on the planet. And you notice they’re not reducing the fees. So, they launched a sister fund at, like, 10 or 20 basis points so they can say, “Oh, well, if you want lower fees, go in this one.” But they have that captive audience of assets. In my opinion, it’s in, like, three categories. They either are too lazy or don’t know. So, they don’t even know that there are cheaper versions. They are capital gain stuck so they’re in a taxable account. They don’t want to sell it because it’ll generate taxes. And I forget what the third one was. Maybe I’m lumping it with the first one. It’s an advisor that just doesn’t want to create a discussion. And so, this is a very similar sort of situation where you have a clearly better option but because of various reasons, not doing it.
Robert: I can tell you that what I’d say for the third one is the existing sales and distribution agreements that all of these incumbents have on their mutual funds because a huge chunk of that mutual fund fee is purely going to sales folks or to access fees from those funds to even be available on platforms that advisors or individuals access.
Meb: So, you’ve only been in this business for a handful of years. You already know where all the bodies are buried, man.
Robert: Renegotiating those agreements might take a decade. And that’s what’s keeping these incumbents from moving their product or restructuring their product and ETFs more quickly. Anyway, so for the new upstarts, this is an advantage because we actually are able to offer a product that has some advantages over the really big players that have been investing in these things for tens of years.
Anyway, so you previewed this but…so I was managing this small hedge fund. We went through bunch of work with the SEC. We actually relied on decades-old private fund to mutual fund conversion law that allowed us to take our little private hedge fund and under…ETFs are regulated. And the same thing as mutual funds. We were able to convert that into our ETF. So back at the end of 2020, the fund converted. We were a little hedge fund with 10 investors. We’re now a publicly traded entity. Six months after that, we went from our 10 investors to…we now manage capital for a little over 600 investors and that’s a crazy amount of growth for a small investment manager to broaden the base of investors that they’re able to direct capital for in a short amount of time.
Meb: Did you guys do an actual…like, was this, like, an actual conversion or did the hedge fund liquidate the assets, sit there and go into the ETF?
Robert: It was a very true conversion. So, our track record started on March 1st, 2019, the day this hedge fund started. And there were a lot of rules we had to follow to do this. Every single investor in the hedge fund had to take shares of the new ETF. Every single asset, even some private Airbnb stock that we were sitting on had to go into the ETF and it all had to happen on exactly the same night after hours. So, there was a little bit of coordination to get all those parties working together.
Meb: This is interesting because I think this is a trend you’ll continue to see. Obviously, the mutual funds are already…it’s, like, snowballing with DFA. It was probably the big one of 2020. So, you’re seeing the mutual funds start to realize they need to move. The hedge funds are probably a little slower. But it’s funny because you go back a decade and we’ve done something similar but we had looked at the challenge of the conversion and I’m like, “Oh, hell no. I’m just going to shut this down and then tell everyone who wants it to invest in the ETF because it seemed like too much work.” Tell me, in 2022, 2021, whenever you guys got this started…when did the fund launch? Was it 2020?
Robert: It was December 30th, 2020 was the conversion date. And so that’s where you can see the public trading record back to then.
Meb: And so, tell me how hard was this. Because I mean, like, running a small hedge fund, I mean, it’s such a pain in the butt with the private placement docs, you got to send people these, like, 60-page things to sign and wire and everything and you mentioned the ETF. It’s such a great vehicle because A, it’s more tax-efficient, but B, they can just go buy it at E-Trade or Fidelity or Schwab versus the huge pain of being a private…so now, like you mentioned, it went from 10 to 600. How hard is that experience today?
Robert: On the investor onboarding piece, you hit on another big reason why this conversion became such a no-brainer for us. Because we had…it wasn’t 60 pages. It was about 85 pages of private placement documents. And friends or people that I’ve worked with or former mentors that were investing with me, they weren’t reading the documents. They were saying, “Well, Robert, we’re investing with you. Just put us through the process of what we have to sign and we’ll get through it.” And that in and of itself was clearly not a great process because 85 pages of documents was not the diligence that the investors actually wanted to do on whether or not they wanted to invest with me.
And this is where I actually think the SEC and FINRA does a pretty good job. Because the rules of the game are the same for everyone that manages a 40 Act fund be it an ETF or a mutual fund, it allows everyone to do their own research as to whether or not they want to allocate with that fund manager. So, I’d say the ETF process of it simplifying from 85 pages down to a 4-letter ticker, this is the type of technology disruption that Silicon Valley and the western world at large tries to build all the time. So that was one really cool thing.
Meb: Let’s talk about what’s your philosophy. What do you guys actually do? Is this a long-short? Are you global? Are you long only? What’s your focus? You’ve got a great name, great ticker. Let’s hear about what you guys are actually doing. Great website too, by the way.
Robert: Appreciate it. We’ll first speak to the portfolio strategy and then we’ll speak to the individual stock selection. And the fund has really been named for the individual securities that we try to purchase. But let me start with the strategy itself so…
Meb: And this is the…listeners, this is the Compound Kings ETF, KNGS and the website is KNGSETF. And also, you got to tell us what Upholdings means too.
Robert: You talk a lot about the S&P 500. Warren Buffett talks a lot about the S&P 500. It’s a great index over very long periods of time. There’s a reason why the majority of investor capital is placed there and it’s also the reason why the majority of active investors use it as a benchmark. That said, the S&P 500 has a few, what we view as weaknesses, which is it’s market-cap-weighted, it’s U.S. only, and it owns a ton of cyclicals. So, when we think about running a fund, first we need to have a reason for managing a fund that offers something different or adjacent to what the S&P 500 is already offering.
So given those three pieces, when we think about at the portfolio level for our fund, number one, we’re avoiding cyclical companies. It’s really difficult to own erratic cash flow. I mean, look no further than a lot of electric vehicle companies right now. Even Ford and Apple are getting electric vehicle inflation in their multiples. It’s really hard to hold stocks like that as long-term investors so we tend to keep cyclicals, banks, autos out of our selection universe.
The second thing that we do is we focus on high market share businesses in growth sectors. We’re primarily finding that today inside of payments, in software, in digital advertising. And then the third piece of it is we are not beholden to the U.S. So, wherever it is that these companies happen to be domiciled, we’re able to participate. I will say the fund is majority held in U.S. equities. Also, it is a little bit misleading for a U.S. company. Majority of Facebook’s growth for example is coming from outside of the United States, not inside of the United States, even though the business itself is domiciled here.
So then this gets to the second piece of…if that’s the strategy at the portfolio level, how do we select these individual Compound Kings that we own? And there are four dimensions to that and it starts, as I mentioned, with the industry. It’s got to be a good growing industry with a relatively small number of market participants. Number two is the player within it has got to have a high or growing market share because you either want to own the leader or you want to own the follower or the entrant that has some sort of technology or regulatory advantage.
Number three is where is this company actually deploying its capital? Are they buying back shares at attractive rates? Are they acquiring smaller competitors at cheap prices? As an investor, I always like to really focus on…when I’m investing in this company, where is the company actually spending that money that I’ve invested into its equity? And then the fourth piece of it is the price because the price is the one thing you can never change about a security that you acquire and I do think the price is the biggest thing that saves active managers long-term because they have so much discipline over where they’re actually willing to acquire shares of some of these great kings that we end up finding.
Meb: You mentioned some of the inputs. Maybe walk us through some sort of growth business. I think it’s easy…If I’m listening to this, it’s like, “Oh, great. I want Compound Kings too.” But how to…like, actually finding those and identifying the ones that will continue…Kind of walk us through maybe a case study or an industry sector name that you think is a good example of what we’re talking about.
Robert: Let’s keep using Facebook as an example.
Meb: Okay. The death star. Let’s go. The evil empire. I didn’t know that the majority of their growth or revenue’s focused foreign.
Robert: Majority of their growth.
Meb: Growth, okay.
Robert: So, when you see incremental cash that is coming into the company, more than 50% of incremental cash is coming from outside. Let’s talk through Meta platforms. As our poster child, Compound King for a second. First off, when we talk about the industry. So, if you just take social media advertising, it is a subsector of the digital advertising industry, which is generally growing at large. Social media within that has grown from just in the last 5 years about 12% to about 19% of the digital advertising industry. So, you have a subsector within a growing sector that is gaining share. First off, you like that.
Now at the company level across Instagram and across Facebook and across WhatsApp, Facebook commands just a lot of different ways to measure it. Anywhere between 75% to 90% market share of social media advertising dollars. It’s a very unique instance where you’re able to almost purely own that social media share game of digital advertising through a single security. In other cases, sometimes you have to own a variety of securities in order to do that. One of the things that really sticks out to us about Facebook’s strength is that if you look at the really distant number two, three, four players, LinkedIn, Twitter, even Snapchat, they are growing and a little bit faster than Facebook but they are not growing fast enough at a rate to take, say, for example, five percentage points away of market share from Facebook in the next, you know, five or six years.
So, you really love the competitive position of a business like that. The one challenge with Facebook, which has created a little bit of pressure on its share price, is the reinvestment. The whole metaverse thing has scared tons of investors out of the stock. The business has ramped its CapEx pretty significantly. A few years ago, when I started investing in Asia, the management team was really clear that it costs the same to build social media infrastructure there but the RPUs aren’t quite as high so their return on invested capital’s going to be a little bit lower. Now, those are all the reasons why this stock is trading at a better multiple than Google or Microsoft or Apple.
However, you have a management team that has a now nearly 10-year track record of talking down the street on its margins. And one of the things we love to look at is over long periods of time, how does a company perform relative to consensus estimates? Ninety per cent of the time, Facebook outperforms on revenue and on margins because of how effective they are at talking down the analysts, at talking down investors about how capital intensive and how competitive the business is going to be in the future. And to us, this metaverse investment that they’re making, which is almost as much defensive as it is playing offense for future revenue growth, is just the next iteration of that because they’ve got plenty of cash to both turn on the buyback machine in a bigger way in the future like we’re seeing Google do now starting to catch up to Microsoft and Apple. But across the four dimensions that we look at…
Meb: The cool thing about what you do, which to me is the entire point of being an active manager…so if you want five bips, buy this and be done with it. If you want someone to be active, like, you want them to be weird and active and different…otherwise, what’s the point? And the vast majority of the legacy mutual fund industry is just this closet indexing. So, looking at your portfolio, it’s concentrated, weird and different. And so, I want to touch on two things. One is, like, the ability to throw in a fat position size on something you have conviction in like META. We had the META ETF guys on the podcast. I’m like, “You guys got to call Mark and sell him this ticker or just tell him to buy your ETF company,” then they can have the ticker. But talk to me a little bit how you view the position sizing while we’re on this topic of Facebook because this is a big slug. How do you think about sizing these positions and how do you address them over time?
Robert: So, there’s a lot that goes into the risk management practices of how big you’re willing to let a single position get. And META might be a single stock but it’s not a single company. Through that lens, you can envision yourself having…say, for example, it’s a 16% position right now. You might actually allocate that and say, “Well, I’ve got a 6% or 7% position in Instagram. I’ve got 5% to 6% position in legacy, you know, Facebook assets and then I’ve got the remainder of it in WhatsApp and some of these other business initiatives that they’re doing.” This particular stock is a unique one.
Where we think about concentration on other securities, a lot of it’s going to come down to how cheap is the price and how volatile is the stock? You can put a cheap stock big in your portfolio but if it’s extremely volatile…volatility is a price ultimately that your investors are paying because investors are not there to know exactly which day to buy your fund and exactly which day to sell your fund. And so, we take the responsibility of managing volatility within the securities that we own pretty seriously. And that means what’s great is that, again, a stock like META has had such low volatility that we’re able to have a much larger position in it.
Now, I can contrast this with some of the earlier stage stuff. If you want to flip to the other end of the portfolio, some of these places where you see 1% positions in Coinbase or Datadog, some of these business models that have the potential to be absolutely phenomenal, enormous businesses years from now but have share prices that are trading at implied multiples that are quite scary. These are businesses that we want to participate in but we use our ability to wait in the portfolio to reflect the amount of conviction we have in that business at its current trading levels.
Meb: The point you made that I think is really interesting about Facebook not just being meta, not being one company reminds me of something about Berkshire but within that, the Instagram goes back circling back to the beginning of the conversation because I’m fairly certain I’ve never clicked on a Google ad in my entire life. But I’ve probably bought, I don’t know, 30 things off Instagram over the years. Like, the targeting, whatever they have going and I was going to say, as a former Everlane guy, excluding Everlane, if I need the perfect white t-shirt, like, as the fashion guy, like, where do I go? It’s like MeUndies or the ones…I’m originally from North Carolina, Winston-Salem, so I got a little Hanes loyalty but the cotton shirts just don’t do it anymore.
Robert: That’s very loyal.
Meb: That’s a really interesting point because a lot of these companies…what people think is just the business, may not necessarily be the driver. I’ve got a bunch of questions but one that we were talking about…I think a lot of people, so if they look at your portfolio, may at first blush say, “Okay, growth.” But, like, growth not necessarily like you’re talking about some of the competitive positioning and the compounding. Are there differences? Are you in that, sort of, broad category or do you think that’s inaccurate? Like, how would you distinguish between the two?
Robert: The job of the active investor is to pursue the greatest amount of reward while taking the smallest amount of risk. And the market is always changing where it is providing those opportunities to you. I say this because back…I mean, we’ve lived through a particularly displaced market over the past couple of years here. And immediately after corona hit, restaurant stocks, commercial real-estate stocks basically were priced to go bankrupt. And shortly after the first shutdowns in March of 2020, the best risk-reward investing you could do was in these assets that the market was saying, “We’re not sure these assets are still going to exist a few years from now.”
So, whether you fall under a traditional value or growth, we’re subscribers to growth is a component of the value equation. And we have found that investors have come to us ultimately for different reasons but I don’t know that we’ve ever necessarily just been thrown into one or two of those buckets. A lot of folks have appreciated…not to pick on one of our competitors here for a second but ARK spends a lot of time on new business models and new technology. But the price discipline that they have and what they’re paying for some of those securities has resulted in a much more volatile fund for them. And we’ve been fortunate that we’ve been able to bring access to similarly innovative companies with a much less volatile fund results because we’ve been so much more careful about the price they’re actually willing to pay for some of those securities.
Meb: You talked to me about something really interesting before I forget, which was moving over a private security. I don’t know if I ever heard of that in the ETF structure. Was that easy, hard? Is it still there? Has it converted to a public security? What was the sitch there?
Robert: So, we get a little lucky on the timing with Airbnb’s IPO that it was pretty close around the time we converted the fund that it made things really easy on us. One little piece of history. The 1940s act under which all these funds are organized allows up to 15% of the fund, of any of these funds to invest into private or categorize it as illiquid securities. So, as it stands in our prospectus, we have the ability to invest up to 15% of our fund into private securities, which is certainly something we’ll take advantage of if and when we see great opportunities there. I don’t know if we’re going to talk about bubbles or not but the late-stage private market is not a particularly great place to be investing at the moment. So, it’s not one that we’re looking to allocate capital.
The other challenge with if you do start carrying private securities in your ETF is you start to rattle the intermediaries a little bit who do such a great job of keeping the premium discounts on our funds so tight. And so, you want to be at a certain size and ensure a certain holding period and ensure really good relationships with the intermediaries so that your ETF doesn’t start to trade funny because it has these private securities that don’t have an hourly or down to the second price attached to them.
Meb: I mean, I also would imagine that would run into trouble if you had a fair amount of redemptions in the fund where all of a sudden that 15% illiquid, if you couldn’t liquidate it, would become 30% or 50%. I’m just trying to think of, like, if the fund ever was, like, a billion-dollar fund and you had 15% in illiquid, I imagine it would be a little more problematic way to go about it.
Robert: It would be a bit of a pain. You would be irresponsible as a fiduciary if you’re taking $150 million in private if your fund were to shrink that much. That said, the SEC is not a brick wall on this stuff and if you push that private across that 15% threshold but you work through and you say, “Here’s our plan of how we’re going to get there over the next year,” what’s cool is that private markets are becoming quite a bit more liquid. And that was one of the things we had actually established before we went through this whole conversion was that if the SEC were to tell us, “Hell no,” we could’ve still found a buyer for our private Airbnb stock and it wouldn’t have been a great price but we still would’ve been able to get out of it. I don’t think it’s that black and white with the private stuff.
Meb: Let’s keep talking some ideas. You had one of the all-time investing GOATs. Just mentioned he was doubling down on one of your portfolio companies. Charlie Munger, I think, recently came out and said he was backing up the truck on Alibaba. So, you’re global. What’s the attraction to the Chinese tax scene? They’ve been getting pummeled a bit over the past year. Is that something where you think is a big opportunity? Is it a falling knife? Are you agreeing with Charlie or what you got?
Robert: This is a big topic you’re opening up here.
Meb: Good. We’ve got plenty of time. I’ve got nowhere to be. Let’s go.
Robert: All right. Well, China Internet was one of the most unique investment opportunities in the entire world because you had the government come in and say, “No foreign competitors.” And that’s your dream because they don’t have to compete against Google and Facebook and Amazon and you name it. And as a result, those businesses only had to compete against a handful of other local domestic companies. And that’s why the leaders there have been able to get to even higher market share than their relative counterparts in the Western world.
So, you like that setup as a fundamental-based investor. And what’s been frustrating is that the fundamentals of those companies have actually done quite well. Good investments in new technology, building businesses like Alipay that transacts six times the GDP of China, transacts through Alipay because salaries get paid through it, loans get issued through it, all these non-GDP things. There are some remarkable businesses that have been built there. Sadly, the geopolitical risks have only worsened. And we spend an enormous amount of time going through a lot of the new regulations that China had imposed. And to be blunt, those regulations are not going to kneecap Alibaba long-term. They’re not going to wipe Tencent off the planet.
However, the securities regulation is what has emerged as the big issue of continuing to hold these businesses because China is making it clearer and clearer that the non-Chinese investors cannot actually own the underlying businesses. And the U.S. government is concurrently expanding its blacklist and saying, “American investors can also not own Chinese businesses.” And this is a completely new risk that…we’re a U.S.-based fund and I talk about this with the team…if we were based in Scotland, it might be a lot easier for us to take this kind of risk in investing in these Chinese securities. But because we are a U.S. based fund, we have in fact been moving away from a lot of our Chinese positions. So, they were as much as 30% of the fund almost a quarter ago. They’re now less than 15% and we’re likely to have that again over the next few months if market prices continue to give us opportunities to move. But we’re deemphasizing it as an area going forward given the…
Meb: I wonder how much of that you could express through just, sort of, either derivative trades or proxies if you really wanted to that would have probably less direct portfolio risk and maybe still give you the positioning. I’m not sure who I’m thinking of but we were talking the other day about one of the cheapest countries in the world but a lot of these are a pain in the butt to transact in, which is Pakistan. And there’s a…Global X has a fund that does it, which theoretically would give you some exposure but less headache, but sadly, it’s small.
Robert: Well, the other thing that’s made investing in China more difficult to do now is frankly, I mean, a lot of great payments and software companies are starting to trade at more reasonable prices again. So, we’re able to pursue what we think are double-digit return opportunities without having to take this existential United States versus China risk. And again, that comes down to balancing all the risks versus the rewards across the portfolio.
Meb: Well, I like following Charlie. He’s one of my favorites. So, he’s about to round-trip on 100 years old so maybe he’s just throwing his final haymaker trades out there but I would take his coattails any time. All right. What else you got in the portfolio? Let’s see. This is a beautiful…you’ve got nice letters too. What’s Upholdings mean, by the way?
Robert: It’s the name of our investment company and when we were thinking about picking a name that would represent our brand, true active investors to the best of our abilities are long-term buy and hold investors. So, we wanted to express that but we also wanted to express that there are positive values in what we do and we can get into ESG if you want for a brief moment here. My issue with a lot of ESG based investing is that folks are trying to develop rules that say companies have to fall into these buckets and then we can own them or not own them.
However, the reality of the investment management industry is every single fund itself is in fact a company. So, where I think the true innovation is actually going to happen from a social impact perspective on investments is how can the funds themselves become positive social impact beneficiaries? We’re only a couple of years old. We’ve hardly built any of this into our firm yet but you’ll see in every single quarterly letter we talk about the organization that we’ve supported in the quarter. The bigger we get, the bigger the impact we’re able to have over time.
And this was one of the key learnings we had at Everlane is that the more transparent you are and the more you build social impact into your business as it’s growing as opposed to, “Oh, well, when we have a bunch of profits, then we’ll just distribute them,” you’re able to actually build a company that matters and can be more inclusive in some ways. So, this comes back to the Upholdings thing is that over time we’re going to be building values into this brand that we’re committing to uphold in everything that we do.
Meb: That’s cool. I definitely saw that in your letters. Listeners, the letters are on the website. We’ll link to them in the show notes. We started doing that with our best investment writing series where we said…people read some of their best research reports in the podcast. It’s not me so I shouldn’t be taking credit for it and we have a sponsor. We’ll just donate it to the author’s choosing. So, we just sent out about a dozen checks to various charities. It was funny though because they…a couple of them responded like, “Who are you, by the way?” Because this is, like … some of them were some tiny charity in some tiny state and town. They’re like, “Why did you just send us some money?” I said, “Oh, that’s from a podcast. Take it for a listen.”
Robert: Look, you’re one of the most transparent guys out there and I think what’s so cool about sharing everything that you do is you get a ton of instantaneous feedback around what people actually care about. And that’s why I do think that you’re in one of the best positions about knowing where and how to help allocate that capital to beneficial causes. I’m not surprised that you guys are having a big impact.
Meb: The transparency of the ETF structure can be, we like to say, the agony and ecstasy of a public fund manager. There’s the flows in and flows out and it’s always a challenge not to get too elated or too despondent when times are good and bad because they both happen. Let’s talk about…speaking to the people out there that want to launch a fund or kind of follow your playbook, talk about the experience. You’re only, what is that, a year, a little over a year in on the ETF side. Talk about it and how are you planning on getting this sucker up to $100 million, a billion and from there?
Robert: I think transparency works in a number of different ways here. And the first…simply at the portfolio level, a transparent portfolio is now table stakes for running a 40 Act fund. And T. Rowe learned this mistake the hard way. They released a ton of these non-transparent ETFs. They’ve hardly marketed them. They’ve hardly gathered any assets and they’re T. Rowe Price. They have trillions under management and they’ve got these ETFs out there that are just hanging around. Capital Group and Vanguard, from everything we’ve heard so far, are not going to repeat those mistakes. And they’re going to be coming out with all their actively managed equity products in the next handful of months. They’re going to be fully transparent and they’re going to be finding ways of leveraging some of their existing IP to try to make those attractive. But where I think transparency has really changed the game for portfolio managers is in actually the sharing of the research.
So, this has less to do with Compound Kings, the fund we run and this has more to do with Upholdings, the investment management company that is investing in expert interviews, in big data modeling, in all the work that you have to do to be smart enough to have a good view on whether or not a security is attractive at a certain price or not. And what we found there is 30 or 40 years ago, pre-computers for the most part, pre-web, the concept of the investor hiding away in the top of the castle in a room reading 10-Ks had a lot of plausibility to it because that information was not widely disseminated. And if you invested enough of your personal time, you could find things in those footnotes that gave you a differentiated view on a security that the market may or may not be reflecting in its trading price.
It’s not that way anymore. Computers and the web have stripped all of that information out of public filings. Expert networks through like Tegus have made access to management and competitors basically frictionless. And so now the challenge is not in attaining that information. It is in processing all this limitless number of inputs into useful conclusions. And this is where when we first started, we would share our research on individual securities with our own investors and sometimes they’d have an opinion or sometimes they’d recommend someone that maybe we should talk to to learn more about that specific business. But we were interested enough in it to experiment further.
And then we launched a Twitter account a year or two ago and we said, “Screw it. We don’t have to just share this with our investors. Let’s just put it out there. Let’s battle test this on the public forum.” And what’s been fascinating to me is how quickly of an instantaneous feedback loop we get over whether or not that conclusion is good, were there things we missed, were there other pieces of data or analysis that should’ve been included in that that wasn’t. What’s so cool is that if you contribute…and a lot of this is on Twitter where we have the Upholdings handle there. If you contribute to that community, in exchange for valuable contributions, you get access to thousands of analysts that are also studying stocks all day.
And if you’re thinking about building a modern investment management company, if you’re not a transparent participating member of that community, I think you’re going to have a really hard time competing at the security level ultimately. And that I think is the really big piece that’s going to take these incumbents a really long time to figure out because…and, you know, I don’t see any of their portfolio managers out there in the Thunderdome yet. And they’ll be there eventually but until they get there, we’re happy to be there for them.
Meb: I think most of the incumbents are just happy to ride out the management fees. It’s like a plane landing. It’s just like, for their career, the next 10, 20 years is going to be like, “I hope it all doesn’t flow out too quick.” And I think a lot about this. I’m like, “What is the eventual dam breaking where it moves on from a lot of these closet indexers, these incumbent funds and moves to better choices?” And it’s happening every year but it hasn’t been an absolute just, like, haymaker. Usually bear markets tend to make that happen because the turnover never goes back to some of the old offerings. But we’ll see.
What other tools do you, like, use? You mentioned some of these, ATIGS, Twitter. Anything else in particular that you think is a useful resource for you guys? And is it just you? You got a team? How many folks y’all got working on this?
Robert: There are three of us now working on the portfolio. The way we divvy up responsibilities, I’m primarily a portfolio manager. One of the analysts is extremely qualitative so he’s living inside of transcripts and expert interviews and testing products and services and things like that to understand who’s got the good stuff and who doesn’t. And then the other analyst’s extremely quantitative. So, we talk about these seas of data and information, whether or not it’s…even of the easy fascinating things to track has been developed attention to the different gaming platforms. So, Unity versus Roblox and you’re able to track, well, how many developers are being attracted to develop for which of these platforms because the more developers you attract today, the more products and revenue you’re going to see later in the future.
And so, connecting these data points from what’s being publicly disclosed by the company versus what are humans publicly demonstrating demand for. Sometimes there are differences between those two things that we have to work through as active managers. So, we’ve combined the qualitative side of it with the quant-based approach on the security selection stuff that we do. And so, then on tools and other things that we use, obviously, we use CapIQ for scraping through all the public information that’s out there. They’re basically a small Bloomberg competitor. ATIGS just snapped up AMSC, which is another extremely popular tool. So now both of our tools are under one company. And the last piece of it is just to promote the Fintwit again. We continue to meet a lot of new folks through there who have been useful both at speaking to specific securities but also pushing the quality of our own portfolio management further.
Meb: Is this one and done for you guys? Are you doing any more funds? You do anything in the shorting world? I’m also curious if you guys do the short lending on any of the securities because some of these are probably attractive to the shorts.
Robert: Yeah, I think lending securities to short-sellers is one of the greatest sources of income for buy and hold investors. What I love so much about it is we actually don’t really love our companies paying dividends because we’re investing in companies that hopefully are pursuing really big growth in their futures. And if they’re dividending cash out to us, then that cash is not going into compounding that share price through a buyback or through some other creative acquisition or something like that.
But sec lending, there’s…securities lending to short sellers is actually a way of generating a little bit of income in a portfolio that doesn’t pull any cash out of your portfolio companies. And this is where I’ve got to give the guys at ETF Architect, Pat Cleary and Wes Gray all the credit is that this is something they’ve been working on for a long time. They experiment with this stuff on their own funds before they roll it out to the other funds they work with. But we’re very excited that that’s going to be added as a feature onto our fund. It started just in the last couple of days. So, we’ll learn more over the course of this year as to how much yields we were able to chase out of that. But I think it’s similar to the tax efficiency rule. When things like this are available, they’re no-brainers. So hopefully, we’re helping push others to do the stuff as well.
Meb: I think the world is slowly waking up to this because if you look at investors, like, 90% of what they focus on is expense ratio. Meaningful. Some of them, which is equally as important, I argue, is the tax efficiencies. We mentioned earlier that just simply picking an active ETF versus an active mutual fund is probably 70 basis points or arguably more important than the expense ratio already. And then third, things like short lending, which can be extremely material, but it obviously is supply and demand and there are a lot of rules and regulations around it. But a lot of fun complexes and brokerages. We went into a long rant about this last year, like Robinhood and others, they’ll lend out your securities and straight-up keep it all. And so that’s something the SEC and now there’s FINRA will probably take a look at in the future because that seems not fair when they’re your securities for people to be lending them and keeping all the money. But who knows? We’ll see how that war goes.
A few more minutes. Talk to me about…you got any Compound Kings on your list that you’re interested in but are either too pricey or you’re doing work on or you can even talk about some of the names in your book. You do have Berkshire so you’ve got Charlie in there and some dividend payers like Apple. You can even talk about a couple of portfolio positions or ones you’re thinking about. Your choice.
Robert: Yeah, those are big ones. Let’s talk about some of the less held names. Let me jump into enterprise software for a second because some of the highest return on investment capital spending that’s happening across America is hiring engineers and writing code and just selling that code to Fortune 500 companies. One of the biggest trends that’s happened in enterprise software…this all used to be packaged and you’d sell the software and it’d be a onetime thing and it’d be at a high margin. And about 10 years ago, there was this great conversion from packaged software into software as a service. So instead of buying Adobe PDF and PDF-ing your brains out, now you have to pay Adobe a monthly fee for accessing their PDF tool.
We’re in the early stages of another massive shift in the enterprise software business model from a fixed monthly SaaS price to a usage-based price. So, carrying on with the Adobe analogy, this would be as though Adobe restructured its business and charged you a penny every single time you PDF-ed a document. And what’s so attractive about this model is it is able to better capture the amount of economic value that is being derived from the software tools that are being built. The earliest incarnation of this business model that we’ve been able to identify and participate so far in has been with Adyen and dLocal, which a lot of people are probably familiar with Stripe in the U.S. Stripe is referred to as a payments company but it’s really a software company that enables the acceptance of digital payments. And Stripe has planted its flag and has some of the best market share in the U.S. with a lot of these businesses. But Adyen is based in Europe, dLocal’s based in South America, and they’ve been able to command similar market share as what Stripe has done here in the United States in their own respective geographies.
And so, what’s so cool about these businesses is that they start by selling a simple…or basically giving away an API to allow a vendor to start accepting payments from all these new, crazy payment methods that are being developed. And what they do is they take a really small take on it similar to Visa or MasterCard that’s so small that the company doesn’t have a huge incentive of trying to build that technology themselves. But they’re able to so quickly distribute that API across so many companies that folks become quite dependent on it. The Adyens and the dLocals of the world have to keep developing more and more complex software for their larger and larger clients, which locks them in even deeper. And the whole time they’re continuing to collect this little toll on the revenue that that business is taking in. And as that business raises its prices over time, the revenue that these payments companies naturally collect goes up over time.
So, this consumption-based enterprise software framework is one that we’re particularly excited about and there are a handful of companies that are in it. They’re not the cheapest companies in the market to own but the consensus estimates are fading growth rates on these companies really fast. And there’s nothing that we’ve seen yet to believe that they’ve achieved anywhere near their market saturation. So, I’d say that’s one of the areas that is not very commonly owned but one of the ones that we’re more excited to be long-term holders over the next handful of years.
Meb: How much of this portfolio ends up being kind of global in nature as far as domicile? I know that the revenues are already sort of a mismatched spiderweb but it’s cool because some of the names I look at, I’m like, “I’ve never even heard of this stock,” which is great, which are my favorite 13Fs to look at. Do you have a set target or does it just vary by opportunity?
Robert: I’ll be frank, which is the way that we look at the world is where the revenue is coming from. So, when we’re doing screens on stocks or understanding where growth is happening, we’re simply looking at the sources of the revenue. We’re not actually looking at where the business is domiciled. And it’s a pretty interesting trend that a portfolio that looks like this that has, call it, 80% domiciled U.S. companies actually probably about half of all of the revenue…and as I kind of previewed earlier…and even higher share of the incremental growth that is coming into a lot of these companies is coming from outside of the U.S. So, I think the way to really build a global portfolio is to almost ignore where it’s domiciled because if you were to go and pull up the FTSE 100 and say, “All right. Let me go through the 100 top companies in there,” you’d be really hard-pressed to find 5 companies that you’d want to own for a really long time. And so instead of trying to take it on the listing-by-listing approach, we try to take it on where’s the most amount of new revenue flowing into and which businesses are capturing that and doing so and able to keep some margin at the end of the day. And obviously, that’s taken us in a couple of places.
Meb: And it’s a fascinating topic. I mean, Morningstar has some new modules that talk a lot about this on where the revenue comes from. We did a post about two years ago that…it’s my opinion a lot of the borders are becoming increasingly meaningless. You’ll have stocks that are straight-up listed in the U.S. that literally have zero U.S. revenue. Same thing in U.K. and elsewhere. And so, in a globalized world, it’s fascinating to see. And tax considerations, on and on and on have a big impact. It’s always odd to me to see people that are unwilling to expand their borders beyond one country. The obvious example is everyone in the U.S. but certainly people in other countries do the same thing.
As you look out to 2022, which is crazy to say, 2023, what are you thinking about? What’s on your brain? I know the main focus is probably just growing this puppy but as you look at the portfolio, as you think about the world, what’s on your brain? What are you thinking about? What are you excited about? What are you worried about?
Robert: One of the things we just mentioned…so we’ll break this up, excited and worried. In our recent letters that even for a company like Google that had one of its best years last year, Google, on a multiple, cash flow is actually cheaper today than it was at the beginning of its run last year. And folks are like, “Well, how is that possible?” They were up 60%. They grew cash flow 30% or 40% but they bought back $45 billion in stock. So, Google is finally catching up to the buyback acceleration that Microsoft and Apple have been pushing so hard for the past few years now.
Google, remarkably for a company that big, that dominative of a market position is one of the easiest stocks we think that can be owned. And so, when we’re positioning in a stock like that, we want to make sure that we’re holding more of it than what the average index is carrying because that’s our opportunity to generate alpha for our investors. We’re going to keep doing work on some of these other new emerging companies where we’re finding exciting opportunities.
On the worried side, I’d say a lot of folks are worried. And the primary reasons why folks that we’ve been talking to have been worried is that people can’t identify what the growth drivers are going to be this year because we’re sitting in a time when employment has been maximized, the Fed is tightening, not loosening, and we’re coming off of ripping post-pandemic recovery growth rates. And the market is at a moment where they don’t know whether to keep fading growth rates off of these high levels or if there’s some way we can pull a rabbit out of our hat and keep doing what we’ve been doing for the last 18 months.
And I think that some of that uncertainty has been showing up in some of these volatile share prices. You’re seeing cyclicals continue to perform incredibly well. The S&P 500 has been damaging the Nasdaq lately. Ford, apparently, has been the best company to own over the past 12 months. I don’t think Ford is the type of stock that I could own that’s going to put my kid through college in 16 years. So, this is where the patient side of being an investor comes in where even if these cyclicals, rent-a-car companies, you name it are starting to generate some cash today, by no means do I think that’s going to turn them into compounders that are going to be able to push these share prices for a decade or more.
Meb: It’s fun to think about when you sort of think about the long-term time horizons and think about what’s going on. Oddly enough in the year where the S&P printed 30%, there was a period in December where we tracked some of the various sentiment indices and I was actually pretty surprised to see the sentiment. There’s a big dislocation between what people are sort of feeling and saying and what they’re doing because the allocation of stocks is quite high but the emotion around it, at least on the AAI, was pretty low in December. We had an old chart on the blog or Twitter, we’ll add to the show notes, links that I didn’t label the chart and it was simply, “First person gets this right, gets something.” I don’t know, a book or Idea Farm subscription. And it was AAI sentiment, bullish percent, and S&P price and it looked like the same two charts. They went up and went down and went up and went down. It really only gets the big moves. That’s not going to get this month or this week probably but it gets to ’99, 2000, it gets to ’08, ’09s right usually. Anyway, this has been a blast, man. Anything else before we let you go to the Tennessee afternoon, Nashville?
Robert: Yeah. Tennessee midlands.
Meb: What’s your favorite music spot there? You got one?
Robert: Oh, we’ve been bouncing around a whole bunch of them since we got here. Our favorite one was a little…I’ll post a note in the links because it had a weird little name that is escaping me.
Meb: Well, there’s one you can show up that’s, like, really old. I don’t even think they take reservations. They pack everyone in so it’s probably, like, the perfect Omicron spreader right now, if you want to get it or don’t want to get it. It was so awesome and I have to look it up. I love Nashville.
Robert: So, you’re going to be down at the ETF conference in February?
Meb: We’ll be there. So, listeners, if you want to come say hi in Miami, it is right around Valentine’s Day so you can bring your significant other and let them sit by the pool while you pretend to do some work with me. If you’re an advisor heading down, hit me up. We may even have some free passes. Those are limited so email quick if you want one. Other than that, yeah, we’ll get some sun and drink a pina colada down there. If you’re going to go, you should come join us.
Robert: We’ll see you there.
Meb: All right, man. Where do people find out more? Where do they go if they want to compound their face off as Wes would say? You got to trademark that phrase too. Kings ETF Compounder, where do they go to find out more?
Robert: So, as I mentioned earlier, we’re the most present on Twitter. We have the Upholdings handle there. And then otherwise, you’ll find the kngsetf.com, K-N-G-S, really easy to…beauty of the ETF. It’s really easy to find and learn everything that you possibly would need to know about us.
Meb: Awesome. Robert, it’s been a blast. Thanks so much for joining us today.
Robert: Yeah, great to see you again, 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 at the metfaberfshow.com. We love to read the reviews. Please review us on iTunes and subscribe the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.
