Episode 11: Show Notes
When it comes to equity fund management, you can never know enough. In today’s episode, we speak to Danilo Santiago, Founder of Rational Investment Management, about the strategies he has implemented to best predict and navigate the tricky world of value investing. First, Danilo lets us know what sets his approach apart from that of other equity fund managers and gives us the lowdown on how earning cycles impact prices. Next, he talks about the four strategies that inform his work and what he considers to be the three legs of a successful strategy. We touch on why Danilo considers multiples but does not factor them into his model and he lets us know what he requires of companies in terms of buybacks and dividends before including them in his portfolio. Next, we talk about the term ‘Circle of Competence’, coined by Warren Buffet and on which Danilo has curated his basis of companies. We dive into the influence of market cycles and macro events and talk about how looking at a company’s methodology guides us in predicting its future. Danilo shares a word of advice: fully invest when you see opportunities, and he explains the value of letting your net exposure vary. In closing, we discuss the importance of having a pre-emptive approach rather than a reactive one and Danilo gives us his predictions for the future of value investing. Tune in today to soak up the wisdom of a master in the field of equity fund management!
Key Points From This Episode:
- An introduction to today’s guest, Danilo Santiago.
- Danilo’s educational background in engineering and business.
- How his approach differs from that of many other equity fund managers.
- How earning cycles impact prices.
- The four strategies that Danilo runs.
- Three legs of successful strategy; full strategy, portfolio construction, fundamental analysis.
- Why Danilo considers multiples but does not factor them into his model.
- The requirements of being included in Danilo’s portfolio in terms of buybacks and dividends.
- Which industries are most conducive to Danilo’s analysis.
- Defining the term, ‘Circle of Competence’ and the influence it has had on Danilo’s strategy.
- How Danilo has curated his basis of companies.
- Defining ‘unknown unknowns’.
- How market cycles and macro events factor into constructing a portfolio.
- How methodology can help to predict future performance.
- Why you should only fully invest when you see the opportunities.
- The value of letting your net exposure vary.
- Who Danilo’s strategy is ideal for: sophisticated, financial, well trained individuals.
- Why you should be pre-emptive rather than reactive.
- Danilo’s predictions for the future of value investing.
[00:00:01] JM: Hi, I’m Jenny Merchant, co-founder of PitchBoard. Welcome to The Pitch Podcast. We’re here to have thoughtful discussions with forward thinking managers for taking unique approaches to professionally investing capital. Through these conversations, we hope to introduce you to new ideas and strategies that will help you better manage your own portfolios.
Before we begin, we want to remind our listeners that everything in this podcast is for educational purposes only. Nothing here is tax, legal, or investment advice. We don’t endorse any products, services, or opinions made by our speakers. Some statements in this podcast may contain forward looking projections. These projections do not guarantee future performance, and any past performance does not guarantee future results. Finally, nothing in this podcast is an offer to buy or sell securities. Speak to your own advisor before making any financial decision.
[00:01:04] A: Hi, this is Andrew from PitchBoard. I had a great conversation with Danilo Santiago of Rational Investment Methodology. He explained his proprietary value investing framework and how we integrate technology into his approach. I hope you enjoy your discussion.
[00:01:18] A: Hi, this is Andrew from PitchBoard. Today I have the pleasure to speak with Danilo Santiago, Founder of Rational Investment Methodology. He uses a rules-based approach within a value investing framework. Danilo, welcome to the show. It’s great to have you on.
[00:01:32] DS: I’m very happy to be here. Thank you for having me.
[00:01:35] A: You want to give our listeners just a sense of your background, I understand you’re an engineer by training?
[00:01:40] DS: Yes, I had a longer path than most into investing. I am an engineer, electrical engineer never worked as such. I started close enough, I was a method and process engineer, initially at the very beginning of my career, which actually, when I’m looking at industrial companies nowadays, I do see them with a different lenses because of that initial training. It’s not everything went to waste there. Then very quickly, I went to commercial bank, Citibank, then to an investment bank, and then to consulting, I went to McKinsey and then all in Brazil, for those five initial years.
I had a lot of different experiences in then I went to Columbia Business School to do my MBA. It was random and lucky for me, the professor that was assigned to teach us, microeconomics had a personal issue and he was replaced by a professor called Bruce Greenwald, which was at a time the person taking care of the value investing seminar at Columbia Business School, because it started there with Benjamin Graham. In my first week of classes, I not know exactly what that was, I had this professor they’re teaching us value investing instead of microeconomics, which I think they’re very close, but not exactly the same.
From my very beginning there, I started to see companies in a very particular way. I took my time during this, that year and a half at Columbia Business School to fine tune my financial skills, because until that time, I didn’t know much about balance sheet, panels, cash flows. Then I made my first real move to investing which was when I rejoined McKinsey, I rejoined the corporate finance practice in New York. That’s when I really was most of my time, most of my days, looking at evaluations, right?
It was from a consulting perspective, meaning three deals situations where companies would say before engaging bankers, they’ll say how much are we worth? How much is that target worth? We would go there very quickly, we had only a few weeks to give the CFO or the CEO, at least an idea of the drivers of evaluations and how much in value they should be expecting for that business. That was an excellent school for me, right? Because it was project from project, very fast, were consulting terms, right? Because sometimes projects might last for a few months. I was at clients for a few weeks, jumping from industry to industry, but having a lot of data, doing evaluations from the inside out, which was a terrific experience for me.
Then, after those three years and a half at McKinsey, corporate finance, I moved to a Hedge fund, big Hedge fund, 2 billion plus. I went there to help them to fine tune their evaluation. They had an origin in looking into financials. When you try to look into industrials or consumer companies, you cannot use the same template and I went there to them bringing my experience now in corporate finance, then I started to apply and develop the first version of the template that I still use today.
That was 2005. I’m now, some of my models, are on version 75, because I open that model and change something 75 times and that’s the core of what I do, right? Which is deep fundamental analysis, fact base, stacking top down, meaning, know what’s the story of this company? What are the drivers, but eventually quantifying everything, but that was this long path from being an electrical engineer to doing evaluations day in, day out.
[00:05:41] A: Do you want to describe what your approach is, and how it differs from many other equity fund managers?
[00:05:48] DS: Sure, I think one of the major differences is, I follow a quatistatic group of companies. There are 60 plus companies that I follow. Some of them, I’ve been following them for more than 15 years, right? Because there are two aspects in the US stock markets, right? To be more specific, that are fundamental for value investing or fundamentals based investing, which is short term earnings drives a lot of the current price. In other words, if you plot, and I do have these in my every single template, the average sell side estimates for earnings, and you superimpose, we share price, you’re going to see a clear correlation there.
Many of the companies that I follow, or actually most of the companies, they do have their own cycles, right? Companies that have cycles will have earnings that will vary, and the price will follow. However, the price always reverts in the long term to, let’s say, the average of those earnings. Specialized yourself, in following a set of companies that are quantifiable, and you become better than the average person out there, in understanding those earning cycles, the average earnings that you’re going to forecast will be better than most.
When the short term earnings goes down, and you understand why, you have the confidence to buy, to short is the opposite when a company is making too much money, because you have been studying that company for years, you know exactly why that’s happening and you have the confidence to short. If you do this, you clearly have the tools to do a long and short strategy, which is one of the main strategies that I do. I run four strategies actually. One is a long lead out, another one is a long aggressive and the other one is even symmetrical in the sense of the shorts can be as big as the long’s, but they are all based on that concept.
That short term earnings influences prices too much but they always reverse to this as average price that’s based on long term earnings. Now, so this is I would say is one leg of the three legged stool that you need to have a full strategy. The second part, which is important is portfolio construction. What I didn’t find in the value investing side, if you will of that investing community is that portfolio construction was done with a lot of gut feeling and a lot of sometimes people would get in love with that idea with that company and hold that company no matter what. I said, maybe there was a better, more rational way to do this.
What I did then was I develop a few specific rules for portfolio construction. In other words, that’s the part that gives me discipline to build my portfolio in a way that was dispassionate if you will, or was not suffering from fear and greed on a day to day basis will do. I build that too, initially on Excel with VBA and now it’s done [inaudible 00:09:04] where using those 60 names that I follow. I coded this software that will to look every day – what’s my fair value for this company? Should I be long or short?
Decide the exact size of each one of those, in other words, longs are 5 percent positions, right? Shorts can be up to 3 percent positions but depending on the member of longs and shorts, I also have net long, gross long limit. Then those sizes will be adjusted. Now a computer does this much better than a person, right? Once you have done this, then it literally takes and this is fantastic with the technology nowadays.
When I run a simulation like I go back, let’s say five, 10 years with my fair values, and with this two simulate the long tried strategy for instance, it takes four seconds for my computer to build that simulations. 10 years day in, day out and tell me what I should have done every day for 10 years, right? Now, the third leg then of this strategy is, how do you implement that? I started in a Hedge fund, I opened my own Hedge fund and wait. We eventually we’ve closed the Hedge fund gave the money back to investors.
Then I had the time to rethink the infrastructure that you need nowadays, again this is 2021 with a lot of technology. What can you do now, with Python coding in API’s from your brokers? What I came up with was, I can now run the same hedge fund strategy in separate managed accounts. I use interactive brokers with one of the more powerful, not exactly user friendly, but very powerful brokers out there in the sense that my computer talks to interactive brokers, through those API’s. I can read my clients positions. I can write instructions for a trading for each one of those accounts. In other words, I’ve have one account or 100 accounts, it doesn’t matter. My two does all this and the big advantage of this is there are many, it’s full transparency for the client so they see what I’m doing.
It’s not that they receive one email a month telling them how much they have with me, because it’s their account, there is no auditor, no administrator, meaning no costs, right? For gran, apart from of course, my fees in trading costs, even in a year like 2020, with a lot of volatility, our trading costs were eight basis points for your long, short strategy, right? Amazing. Technology change over the last 10 years.
The whole Hedge fund infrastructure, it’s not necessary anymore, you can do this in a much cheaper, transparent way, with managed accounts and there you go, you have the three legs of your stool there for your strategy, you have the fundamental analysis, where the long term good performance will come from, you have a methodical way of building a portfolio in a very efficient way of implementing those portfolios for your clients.
[00:12:17] A: Then you’re looking at a stock, and you’re looking at the short term earnings and the long term earnings and how they tend to deviate. Do you also look at what the multiple is doing? Because of course, there’s the earnings and then there’s also what multiple the market is willing at any time to pay for those earnings. Assuming those earnings are positive. Does that factor into your model?
[00:12:39] DS: We do look at multiples, but I don’t use them, because my models are a discounted dividend model, right? In other words, my fair value is 100 percent based only with inputs from fundamentals, right? Because the multiple means using multiple means well, I will decide if I want to buy these depending on the share price. Of course, I will take this in consideration when pulling the trigger in a position but my fair value, doesn’t use the price from multiples of other companies, let’s say by doing parables, right?
There’s no influence from price and you might say, “Well, but how do you know, if the market follows that?” Right? That’s the benefit of having those tools, right? Having technology, knowing how to code, because what I did, and I showed this sometimes to my clients live, and I do with them as I look. Here’s my shared values. Let’s assume that they actually don’t work, meaning interest rates are very low, the discount rate that I’m using for my models, which by the way, it’s still close to 10 percent, it has never changed in regardless of interest rates. I do an exercise with them where I lower the discount rate for my companies. In other words, I increase their valuations right by let’s say, 30 percent, 40 percent, 50 percent, that’s what if we feel do, reduce our risk free rate from let’s say, 5 percent to 2 percent, that’s exactly what happened with evaluations, they go up by 50 percent, sometimes, 100 percent, depending on the duration of that cash flow.
When I do that exercise with my clients and run this same simulation, you only change the fair values, and say, okay, let’s go back 10 years and run the same simulation, making the same decisions, should I buy this company? Meaning, is this below my low case for 10 days? Or should I short. Is this company above migrate case for 10 days, in controlling the position with all the rules, longs being 5 percent shorts been 3 percent, went after changing the evaluation the way that I just described, the result is awful, right? In other words, you stay long companies that you shouldn’t have stayed longs. You avoided shorts that you should have performed or are placing the portfolio.
It’s fascinating to see this life in the sense that you can see that the market is indeed pricing companies and again, I’m talking about US companies that are industrial companies or consumer related, right? Could be a company CSX or your company, could be Pizza Hut, or Papa John’s, could be Vulcan materials that sells aggregates, could be Lowe’s Home Depot, right? Companies that you know, right? Those companies, the market tends in the medium term, follow a discounted dividend price. It’s fascinating. I can pass that. That’s the best part of this, right? I mean, if you have a too, you can see this in action.
[00:15:38] A: I’m guessing that because you’re using a discounted dividend model, that a requirement for a company to be included in your portfolio is that they pay a dividend.
[00:15:48] DS: Not necessarily dividend, because our company in the discounted dividend model, what they could do with that excess cash, they could give in dividend or do buybacks.
If a company is doing buybacks close to a fair value, it actually doesn’t change the outcome for the investor, it’s the same. Dividend is nowadays taxed as income. In if a company does a buyback and share prices go up the gains, so far, I still taxed at a lower rate but in value terms, if you exclude this tax impact, there was no difference at all between buybacks and dividends, again if buybacks are done close to a fair value.
[00:16:28] A: Are there certain industries that are more conducive to the kind of analysis you do than others?
[00:16:35] DS: Yes, if you look at the list of companies that I follow, or the industries, you’re not going to see financials, because they’re too opaque. In most of my initial career, as a consultant, I was working inside banks, and I worked inside banks, right? I know banks very well but it’s impossible to model from the outside. You’re not going to see technology. I love technology, right? I mean, I’m sitting here in front of four 4k monitors, with my semi-professional recording instruments, and I code in Python, I do those very sophisticated spreadsheets, if you will, for VBA macros there, I love technology, but it’s very difficult to forecast each one of those, right?
Then, I exclude technology in pharma companies too because some of those companies, they have a very binary outcome, depending on the success of one specific drug. There is a certain art, if you will, in selecting those companies, they need to be companies with a lot of history, where I can look at their financials and understand how their cycles behave. Then I can model down the way that I want to, right?
When I say model, I just want to give the impression that I don’t look at the company in a qualitative way. I do, right? I follow who their top managers are, like know, the CEO, CFO, COO, their backgrounds, how strong they are. I will have a series of notes telling the story of that company, right? Before any configuration is done.
Eventually you have to quantify. What is the typical margin for this type of business given? How many competitors they have? How easy it is to replicate their product? Because this is at the end what will drive my final fair value. But you have to be smart in the sense in selecting the companies that you’re going to look at. You can’t look at everything, because sometimes it just doesn’t work.
[00:18:34] A: That’s something that sets your process apart from others, right? Is that you have I think, what you’ve described as a circle of competence.
[00:18:42] DS: Yeah. This is paraphrasing Warren Buffett, right? He says this all the time, find your circle of competence, and play there. I don’t need to invest in every single company. I just need to invest on companies that I know very well, which increases my chances of being right in that analysis, right? That’s one key difference, I believe, from what I do. I’m not in the, what I call the idea strategy. I’m never running after new ideas. One or two companies that I follow might be acquired in a certain year, and then I replaced them, but that’s it out of 60 something I need to replace one or two per year.
[00:19:22] A: How have you gone about over the years building this knowledge base of these companies?
[00:19:29] DS: There was a lot of trial and error, right? In the sense that I have a bunch of companies that I would to look into. When I read an interesting article, for instance, or I talked to a friend to appear, and we talked about a specific company signal, this is looks a company that could enter into my knowledge base. I mean, my circle of competence and sometimes friends they know me well they say, “Hey, Danilo I just look into that company, I think would like it.” Even clients, they do this right? I have this bunch of companies.
What I do is when I have some extra time, or go and sit down and say, “Look, I’m going to spend a couple of weeks taking a first look into that company.” Right? This is a quick look for me two weeks, right? I will try to develop my template but sometimes it’s quite frustrating, because you’re there, you’re in the middle of week two, and you realize that you actually can’t forecast a company well. Meaning there are things that are not really forecastable. Or there is a possible event that make their value change too much one way or another. I have to freeze them and say that maybe one day, I’ll come back to those companies.
But over the years, and now I have been doing this for almost 20 years, those companies they have been well curated, if you will, in terms of yes, I do know how they work, I understand what are the drivers off their cash flow drivers, if you will. Again, it doesn’t make it easy, right? Companies are highly complex systems and on top of this, from time to time, we have a thing epidemic, right? It goes in throws them running in different ways, with CEOs and CFOs trying to react to this huge event|, that for some part, very few was catastrophic.
Think about a company kind full cruise lines. For orders, it was the best years ever, in their history like Home Depot and Lowe’s, right? Again, doesn’t mean that you need to go and buy Home Depot and Lowe’s, because I think they are quite expensive but it was a pandemic was fantastic for those companies, right? Even if a company very well, there is a series of knowns and unknowns, which are hard to forecast, meaning what’s their margin is going to be in five years.
There is also the unknown unknowns, right? Now there is a pandemic coming and who knew that it would become such a massive event because we had other pandemics like the H1N1, the SARS, MERS, all those viruses, they were pandemics, but the reaction has never been similar to the one that we just saw. On top of the regular challenges of calibrating the drivers that you have for a certain company, you still have those massive events.
[00:22:22] A: When I hear it from unknown, unknowns. I think back to that vote of Donald Rumsfeld, which I suspect you’re –
[00:22:22] DS: Yeah, no, that’s exactly, because it took me some time from this, what these guys mean by that, but it’s when you are modeling a company, that’s exactly what we’re doing day in, day out, right? Because if I get any company that I follow, let’s say a company Herman Miller, right? Furniture, I know this company extremely well. I know who their competitors are, the big macro issues that they face, imports, etc.
Then the question is, how much will they sell in this new environment? Right? I mean, how will offices be used in the future? We were talking about this before, right? We started recording, but not only how will offices look is what happens over the next five years for Herman Miller? Because, yes it might be that office space, let’s say we will get reduced by 20 percent. However, the 80 percent that we remain will need to be remodeled. Is this good or bad for Herman Miller? It might be actually good, right?
All those items that you know what they are, but they’re very hard to calibrate. That’s when experience kicks in. Then you have to put on your manager or almost consultant hat, if you will, and say “Look, if I were looking at this company, as a project in a consulting company, and trying to forecast how their space would look in the future, well, that’s exactly what I need to do now.” Right? You have to do this all the time to be a good valuation professional, if you will.
[00:23:59] A: Yeah, I think you make a very good point about how a once in a lifetime event, a pandemic comes around and you just, it’s almost impossible, even as it started to unfold to predict how consumer behavior would change, right? There would be a renovation, boom, for example. Right?
[00:24:17] DS: Exactly. With the numbers got released yesterday from the Case-Shiller index, if you measure housing prices, versus on inflation line, we just broke the record in May of 2006. Who knew, right? Who knew that we would go to a record housing price, driven by a total gut feeling, reaction to this pandemic. This is extremely surprising and it’s one of those unknowns that just hit you in the face there. However, it’s also remarkable how companies can quickly adapt.
One of the benefits of having a static group of Companies in following them in a pandemic hit. I had to work extremely long hours early last year, right? To go and try to incorporate what a pandemic will do to my companies. In many instances, I got it wrong, meaning I forecasted a strong recession for them. I said, “What I mean, these are pandemic, people are going to be extremely scared, and who is going to buy RVs.” I went to Thor industries, one of the companies that I follow, and I simulated a very strong recession, not as strong as eight or nine, but strong.
Luckily, that was not sufficient to take the company out of my long side of the book, right? I kept buying more as it declined, but in part, or mostly because I knew those companies very well, their analysis was ready. I had the time to react incorporating back of the pandemic, and I had to buy, I had the chance to buy a lot of them in March of 2020, right? Although you can’t forecast those events, if your approach is such that you have the tools to quickly react and incorporate a massive event, like a recession, a pandemic, or whatever it is, it will serve you very well.
[00:26:18] A: You think about market cycles or macro events generally, when you’re constructing your portfolio?
[00:26:25] DS: I will not try to forecast a macro event but clearly, they move a lot of my companies together, right? If my investors, I send to them what I call a portfolio action from time to time, when a company gets in and out of the portfolio. I send something to them. Here is why this company left their portfolio, or here’s why this company got in. I take those opportunities also to explain how I’m seeing the group of companies together. Now what’s happening with my circle of competence? When you see during economic cycles is very clear, when I run my simulations, you can see a peak of shorts, close to economic peaks, or when there was too much excitement, either in the economy or at the market and conversely, the number of loans gets reduced.
When you are hit by a recession or a crisis ,a true one, let’s say 2001 and 2002, or wait 2009, which was a very severe crisis, the opposite happens. I start to close a bunch of those shorts so the number of shorts gets reduced, and then the number of long’s increase. I do plot this in a chart, so I can show my investors. I can tell them look, in May of 2021. As of now we have 24 shorts in only eight longs, and the long, short strategy is 20 percent net short, which is my limit, I can go up to 20 percent net short, and I can go up to 60 percent net long.
Right now, again, although I’m not making any conscious macro, slash market forecast, what I’m telling them, “Look, now it’s the time to go to a long short construct.” I hope you’ll follow my advice in that part, because I can see when I see 24 shorts and only eight long’s it is close to peaks and valleys of those two drivers of portfolio construction. It gives me a clear view of where we are. Again, I will not exactly model differently a company, because of this, but the portfolio will change a lot because of those cycles.
[00:28:38] A: You can extrapolate from how the portfolio was constructed to perhaps some, a view about the market.
[00:28:47] DS: For sure, because if you have a methodology that does not react to economic peaks, slash markets, right? Economic bottoms in the press markets, well, then you’re missing the chance from again, in the long run, benefit from changing your beta exposure, if you will, right? Even in my long only strategy, I do this, meaning when I don’t have enough names, I go to cash. My long only construct is now 60 percent cash, right? Because I only have again, eight longs, they can only be 5 percent positions. This is 40 percent gross exposure.
[00:29:26] A: There’s no need to be fully invested if you don’t see the opportunities, right?
[00:29:31] DS: Exactly, because if you do you lose the beta component, right off your returns, meaning well, but you’re now fully invested and this is a market peak is an economic peak. What happens when a recession hits? A real one, while you’re going to have a huge drawdown, it’s like are you sure that you want to go through that right now? Right? So then, that portfolio construction was done through a lot of simulations, because I can go to my too in change few specific drivers and say, “When you go long, when you go short, what are the size of the positions?” What you learn through this exercise is that letting your net exposure vary, it’s an excellent way to capture those market cycles or economic cycles.
[00:30:17] A: What investor tends to be attracted to your strategy? Or I guess another way of saying that would be, who is your strategy ideal for?
[00:30:27] DS: So far, what I realized is I’m a very numbers oriented person, right? Then when my investors call, I like to show them spreadsheets. I like to show them the coding Python and or at least the charts and the tube or plots, because I want full transparency, from what I do. I want them to really understand what I’m doing with their money. Meaning I want them to make sure that I’m not speculating with their investment.
So far, is the type of highly sophisticated investor, right? A lot of them are MBAs. They are managers at companies, that they do have a certain spin into finance. I mean, they do understand valuations, right? They have worked with this, or they still work with this type of line of work, because I imagine that for some prospect clients, when I start to talk to them, I come out as too complicated but it’s funny, though, because although, yes, it is my approach is very complex, the fundamentals behind it, are very understandable, right? In the sense that I can open a huge valuation model, and explain to somebody that has never seen one, exactly where the drivers are.
If we are talking about a trucking company, they’re going to see that I have lines there, with how many miles those trucks will run, and how much they charge per mile. How much they spend in Caltex to keep that fleet at a certain average age, right? It’s a lot of explainable drivers, which there’s another group of investors, which I call the business owners, because although they were never trained on the valuation, or finance side, they do see the business side and they it, they say, “Oh, I understand.” What you’re doing is, you’re looking at drivers that I would at my business. You’re just quantifying these in a different way to be able to do this to the public markets, that’s exactly it.
I would say that they are either sophisticated financial, well trained individuals. They’re the group is the business owners that they see themselves in the companies that I follow.
[00:32:40] A: Right. Define if there’s more interest in strategy like yours, especially the long short one, because of how much equities have run over the years.
[00:32:50] DS: The interest will come when we have a more prominent correction. Unfortunately, right? –
[00:32:58] A: That’s always the way it happens, right?
[00:32:59] DS: Yes, they are reactive. Now you urge them to say, “No, try to be less reactive and try to be more pre-emptive,” of where you are, because you are fighting against your fear and greed. The last page of my presentation is exactly this. I have the three main strategies that I run, right? They long short, the long only, and the long aggressive. The long aggressive means, positions can go up to 10 percent. I never borrow money, but it’s no 10 percent positions, even that one, because it let position goes a little over my calculated fair value if you will, that one is to 100 percent fully invested, and is doing extremely well this year, right?
I’ve been telling my investor no stay on the long short, meaning I’ve been wrong with my own strategy in that sense but in that page, I explained to them that you’re playing with fear and greed, right? The long short strategy has much more protection, and when you see a long short strategy with a 20 percent net short exposure. In other words, if the market were to fall 10 percent today, it would go up 2 percent, right? Obviously, we are playing much more with the fear part, meaning economic cycle, huge stimulus backs from the government to record consumer spending, although with high unemployment, no strange situation, extreme level of excitement with markets.
A lot of weird assets out there NFT’s, right? Even cryptocurrencies, whatever. Very new to investors, right? These are usually peak events, right? Or associated with peak markets. Then after recession hits, that’s the time to be greedy. That’s when 2020 was so fast that I didn’t have enough time to recommend to my clients to change the other strategies. My intention is as we go walk into our recession, and eventually I go from eight longs to 30 longs and from 24 shorts to seven shorts, I will send them emails and communication saying, “Look, maybe now is the time to go to the long only or even the long aggressive recession and ride the recovery for five years.” Easier said than done? Right?
Know that again, when I have a lot of longs, it means that a lot of companies went down in value. Then there’s fear, and then people they don’t act. I hope that I can help my investors to do this. Some are quite active in doing this, even in the more shorter term, because I can change the structures that I’m running for them, very easily and the cost is almost zero because of trading costs being so low.
I do have investors that say, Can I go to the long only now? Can I move to the long short? Again, highly sophisticated investors involved in the market, they use my strategies as a way to express their own views. It works quite well, quite frankly, they’re very good on actually doing that timing even better than me. Again, to get someone that is got scared or hurt with a crisis in the past, it’s very hard to make them to be pre-emptive but that might be the right thing to do.
[00:36:10] A: Do you see a coming resurgence for value investing? I mean, as you said, there’s been momentum in a lot of asset classes. As you said some that we six months or a year ago, we maybe, wouldn’t even have heard of I mean, who would have thought that these NFT’s would be a thing? Do you see something that happened, hosts the tech bubble, where growth in momentum names really got crushed, but that value came back into vogue?
[00:36:37] DS: I believe that we might see something similar. Sometimes it’s not necessarily because value is coming back, is just because the tech growth stuff is coming down. If you go and look at a lot of the famous value investors that you can find out there, you’re going to see that a lot of them are from 2000, 2001. It’s no coincidence. Why is that? Well, because they were buying companies that were left for that, right? They might be sputtering for a while in 2002 or 2003, because the recovery was still taking hold but the other stuff, the indexes, were still coming down very strongly.
In a relative ways they were heroes, right? You look at the history of some of those value investors, the famous ones, you’re going to see that they started exactly on those years. You see a lot of people talking about, well value investing has been dead for 20 years. I disagree, though, because the market has always follow the discounted cash flow of a company and this company that cash flow around 10 percent, right?
When we were talking about how I build a portfolio, what I can see with my two, and when I run my tool, with for the last, let’s say five, 10 years, and I use my current fair values, and I discount them back by the cost of equity going back to the past, and I use the dividend adjusted share price. I’m being consistent there. I don’t want to get into the details on this but that’s the right way to do. You can discount your value today by the cost of equity and compare that with a dividend adjust share price. That’s the correct way to do it.
When I run the simulation, the return that I get for my long short strategy, if you will in or return is over 20 percent, right? Meaning, says like, “So then you are you telling me that you can deliver like never?” Right? Because those valuations now, incorporate things that I didn’t know. Let’s say five years ago. Again, I’m just showing the potential of a methodology that’s only based on fundamentals in potential returns. In other words, imagine that you had this crystal ball that will give you all the fundamentals of a company for the next five, 10 years.
No share price information, only fundamentals, sales, margins, etc. If you were to discount that at 10 percent, and use this as fair value, and use those rules that I have here, you’d make a massive amount of money, you’d beat Warren Buffett by two times. Those great returns, they were happening in that simulation, even in the past, let’s say five years, when people were saying, “Oh, value investing is dead.” I don’t think that’s true.
I mean, maybe some of those allocations where people call value, let’s say to financials or other industries or other specific industry, they suffered too much in dragged those aggregate analysis of what’s value what’s growth, and it reflects badly in one series versus another and they say, “Well, value has been dead for 20 years.” Quite frankly, I don’t see this.
The market keeps following fundamentals in the long run, right? In the long run for me, it’s like five, 10 years. Let’s see what happens going forward. I don’t think this will change. It’s just a matter of the manager getting the fundamentals of the company right.
[00:39:55] A: Right. Okay. Well, let’s leave it at that. This has been a really fascinating conversation, Danilo. Thanks so much for your time. Thanks as always to the listeners of the Pitch podcasts. We’ll be back again soon with another episode.
[00:40:07] DS: Thank you for having me.
[00:40:08] JM: Thanks for joining us on this episode of the Pitch Podcast. Make sure you check us out online at the pitchboard.com. If you liked our podcast today, please make sure to subscribe to the Pitch podcast so you don’t miss an episode.