Tobias Carlisle The Non-Warren Buffet Approach to Value Investing

11th November, 2021

The Non-Warren Buffet Approach to Value Investing

Episode 19: Show Notes.

Today’s guest, Tobias Carlisle, believes that deeply undervalued and out-of-favor stocks offer asymmetric returns, with the potential for a limited downside and a greater upside. Tobias is the founder and managing director of Acquirers Funds. He’s written three books on value investing and has significant experience in investment management, business valuation, and corporate governance. Today he introduces us to the concept of the Acquirer’s Multiple, which is also the title of one of his books, and what he believes is the secret to beating the market. In this episode, he explains how he developed this concept and what it is based on. Tuning in, you’ll hear what is meant by mean reversion and the different ways a discount evaluation is removed. Tobias explains why excess debt doesn’t scare him off, what three factors he uses to determine a margin of safety, and what he looks for when he does a forensic accounting diligence of financial statements. Tune in to find out more about value investing and how Tobias has achieved so much success through it.

Key Points From This Episode:

  • An introduction to Tobias Carlisle and the strategies for the funds he manages.
  • The ways a discount evaluation is removed.
  • What mean reversion is and why it’s a safer bet.
  • How Tobias developed the concept of the Acquirer’s Multiple and what it is based on.
  • Why excess debt doesn’t scare Tobias off.
  • The three factors Tobias uses to determine a margin of safety. 
  • The role of humility and acknowledging what you don’t know when investing in a company.
  • The time horizon Tobias looks at for a stock to mean revert and why the valuation is easier the further out you go.
  • Thoughts on when to cut your losses if it doesn’t mean revert.
  • Business performance versus investor perception and which plays a greater role in stocks that do well.
  • The industries best suited to Tobias’s style of investing.
  • Thoughts on why people continue to buy expensive stocks when cheap stocks tend to outperform them in the long run. 
  • How Tobias goes about doing a forensic accounting diligence of stocks, and what he looks for in the results.
  • The two schools of thought on why value investing works.
  • What Tobias looks for when shorting stocks.
  • Whether or not there are currently that many deep value stocks out there, given the overall rise in asset and equity prices.
  • Why Tobias believes that value can do well on an absolute basis on a three to five-year time horizon.
  • Insight onto the two ETFs that Acquirers Funds run and how they differ.


[00:01:04] Andrew: Hi, this is Andrew from PitchBoard. I spoke with Tobias Carlisle of Acquirers Funds. He talked about how he became a value investor, what he looks for in a value stock, and the two ETFs he currently manages. I think you’ll enjoy our discussion.


[00:01:18] Andrew: Hi, this is Andrew from PitchBoard. Today I have the pleasure of speaking with Tobias Carlisle founder and managing director of Acquirers Funds. He’s written three books on value investing and a significant experience in investment management, business valuation, and corporate governance. Tobias. Welcome to the podcast. It’s great to have you on.

[00:01:36] Tobias Carlisle: Thanks for the very kind introduction, Andrew.

[00:01:38] Andrew: I gave a quick overview of your biography there. Can you tell our listeners a bit more about your background?

[00:01:43] Tobias Carlisle: Yeah, I’m an Australian. I started practicing law in Australia in 2000. Worked in M&A, doing tech M&A mostly. Got transferred to San Francisco, where I met my wife. Now I live in Los Angeles with our three kids, and I run a business called Acquirers Fundsthat has two funds. One is a large and mid-cap, deep value fund called the Acquirer’s Fund, and the ticket for that is ZIG. We use the same strategy and apply it to a small and micro universe in another fund called Roundhill Acquires Deep Value and the ticker for that is DEEP. So, the strategy in both is the same. The idea is we’re looking for undervalued stocks, but they’re deeply undervalued, which typically means there’s some problem with the business in the short term or they’re compressed because they just haven’t done anything.

So, where a Buffett style investor might require very high returns on invested capital, some defensible moat and long-term growth. I don’t necessarily need that I’m looking for something, it’s just a big discount and probably a cyclical trough. So, we do buy cyclical and the idea is that you buy them at the bottom of the trough and as they come out of that business downswing, and they go back into an upswing, you get both an improvement in the valuation and some of the removal of that discount to the valuation. Those two things acting together, the way that deep value generates returns.

[00:03:22] Andrew: The discount that gets eliminated, in what ways, there’s two ways, right?

[00:03:27] Tobias Carlisle: What tends to happen is, and there’s research on this from 1994, a very famous paper called Contrarian Investing by Lakonishok, Shleifer, Vishny. The idea that those guys identified is we have this propensity as humans to take a trend and just to project that trend out to the horizon. So, if the stock price is going down, we assume that that will continue to stock prices going up, we assume that will continue, but then also in fundamentals serve, we see revenues going up or revenues going down or profit lines going up or down. We assume that that’s the natural state of this business. When it turns out that often the better bit the shore a bit is mean reversion.

What that means is, simply that you have a cyclical that perversely cyclicals often look the best when they’re at the top of their business cycle, because that’s when they’re making the most profit just before they swing down the other side, they look worst at the bottom of their cycle. The way that you’re trying to take advantage of that as you’re just normalizing over a four-business cycle, which can be seven or 10 years, something like that, and then looking for a discount from those normalized earnings.

Then as the business starts to pick up, folks change their mind about the trajectory of the earnings or revenues or whatever the case may be. Project higher prices down the road and that leads to elimination of the discount from that normalized earnings and typically when that gets back to what we would guess would be the normalized run rate. That would be the time that we’re looking to exit the stock. Doesn’t have to be cyclical, Cyclical zoning makeup a portion of the portfolio, we find them wherever we find them, but that’s essentially what we’re looking for a discount to a normalized run rate for the business.

[00:05:15] Andrew: Are you willing to hold a stock that’s been at a deep discount past fair value when it turns around into overvaluation? I mean, given that stocks do tend to just swing from these extremes of being very undervalued and then sometimes very overvalued or are you just want to close that gap and then you’re happy to exit?

[00:05:40] Tobias Carlisle: Well, I just  realized I didn’t answer your first question. Probably there are multiple ways that discount valuation is removed. One of the ways is the company gets taken over and that happens reasonably frequently. The other way is that the incumbent management team takes advantage of that undervaluation and uses that opportunity to buy back stock, which is also a means for closing that gap. What that means is that the valuation for the stock is not static, it’s changing over time. So often the valuation is going up, if they’re doing things that are good.

So, we would potentially look to hold that for as long as possible, but the challenge is always that the funds are evergreen; they’re  always supposed to be positioned for what is coming over the next one, three, five years. We’re always trying to recycle the most overvalued names or the things that are closest to fair value back into things that are deeply discounted too. The fund itself, on a look through basis is always at a big discount to where the rest of the market is.

[00:06:47] Andrew: With the rise of private equity. Is there an increased propensity for other players to step in and buy these deep value stocks like to take them over?

[00:07:02] Tobias Carlisle: Look, that’s a great question. I wrote a book called Deep Value that came out in 2014. One of the things that I pitched to Wiley, who was the publisher at the time, was that, at this point in time, there’s this record amount of – this is in 2014, there’s this record amount of dry powder that these private equity funds have. It’s my expectation that we’re going to see a lot of this money deployed. What has happened is that that’s not really been the case, they haven’t been hugely active, and a lot of that private equity has been deployed at a much earlier stage, not a buyout, but expansion or even at VC, venture capital type stages.

That hasn’t really happened, but to the extent that they do get taken out, it tends to be a financial acquire and that’s our objective to buy it at a discount to the price that of financial acquire would buy it, because that’s the lowest amount that will be paid for it. If a strategic acquirer comes along to bolt something on, they might find a product that they can pass through their distribution channel that’s very common, they can pay a lot more that business is worth a lot more to them than it is to a financial acquirer who’s looking to get a return purely out of the business paying down debt or whatever the case may be.

[00:08:17] Andrew: Right, so the strategic acquire can add value?

[00:08:20] Tobias Carlisle: It’s worth more to them, they can – they can pay more than they typically do. It’s been an unusual period in the market too, which typically acquire as have two well-known, phenomenon that an acquirer tends to overpay for a target and risk ARBs will go on and they’ll get they get long the target and they’re short the acquirer, that’s how they generate a return.

The last few years, that has not been the case, it’s been for some reason that phenomenon has reversed, and acquisitions have been better than expected. I don’t know whether that’s a secure thing. Acquirers have got more discipline or whether that’s just a cyclical thing was we’ve been in a very strong bull market, and we will see the full effect of that once we get more closer to a normalized valuation on the market.

[00:09:05] Andrew: Your funds are based on the Acquirer’s Multiple proprietary term that you created; how did you develop this concept? What’s it based on?

[00:09:14] Tobias Carlisle: When I was in university, I did business in my undergrad, and I spent a lot of time reading old financial papers. One of the papers that I saw just said that there had been these extraordinary returns to using very simple financial metrics and they said that the metric that they favored was this the one that private equity firms and leveraged buyout firms favor which is EBIT, operating income on enterprise value and the reason is very simple that they can manipulate, they can change the funding mix from debt to equity and as a tax benefit to paying down interests, which that reduces your tax so you can dedicate a little bit more money to paying down debt.

I did some testing, worked with a guy who was doing his PhD, but we went and found every bit of industry and academic research that we could find on fundamental analysis and tested all these ideas. The thing that we found was that operating income, whether it’s EBIT or EBIT scaled against enterprise value generated the best returns. So, I just call that Acquirer’s Multiple was the way that it was, the term was loosely used in one of these magazines or one of these periodicals that came out, I just, I can’t for the life of me, remember which one I’ve searched that term 1000s of times to try and find the source of it. It’s not my own source, but it’s mine now, because it’s lost to the sands of time.

[00:10:44] Andrew: Yeah, I’m just imagining you’re going through old databases trying to find the paper in, what we seem to live in an age where it’s not on Google, it doesn’t really exist or it’s tough to find, right?

[00:10:56] Tobias Carlisle: I think that’s the case, it was thought that this was in back in the day, and you had to get these things in ring binders, and you got the new edition and you just clipped it into the ring binder, it’s like pre even CD ROM, what was it called the multimedia pre-multimedia, pre all that stuff? I’ve never been able to find the source of it, but it’s not my original term. It’s just I just thought it describes what is going on really well. It’s the metric that has been the most predictive of returns, because I think it’s the one that gets closest to the reality of the problem with simple metrics like price earnings or those metrics is that they’re not adjusting for the capital structure where there are many companies that might appear cheap.

You find this, if you’ve done any testing with price to book or anything like that. The problem with price to book is that what you think you’re buying is a whole lot of assets really cheaply. What the portfolio ends up being is filled up with all these really highly levered companies that it’s a billion dollars in assets with $900 million in debt, with $100 million in equity, trading for $10 million. So yeah, it’s a big discount to the equity, which price to book there is 110, but the reality is that you’re buying is heavily indebted pigs.

The Acquirer’s Multiple does that accounts for that debt and then we’re looking on an apples-to-apples basis, is this thing really cheap or is it is it’s valuation submerged like an iceberg where there’s this big chunk of debt sitting below the surface that you’re not really taking into account?

[00:12:31] Andrew: Is debt something that really scares you off or I mean, excess debt, I should say?

[00:12:36] Tobias Carlisle: Not necessarily. It’s one of those things that is employed properly it definitely does enhance your returns. But it also increases the risk in an edge case where you just vote for whatever reason, all industries, well, it used to be the case, most industries go through these cycles, some industries cycle, more commodities have huge cycles. Other industries have advertising has a cycle as well. It’s just when a cycle goes against you for long enough, and you can’t cover your debt, it happens all the time, your equity gets wiped out.

So, from that perspective, I think you’re better off avoiding it and the return seems to bear that out that the more debt you have, the worse your returns, but there’s also a tipping point where if provided that you’ve got a modest amount of debt that does seem to enhance your returns. There are plenty of people out there who employ a strategy of Dan Rasmussen has a strategy of buying listed companies that have the qualities of a listed leveraged buyouts so that they weren’t taken private, but they’ve taken on a whole lot of debt. So, you can participate as if you’re an equity holder and a buyer with the non-recourse debt.

Those things will still occasionally like the downswing might be worse, if you go through a 2007, 2009 type recession, then that might damage their portfolio more than it might damage mine. So, which tends to be net cash and when they get the valuation going against them, I say, they’re a little bit anti fragile in the sense that they’ve now got an opportunity to buy back stock really cheaply. They can buy competitors; they’ve got options to do something when the market goes against them. I have a preference for cash over debt. But that probably penalizes returns through a lot of a cycle, knowing that you’re going to catch up when you get the pullback.

[00:14:23] Andrew: Is that cash – is that going backto Ben Graham’s margin of safety that you want to have some protection in there?

[00:14:32] Tobias Carlisle: That’s one of the sources of margin of safety is balance sheet strength. I think there are more than just one source. Another source is the quality of the business. Some businesses just earn more money out of every dollar that they generate in revenue, they just hold on to more bigger margins. The thing that I have pointed out, so I often make the distinction between Joel Greenblatt has a thing called the magic formula which is basically a quantitative expression As Warren Buffett does in the sense that it has this wonderful compass. Buffett says he’s wonderful companies at fair prices in preference to fair price, fair companies at wonderful prices. What he means by that is, companies that earn a higher return on invested capital.

The problem is that it’s often not sustainable, that high return on invested capital is highly mean reverting. If you add that into your analysis, you tend to slightly underperform just a pure value screen. The metrics that indicate quality, I think, besides a high return on invested capital, the best metric is very fat margins, are very stable margins. So that’s something that I like to see. That’s often that excludes financials and commodity type businesses, often not always.

In those other instances, I’m trying to buy things that have lots of cash flow coming in. That’s my definition of margin of safety, where there’s some business quality there, in addition to balance sheet strength and then the final source of a margin of safety is just buying at a big enough discount. So that often I look at some of the businesses that are listed now that are the ones that are the most popular. I agree that they are phenomenal businesses with phenomenal management teams being run very well. But the price that you pay for them in the market right now is so high that everything just has to keep on going right for the position to win a market return.

Whereas I prefer things where let’s assume that everything doesn’t go right. Can we still get a market return or better? I mean, if that’s the case, then that’s the position that I like to put on. I think there are three sources of margin of safety. One is the price you pay a big enough discount, the quality of the balance sheet and the quality of the business.

[00:16:46] Andrew: Those stocks that you mentioned, the ones that are richly valued, even though they’re earning money, do they in a sense, have a negative margin of safety in the sense that they really are trading in excess of where some long-term fair valuation would be?

[00:17:02] Tobias Carlisle: It’s hard to say, because if you had asked me that question five years ago, I’d have said, “Yes, that is the case.” Now, I’m probably a little bit more humble after being beaten so badly in the market for so long by so many of these stocks that I thought were extraordinarily overvalued. So, I approach the problem now, like let’s say the markets right, but let’s just assume that this valuation or this multiple even though it is optically very high, let’s assume that this indicates that the market knows something about the quality of this business that I don’t truly appreciate. What does this business have to do to justify this valuation?

I think that in many instances, what the market is asking if the business is unlikely to manifest, but that doesn’t mean that it won’t manifest in certain instances. So, you can look at some businesses, so that the one that they always everybody, always quotes is Amazon trading, 10 times price to sales. Is it 10 times sales in the 2000 something like that, or over the next 20 years, 20 something years, it’s going to generate 18% a year, which is not the ordinary experience for companies trading at a premium to 10 times sales, the ordinary experiences return to about 4.4% compound, which is about half the market return.

You can always find instances where there are companies that defy the base rate. I’m very careful now. I’ve learned my lesson enough times that they don’t possess a margin of safety. But I do think that you have to be careful what you’re requiring from the company to justify the valuation that you’re paying. I think in many instances, they’re going to disappoint. Is that a negative margin of safety? I would say yes, but it depends on the – case by case analysis.

[00:18:45] Andrew: We’re going to segue just for a second night, I think it’s very interesting how you serve. You talked about being humble when considering these things. Is that something you think all investors should or shouldn’t take into account that they could be wrong? I’m thinking about there’s a George Soros quote, something to the effect of he looks for reasons why he might be wrong. Do you think alot that  you may not know everything? Or that you may have to adjust your prior beliefs? Is that something you think about a lot?

[00:19:19] Tobias Carlisle: It is absolutely the case that it’s impossible to know everything about a company that you’re invested in. It’s likely that the thing that you haven’t considered is the reason why the opportunity seems to exist to you. I’ve worked in listed companies as a general counsel, and I’ve sat in on board meetings. The difference between what even an outside director understands about the way that a business operates, and the internal directors is vast. Those are guys who are sitting on the board getting all of his privileged information about the operation of the business. I think, what chance does even an outside investor who’s thoroughly studied the industry, knows the industry, what chance do they have of working out what’s going to happen?

Having said that, you have to be able to use this incomplete information to put together a picture of what you think is going to happen in the business. I think that the function of humility is just so that you don’t get too excited about any given position and put on too much or overpay for it. Your assumption is always that probably you don’t know enough, probably the valuation is fair, the market has it right. It’s something that you just, it’s the unknown, unknown, that is always the thing that kills you in this business. So, I try to build that into every stage. That’s a portfolio construction question as much as it’s a sizing question. It’s a diversification question. It’s a valuation question. It should be in every single level of investment.

 [00:20:52] Andrew: I guess it’s a lesson for all investors about the dangers of hubris, right? That to always assume you know everything or that you’re absolutely right is, it may work at some of the time, but if it doesn’t work, it can be catastrophic on a portfolio.

[00:21:10] Tobias Carlisle: You need to be a little bit arrogant to put on a position where you’re implicitly saying, when you put a position on that the market is wrong, and that I am right. In this, I’m buying this thing, which seems optically cheap. But there’s just so much that can go wrong. There are so many forces that are conspiring against you to there are competitors or other investors, there’s a regulatory environment, there are lots of stakeholders who have an interest in the business that potentially runs contrary to the equity holders, including management.

Management isn’t necessarily aligned with shareholders, unless it’s explicitly the case in their proxy. I think that you just need to be aware of how difficult it is. That informs everything, what valuation am I prepared to pay for this thing? What portion of this do I want to have in my portfolio? All of those considerations militate against you becoming too confident about a position, too confident about the portfolio. Having said that, you’ve also got to be cognizant of how rare good opportunities are. So, when you see a good opportunity, even though it might have a little bit of hair on it, you have to recognize it for what it is, and perhaps be prepared to bid a little bit harder on it.

[00:22:29] Andrew: When you buy a stock, what time horizon are you looking at for it to mirror?

[00:22:37] Tobias Carlisle: I think that the valuation is easier, the further out you go. The reason I say that is there are some businesses that just can’t, you can’t project them out, three, five years, 10 years. I don’t think you can predict what any business is going to look like in five beyond five years, but between three to five years. I think you can get a fairly good idea about where the valuation will be for some businesses. Those businesses are really the ones that you want to hold in the portfolio, because they’re the ones that are a little bit more predictable, the ones where you can see where they are going to be.

Then I think that a time period of three to five years is enough for short term issues, to wash away management to capitalize on that discount to valuation, and to grow the business beyond that. So you should be looking at a materially bigger or a significantly bigger enterprise in three to five years’ time with the discount to valuation closed.

[00:23:34] Andrew: Your investor, not a trader, but are you willing to put a stop loss on a stock because of course value stocks the adage is sometimes the cheap gets cheaper?

[00:23:46] Tobias Carlisle: Yeah.

[00:23:47] Andrew: If you buy a stock at $20, and it goes to 16 or 15 even though you might be convinced by the long-term prospects for the business, and they will ultimately mean revert. Do you cut your losses? Or are you usually confident enough that it will turn around in a short period of time?

[00:24:09] Tobias Carlisle: I’m not confident in any individual position. I think that you’re about 50/50, fit to be right. So, the idea is that a lot of the positions in the portfolio are just going to be wrong, they are just mistakes, the market is absolutely right. They should be trading at a big discount of valuation because the valuation is shrinking. That’s the classic value trap in my estimation is something that looks cheap on its current valuation and then you wind forward a year and you revisit it and you’re down 20%. The valuations down 20% is still at a big discount evaluation and you just keep on doing that until all the money’s gone..

So that’s the horror value trap for value guys, because there’s no signal to get out of the stock, it’s always undervalued and at some stage you just have to decide to rip the band aid off. But I would never do that for I will never use a stop loss just because I’m already saying that I think that stock prices can become irrational and can become detached from underlying values. If I’m saying that, then I’m also implicitly saying that there’s no reason why we can’t become further detached in either direction can become more valuable, more undervalued.

I think that the better way to do it, is to say even though we know in any given quarter, there can be a lot of variation in fundamental returns. It’s highly unlikely that I’m going to get the downswing. If I pick the bottom of the downswing, I’m talking fundamentally, I’m not even talking stock price. What are the chances that I can predict that this is the quarter work, where everything turns around? Vanishingly small, almost impossible to do that, I think that you need to be a little bit patient and need to give this position some time to work themselves out. So, you often buy, goes down a little bit, buy a little bit more, goes down a little bit, buy a little bit more until eventually, the business turns around or the valuation starts improving.

That’s the approach that I have taken. If I still think on a normalized basis that the business is going to do. Okay, or I can see the factors that are driving the poor returns or that the lack of cash flow with the case may be, and I know that that’s not that state can persist forever, that state must come to an end at some point, then I’m prepared to hold through those periods, having said that, we make mistakes all the time. We can reverse course, pretty quickly if we do.

[00:26:26] Andrew: When you say that more of the return from the stocks that do well, does it tend to come from more from the business itself turning around or is it more investor perception and so you get a – and investors are willing to pay a higher multiple? I’m sure, it’s a mix of the two, but does it tend to be one or more of one or the other?

[00:26:49] Tobias Carlisle: Yeah, at a time period thing in the short term, it’s always going to be multiple expansion or compression moving around, and then the longer term becomes business performance. I don’t think that multiple compression or expansion is predictable at all. It’s asking you, what will the next guy think about this business or what will they think about this in a quarter or two quarters? It’s virtually impossible to predict that. When I say virtually impossible, possibly, Jim Simons and Renascence have figured out a way to do that, but for most of us mere mortals, it’s too hard.

I think the way that you can simplify your life and calm the process down, is to look further out. There are many instances where you look at things and just, I have no idea what’s going to happen in this business. Over three to five years, I just don’t know. It’s just not possible to know. But there are others where it’s not that complicated a business in three to five years’ time. Do think that whatever this current issue will be, this is a short-term thing this will be over in several quarters. Then beyond that, this will probably be a business that goes back to looking the way that it was before, and it should then attract a valuation that is more appropriate to the business.

So, I’m saying a little bit there that I think that it’s going to be multiple expansion or compression. My evaluations never rely on the multiple expansion or compression. I always look at the – I say, what if the multiple doesn’t change what are we going to earn out of this business? Part of that is a yield question. That’s always going to be dividend and buyback adjusting for any options that they might be issuing. Then there’s also this growth, active growth, which is the amount of money that they generate beyond maintenance CAPEX. It’s reinvested in the business to expand it at whatever return on invested capital.

This business averages over the very long term and over three to five years of that occurring. Reasonable business so the long run average return on invested capital for the S&P 500 is around 13%. They pay out about 30%, so they’re reinvesting 70%, 60 to 70% of their earnings in any given year at a return, approaching 13% a year. After three or five years, it’s like a third of the capital in the business has been reinvested by the existing management team. You would hope that they’re continuing to get at least their long run return on invested capital and with any luck, because we know that they’ve gone through a trough, they’re getting a little bit better, they’re getting a higher return from the investment.

You can get a rough idea what this business is worth assuming no change in the multiple over that three-to-five-year period that you hold it. That’s the way I mostly think about evaluation, so it doesn’t really turn on the multiple, but having said that the multiple does tend to mean revert too.

[00:29:37] Andrew: Do these, the companies you buy, do they tend to be dividend payers or have the ability to pay dividends?

[00:29:43] Tobias Carlisle: It’s not something that I ever explicitly screened for or against. It’s slightly irrelevant to me. That’s a slightly nuanced question, because I think that I favor dividend payers because it is, I don’t screen for it, and I don’t use it as part of my process. But when I see a company paying a dividend that is a real expression of that real free cash flow that’s being paid out of the business. That’s the actual fruit of the entire business that’s coming up. But it’s not the only one and it’s a particularly tax inefficient one.

Better is an undervalued company with that free cash flow using that to buy back stock, that’s ideal, because that just means that the valuation and the stock that I hold, is continuing to concentrate and grow, but when you when you look at my funds, they do tend to have a higher dividend yield than the average fund and the average holding in the category the index. That’s just by virtue of the fact that I’m buying the cheaper, the payout ratios are about the same as the rest of the index, so it’s just a valuation question rather than then paying out more capital with this reinvesting in growing faster than the average company in the index.

[00:30:50] Andrew: Are there any specific industries that tend to be best suited toward your style of investing?

[00:30:57] Tobias Carlisle: I like industrials, just because I think that there’s simpler businesses that can largely be understood. It’s been a treacherous time in the markets, because the rise of software as a service to technology has expanded beyond what had previously been infamous information technology as a sector. Amazon is a completely different business to Google. That’s a completely different business to Facebook, I know Google and Facebook are ultimately selling advertising, but they’re still completely different businesses in the way that they face the world to examine them.

Amazon’s a retailer, Google’s probably more of an advertiser, but it’s also a good business enterprise. Microsoft threatens to nitpick their businesses that are just so distinct that I don’t think of them necessarily within the bucket that they exist. They’re encroaching all the time on other businesses that are not necessarily direct competitors with them, their definition of competitors broadening all the time. To me, it’s almost irrelevant what sector something is in, unless there are some things that are fairly well established, a goldmine is always going to be a gold miner, unless it’s Australian or Canadian in which case it might turn into a tech company. You never know.

[00:32:12] Andrew: I remember back in the tech bubble, there were nominally gold companies turned into tech companies. Then when the cycle term, they went back, and I’m sure there apparently have been cannabis companies.

[00:32:26] Tobias Carlisle: It’s a feature of the Australian and Canadian stock markets in particular, that they’re heavily financials, both of them, half financials. Then there’s this huge base materials, whatever it’s called, because both countries tend to be mining countries in that. That has given rise to this very large portion of retail investors who are like that a lottery ticket junior miners in both countries. If you’re the person who invest in the junior miner before it’s made a discovery, then why not invest in a tech company before it’s commercial holds its tech. It’s basically the same bedroom.

[00:32:59] Andrew: It seems with like with a lot of the junior miners, not all of them, some of them are legit, but some of them they’re less looking for gold or base metals than they are looking for investors to bid up the stock.

[00:33:13] Tobias Carlisle: 100%. The thing is that people who like lottery tickets that behave is well documented. That’s why that, if you look at the long term returns too, we look at this Fama French data, Ken French who’s old Fama French has a database that’s free online, where you can just pull down this state or anytime you want to look at and they divide the universe of investable companies by price to book, price to earnings, I think he’s got price to cash flow in there. You can look at it ranked in 10 different deciles or five different quintiles or three different tarsals, whatever, however, you want to cut that data, whichever way you look at it, the value stuff, which is the cheap stuff, that the stuff that you pay less for each unit of book or earnings or cash flow, over the long run has massively outperformed the expensive stuff.

But the question is, well, why do people keep on buying the expensive stuff given that the experience is so much better in the value stuff? The reason is that all of the lottery ticket winners or the massive winners always come out of the expensive stuff, because really good businesses, the market recognizes really good business and pays up for them. Most businesses disappoint when people pay up for them, but there are enough of them in there, that Amazon probably that’s never been a cheap stock. Google’s never really been a cheap stock. I realized that it has been cheap on occasion, but really cheap Microsoft really cheap.

Those businesses, everybody knows they’re really good businesses. They look at the experience of someone who bought Microsoft 10 years ago, 15 years ago. They can see that the monster returns that they’ve had. So, I think that that’s the justification for buying those things that are optically expensive, because that’s where all of the big winners have come from even though the base rate is better in the value stocks.

[00:34:55] Andrew: Do you think there’s a big recency bias at play there that going back to something you said at the outset that people do tend to extrapolate the recent past into the future?

[00:35:05] Tobias Carlisle: 100%. That’s the I think that – that’s the thing that drives markets for the most part that something is an unexpected winner. It’s unexpected because often it comes from undervaluation. We can look at the recent experience in the market that has been a big run in GameStop. So, GameStop started out as this basically nearly defunct retailer of video games. It was sitting in my oval website Acquirer’s Multiple, which has all of these screens for cheap stocks in them. It was the cheapest stock in my screen for a year or 18 months or something like that, because they had a whole lot of cash on their balance sheet, even though they were losing money and that cash was probably balanced out by all the obligations that they held as storefronts or their lease obligations.

It was still cheap, there was this period of time where you could buy it potentially and rely on the management may be doing something right with it, then all of a sudden the chewy guy comes along, takes a big position, turns it into a hot stock really gets hold of it and it goes through this monster runs, then people start looking for these things or when remember when the herd whichever rental car when it went bankrupt and it had the monster run out of bankruptcy. People start looking for bankrupt companies, if that’s the thing it’s going to generate the returns of GameStop type companies like GME with behind. Let’s look at AMC, which is another font or suffering business model, maybe that can turn around.

I think that that is what drove people that look for these things, worked really well, let’s go and find the proxy for that thing and then let’s do that in the market. It’s been successful over and over again, in the short term in recent times. It’s not been something that’s worked historically, because what the initial phase of it requires deep undervaluation.

[00:36:52] Andrew: You do a forensic accounting diligence of stocks, rather than just a simple screen. How do you go about doing that and what issues do you want to cover as a result?

[00:37:04] Tobias Carlisle: The thing that always concerns me as a, as a former corporate advisory lawyer, one of the things that junior lawyers do a lot of is diligence and it’s going through all of this holdings that companies have and that if you deal with small companies that are undervalued for long enough, you encounter these funny financing arrangements that pop up all the time where they’ve got some convertible note, that’s very material to the valuation. The note converts at the option of the person who’s stuck it in the bridge is typically a hedge fund. It’s because the company was in financial straits, they needed to do a deal to keep some liquidity or to keep some solvency, so they did it with a big fund where they get a chunk of money that converts at very good terms.

Buffett is a classic example of doing this in very big companies. He will do this for Goldman Sachs with. He’ll get a preference share deal that nobody in their right mind would ever issue unless they’re in some financial straits. So, if you’re a deep value investor, you’re often looking at things that there is some question about their ability to continue as a going concern. It’s just the nature of the business. So frequently, there will be some unusual financing arrangement disguised in the notes for whatever reason doesn’t show up in the financial statement. So that’s the thing that always concerns me the most, there’s some material financial arrangement that has some contingency to and it’s not – doesn’t need to be disclosed, other than in the notes. That’s usually what I’m looking for.

The other things are just around the edges, like how much of the accounting earnings are actually turning into cash flow? Because that’s the trap that will catch high profile companies all the time. So that’s the Enron trick where they were really not making any cash flow, but they were making these huge accounting profits all the time. I want to see the conversion of accounting profits into cash flow. The things that you can look forward to – this is more of like not really a financial diligence question, but this is just something that you can stay in the financial statements, just in a cruel and unusual accrual building up, because double entry bookkeeping requires that that profitability is captured somewhere.

So all the great frauds have had these weird, these gigantic, weird accruals on their books like Joseph Banks had this, they had a huge suit inventory, which they said was appropriate, because when men come in to buy a suit, they’re not going to hang around, they just buy this suit, if it’s not there, they’ll go and buy it from somebody else, so we need this huge entry, but there are some questions raised by shorts. John Hampton identifies this huge entry, and they try to justify it but that accrual creates, that is potentially an indication that they have overstated profits at some stage. I’m always on the lookout for weird accruals with an asset that’s way too big. That doesn’t make any sense for the rest of the business, like why not liquidate that asset and then use that to buy back some stock or free up some capital?

[00:40:00] Andrew: Do you find you’re often combing through the MDNA and in the annual reports, various filings to uncover these little nuggets of information that maybe cast a different light on the financial statements?

[00:40:16] Tobias Carlisle: I always look for them. Very rarely do they turn up very rarely, that the one out of 100 positions that almost makes it into the portfolio that just gets pulled out at the last minute, because there’s that undervaluation that probably, I’m always trying to figure out, why is this thing undervalued? Why don’t other good investors who have looked at this thing, why don’t they have a position? Why hasn’t this been pushed back to valuation? Often, it’s because everybody knows, it’s just, nobody says it out loud. Everybody knows that this thing’s got this problem and there’s a question about, is this fraud? Is this just some weird way of manipulating earnings? Is this just an idiosyncratic way of managing this business? It’s a little bit of a question. That doesn’t get resolved until either. No, it was no issue. We should have taken that opportunity to buy some, or it turns out, yeah, there’s some fraud going on. We were always to avoid that one.

[00:41:10] Andrew: Right. Yeah, I guess it’s a question of is, is the market really being inefficient or does it actually know something at some level and the price is appropriate and the direction that the stock is going at is the right direction?

[00:41:26] Tobias Carlisle: I think that’s often the case. I think the market knows for the most part. I think that what I would have initially said there are two schools of thought about why value investing works. One is this Fama French argument that it’s a risk, you’re taking on some additional risk, and you’re being compensated for taking on that risk. So, there’s no alpha in it. The other argument is its behavior, which is the one articulated at the start where people extrapolate out some trajectory and earnings or revenues, and then they don’t properly account for mean reversion.

I would have said, I would have argued forcefully for the mean reversion argument for a very long period of time, but I do think the longer that I spend on the market the more that I do think that there is something to the risk argument that you are being compensated for taking on some risk as a value investor, particularly a deep value investor. I think that some of the evidence for that is that the portfolio tends to break down about half work and half don’t. It’s just that ones that work do tend to have that asymmetric property where they work a lot more than they lose, because they’re already in the penalty box. Now, they’re already we know that they’re undervalued, that is undervalued for a reason.

[00:42:32] Andrew: You also short stocks, right? What are you looking for, on the short side? Is it just the mirror opposite of what you would look for as a candidate to buy?

[00:42:48] Tobias Carlisle: It is, but the difference is that valuation plays less of a role in a short than it does in a long, because a short is something that often that I just can’t fix evaluation for. The value is potentially nothing. The reason is often that there’s some fraud or earnings manipulation or financial distress that just makes valuation an impossibility. So, what I’m looking for are those statistical indications of fraud or earnings manipulation, in addition to some extreme overvaluation. Then also, they’re losing money, so they have some, they’re burning cash, so they have a funding requirement that needs some capital at some point, that we’re either going to borrow that money or they’re going to issue stock, both of those events should be a catalyst for a reckoning in the stock price that should cause them to go down, basically. So, I’m trying to short-ahead of that reckoning.

In many instances in the ordinary course, I think it’s a reasonable bet that they are potentially companies that are going to have that reckoning. But there are many, many instances of companies that terrible looking business, terrible looking balance sheet, stocks up 30 percent, a year, year after year after year, because the story is so good. The example I always give that is Tesla. It almost invariably, I get a whole lot of hate mail because it’s an incredibly polarizing company. There are people who think that Musk is a visionary, genius entrepreneur, who is saving the planet by building electric vehicles and rocket ships to take us to Mars when earth becomes unlivable.

Then there are other people who say, even if he’s doing all that stuff, it’s already factored into the valuation. The financial statements are impenetrable to people who are good at reading financial statements. Part of the reasons that it changes from quarter to quarter, and they do things that are very unusual in their statements, for example, they will take a word that would otherwise be readable by a machine and insert it as a graphic, so to a human eye the word just seems to be part of the paragraph. But to a machine it can’t read that word. I can’t think of any reason why you would do that other than to disguise from this optical reading these people who are trying to search for these keywords to disguise the fact that you’ve got that word in your statement.

I have been short-test when I think of probably broken even on the short. I’m not short, haven’t been shorted, since it went into this monster run very fortunately. But I’ve been short on different occasions, and it meets many of the criteria that I have. It’s impenetrable financial statements that don’t seem to match reality and an extremely high share price relative to the fundamentals. It’s one that it’s a polarizing stock, there are people who feel very strongly in favor of it and there are people who are very strongly against it.

[00:45:44] Andrew: I guess, if you’re a value investor, shorting stocks, you must worry that the momentum investors will in a sense ruin that and that your short play, right?

[00:45:59] Tobias Carlisle: So, one of the things that I do with my shorts is, I just make sure that they’re not up a lot over the preceding period of times. We use a momentum overlay to make sure they’re not the stocks that are momentum buying program would pick up. We’re looking for things that have stagnated for about 12 months. The reason that I think that’s important is it shows that the market is no longer – that the market isn’t buying the story, whatever the story is that the management team is telling the market is becoming wary about that story, because the fundamentals aren’t matching the story.

So that keeps us out of things in all like Tesla that had been up a lot, by virtue of the fact that was up a lot, because it goes into these momentum-type buying programs. So, we avoid it when that happens. So, we avoid the gigantic ramps like that, but in Q1 of this year, Q4 of last year, there was those that reopening trade started in Q3 that bled into these heavily leveraged financially distressed stocks, because that was the idea was, were you buying this often, it’s a cruise liner that’s got a whole lot of expensive ships out there, they’re not making any money and they’ve got some debt as well.

There’s some question about whether they can survive or not? When it looks we’re reopening, and we’re going to go back to work, all of a sudden, that becomes potentially we go back to taking cruises again. All that stuff rallied really hard, so it was a really junky value rally. That caught us a little bit the long book was doing okay, because it was a value rally, but the short book was getting hurt, because it was a junky value rally. That eventually petered out. But it was painful for a period of time. It did reverse course. So, we had a much better Q2, Q3 is that all of that reverse course.

It’s always an issue where you’ve got to mark the market issue in the shorts that in the short term, you can get hurt and carried out potentially. We keep them very small, like that’s the other thing I should point out. They’re much, much smaller, short is much, much smaller than long, so long could be three to four percent, short would be one percent or less.

[00:48:00] Andrew: Is it more difficult to be a value investor now compared to the past? I guess, what I’m getting at is not so much the underperformance versus growth over the last number of years. Are there that many deep value stocks out there given the overall rise in asset prices and equity prices?

[00:48:23] Tobias Carlisle: It’s a good question. I think that when Benjamin Graham started looking for the companies that he was looking for trading at a discount to liquidation value. He had to do all that by hand, painstakingly putting together financial statements contacting companies getting annual reports. There’s nothing like that now. It’s trivial to run a screen to pull out any quality of any business and put together a portfolio of undervalued stocks. I don’t think that is the reason why – I think that’s the reason why a liquidation value type analysis is just about useless. It doesn’t really work anymore.

The valuation question, that’s more of a philosophical argument about whether I mean, what drives stock returns ultimately, is it high rates of growth in revenues and earnings or is it a valuation question, or is it some combination of both? It’s probably some combination of both valuation is a very big component of it and has been historically. I think what happened five years ago is that value got very expensive, because it had an extraordinary run from the early 2000s on a relative basis, the value portfolios were comparable in on a multiple basis to the growth portfolios, but the growth portfolio is growing at a much higher rate.

So, there was this 2015, you could buy better quality companies for the same valuations as you could buy these worse quality companies. So, it would have made more sense to own the better-quality companies in that instance and to avoid the shittier companies. Now, that has reversed and you’re paying so much for these high-quality companies that they really have to do something extraordinary to justify those valuations, whereas the cheaper companies are so cheap, that it doesn’t actually require any multiple rewriting for them to outperform the market.

So, it’s a function of the market changes its approach to these, it swings around, it favors growth for a period of time, it favors value for a period of time. The difficulty in being a value investor has just been that it hasn’t worked for a period units, the longest period on record, but it hasn’t worked, having said that, I think that it’s bottomed in about September last year. So, we’ve had about a year of outperformance. I don’t know whether that’s a function of having a big crash in March 2020 and traditionally value leads out of a crash or whether it’s just a function of the market recognizing that the opportunity set is much better in value than it is in growth, whereas 2015 years of reverse, and the market figured it out over a period of five or six years.

I think we’re now seeing the reverse now. I can look at my portfolios, you can go to Morningstar, and you can pull up Ziggs portfolio and compare that to the index, we’ll compare that to say, Ark, which is Cathy Woods vehicle. The embedded returns in the value portfolios are now so large that it doesn’t require any valuation change for them to perform whereas the growth companies really do have to keep on expanding their multiples at very high rates, because they’re already paying so much for those fundamentals. I think that the next one year into it and we’ve probably got five to 10 years to go of probably value working better than growth.

[00:51:36] Andrew: Is that true even if we enter a bear market? I mean, I guess what I’m saying is, even if value outperforms growth on a relative basis, we’ll do you think that on a three-to-five-year time horizon that in value can do well, on an absolute basis?

[00:51:55] Tobias Carlisle: I think, value does well on an absolute basis over a three-to-five-year period. The path that it takes to get there, it’s virtually impossible to predict. I think that the – to go back to the Fama French, the Ken French database, you can look at the valuations paid for each of those deciles. The most expensive, we’ve never played multiples like this before for the most expensive stocks. This is the most expensive that the most expensive stocks have ever been. This is not the cheapest of the cheap stocks have ever been, cheap stocks are still relatively rich to their – about their long run average to little bit rich, which means that they’re probably going to generate a return that’s below their long run average, even though the long run average is exceptionally good.

I think that probably what happens is at some stage, we have some reckoning and that will crush the most overvalued stocks. It won’t impact the undervalued stuff quite as much, but I still think that over that time period that you gave us about right, three to five years, value outperforms that and it does so on an absolute basis, but there could be some volatility in the interim.

[00:53:03] Andrew: You spoke at the opening about the two ETFs that you run. Can you tell our listeners just a bit more about each of them? How do they differ what stocks they tend to own?

[00:53:14] Tobias Carlisle: The US focused both the ZIG is mid-cap and larger. So, it tends to – but mid-cap is my favorite part of the market. People if you ask them, “What do you prefer?” They’ll always say, “Well, I prefer large cap, or I prefer small cap,” for whatever reason, that they prefer one or the other. Mid-cap is this appreciated or underappreciated part of the market where you get, basically you get small cap returns, and you get large cap volatility. So, a risk adjusted basis the mid-cap portfolios have always generated the best returns. That’s not necessarily always going to be the case in the future, but it has traditionally been the case.

So that’s where I try to cluster that portfolio. It just ends up owning a lot of these mid-cap companies. I like that because they’re professional management teams, they’re well capitalized. If the management team isn’t doing the right thing, they’re a private equity firms, they’re activists who are hunting for these kinds of things and pushing them back into position, they never really get too far out of their valuation range. I like that little part of the market. I think that the embedded returns in ZIG are pretty good at the moment.

The small and micro-cap, same argument, they’re just not particularly well followed. It’s been a huge bear market in small and micro-cap for about a decade now. It’s massively underperformed to the point that size, which had traditionally been an academic factor predicting returns, has now generated no return. So, there’s a question about whether size as a factor continues to be useful or not, there’s an argument that it’s not useful at all. I think that’s a good bet signal to value guys, when somebody says the undervalued small cap companies just can’t win.

I look at those portfolios and I think well, I don’t really need to do – The expectations for these companies are so low that with no multiple rewriting again, just on the basis of the yield and their organic growth, they can do very well. That’s deep, so those are my – I’m talking about work of course, but I have also positioned my book here because I think that there’s a good opportunity in value in particular, and in mid-cap and small and micro.

[00:55:26] Andrew: If an investor wants to learn more about your funds, or your investment strategy, where can they go? What’s the website?

[00:55:33] Tobias Carlisle: I have a website, and I have a podcast, I have blog posts, some little screeners where you can learn about the positions that we like to put into the portfolio. I’ve written a book, which is The Acquirer’s Multiple, which you can read in about two hours, and it’s written to a fifth grade reading level, it just explains the philosophy at a very high level, why we do what we do, as opposed to other better-known value investors like Warren Buffett. I’m on Twitter too @greenbackd where I tweet at everything that occurs to me in the moment.

[00:56:10] Andrew: Those are the best tweeters. I have too much of a filter to be good at Twitter. So, I admire you. We’ll wrap it up on that note. This has been a fascinating discussion. Tobias Carlisle, thanks so much for your time. We really appreciate it. Thanks, as always, to our PitchBoard listeners for their attention. We’ll be back soon with another episode. Take care.

[00:56:29] Tobias Carlisle: Thanks, Andrew. That was fun.


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