DREW BESSETTE: Today, we have Tobias Carlisle, portfolio manager at Acquirer's Fund, discussing global macro with Chris Cole of Artemis Capital. Carlisle describes his approach to finding undervalued, out of favor stocks that offer the potential for asymmetric return. He discusses how mean reversion or the tendency of beaten up stocks to bounce back materially impacts his portfolio. He also outlines the forensic accounting diligence his firm employs both to verify long positions and identify short ones. Carlisle argues that finding deep value in a market saturated with liquidity is tough, but rewarding. It's a great conversation. I hope you enjoy.
CHRIS COLE: Hello, everyone. My name is Christopher Cole. I'm here with Real Vision today in our offices of Artemis Capital, and it is my pleasure and honor to be interviewing an old friend of mine, Toby Carlisle, who is the founder and principal of the Acquirer's Funds. Toby is an expert on value investing, and has written four books on the topic, which are really new classics in the field, and should be read by any serious value investor. I'd like to introduce Real Vision to Toby Carlisle.
TOBIAS CARLISLE: Thanks for the very kind introduction, Chris. I'm very happy to be here. I'm so happy to be doing it with you.
CHRIS COLE: Well, Toby, tell us about how did you get into value investing.
TOBIAS CARLISLE: I was a mergers and acquisitions lawyer in Australia initially and then in San Francisco, went back to Australia to be a general counsel of a public company that was a telecommunications company. I started working 2000 right at the very top of the dot-com boom, saw the collapse, and then saw the emergence of this new breed of investors that new to me. Nobody had really heard from these guys since the '80s, but they were the guys who've been doing the takeovers in the '80s had returned. They weren't known as activists at that stage. We didn't really have a name for them.
They're looking to get control of these busted dot-com businesses that had raised a whole lot of cash, had an enormous amount of cash burn. It was hard to figure out what they saw in these businesses, because I had read security analysis, the Graham and Dodd book, and I'd read Warren Buffett's letters, and he talks about looking for a wonderful company at a fair price. These weren't wonderful companies at all. They're terrible companies, terrible businesses, but because they had raised so much cash, they traded down the discount to their cash, these guys were looking to get control, looking to get control of the cash then to either liquidate the company or use it to buy other companies.
That period from early 2003 to about 2007 was a golden age for value. Deep value guys coming through activists, private equity firms taking company. I just thought if that ever happens again that the market gets cheap enough that that strategy of buying sub-liquidation value companies, if that opportunity presents itself again, I'll take advantage of that and try and buy those companies. When the 2007-2009 collapse occurred, I stopped working as a lawyer, set up a little fund, set up a blog talking about buying the sub-liquidation value companies. I just fell in love with the strategy and the process. I continue to research, write some books and that's how I get to here.
CHRIS COLE: I think one of the most interesting things about your research is that you have, there's so many individuals that follow the value investing framework, and I think everyone's knowledgeable with a canon of material out there, securities analysis, Benjamin Graham, but you've added some new twist to that through quantitative research, and I wanted you to talk about that and how that plays into the concept of the Acquirer's Fund?
TOBIAS CARLISLE: Well, I think rather than adding too much of a new twist, what we've done is just revived some of the old ideas. Because Warren Buffett has been so successful, and he's the avatar of value, and he preaches this wonderful company at a fair price philosophy. Many of today's value investors have similarly embraced that philosophy and so they look for particular things, high returns on invested capital, moats, compounding type businesses that grow very rapidly. Then they're trying to buy at a fair price which might be saying a market multiple for a company that is better than that.
That's one very small part of value investing. There's a much broader universe out there. The idea is simply that you're buying something for less than it's worth. Typically that's hard to do, because most companies don't really trade at a big discount to what they're worth. The places where you find those big discounts is in financial distress where an industry might be going through a down cycle. That is what I described as deep value, where what we're trying to do is we might be trying to buy at a discount to balance sheet value, we might be trying to buy a cyclical company at the bottom of its cycle, and then trying to buy at a further discount to that.
Then we're hoping that there's an uplift in the way that the business performs and then you will still get the discount between the intrinsic value and the price at closing. You have two ways to make money. We did some research, I did some research with [indiscernible] PhD at but haven't found every bit of industry and academic research that we could find that had been published from Graham onwards, from the 30s onwards, and we tested that in a system to see what works, what continues to work, what stopped working, what never worked. There are many things that were perhaps a product of data mining.
We looked at how do you identify a good credit? How do you find something that's financially strong? How do you Identify earnings manipulation? How do you find statistical fraud? How do you find businesses that are very cheap and can grow and buy back stock and the product of that research was a book called Quantitative Value. I noticed this unusual phenomenon while we were doing it, that very undervalued companies behave in an unusual way that sometimes the things that the less attractive the business, the better the performance of the stock, because they just get too cheap and so nobody in their right mind would go and buy these things unless you can find some of these other indicia of value or quality in there.
That was a book called Deep Value that came out 2014 discussing the mechanics of mean reversion. Those mechanics are simply they're private equity funds, there are activists who will come in and turn these companies around. There's also management in there, not liking the performance of the company. They might be beholden to the industry cycle and as other participants in the industry leave, the ones that remain can ask for higher prices for their services or for their goods and so they then get a period of very good performance.
I just found that a fascinating approach and it's not one that is discussed much outside of Buffett. Buffett's wonderful companies at fair price. My research is focused more on those type of businesses and that's what the fund does. The fund to buy-- we like balance sheet strength is great, and we can find it so we will have a strong healthy balance sheet, lots of cashflow coming into the business as well, lots of free cash flow. This is on the long side because we did run long/short. We like the company to be buying back stock. I think that's a very powerful signal which shows that there is that free cashflow there, it's genuine free cash flow, management's thinking like you would want management to think taking advantage of that undervalued stock price.
I think when you see a material buyback, that also indicates that the stock is undervalued because you see lots of buybacks through the cycle, buybacks tend to peak at the top of the cycle. There might be mopping up option issuance or just trying to goose the stock price at the very top of the cycle. That's not the buyback that you want. You want material buybacks. Those things together on the long side, that's a pretty traditional-- we're going to find, we will own cyclical companies, we'll buy companies that it might be difficult to understand the reasons why we're buying them because it might look like the business is in a particularly good one, that we think that the combination of balance sheet strength at the bottom of the cycle, it'll look like a healthier business going forward.
On the short side, we're looking for somewhat of the reverse of that, something that's extremely overvalued to the extent that you can identify a value to some of these companies. It's very hard, there may not be any value there at all, but more importantly, they're in financial distress. There's some statistical earnings manipulations, statistical fraud, they have negative free cashflows so the way they're financing the businesses by raising equity or selling debt. That's a game that can go on until it stops, until the market no longer lets you do that.
We also look for broken momentum because many of these companies will finance themselves by telling a great story, even though the financial statements don't reflect the narrative. The narrative is wildly diverged from the financial reality of the company. That's what we like to find on the short side, really compelling narrative but none of that is being reflected in the financial statements. When the market starts seeing that too, and that momentum has gone from-- or the momentum is broken, we'll take a short position.
In the ordinary course, we hope to make a little bit of money on the short side, but the real function of the short so when the market collapses, they should provide more protection than their weight in the portfolio. You hope through a 2000 or 2007 and 2009 type scenario that it would perhaps prevent you from drawing down as much as the market.
CHRIS COLE: You found that there are certain quantitative metrics that are highly indicative of a quality value play. Maybe to talk a little bit about that, and how that differs from some of the other viewpoints out there on that.
TOBIAS CARLISLE: It's become much more popular, it's voguish now to largely to ignore balance sheet quality. For a company to grow very rapidly, it helps it for it to be asset wide and they might run with very substantial amount of debt on the balance sheet which when they're running up, that means they run very fast, and they'll go year after year, performing very well. The problem is that it doesn't allay so much in the way of-- there's very little balance when you go the other way. What I like is balance sheet strength. To the extent that we're using these statistical measures, it's not necessarily a new invention.
I don't regard it necessarily as, it's not like a NASA level analysis of the companies. It's just we're trying to find a-- it's a sensible approach of doing it. The reason we do it that way rather than trying to be more discretionary and more ad hoc in our approaches that we think that there are good behavior reasons, and there's lots of research that indicates that a more systematic, disciplined, quantitative, replicable approach to doing it means that through the bad times, you're able to keep on functioning and doing what you should be doing, buying the right stuff, you don't swing for the fences, keep sizes of positions fairly small, consistently apply the approach, because every strategy has good times and bad times and value has gone through a very rough time.
Since the start of the year, if you track the factors that have done well, it's the factors that have done well for the last few years, momentum is done very well, growth has done very well. Value has done very badly. Quality has done very badly, which is historical. Typically, what happens is there's a value premium, you get a little bit more performance for buying these companies that are trading at a discount to intrinsic value, and that's not been the case.
CHRIS COLE: Let's talk about that a little bit. It's really, really interesting, because, I'm a volatility guy. You're a value guy. Years ago, we bonded back in Santa Monica, two completely different disciplines but we share some things in common in the sense that value can perform during periods of market crisis. I'm curious for you to talk a little bit about the history of value over the last 20, 30 years, how it performs in different market cycles, its defensive properties, and to answer this question, value has underperformed for 10 years, is value investing dead? Is it dead? To get your take on that, not that I believe that, but.
TOBIAS CARLISLE: That's a question I get a lot. Is value dead? Can value come again? I don't know but I can go back to that-- we have pretty good data on value back to 1951, point in time data to 1973. There are very distinct cycles through that entire period. Over the full period, the outperformance for just a simple price to a fundamental whether it be price to book or price to cashflow, enterprise value of cashflow, enterprise value to EBITDA, even price to earnings, very simple metrics. The outperformance to the low price to a fundamental which is a reasonable proxy for a value stock has been massive.
The growth side of that equation where you're paying a higher price for that fundamental has been pretty weak. Behaviorally, you might say, well, why would you pay that higher price? Because the very best performers have always been expensive. Walmart, for most of the time it was listed was always very expensive. Microsoft's mostly always been pretty expensive. The companies that you buy that have these low prices to a fundamental tend to be junkier companies, cyclical companies, but you get paid to hold those companies.
You don't get paid all the time. You get paid over the full data series and the full cycle as well because value performs various different ways through the cycle. From the bottom of a crash, value does spectacularly well, value should provide some protection through a crash. At the tail end of a bull market, value looks terrible because the bid from value guys goes away. The people who are feelers and who are prepared to pay increasingly higher prices will do very well through that tail end, but then there is some justice for those guys. There's a typically very significant crash to the momentum growth side through the cycle.
There have been about six periods where value has underperformed materially. They're all were very well known bull peaks. The last one was 2000, in the run up to the dot-com, value performed very badly. They're all the covers has Warren Buffett lost his magic.
CHRIS COLE: The barons won.
TOBIAS CARLISLE: Then value did then go on to perform pretty well for that for the early 2000s. Then it's been week again, so it depends on how you measure value. Price to book value, that's the value factor. That's the academic definition of value. No practitioner uses price to book value, but that's the one that everybody points to, because that's the one that the academics prefer, because it's very simple to calculate and there are some good reasons, it's less volatile, the fundamental is less volatile where earnings is moving around, book value is reasonably static from quarter to quarter. It's a reasonable proxy.
It really hasn't outperformed for 14 or 15 years. There are many reasons for that. Partially, it's the composition of balance sheets has changed over time. There are companies out there that have bought back so much stock that actually got a negative book value. It's very difficult for book value to categorize them as a value stock, even though if we would look at them on another measure, like a price to earnings, we would regard them as value stocks.
Book value hasn't worked, but there's no practitioner who actually uses it. If you use an ensemble of measures that might be cash flow and earnings, and sales, even, that would have helped you keep up for the market for longer but it's still failed sometime over the last five years. If you have some craftsmanship, which is what the more quantitative value guys describe as their own mix that they use, where you might look at other things besides simple values, you might look at the quality of the balance sheet, the quality of the earnings, do the cashflows match the reported earnings, because that's important. You can have wild deviations where companies are reporting good earnings, but it's not reflected in cash flow generation.
If you use all of those measures, which is what most practitioners are doing, that kept up with the market, and that outperformed pretty well until about the start of 2018. Since 2018, that hasn't worked very well. That's a shorter period of time. That's probably what most practitioners have seen. It's been a period of weakness for value. There are pockets like that through the data series where that happens and then immediately afterwards, there is some very good performance for value.
The thing that would make me nervous is if value was underperforming but the portfolios as they reformed at each rebalance that aren't reflecting the discount that we're seeing, but what has been happening is the value portfolios have been getting cheaper so that the price ratios are wider. What has happened now is that the most overvalued stocks are extremely overvalued, more overvalued than perhaps may have been ever. The undervalued stocks, maybe at their long run mean, maybe a little bit rich to the long run mean. I think at some stage, we don't necessarily have to have a crash, the cycle can just go back to value, but most likely what happens is that there's some crash that resets the market.
In the crash, what has happened when momentum and growth have run like this is that the downdraft has been massive for them. It's been to the tune of 80% or 90%. I think value could pull back a little bit. I think that you want to be long short as a value guy going into the next crash to really see the performance and maybe capture some outperformance on the way down and then to be fully invested when the market finally does not turn and I think it will be a very good period for value from the bottom.
CHRIS COLE: This is a powerful idea that in a late cycle, if we're entering into some late cycle secular change or some recession, value will drop like momentum stocks, but will drop less in a market correction and that a long/short, something that is short the momentum stocks, the hot stocks, the highflyers that are making money and long the inexpensive value stocks, that long/short positioning will outperform and deliver alpha. It's interesting too, because even if you're just a macro guy and you don't pick stocks, I'm a volatility trigger so I don't pick any individual stocks, but I paid very close attention to the value momentum relationship.