During their recent episode, Taylor, Carlisle, and Gary Mishuris discussed:

• How Value Investors Use Intrinsic Value Without Predicting the Future
• The Price Asks the Question: A Mental Model Every Investor Should Know
• Why the Hunt for the Next Amazon Loses More Money Than It Makes
• Strategic Catalysts: How Warner Bros. Created an Auction for Its Assets
• Turnarounds 101: Why Waiting for Evidence Improves Returns
• Using LEAPS in Value Investing: Rare but Powerful Tools When Mispriced
• Auctions, Ego, and Reflexivity: How Price Can Change Value
• Building Better Investing Networks: Lessons from Ant Colonies

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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TRANSCRIPT

Jake: Looks 50.

Gary: Yeah, well, it’s funny.

Tobias: We’re live, fellas. We’re live. We’re live. This is Value: After Hours. I’m Tobias Carlisle, joined as always by my cohost, Jake Taylor. Our special guest today is Gary Mishuris of Silver Ring Value Partners. How are you, Gary? Good to see you.

Gary: I’m Good. Thank you for having me. It’s been a while. Good to catch up.

Tobias: It has been a while. For folks who didn’t catch the first one, don’t know who you are, give us a brief rundown of your strategy and philosophy at Silver Ring.

Gary: Yeah, absolutely. Well, as we were just talking, I’m originally from the former Soviet Union. That’s where the accent comes from, from Leningrad. Came when I was a kid, grew up in New York, started investing when I was at MIT. Warren Buffett came to speak on campus and that was my first introduction to value investing. Got lucky to get a job at Fidelity in equity research, where I had a great mentor, Joel Tillinghast, who managed the low-price stock fund. And that really kind of gave me my initial kind of direction as an investor I would say, predictable businesses run by honest people with a big margin of safety. And that, I would say, still probably captures like 80% plus of what I do.

So, Silver Ring is the partnership. It’s long-only concentrated, probably between 10 and 15 investments most of the time. And I am very focused on quality in the sense of being able to predict what the business looks like over the long term, roughly obviously. And I still demand a large value of margin of safety to the intrinsic value.

Now, it’s probably evolved a bit in the sense that I’m not saying, it has to be under 12 PE or it’s terrible or anything like that, but I’m not new age enough where it’s like, “Hey, it’s 50 PE, but it should be worth 75, and therefore it’s a great value.” Not saying that’s wrong. That’s probably true for a small subset of companies, but that’s just not my circle of confidence.

Tobias: Can you give us an example of a holding that you have or something that you’ve owned in the past that sort of illustrates your strategy?

Gary: Yeah. I think there have been a number of these kind of little companies. I’ll give you a quick, recent example. There’s a recent spinoff that I bought a year or two ago, I forget exactly, called PHINIA. It was an automotive supplier, right during the peak scare of electric vehicles, that internal combustion engine companies were all going to die. And the stock was very, very cheap. It was probably trading I want to say six times earnings of free cash flow. The research calls I read on expert networks suggested management was both honest and competent, which is always good. They had a very large–

What PHINIA did is they basically did gasoline direct injection stuff. So, directly related to the ICE engine. So obviously, people thought, “Hey, this is a dying business.” But I think what they were missing was, number one, that more than half the profits came from the aftermarket business. It is a very steady, predictable business, low growth, moderate growth, but much more immune to changes in kind of where new vehicle sales are going in terms of electric versus not. And the actual threat to the older business, the actual new parts business was a lot less in my view than was perceived.

So, you had a business run by good people, limited financial leverage. I thought it was probably a single digit growth business long term. Plus, I thought the management had some nice tuck-in capital allocation opportunities to add value and you could get it for basically 15% free cash flow yield and so forth.

Now, stock has rerated quite a bit, but I still own a small position but that’s a good example where there’s just a different– I have a varying perception about the long-term cash flow stream of the business. So, that’s one maybe another company– Happy to go in any direction but another quick one– [crosstalk]

Tobias: Well, just before you go, let’s just talk a little bit about EVs versus ICE and then maybe what self-driving does to that market. So, let’s start with what’s your take on the evolution of that industry? Electric vehicles versus internal combustion?

Gary: Yeah. Look, obviously I didn’t know and I don’t know. So, you kind of look at intrinsic value as a range as I’m sure you guys know. So, I ran different– when I kind of underwrote my intrinsic value range, I said, “Okay, maybe the range of penetration over the next 10 years is 30 to 50,” or something like that.” And we were starting sub 10 I think at the time and I think it’s important–

If you’re listening to this, one important idea is that something can be true but not material to your investment thesis at a certain price. So, when you’re paying six times earnings, you’re not so much worried about year 25 or even year 20 because if you’re roughly right, that earnings are not shrinking, you’re going to get all your money back and then some much sooner than that. So, I don’t know and I didn’t know what year 20 electric vehicle penetration looks like, but I was fairly confident that just mathematically, it would be almost impossible for it to be much more than 50% over, say, a decade timeframe, and by that point, the rest was upside.

How Value Investors Use Intrinsic Value Without Predicting the Future

Gary: And as far as self-driving, I think, look, it’s a risk, but it’s in that same category where, sure, self-driving, if it’s successful, reduces vehicle utilization, so presumably it decreases number of– the car park shrinks, presumably, I imagine. But again, in the next 10, 15 years, maybe it starts to kick in towards the second part of that range, but again, if you’re buying an investment with a big enough margin of safety, I don’t think you have to answer those kind of tough questions because let’s be honest, what do I know about EVs or self-driving that you or anyone else doesn’t?

Tobias: Yeah, it’s a question. It’s an interesting question, but I like the way you frame that. If you’re paying six times, you don’t need to think out much more than six or so years into the future because you get your money back in the short term.

Gary: This is like a mental model that really hit me over the head probably—So, I’ve been doing this for 25 years. About 10 years into this, I had this realization which is kind of shouldn’t be. It’s like an embarrassing realization because it’s like, “Well, Gary, why didn’t you realize this day one?” But the realization was the price asks the question. I teach a value seminar at Babson, and I always– I go through this example with them and I say, “Look, okay, you have a company, it’s been earning a dollar a share giving you a quarterly dividend of 25 cents. Okay. Let’s say the stock is at 25 cents. What is the question the price is asking?” And a lot of times, students are like, “What do you mean? What kind of question? The price isn’t asking. It’s silent, just a number,” but the price is asking, basically, will this company survive long enough to pay one more dividend?

Now, you bump the price up to a dollar. Well, it’s saying, “Well, we’ll survive for a year.” You bump it up to $10. Now, the price is asking. Maybe something like, “Will this business ever grow again 10 times earnings?” If the company grows, it probably should be worth more than that. And now, you bump it up to $20, now it’s asking, “Will this company grow double digits for five to ten years?” So, at each level, the question the price is asking is very different, but the company hasn’t changed, same company, but the question being asked of you as an investor changes quite a bit.

The Price Asks the Question: A Mental Model Every Investor Should Know

Gary: And so, I think this is kind of an important mental model that you have to answer a certain number of questions to be correct on investment, but those change. And as Buffett says, investing is like a multiple-choice test, but you get no penalty for passing on as many questions as you want to pass on until you find one or two or three, you’re like, “Yeah, I’m pretty darn sure I have a good answer for this one.” That’s the thing PHINIA for me, was that I don’t know the answers to the tough questions that you’re asking, which are legitimate at a higher price, but at that price I didn’t need to know that.

Tobias: Yes. So, you–

Jake: Do the questions get harder or easier over longer time horizon? So, I’m thinking if you could say you know the culture of a company is leading it in the right direction and like 10 years from now you know it’s going to be a better business than it was today because all the momentums are in place and it’s easier to make that bet maybe sometimes than what’s next quarter going to look like.

Gary: This is an awesome point to bring up because I’ve seen this chart floating around, you’ve probably seen it too, where it’s like as time horizon approaches infinity, basically the only question you need to answer is management. And essentially, if you are thinking about an intermediate timeframe, let’s say three to five years, which a lot of value investors, I think, may focus on that time frame, and I think rightfully so, because it’s long enough to get past most people’s kind of like the most competitive part of the market, which is 0 to 12 months. So, I think like two years to five years is pretty good for special situations, reversion to the mean, all those kinds of patterns, if you will.

Then, the question you’re asking as well, is it easier to say, okay, I can’t answer the path there, but I see this is an amazing culture. It’s getting better and therefore I know the destination. I don’t know exactly how it’s going to wiggle there, but I can just kind of– I think the answer is yes, but I suspect the degrees of difficulty is very, very high. And I think there’s a couple of things involved to unpack. One is–

So, I was mentoring one of my interns and we were rereading Nick Sleep’s letters. They’re kind of classic now. Many investors, he transitions from this like

but approach to “Hey, Costco, Amazon, Berkshire, shared economy scale, great culture, big moat, fire and forget.” And what I try to– And I think that’s amazing, great skill, kudos. No criticism whatsoever. The challenge is how many false positives are you going to have along the way? And that’s going to vary by whether you’re Nick Sleep or me or someone else. And also, everything looks more obvious in hindsight. You can go and find a whole bunch of articles that were saying how amazing Kmart was and will Walmart survive or something like that in the early days.

So, I think I worry that your insight is exactly right. And I think the huge wins like the 100x returns or 50x returns over decades probably come from or have to come from that kind of insight. But then, the challenge is, A, is it within your circle of competence, your being whoever is doing the investing. And also, how many other ones that you’re going to pick thinking that they’re Costco but it turned out maybe they’re BJ Wholesale or whatever or thinking you have a Riley Automotive and you get Advance Auto Parts. And also, what kind of price are you paying for that? Meaning when you’re wrong on that inside, how much money do you lose? If you’re paying 40, 50 times earnings at whatever Costco’s at today and you turn out to be wrong either about the magnitude of their investment opportunities or the culture changes over time or whatever, how much are you losing on the ones you’re wrong?

So, I think the answer is yes, true. But I always encourage people I mentor and my students is don’t try to copy people or clone people. Figure out your strengths and weaknesses and figure out what’s within your circle of competence. Learn from a bunch of other people, but then put it through that filter of what can you do really well. So, I’m not sure I can do that really well, but I respect people who can.

Tobias: I think we’ve great– [crosstalk] Just that it’s so competitive from 0 to 12 months. But then also, like there’s no– Quantitatively, there’s nothing predictive beyond five years. I can’t find anything that works in year six and seven and beyond. Like, you get the bulk of the prediction sort of in the early part out to five years. So, it’s a good little– I think two or three to five is the right sweet spot. Sorry, JT.

Gary: Yeah. And I think it depends on like so I kind of have a collection, if you will, of investing patterns that I try to find and I think that time horizon would probably match the pattern. To use an example, if you use a turnaround as an example and I don’t say specialize in turnaround, but it’s one of the patterns I’m comfortable with and I’ve made a lot of mistakes and learned through those mistakes. And the turnarounds kind of follow this arc where new CEO comes in, assesses the problem, formulates the plan, begins implementing, blah, blah, blah. And there is a certain natural timing to those steps that doesn’t matter if you have AI and robots or not. The human component of that of changing culture, changing behavior, changing incentives, there’s just a human element that paces that.

And I think that is a beautiful pattern because the turnarounds, for example, what I found is you don’t do anything in the early kind of 0 to 24 months most of the time. You wait for the implementation. You wait for early evidence that it’s tracking. And usually, that means you have to monitor KPIs before they hit the bottom line. So, you’re not looking for EPS change or free cash flow change necessarily. You’re looking for whatever the intermediate metrics which are going to lead down the road to bottom line success. And then, your probabilities shift drastically because you know most turnarounds two-third plus don’t turn. Once turnarounds start to turn, very few of them go back down. And so, in that sense, you can actually–

Turnarounds 101: Why Waiting for Evidence Improves Returns

Gary: Sorry, I know it’s like being like very wordy here, but you can shorten your time horizon, give up some of that initial upside because the stock will be higher somewhat once you see that initial evidence. But the beauty is that your probability, I believe through experience strongly adjusts much higher than what you lose on that initial stock movement and your IRR is much better. So that’s an example where you’re probably shrinking your time horizon because you’re waiting for evidence.

Because in the early part of my career I would confuse the possible with the likely and say, “Oh, management is forecasting this turnaround. This is what they’re going to earn three dollars, I’m going to take three dollars, multiply by some multiple 15 times 45. Stock is at 20, awesome.” Yeah, but that’s a lot of times the best case and most of them never make it.

Sometimes it makes sense to shrink the time horizon again, not into the like this three month window where you’re trading, noise trading, but in a very concrete way of where you have a specific, I don’t say catalyst, but sometimes catalysts, sometimes business progress, sometimes actual events whether it’s reorganization, whatever, where you are shrinking the time horizon and that event acts as the catalyst to shorten the horizon.

Tobias: JT, do you want to continue on?

Why the Hunt for the Next Amazon Loses More Money Than It Makes

Jake: Oh, I was just going to make that we’ve joked before and were talking about Nick Sleep and all these, everyone not doing enough of their own matching of what fits their strengths and weaknesses. But we’ve joked before that there’s likely to be more money lost trying to find the next Amazon than there ever was made on the original Amazon.

Gary: Yes. Well, a few years ago before AI was the hot thing, I would give my students the description of two companies and I would say, “Okay, so you have these two companies and let’s say it’s 1999. One is old line retailers selling clothing and related soft goods. No Internet presence and no intent to have an Internet presence. The other probably is making kind of the plumbing of the Internet switches, routers and so forth. And let’s say that the Internet is going to take off, that E-Commerce is going to be amazing, which of these companies do you think would make a better stock?” And they kind of suspect, that’s a trick question. Obviously, it’s a trick question, otherwise why would I be asking? But they still don’t–

And of course, most people say, “Well the router company,” and it’s not even a valuation thing. So, the router company is JDS Uniphase and the clothing company is Ross Stores. And again, you have this boring mundane business where you, who could have thunk that this is going to not only survive but thrive, but nevertheless you have kind of a business that has been able to compound capital for a long time despite all these secular changes around it. So, I think again, playing your own game, it’s like in poker. You see unless– Some people are experts at all forms of poker, but when I used to play poker semi-seriously, it’s like, “Okay, I knew two forms of poker, Texas Hold’ Em and Pot Limit Omaha. So, I’m not going to go play seven card stud because I just don’t know the game.”

And then, I think investing what happens is, well, there’s some guru that happens to come around. They have enormous returns for some three-to-five-year period. That probably means that style is in favor, they get on, they write a book, they do interviews and they say, “Oh, look at me, I’m so amazing. I figured this out. This is so simple. If only you do these simple things–” Right now it’s like, “Hey, buy good companies managed by good people and just hold them, never sell them,” something like that. And everyone goes and rushes out and copies them.

But two things, one is even if this person is truly skilled and telling you how they’re actually doing, it doesn’t mean that you are going to be able to replicate that because your skills are different. And number two is there’s a very good chance that this person is just on a hot streak and everybody is ascribing some mix of maybe some skill, but a whole lot of luck over that period of time and calling it all skill. And the crowd saying “Must be all skill. Because look, he wrote a book, he wrote this, he has this.” And of course, ex-post ante, you go and you look at their returns and not only the returns bad, but the asset weight returns awful, they’re like negative.

I’m not going to mention anyone by name, but I’ll imply– I think Buffett always says criticized by category and praise by name. But back in the Internet bubble days, to get us away from the current set of folks in that category, there was a firm that was based in Silicon Valley and their claim to fame investing was that, “Hey, they were closer to where the tech revolution was happening, so they had an edge figuring out these technology companies.” Cover all the magazines, yada, yada. Of course, haven’t heard from them for a while after the bubble popped. So, I think the message is like, just try to be a better version of yourself, not a secondary version of someone else.

Tobias: Gary, you were going to mention a second name. Do you want to take us through that second name?

Gary: Yeah, I mean, Warner Brothers is a current example. And I think it’s relevant because catalysts are important. And I used– It is interesting because I used to think catalysts are for momentum people, because when I used to hear the word catalyst and I used to associate with a, someone needs come, expects the company to beat the quarter and that’s going to be the catalyst, but that’s not what I mean, because like you don’t know if they’re going to beat the quarter. Even if they beat the quarter, you don’t know what was expected, that’s a different game. That’s in that zero-to-twelve-month kind of trading game that I would be the path yet and I don’t know what to do.

I think there’s a category of catalysts and actually Seth Klarman made a good point about his letters several years ago and he wrote something along the lines of a fully uncatalyzed portfolio of equities has a very long duration. And then he went on to explain certain implications of that. So, if you think about equities as bonds with variable coupons and no maturity duration of a bond, kind of center of mass of those cash flows for a bond, it’s obviously heavily weighted by when the bond matures because that’s the biggest cash flow for most of the bonds. For equities there’s no maturity, so it’s like the cash flows and you kind of figure out where they are weight. So, the center of mass of an uncatalyzed equity portfolio is very far away from the point current point in time. If you have a–

And his point was a better portfolio would be yes, some, maybe some in that category, but some in the catalyzed category where there’s going to be a reason for the rerating or even better actual event that forces your thesis to be put to the test yay, nay. And probably the simplest example of that is a bond. Let’s say you buy a distressed bond, let’s say it matures in 18 months, you buy the 50 cents on the dollar thinking it’s money good. Market says not really, that’s why it’s a 50 cents on the dollar. 18 months comes around and again, I’m simplifying, there are probably some in between cases where you have some debt for equity swaps or whatever.

But let’s just say there’s two scenarios. Either the bond they pay back or they don’t. And that’s a very hard concrete catalyst. Hard, I mean it truly will, like you’re going to get your money back or you will know if you were right. And then there’s the second category of catalysts which are much more common in equities, which are these I call “non-hard catalysts.” And so, Warner Brothers was an example of that. So had a long history with Warner Brothers back to when it was Discovery Communications before they did the merger with Warner Brothers that’s been a disaster. Which by the way, as a quick side note, you know, there’s a lot of hate in the stock when some gas fly shareholder is like screaming at how the management is overpaid at annual meeting, which did happen here. It’s one of the signs, by the way, she was probably right.

Jake: Yeah, it’s a little egregious there, wasn’t it?

Gary: No, it is. But the point is, if things are going well, nobody is going to bring that up.

Jake: Nobody cares. Yeah.

Gary: It’s only brought up when people are frustrated, the stock is down, everyone hates what’s happening here. So, there’s a few mental models came together, and I think like Charlie Munger likes to talk about Lollapalooza effects in the sense that if you combine multiple mental models and they all align, you get these like multiplicative effects, that all multiply the outcome many times. There were a few things, like one common pattern that I’ve come up, but intermittently common pattern they found is there’s a good company, bad company combination, which is what we had here. Like the simple way to think about it is let’s say you have a company, it has two divisions, A and B. A is earning two dollars, B is losing a dollar, the company has EPS of a dollar overall. The market doesn’t look too closely, assumes nothing is going to change. And it says dollar times, 15 times, you get $15 share price, good luck, go back into the market.

And let’s say hypothetically, the company just shuts down the money losing business and all of a sudden, its earnings double, go from two dollars minus one dollars to just two dollars. And if the multiple doesn’t change, presumably it shouldn’t or go up with anything because the better business is what’s left behind. All of a sudden you have a $30 stock, so that’s a simple kind of model that I’ve seen time and time again.

So, you had that here because Warner Brothers was a collection of a few assets. The bad assets were the declining cable networks, which we all know people are cutting the cord. They’re switching to data only, plus Netflix or something like that, and they’re canceling their cable bundle subscription. And so that business had high single digit top line decline in recent years. So, the market assigned a very low value.

And then you had very valuable businesses, the Warner Studios, the HBO brand and the libraries attached to those. And those businesses had huge modes. And one good way of thinking about it from Buffett is just asking how much time and capital would it take someone who had abundance of both of those things to make something a bad business. And so here, Microsoft, whoever has the most money today, Nvidia, I don’t know who it is these days decided they’re going to enter this business from scratch and they’re going to make this a tough business for Warner Brothers, what they do? And the answer is not much. Or at least it would take them, you know, 10, 20, 30, a long, long time before they could make a debt. And even then, there’s no guarantee that they would be successful. So, that’s one way. Like, there’s a sand check assisted a business.

So, they weren’t a high growth business, but a very durable mode, very long, kind of early in my kind of origin story I talked about Joel Tillinghast in Fidelity and predictable businesses. So, these are very predictable businesses. Not in a single year because the studio hit rate varies. But on some kind of a rolling five-year basis, you can pretty much say, “Hey, these businesses are going to do roughly X.” And the market was focusing on the negatives and not giving much credit to the positives.

And then, the company announced the reorganization and they basically said, “Okay, we’re going to actually spin off the bad co or I think people use the less polite term starts with an S end with a T.”

Jake: You could say it.

Strategic Catalysts: How Warner Bros. Created an Auction for Its Assets

Gary: This is a family show. So, I don’t want, I don’t know how all the folks are listening, so I’m not going to say it. But I think you can imagine what’s in between the S and the T. And they’re going to get rid of the bad co and just keep the good co. And I said– And that like light went on, okay, this is a catalyst. You had this potential energy or what is the business theoretically worth? That didn’t matter because the market’s like, “I don’t care what you theoretically worth. Nothing is changing. No one is forcing me to value it differently. So, I, Mr. Market, will value however the heck I want. And right now, I’m mad at the management. I hate the industry they’re in. I hate the decline in the cable network. I’m going to value it low and you can’t do anything about it.” Management says, well, no, actually we’re going to do it. And so, they announced these plans and that plan–

Again, I would say it’s in a kind of soft catalyst category because it’s not a hard catalyst. Like when the separation happens, the market doesn’t have to change the price. It’s not like a return of capital or something like that, but it was a pretty good bet that once the main reason for the hate and negativity was going to be know funnel off separately with the law of debt by the way that their main co or the good co would be valued a lot differently or perhaps would be attractive to other to a different set of shareholders. And if nothing else, the cash flow stream from that company would be very valuable and they could just return it. And if that valuation didn’t change, they could buy back shares. In this case you had Dr. Malone on the board, so you had a pretty good guess that they were going to be smart about capital allocation, not just going to blow it.

So, you kind of put all those things together. And the last thing, I’m almost hesitant to mention this because when I’m going to mention this, people are going to think like this. Gary sits and does this all the time. This is the exception, not the rule. Caveat emptor, buyer beware, whatever yellow triangle warning attached, but occasionally this might be heresy like value investors can use options within a long-term value strategy. And again, when I started investing, I used to think all options were complete gambling. And I by the way think that if you never touch an option in your life, you probably are fine. You can still do very well as an investor, but there are times, there are probably four or five different patterns where you can use them well within the intrinsic value framework, especially if you’re disciplined how intrinsic value ranges and have processes and position sizing and all of that dialed in.

In this case, there was an accelerated time horizon which kind of made sense to align with options strategy because like what’s the biggest downside of options? It’s like time. As an investor you ideally want time on your side. So, like the number one, two and three terrible thing about buying a call option is time is against you. If something doesn’t happen within the time frame of the option, you basically get nothing even if you’re right eventually on your insight as opposed to holding the equity. And how do you offset that disadvantage? Occasionally, the option is much, much more mispriced than even the equity. And in this case my rough estimate was the option was trading below 10 cents on the dollar of fair value for that option. And so, you had like a catalyst, you had a pattern for where value is likely not guaranteed to be unlocked. You had this good co, bad co situation. And so, I actually expressed that position in options because I thought that was the most mispriced kind of security related to this event. So again, hesitant to mention it because, I don’t want the blurb to be Gary trades zero-day options. I really don’t. But once in a while, this is maybe the second or third time in 10 years I’ve done this. You can have a very big mispricing stacked on top of a already big mispricing.

Tobias: So, you bought a call? Is that the–

Gary: Yes. And so, the other thing I should have mentioned is I bought LEAPS. So, LEAPS, if you’re listening, you’re not sure it’s like just longer-term call options. So, in the US they probably go up to 30 months, but definitely you can get them for 24 months out. And so, if you think about how options are priced, in the market, are priced by something called the Black Scholes formula. And that assumes basically random movement around the current price with a drift term at the risk-free rate, meaning that the price moves in time forward at whatever, let’s say four percent, the current risk-free rate.

That’s about right for like a short-term option. The longer the time frame of the option, the more wrong that becomes. But that’s still how it’s priced. And so, the longer options are partially mispriced based on that. I don’t want to geek out, but essentially, it should be moving forward in time by something like 10% if they’re not paying a dividend, not by three or four percent, so that spread adds up over time.

And also, market makers who sell you these options, they’re not sitting there and looking at fundamental events. So, if you look at Black Scholes, you have this normal distribution, I assume and promise, this is the most math I’m going to use in this conversation. Mostly because despite my MIT background, I’m not that good at math. But here you have kind of a binary event that changes the probability distribution. And you have this very binary situation where you could have a much higher price, but that’s not priced in.

Using LEAPS in Value Investing: Rare but Powerful Tools When Mispriced

Gary: So, there’s a couple of these mechanics which makes essentially the way the market prices options in this case much less aligned with their fundamental fair value. I don’t want to say intrinsic values because in options intrinsic value has a very specific meaning, so just using fundamental value. So, in this case, I bought Leaps. They’re probably on average like 18 months or so. And normally I wouldn’t be very uncomfortable with that because my time horizon is much longer than 18 months. But again, the event was supposed to be nine to 12 months away. I had an extra cushion of six more months if the spin-off would be or delayed or if the rerating would take time. And again, the price asks the question. I bought them between 8% and 10% of the of my intrinsic value, so I need to be right less than 10% of the time to break even. And if I’m right, And I think, I can make many multiples of my capital with a very precisely define downside risk. So again, for consenting adults only, I would not recommend this to most people. But occasionally if you know what you’re doing, I think there is extra value to be added in that area, which I think is pretty inefficient and rarely talked about.

Tobias: And in the spin, did you take the spin co or did you take the?–

Gary: The spin hasn’t happened. So, what happened was– In a normal situation, I think you just want to reassess because like everything is a price and a declining cash flow stream while it’s hard to value and there are all kind of reasons for why to avoid declining businesses. But if it’s absurdly price, again that old example, if it’s price and one times earnings and I just need to know that they’ll survive for a year, I can maybe underwrite that and be comfortable with that. So normally you want to see where the prices land figure out which is the most the piece that’s still the most mispriced and reassess.

In this case, the catalyst not only attracted public market interest, but also the strategic value I talked about of these com in these modes, these irreplaceable assets attracted bidders. So, you had Netflix come in, you had Comcast come in and you had Paramount Skydance come in. Now when I wrote my letters to my partners about this position, so this is not like Monday morning quarterbacking, I literally wrote that is a very strong positive optionality in the sense that these assets should generate an auction and they should be very strategically valued.

Now, I didn’t know it was going to be Paramount Skydance, but that’s not important. The important thing is it was very obvious that these are assets that are scarce and multiple people would want them. It doesn’t mean that they will definitely be a bid, but that’s a scenario as you’re thinking about the probability distribution of outcomes that makes the right tail better and probably truncates to some degree some of that left tail. So, you have this auction dynamic. And auctions are amazing because we all think of rational investing in numbers. Auctions are so irrational. So, when I was a young analyst–

Jake: You’re on the right side of the auction. It’s amazing.

Gary: Yes. Well, I tell you this quick story. So, I was a young analyst. I convinced them to pay whatever three grand to send me to Harvard’s behavioral finance seminar. And I was like, 22. Everybody that else is there– Me, I’m 46 now, so they’re like, my age, I’m half their age. And one of the Harvard professors, Max Bazerman, did this auction I’ll never forget, and he took a $20 bill, and he sold it at auction for $23 in front of us to some grizzled investing battery. And I was like, “WTF? What just happened?” So, I came up to him after class and said, “Professor, was this just like a trick? Is it like only you can do?” Like, how?” He’s like, “No, I’ve done this hundreds of times to MBAs, to experienced professionals. It always works.”

And I wrote about it in my Substack article. You can check out the mechanics of the auction if you want, why it works. But the point is, it always works. And then years later, I was the speaker at an investing conference on a big stage in Vegas. I was invited to talk and inflation. So, I took a $100 bill, and I sold it for 120. I was a little nervous. I’m like, “All right-

Jake: Blows up

Gary: [crosstalk] Don’t let me down here.” And the thing is, auctions frequently don’t have a stable Nash equilibrium. No, again, geek speak for they keep going. And I think in this case, the mental model is that– So, I’m a big fan of– You know, like, intrinsic value is my true north, I get it, but I think, again, this might be sacrilege to some, but it’s not the only model for markets.

I’ll give you another very legitimate counter example. George Soros and theory of reflexivity. And intrinsic value says, “Okay, there is this correct value, the private value of this business. It acts as a source of gravity, pulls the price towards it,” that’s the intrinsic value model. George Soros says, “Well, no, value doesn’t drive price. So, there are cases where price changes value.” And you first hear about this, you’re like, “What? That makes no sense. How price changes value?” Well, perfect example was Bears Stearns during the great financial crisis.

So, you had this company, there was some concern about its viability. Stock went down. Stock went down. People noticed the stock went down. Some more clients left that caused the stock to go down further and that spiral continued until they eventually were acquired for a pittance by JP Morgan. So, in this case, the price was the mechanism that changed the value because it was a feedback loop. Again, doesn’t apply all the time, but there’s a subset of situations like a lot of run the bank kind of situations, like Bears Stearns where it does apply.

So, an auction model is a different model from intrinsic value. Because the question is these guys are no longer sitting there, the bidders saying, “Mm, what’s the DCF intrinsic value of Warner Brothers?” That’s not– I mean, yes, that’s kind of someone that’s doing that. But they’re saying, “We are alpha billionaires, we’ve publicly committed we want to buy this thing. We are not used to hearing no for answer,” or to quote Tony Soprano, [unintelligible 00:39:49] they’re used to hearing, “Yes, sir.” And they’re no longer buying just a cash flow stream. They’re buying redemption for their ego so they can look a certain way to others and have the assets they want, so forth.

So, I’m not suggesting you should gamble and say, “Hey, if we get intrinsic value, just hope that the auction price will go insanely high.” But it is just the reality of it is it changes the probability distribution of outcomes for prices. And if you just ignore it and say, I’m going to sit in ivory tower and say no, I’m just going to run theoretical DCFs. Okay, but then the situation has changed.

Auctions, Ego, and Reflexivity: How Price Can Change Value

Gary: And I think what I did when it happened very specifically is I’m very risk averse. I have most of my family’s capital in the partnership. I’m not fooling around. So, I took most of the profits from the investment. But what I did is I kind of created upside optionality through a tail position which was relatively small amount of capital but very convex to the auction playing out. And that was proved very successful because it’s been playing out. Now, was that lucky? Sure. Of course. Any good outcome has a component of luck. Anyone who says that there’s zero luck in anything is just lying or selling. But was a random luck like a lottery ticket? No, I think it was a favorable probability distribution that happened to hit as opposed to just blind luck.

So again, they’re kind of, if you combine enough mental models, and you overlay it with your circle of competence of what you’re good at and comfortable with, I think you can do fairly well. Much better than just kind of trying to copy whatever is working lately.

Tobias: Good one. JT, you got some vegetables for us?

Jake: I do. And this is the– We had a little break and we’re back with. Is it season 8? Toby, am I right on that?

Tobias: You must be. Yeah, season 8.

Jake: Yeah, I agree.

Tobias: Happy New Year, everyone.

Building Better Investing Networks: Lessons from Ant Colonies

Jake: I agreed to do five episodes back in 2019. What the hell happened? So, first veggies of season 8, the New Year. So hopefully, these are– I’m setting the bar high for myself for the rest of the year. So, today’s episode starts with a random question that I was pondering one day, as one does. Are there any examples of the farmer’s fable that are actually found in mother nature? So, if you remember– Longtime listeners will remember our segment we did on the farmer’s fable, which is basically that one farmer can have a great year and then a brutal one and it’s all based on luck. But if you add a second farmer with a different luck and you pool the harvest, you can then end up shrinking the swings that happen and that, and you get the same average but much less variance on the luck. And if you add that second– It’s almost like magic, like you get a better geometric compounding return or harvest and you’re able to limit the downside through sharing.

So, I was wondering, mother nature surely has discovered this and transformed random individual uneven outcomes into collective stability. And of course, the answer is yes, she has. And it’s in ant colonies and we’ve done lots of ant-based veggies over the years. So how about one more?

So, it actually led me to a new term I hadn’t heard before, which is trophallaxis, T-R-O-P-H-A-L-L-A-X-I-S, and it’s the mouth to mouth sharing of food among ants. So, here’s the strategy. Like everything, ants live in a world of uneven outcomes. And one may find a sugar cube when he’s out wandering that you dropped at the picnic. Another may find nothing. Another might come lunch for anteater while it’s traipsing around. It’s the same asymmetric return patterns that our farmers might face.

When a forager ant finds food, they don’t store it in their own personal hiding place. They return to the nest and share it through trophallaxis. These tiny droplets, mouth to mouth with their nest mates and those nest mates then share it with others and so on. So, it’s really this variance reduction algorithm, it’s nature’s way of averaging. So, you might be wondering why, mouth to mouth, why don’t they just dump everything into a big central vat? That’s what I was wondering, wouldn’t that be a lot more efficient? But there must be a good reason why they don’t do that. And there is a good reason and it’s that a central vat actually destroys information. So, when a forager ant shares a droplet of food, she’s not just feeding someone, she’s also sending a little data packet to them. And that droplet carries chemical signals, how dense the food is, how fresh it is, how clues about where it came from. In other words, they’re not just moving calories, they’re also moving information when they do that.

So, when it passes from ant to ant, the signal strength gradually fades. But that fading itself also has some information in it. And so if it was all homogenized into a big vat, you end up losing that nuance. And so high-quality nectar would be blended with the low-quality nectar. Fresh environmental cues mixed with old ones and now the ability to infer what’s happening outside of the nest would start to collapse. Plus, there’s the risk of that’s magnified of contagion risk if you are putting everything into the same vat.

So, you could think of this as like a kind of a risk archetype principle. The network is modular and localized failures. And then you have centralized would be globalizing that risk. And I’ll let you guys, kind of make your own analogy and jokes about central bankers creating fragility here, but [laughs] so what takeaways can we borrow from this as investors? Let’s see if we can try to land this. I’ll offer four simple suggestions.

One, maintain a forager network and feed it small steady packets. So, keep a lightweight habit of swapping tiny idea droplets with a network of trusted people you can help feed each other, which is essentially– It’s quite helpful when you’re running low on targets. The goal isn’t to outsource your thinking, it’s to keep your pipeline non-empty and let the network’s uneven discovery rate kind of smooth out the dry spells of your own search through good inbound ideas. Two, share signals, but not full vat conclusions. So, ants don’t pour everything into one soup. They pass these packets along that still carry a lot of context. You can copy that when you share, capture the source of new ideas and timestamp them, plus where you got them from. And Journalytic, by the way, just put a plug in for that, it’s great for this. But it keeps information from getting homogenized and will help your future analysis of networks that you should trust more or potentially ignore.

Three, build modularity so that bad ideas don’t go colony wide. So don’t blast every idea that you ever have to everybody test it in like a small pod first, one or two people who think differently before you kind of bring it globally. And this preserves the independence and kind of localizes contagion of stupid ideas. Bad thesis can die in a corner instead of becoming this like group’s shared delusion.

And four, use a quorum rule before an idea graduates. So, the idea behind this is that ant colonies don’t commit until there’s enough independent ants reinforcing the same trail. And so, you can copy that by limiting your deep dives until you maybe you’ve had two or three independent pings, different people, sources, angles pointing at the same name or theme. So, this can kind of filter out a lot of noise without maybe killing the serendipity. You only have so many deep dives that you can do in a given year, so you want to make them count.

So, to wrap things up. Yes, mother nature has solved the farmer’s fable. Ants pool this upside and then they limit the centralizing risk they share in packets, keep information intact, stop single failures from going colony wide. And so, you could take some inspiration for how you design your idea flow network to more resemble the evolutionary wisdom of ant colonies that’s been honed for more than 100 million years at this point.

Tobias: Good one, JT.

Jake: Thanks.

Tobias: Gary. Do you know anything about the Magnum ice cream spin?

Jake: I’ve eaten a lot of Magnum bars. Does that count for anything?

Gary: Yeah, no, primary research doesn’t count in this case, I suppose. So, the short answer is it’s on my radar screen, but it’s obviously not at the top of my list, so I don’t have anything useful to say.

Tobias: Okay, there was a question about that from the comments. So, what was it like working for Joel Tillinghast? What did you, what did you learn from him?

Gary: Yeah, and again, not to overstate it, I worked in the research pool. Joel happened to kind of click– Joel and I clicked and he became my mentor. I’m in touch with him to this day. Well, a few things from Joel. He was super hardworking. I was there on Saturdays, probably to the detriment of my relationship at that time. Well, definitely to the detriment. And he was there on Saturdays reading annual reports and 10-Ks. But that was really, I don’t say inspiring, but kind of inspiring as opposed to this like, hierarchy of like, “I’m senior, you’re junior, I’m partying and you’re doing groundwork.” He was there rolling up his sleeves reading 10Ks reports.

I also just thought that he was one of the few, very few. So, I have about 45PMs that the Central research pool supported at the time, domestic PMs or more internationally. He was one of the few, probably a single digit number that were actual intrinsic value investors. So, I think it gave me the confidence that worked because he was a successful investor with a very rational approach that worked and that used the intrinsic value framework that I was this passionate young analyst. I just heard Warren Buffett. I’ve been going to Berkshire meetings and gave me that push. Kind of in the sea of, you know, I don’t want to say anything bad about anyone, but a lot of the PMs there were, let’s say-

Jake: Different styles.

Gary: -for the time horizon and– Yeah, different styles, but definitely not intrinsic value oriented, let’s put it that way.
And I think the other thing that stuck when Joel once told me at lunch, I asked him, “How did you formulate your investing style?” And one of the things he told me that resonated was he just said, “I wasn’t sure if I’m a good stock picker. So, I wanted the style that worked with it.” I’m like, “Wait, what do you mean? Isn’t that what we do, stock picking?” But I think I understand what he meant, which is he doesn’t consider himself particularly good at figuring out what new thing is going to go to the moon or what’s going to be the new this time is different kind of situation.
So, he wants businesses that don’t change for the worse and that you can take where they’ve been and use that as a reasonable prologue to where they’re going to be and that resonates to this day.

Jake: Did that lead to more or less concentration in names then?

Gary: Well, concentration is probably, it’s a long topic. I mean, I wrote an article for CFA magazine a while back on it, but I think it’s a natural– It’s an outcome of your other dimensions of investing style. For instance, like Joel had this cartoon in his PM presentation where a guy walks into a store and says to the storekeeper, “I want high quality and low price.” And the shopkeeper says, “Sure, I have both. Which one do you want?” [laughter] The job being obvious that you can’t– Most of the time you have to pick in market. It’s like do you buy some secular challenge, over levered POS garbage or do you buy the company that everyone is saying is amazing compounder, but at 50 times earning, and once in a while you have some dislocation, some insight, some situation, some cat whatever where you can have things that meet your quality and also have a price margin of safety. The overlap between those is not frequent or large. So, if you want to maintain that overlap, you almost have to be a concentrate investor.

And then, there’s degree of concentration. Again, if you are following a Ben Graham strategy of pure reversion to the mean or more pure reversion to the mean, let’s say you’re buying. I know net-nets aren’t the thing anymore for the most part, but let’s say you were buying a bunch of net-nets, you want to package them in a large group, a large bundle because some of them won’t work out at all. But on the average, there’s probably excess return to be had there.

If you’re buying Phil Fisher style compounders where the point is you want before we start with talking about amazing cultures and how things evolving, culturally in the right direction, that’s very rare. So, if you want to escape from the mean in this rare situation where there’s a larger investment opportunity, great management, great culture and a big competitive advantage, you’re going to naturally have a lot fewer investments. So, I think it’s a combination of things. Plus overlay on how much do you care about losing versus winning.

I grew up poor, I’m an immigrant, came here when I was 10. My mom raised me as a single mother. She started welfare for a couple of months before she found her first job. So, I’m just naturally very risk averse. So that probably makes me a little more diversified if I were purely saying, “Well, Kelly criteria, this is what I should be doing. I should have these huge positions.” I’ve seen people have half of their portfolio in the stock and use Warren Buffett partnership days as justification. And I can tell you are not Warren Buffett and chances are this is not American Express during the salad or oil day. So, before you put half of your money portfolio into one investment, just be realistic. So anyway, long answer to a short question.

Tobias: I might be misremembering this, but I thought I read the update to Uncommon Stocks. It’s written by, with the intro by his son. And I think he said that he had something like 800 positions when he died. Do you guys remember the intro like the preface to Uncommon Stocks?

Gary: I don’t remember. I will check that. That’s not what I remember because most of his returns came from a very small handful.

Tobias: No doubt.

Gray: [crosstalk] a couple, a few others.

Tobias: You get that long right tail of performance and so you can put on lots of small positions and or over the lifetime, you accumulate those positions.

Gary: You can but then the challenge becomes how do you manage that. And I think this is again very fascinating topic because I’ve been thinking about the last few years is about how do you react to change investing too? I think value investors are terrible at updating their thesis to new information, me included. And I’ve been working on myself on like frameworks and mental models to force myself to be more pensive to change, especially if something is changing for the worse. Like I used to– Like automatically I bought a stock if it got cheaper, price dropped, I’m like, “Man, yeah, I’m going to show the market, I’m going to buy some more. Look at me.”

Jake: Look at my conviction.

Gary: Yeah, terrible way to invest because you have to compare the new price to the new circumstances. And there was a perhaps apocryphal joke with Fidelity going around how a PM lost a quarter of his portfolio in a single stock. It never having been more than a five percent position or something like that. And it’s like, how do you do it? Well, you’re like, goes down, you re-up, it goes down, you re-up. And so, I think that to your right tail, to your 800 stocks kind of thing is if you are kind of a [unintelligible 00:55:46] watering the flowers but then cutting or reversing what you said, watering the flowers but then cutting the weeds, then yes, you could start with a very wide field. But perhaps it’s create a detection mechanism for these truly exceptional outliers. And once you get incremental evidence, you kind of bet more.

I’ll tell you, Will Danoff, who’s one of the other amazing investors I had the privilege of working with at Fidelity, once told me it’s like, I was watching Will and he was doing the opposite of what value investor was supposed to do, he would sell a stock when earnings were bad and the stock was down. He would buy more when the stock was up because earnings were good. And I’m like, and say that, I’m like, “Bro, what are you doing? It’s like pulling momentum stuff. Like it shouldn’t work, like why?” And kind of I politely asked him about it and the whole one day he kind of turned to me, said, “Well Gary, you play poker?” I’m like, “A little bit.” He’s like, “Well, what do you know– When I get two aces, I bet, right?” I’m like, “Yeah.” “Well, when I get a third ace I bet more, right?”

And that stuck with me because it’s like, okay, you can’t have a static view of value, right? Value is an estimate number one and a range, and it changes, right? So, you think something’s worth a hundred. That’s not the truth, it’s your estimate. There’s a range, maybe it’s 50 to 150. And that value can also change through events. Competitors acting, management acting, whatever. And so, I think reacting to changes in value or events that would inform the value changing, super important. So yeah, if you’re going to do that, sure, start with 800 stocks. But if you have a portfolio equal weight of 800 stocks, you’re not doing the Phil Fisher approach, I can almost guarantee you that. At some point you have to have concentration in the winners because these are power law, distributed type of investing approaches like VC. VC is great by the way because you start with a very broad fund, but you feed the winners and you starve the losers.

Tobias: Gary, what was the name of the ticker of the first stock that you were discussing with us?

Gary: PHINIA? PHIN.

Tobias: Just we’re coming up on time so let the folks know where they can get in touch with you or how they can follow along with what you’re doing.

Gary: Yeah, absolutely. First of all, again, thank you for having me. My Substack is a great place. So, I write the Behavioral Value Investor on Substack, basically talking about the intersection of long-term value investing, behavioral finance and how to use the two to become a better long-term investor. And I’m pretty active on LinkedIn, so happy to connect there as well. Just look for my name, Gary Mishuris. And happy to connect that way as well. So, if you want to reach out, please do. Happy to hear from you.

Tobias: JT. Journalytic, any updates there? Anything you want to let the folks know about.

Jake: Two asks. One, today is the seven-year, if you can believe it, anniversary of The Rebel Allocator. So, that was I know-

Tobias: Whoa, congrats.

Jake: -long time ago different person wrote it I think but so that’s kind of fun. And then second thing is Journalytic related and we need UI developers so if you or somebody you know is a UI developer and loves investing even better check out we have a LinkedIn hiring post for it so please send them our way they will be put to good use and it’s a great team to join and we’re building some really cool stuff that’s going to come out this year that’s going to be really more. Stay tuned for that.

Tobias: Good one. Thanks folks. Gary Mishuris, Silver Ring Value Partners thank you very much for being with us today.

Gary: Thank you, guys appreciate, you having me.

Jake: Thanks Gary.

Tobias: And we’ll see everybody same bat time same bat channel next—

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