You're listening to Teip on today's show, we have a returning guest that always has such valuable insights, and that's Mr. John Huber, who's the managing partner at Sabre Capital Management. During the discussion, we talk about how to make growth assumptions for companies, how to identify high quality businesses with an enduring competitive advantage. And then we talk about how covid is impacting certain businesses. So without further delay, here's our interview with John Huber.
You are listening to the investor's podcast where we study the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast, I'm your host, Broaddus, and as always, I'm accompanied by my co-host, Preston Peche. Today's topic is value investing in 2020. And we are grateful that you, John, have taken the time to speak with us here today. We really couldn't find a better guest to guide us through this.
Thank you. Thanks for having me on. I really appreciate it, John. My first question to you is about investment ideas. Investors generate investment ideas in different ways. They might start with a stock screener that might speak to a mastermind group. Everyone pitches a stock or it might be on the investor's club dotcom. I mean, this is just to mention a few options. How do you generate your investment ideas? So it's a great question. I get this question a lot from prospective investors that people want to understand the process.
And so to me, investing is a negative art, meaning identifying what not to do is often as important as knowing what to do. I think a lot of investors think of investing ideas like an assembly line where you simply piece together certain inputs and outputs the finished product. And in this case that would be an investment idea. But it's my observation that the world doesn't work that way. I think great ideas involve a lot of preparation, a lot of hard work, diligence, patience.
But serendipity plays a role as well. So I think you need to position yourself to be open to those serendipitous moments because they come from unexpected places and sources and they come at unpredictable times. So we know this business requires great investment ideas. And if that's true, that great investing ideas come from unexpected places. And I think you need to solve that problem by using different methods. Asking an analyst to come up with a new idea each month or each quarter is going to be suboptimal because great ideas can't be produced on demand.
So for me to solve this problem of finding great ideas, I've tried to come up with a way that I think works for me. It's not the right way to do it necessarily for everyone. But for me, the process is to think of myself not as an investor, but more as a student with the objective of learning about a variety of subjects. So my wife always she's always wondering what what is I do all day? And she's never quite sure how to describe my job to other people.
And so I tell her the easiest thing to say is that I'm a professional student, which is also causes more confusion. But I really think of myself more as a good nonfiction writer who's working on a book. My work involves a lot of reading, a lot of note taking a lot of phone calls to learn from people who know more than me about a specific topic. And then finally, a lot of time thinking about everything that I've been working on.
So the goal for me is simply to learn. And more specifically, I'm trying to learn about a different business model. I try to learn why some companies are better than others. One of the things on my daily task list is to read a report or a filing on one new company every day. So I read a lot of the primary sources, a lot of the annual reports. I read a lot of the write up Sandvik and other places.
I do find it really helpful to learn from others that share their work. So I read all that stuff. But the day to day goal isn't for me to find a new investment idea, even though that's the desired outcome. To me, it's more a process of trying to position yourself to learn, be curious and be OK. Spending a lot of time reading about a topic that might not lead to a specific action within the portfolio at that moment.
And the thing about it is to boil down my process. It's to try to produce a watch list of companies or build a watch list. I think of my job every day is coming in to work on building my watch list of companies that I know well and then just waiting for the market to give you a price. But that process involves, like I say, a lot of reading and a lot of patience. If you have a goal of finding an investment idea this week or this month or this year or this year, try to find a couple of new ideas every year.
But if you're trying to manufacture an idea, I think that's where investors run into problems. So, John, we all learn from Warren Buffett that we're all supposed to invest in so-called wonderful companies and if only it was that easy. Could you could you please provide some examples of qualitative and quantitative factors to help define what a wonderful company is? The best investments over the long run come from the best companies. So if you're trying to figure out which stocks are going to go up next year, then there are all sorts of other factors to consider.
But for long term investors, it's really simple. The best investments come from the best companies over time. So the question is, how do you find them? Peter Thiel gave a talk. He called Competition is for Losers. And this was at Stanford maybe six or seven years ago. And you can find a talk on YouTube. But I had two takeaways from this talk. Basically, the two types of companies, monopolies and non monopolies. And he says monopolies make money and non monopolies don't.
He's got an observation that I think is actually quite accurate. And he basically says monopolies are always trying to say they're not monopolies. And this is sort of relevant in the current news. We just had the big five or four of the big five tech CEOs on Capitol Hill at the hearing on antitrust. And they're all basically trying to say that they're not monopolies. Google says their competitors are just a click away, they like to say, and all of them are trying to say they're either a small piece of a big market or they're in very competitive markets.
And so you have the monopolies. They're always saying they're not monopolies. The non monopolies are always trying to say that they are monopolies and just sort of an interesting observation.
So to me, it's not exactly black and white, but I think it's a good mental model to keep in mind that monopolies are the businesses that make money. And I'm using the term loosely. I don't think it's as black and white as Peter Thiel suggest. There are some companies that can produce profits that are obviously not monopolies. But again, to me, you have a really simple choice as an investor. I think there's two categories to look at and the first categories is the company monopoly.
And the second category is, is the company building towards becoming a monopoly? And again, it's not the Sherman definition of monopoly, it's not the antitrust laws, but it's basically looking for a company that produces high returns on capital and can produce economic profits. And so what are some attributes that these monopolies or future monopolies have? There are some common denominators. So obviously the business has to make money. A wonderful company has to generate high returns on capital.
And that's where, again, that's where economic value comes from. The goal of investing is to simply produce high returns on your capital. And the same goal exists for businesses is to earn high returns on the capital that investors funded it with so high returns on capital to meet the definition of a great business. That's the result. There are some attributes that or characteristics that I think can lead to that result. And the first one I mentioned is adaptability to change.
So I think it's extremely important nowadays because I think change is a constant. Now, I've said this before. Buffett likes to say that he invests in companies that are resistant to change. But I think the critical question today is to ask whether the company is adaptable to change, because I'm not sure there are any companies, even the monopolies that are resistant to change any more. The world moves and changes so quickly and barriers to entry are generally so much lower that if you're not willing to embrace change, then change is going to embrace you and that will be good for your company.
So obviously management is important, but also the employees at the company. Human capital is much more valuable today for many companies in the physical assets alone because people and the ideas they generate where much of the value gets created. So I think it's important for the company to be able to retain and attract talented people. And I think it's important to be adaptable to change. And you and I did a podcast last year on Facebook specifically, and I think Facebook's an example of this, this adaptability to change.
Zuckerberg is, in my opinion, a great CEO, despite all the hate he gets. I think he's very adaptable to change. And it's a quality that is valuable. Facebook IPO when the company was facing what I would call an existential crisis, and instead of doing what would have looked better to Wall Street in the short run, which would have been to continue to build the cash coming from the desktop advertisements, Zuckerberg saw that the world was heading toward mobile and they needed to rapidly reinvent their business or would soon die.
So part of the solution there was famously buying Instagram, which was a mobile first application, but part of it was reassigning engineers and staffing them with the task of killing their golden goose, essentially in order to figure out how to find a way to fit advertisements onto an app made for a phone. So and they were able to do this, and that was probably the most significant. But the company also had to make a shift when it became clear that Snapchat had found an interesting idea of vanishing messages.
So they tried to buy Snapchat. They got rebuffed and they created Instagram stories, which has been a massively successful product, both in terms of adoption and in terms of collecting revenue. And so the company. DEBITED from desktop to mobile, then from text to photos and then video, and now they're trying to adapt again as the latest trend, the addicting videos of Tic-Tac. And they just announced this week that there are they just they announced this previously, but they just actually launched their product called Instagram RELS, which is basically a tic tac clone.
So we'll see if that will end up being successful. I'm not sure if it will or not, but it's another example of how forward thinking the company is and how flexible the culture is there, which I think is good. So another example of an attribute that I tend to look for is high gross margins. And this is one that is not necessary. So not every company has to have high gross margins. In fact, many great companies have low gross margins.
But in general, I'm attracted to high gross margins. And we can keep talking about Facebook for a second because of their incredible business model, which users generate the content. So Facebook doesn't have to spend money acquiring content and also advertisements ourselves serve and they're essentially automated. So Facebook doesn't need nearly as large of a sales staff. They don't need the sales staff that a traditional advertising firm would require because the ads are automated. So Snapchat is an example of SNAP has forty seven percent gross margins.
Facebook has eighty one percent gross margins and those largely because of those two differences. So the high gross margins are attractive because it leaves a lot of money left over to spend to pay engineers to work on R&D, sales and marketing general aspects. And there's still a lot of money left over for shareholders. Another thing to look for is economies of scale. I think a lot of great companies exhibit this characteristic, and this is simply a business that has high fixed cost but very low marginal costs.
And this does two things. The high fixed cost makes it hard for new companies with little or no revenue to enter and low marginal costs. And so Copart, here's a great example of this. The company owns a large percentage of the auto salvage auction market. So if you total your car in an accident, the insurance company takes it and then sells it to a buyer at one of copilots auctions. And Copart invested a lot of money over the years to to buy the land and build this model that they have essentially the junkyards where the vehicles are stored temporarily.
But Cowbird doesn't actually buy the cars. It just takes a commission for connecting the buyers and sellers. So there's no inventory risk. And each sale that runs across its network, the auctions are all done online. So each sale is very, very high margin and each incremental dollar is very nearly not quite pure profit, but it's very high margin. And so the business is high fixed costs, low marginal costs, and it's difficult to replicate the assets in the network that Copart is built.
And so another example is Amazon, obviously a well-known example, Amazon developing its warehouse network in the early days, high fixed costs, but then they allowed third party sellers eventually to use that infrastructure and they took a commission on each sale. And that that meant each dollar of incremental revenue was pure profit. And they built the infrastructure initially, which was expensive to build and carries a lot of cost to maintain. But each new dollar, again, has very low marginal costs.
Now, reality, Amazon and others like Netflix is another example. The company, in theory, has fixed costs of very high margins on a certain amount of revenue over that fixed cost base. But in reality, what they do is they end up reinvesting those high margin dollars back into the business. And this does two things. It adds more fixed cost to the initial base, which still is the ability to reap the high margins. But it also makes it harder for competitors to attack the business because now the fixed costs required to compete are even greater.
And so it helps widen the moat, which Amazon is famously tries to do. Netflix sort of has a similar strategy to buying content. The content is somewhat fixed and can be spread over the entire user base. But then each incremental user, incremental new user that wants to access that fixed amount of content is largely profit for Netflix. To me, this is somewhat debatable because Netflix, I'd argue the content is more variable than fixed because if they stop making new shows, users might obviously leave.
But I do think there is at least partially a dose of economies of scale that works in Netflix's favor there. So those are some examples on economies of scale.
Another thing that has been a theme of mine over the years, Sabre's portfolio is toll roads. So the toll road is obviously a metaphor here. It's a business that owns some asset that is so valuable that it can charge a price that far exceeds the cost to deliver that product or service. So customers are willing to pay that toll for access. And a great example here is VeriSign. This is a company we owned in our fund for a number of years, and VeriSign owns the dotcom Internet domain names.
And so anyone who has a website address ending in dot com or dot net pays an annual told VeriSign. And the company has one hundred sixty two. Domain name, it collects eight bucks a year for each one, so it's a great business cause virtually nothing to serve a new website. So every time you sign up for a new website is essentially pure profit for VeriSign. Electrons are essentially costless.
Basically, VeriSign is has essentially no cost to add an incremental new dot com domain to its user base. And so it's got sixty five percent gross margin or sixty five percent operating margins. It's incredibly profitable business and it does have leverage for those reasons I just described. So that's that's a toll road and that's about as close as a toll road as you can get, metaphorically speaking. But another example are the companies that aren't exactly toll roads. But MasterCard is an example of a business that to me is essentially a toll road on global commerce.
So they did one hundred eight billion transactions last year, ran across MasterCard's network, four point eight trillion in dollar volume, which grew 13 percent. Transactions actually grew 20 percent. So, you know, in a nine trillion dollar economy, there's actually still runway ahead. But MasterCard's position, along with Visa, they're basically toll roads on global commerce. If you want to participate in the global economy, it's likely you're going to have to pay MasterCard's toll.
So it's a monopoly in a sense. The last factor I wrote down here was intangible. There are certain intangible qualities. This is sort of a catch all category, but sometimes a company's value comes from something that's intangible. And so I'll give you an example of numbers. A homebuilder home building is a tough business. You have to sink lots of money into the land, which you need to build homes on, obviously, and then you sell the homes.
Then you have to replace the land. And so the land's expensive. And since builders don't generate huge profits, they never have enough money to pay for the land. So they finance the land with debt to finance, most of it with debt. And this leaves them vulnerable when the next downturn comes. So they're left with lots of land and inventory that's hard to sell and then a bunch of interest charges that don't go away.
And so MVR escapes this by using options to tie up the land that they need. So they put up a small fraction of the cost of the land. And essentially the seller finances the land for the cost the option premium. So NPR finds the buyers when they want to build a house and then only then do they exercise the option to take down the land so they're not left holding the bag if a downturn comes and the worst case is they lose their option premium in that case.
So NPR has no debt, requires much less capital, faster inventory turnover and all of those lead to better returns on capital with less risk. So it's such a great model. Homebuilding is more or less a commodity industry. Why wouldn't other builders copy it? And some are trying to do that. But it's very hard because of the way most builders incentivized their CEOs. So if you go through all the proxy statements of NPR's competitors, almost without exception, you'll find that the bonuses and the compensation structure that exist are often linked directly to total volume of homes sold or total earnings or total revenue or something on a gross basis, not necessarily the return on capital that's produced just the total amount of volume that's produced and regardless of whether the growth creates any value.
And so the easiest way to grow homebuilders revenue and profits is to go out and buy more land and build more homes. And in homebuilding, that means taking on more debt and not sharing the profits with a land developer. And so they're incentivized to make as much as they possibly can with and they're using other people's money to do that. So they're incentivized to go out and create gross profits without any regard for the return on invested capital. And so so MVR has a model that is very hard to copy because of the incentive that exists in the industry.
And I'll give you one more example of an intangible sort of a miscellaneous advantage that I just noticed recently. I was reading the S-1 filing for Rockit Mortgage, I think it's called rocket companies, but Rocket Mortgage or Quicken Loans is their brand name. They're one of the largest mortgage companies in the country. And this is interesting because I just read an earnings press release from a company called Mr. Cooper, which is a strange name, but Mr. Cooper was touting the stat they called industry leading, and the stat was their recapture rate.
And so mortgage company collects money by making loans and it also collects money by servicing loans, which means collecting payments, passing the cash flows along to whoever owns the mortgage. Usually an institutional investor who owns the security that the mortgages inside of. And so servicer collect a small fee for each monthly payment that they process, basically, and it's only a few bucks on each payment, but spread across thousands of mortgages over many months and you have a nice residual stream of cash flow.
But the problem for servicers is that their customers might refinance. So this means they might find a new. Company with a better rate, and that would mean you lose the stream of cash flow. So mortgage companies are always trying to keep or recapture these clients when they refinance. And so Mr. Cooper was touting that 30 percent recapture rate, which beats for every hundred people that refinance. They keep thirty six of those refinances and that's above the industry average of twenty two percent.
But interestingly, rocket mortgage has a recapture rate of seventy six percent, which is three and a half times the industry average.
So why does Rockit mortgage do so well at keeping the customers when they refinance? The answer could be a variety of things, could be their sales culture. It could have to do with their technology. They have a really good user interface. It's super easy to get a loan from Rockit, but they're good at retaining customers and in the mortgage business, that is incredibly valuable over the long run. If you can keep more of those customers and retain more of them, the value of your Mazars, the mortgage servicing rights that you own are more valuable than they would be with someone else.
So those are a few attributes I look for when seeking out wonderful companies, as you say, to invest in. Thank you for a fantastic response to that, John, and I think along those lines of intensifying moats, I have to say that I love the quote on the front page of the website where you say that, well, I probably shouldn't say your quote. I think Buffett might have a different opinion, but the famous Warren Buffett quote, that is, I don't look to jump over seven foot bars.
I look around for one foot pass, I can step over. I just absolutely love this has been my signature on our value investing forum for years now. And so with everything you just said to us about identifying Moat's, my question for you is which investments in the past has been one foot pass to step over? That's a great question. So one foot hurdles are a central piece of my strategy and it's a pillar of my investment approach that sometimes even the biggest, most well followed companies can get mispriced by the market.
And so you just have to look at the 52 week high and low list in any given year. Doesn't have to be a volatile year like 20, 20. I've done this over the last four or five years. I do this about once a year and you can look at the variance between the high and low price of the biggest stocks in the market, whether that's the S&P. Five hundred as a whole or whether that's even the top 10 mega caps.
I have a chart that I keep at the top 10 companies each year, the biggest 10 companies. And it's remarkable how much their stock prices change in any given year, the stock prices. This is obvious to most people, but it's worth noting because it is so interesting, the variance between the 52 week high and low is usually around 50 percent for the mega caps. And obviously the fluctuation of their actual underlying value does not change by anywhere near that much.
So that just tells you that there's from time to time opportunities to capture value even when the company is well followed.
So the idea that you have to have an edge and informational edge, I've never I've never bought into that theory because a lot of times the biggest companies in the market get mispriced. So when you look at one for hurdles, they often come from this category, not necessarily the biggest companies, but companies that are well followed. There is no information edge, but from time to time, for whatever reason, the stock gets mispriced. And so an example of this is happens to be the largest stock in the market.
But Apple is an example. It's a stock we've owned for a number of years. And I think it's been a one for hurdle on a couple of different occasions. But initially, back in early twenty sixteen, the stock was trading at eight times free cash flow. So you had one of the world's most valuable brands and one of the stickiest ecosystems trading at an incredibly cheap price relative to what I would consider to be normal earning power. And it was it was a remarkable situation where the market was, I think, doing two things.
One is they were valuing the company and Apple always used to get value this way. It's in recent years it's it's gotten revalued. The market has started to value it more like I think it should be valued more like a consumer brand, like a Nike or Starbucks or some of these great consumer brand companies, because that's what it is. It's probably the most valuable consumer brand in the world. But for a long time, it was valued like a consumer electronics company with hardware margins.
And the idea was for Dell, your margins are going to revert to the mean at some point, or if your HP or any of these commodity hardware companies, any sort of economic profit you create, is going to be fleeting. And that was sort of the narrative around Apple in early twenty sixteen because Samsung had a phone that was competing and Google was starting to compete. Amazon was even competing at that time and people were worried about Apple's margins. And I think the other thing was just simply that Apple's iPhone sales had temporarily stalled.
And so even when a majority of market participants were agreeing that Apple's long term future was still good, they still have bright future people worried about the next three months, next six months, next 12 months. And so people would say things like the stock's dead money or something. And so no one wanted to own the stock. The stock got really cheap. And so I think that's an example of a one foot hurdle. The broader point to me is is very much worth paying attention to very high quality companies that for one reason or another, it can get mispriced.
And Apple from that point has compounded at 40 percent a year for the last four and a half years. It's a really remarkable situation in a stock where there's two hundred analysts, there's absolutely no informational edge. And so the lesson for me from observing that from watching Apple over the years is that you don't need an informational edge. Informational edge can be very valuable, obviously. But I think in nowadays where information is much more of a commodity because the barriers to entry, the ease, it's much easier to acquire information.
So it is becoming more of a commodity. And so I think the edge now is called time horizon edge, looking out longer term, being able to look out three, four or five years when the market has a hard time. Most market participants are not willing to look out past the next year or so. I think that's a good example of a one third hurdle.
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That's P Betacam less tipi experience a saving in your shipping costs with a free trial of Central online from Pitney Bowes. All right, back to the show. So, John, when we create our investment thesis and make our growth projections for a company, a really important component is the addressable market and the addressable market size. For me, that's always been a real challenge to try to understand and wrap my head around in a realistic way. And when you're listening to the corporate management talk about how much of the addressable market they plan on capturing, they're obviously incentivized to blow it way out of proportion.
And it's it's not something that I really put a lot of credence in whenever I hear management talk about what they're going to address in the addressable market. So I'm kind of curious how you look at this and just some of your thoughts on it. I'll go back to something Peter Teal said in that same talk that I just referenced earlier, he said that great companies create X amount of value. He has this equation. He says great companies create X amount of value and then they capture Y percent of X.
. So that's the equation. X is the value created. Y is the share of that value. So you can think of X is the market size and Y as the share of the market. And to me, the most important variable in that equation is the Y, not the X. The Y is the percent of the market because most companies will not get to monopoly like economics with a tiny share. There are a lot of exceptions. Obviously you can I mean, there are some great companies.
Geico had one percent market share and it had phenomenal economics and now it's got 10 percent market share. And so there are a lot of exceptions to this. But I think generally, if you have a business with a tiny slice of a huge market and a business with a big slice of a smaller market, the letter company will usually have much better economics, much better returns on capital. So ideally have a company with a big share of a big market.
And then that's when you get the true mega cap monopolies like the Googles in the Amazons. But I think most investors, and especially most startups, are much too focused now on the size of the TAM, the total addressable market, and they're not enough focused on building a strong position in whatever market they're in. And I think it's easier to for companies to build a strong position in small market first and then expand from there. I talked about Amazon and they first dominated a small niche selling online books, and then they went to different e-commerce verticals and then they went into ancillary businesses and then they went to the third party platform and then they started us.
So what you're getting at is even beyond just the addressable market, you're talking about businesses going upstream and downstream from their original product line. Do you have any other examples of that in practice? I have a friend who specializes in buying and selling single family homes in the two hundred fifty thousand dollar price range near a local military base. He made thirty seven investments last year. He focuses almost exclusively on a single asset class in a very small submarket, in a very specific price point.
And he even specializes in how he sources these assets generally from he generally gets them from the courthouse. So he's built up this business over the years and he has come to be extremely good at it. And he's got a fairly sizable payroll. He cuts out the third party vendors so his own staff do all the repairs and maintenance on the homes. And he slowly has built up his own painting crew. And then one day it dawned on him that he could start painting for other real estate investors and then other homeowners.
And so now he's got a company that's booked through the fall and he's doing very well with it. So he plans on kind of doing the same thing for property management, just basically using what he's created for his own business and subcontracting it out to other people that want that service. So I told him he's like a mini Amazon. He's developed an expertise for his own properties, and then he sells that service to third parties, which is really nice, high margin revenue for him.
And so it's a great little business. Now, obviously, the TAM is tiny and the total value of his company has a ceiling, obviously, but he's created a significant amount of economic value for himself because he didn't start out by saying, hey, US real estate is a twenty two trillion dollar asset class. He started out by saying, hey, let me work and build up some expertise here in this small little market and try to get good at one tiny market and then go from there.
And so I think this makes a lot of sense as a general business strategy as well. So how do we identify the TAM? It's hard to know, but I'd first look for companies that are in strong positions in their markets and then working toward building a strong position. And then secondly, look at the TAM. And I think the world is filled with mediocre companies in massive markets. And one last point I'd make here, Steg, is that the very best companies often figure out how to expand the markets that they're in.
So the best management teams tend to expand the TAM. So Facebook and Google are famous for this. They created businesses that wouldn't have existed without the products that they own and they operate. There are thousands of small businesses that exist solely because they can find customers on Instagram. And so Facebook's market wasn't the size of the digital advertising market when they started or even the advertising market overall. It was the advertising market that they would help single handedly create. And lots of other examples as well.
Etsy created an entire ecosystem of homemade stuff that can be sold on its platform. They created an entire market that wasn't there before. Apple's App Store created a huge market. It started with 50 or I think Tim Cook just said in the story the other day, it started with five hundred apps, 12 or 13 years ago. Last year did five hundred billion in total volume. Basically the total amount of commerce that went across that app platform, the app store has estimated to be half a trillion dollars.
So incredible business. An entire generation of developers have created businesses because of the App Store. Instagram doesn't get started without the App Store. Most likely Uber might not exist without Apple. So. So there's something to keep in mind. The very best companies can expand their markets. But generally, I spend a lot more time thinking about the competitive position than I do thinking about the size of the market. So, John, Warren Buffett has this famous example where he said that it was obvious to everyone that the car would replace the horse as the preferred method of transportation.
However, what was much less clear was to pick the winner in the industry. So I know this is a grateful question to ask, but how do we pick winners in an industry? That's a great question, and I think it goes back to the what I said before about adaptability to change. So I think companies now have to have an element of flexibility, malleability. They have to be able to change with the current environment. And the reason for that is because the speed of information, the speed of technology, the speed of evolution in the business world is so great that companies can no longer rest on their laurels.
So you can no longer rest on a competitive advantage that was built 50 years ago because that advantage is now being attacked, because it's a lot easier for new businesses to get started, partly because of things like the App Store, things like Facebook and Google. It's easier to reach customers, to acquire customers, and it's easier to start businesses that can grow very rapidly and very quickly over the Internet. Even if they operate in the physical world, they can acquire customers using technology.
So, yeah, it's very difficult to pick winners. I don't have a good answer to the question, Steg, but I would focus on companies that are building strong positions in their market. And like I said before, focusing less on maybe the size of the addressable market. Don't worry about the twenty two trillion dollar US real estate market. Think about how can I dominate the small niche in Wilmington, North Carolina, or something like focus on companies that are building strong moats, have strong competitive positions in their markets, and then think about how to expand and how to go from there.
So I think the winners in an industry will be exhibiting the future winners in a given industry will likely be exhibiting some characteristics of those quality companies that we talked about earlier. They'll have some degree of profitability or the unit economics will look attractive now and each situation is different. That's part of this game. It takes critical thinking and analysis to determine that, but there's no way to fit that into a box. Every situation is different. It takes a lot of thought and a lot of flexibility on the investing side as well.
You have to be willing to adapt your thesis as things change and businesses get attacked and businesses grow. And that's part of being an investor, I think, these days. And I really like that you didn't have a fixed set of rules of how to do that. I mean, the question that I asked him, not even Buffett said he had a recipe for that. But in continuation of that, we do know that the mighty fall and companies have shorter and shorter tenure in the SP 500 and disruption of existing business models are just happening faster than ever.
And it seems like it's accelerating.
So keeping that in mind, what are the implications for individual stock pickers like us?
It's a great question. I think the S&P five hundred index is an active index in a sense, because what it does is it's a great investment vehicle because it allows you to own the best companies at any given time. So the best companies, meaning the biggest, those two don't always equal the same thing. But generally over time, companies that fall out of the index that die off the Pennsylvania Railroad, even a company like General Electric, which is still in the index, but a shell of its former self, these companies come and go.
And that's, as you say, you have to be aware of. That is a stock picker. You have to adapt as companies adapt and companies change. And so it's the same theme that I've talked about. I think the important thing is focusing on companies that have competitive advantages currently and then finding companies that are durable. So durability is a very important feature or attribute that I look for when I'm looking at companies as companies that can withstand these changes and they can withstand attacks.
So they have good economics now, but they have some competitive advantage that gives them durability. And there's a lot of things I talked about earlier. Maybe it's a tollroad business. Maybe it's a company that has high fixed costs that provides sort of a barrier to entry. But I think, again, the most important thing, not to beat a dead horse, but to me, the most important attribute you can look for now is high quality human capital, meaning the talent level of the employee base, because that's where ideas that's where great ideas come from.
And that's where you can create a culture that can adapt. Humans can adapt to change if they're in the right environment. And so the companies that will do best going forward, I think will be the ones that can change and navigate these waters that you're talking about.
So, John, you've said that the vast majority of losses in the stock market come from picking the wrong business, not picking the wrong valuation on the right business. Elaborate more on that idea and provide a few case studies of both the scenarios, if you could. I think my mistakes have come when I focus too much on what I'll call optical valuation, and that means like the current P ratio, for example, the current price to free cash flow, as opposed to focusing on what the business looks like five to seven years down the road sometime in the future.
So the longer holding period, the more important it is to own great businesses. So one of my philosophies is that and I mentioned it earlier, but the tenet of our approach is that great, great investments come from great businesses. But it's also true that the longer you're holding period, the more critical it is to own quality companies. Because in the short run, like I said before, valuation drives a lot of stock price reactions is actually more important to consider what someone else is willing to pay for your stock.
If your holding period is only a year or two, you're more concerned about what somebody else is going to pay you for that stock or what the perception of the market will be in a year or two, versus if you own a company for five, seven, 10 years, you're much more concerned with what that company is going to look like. So Buffett says the tailwind, something that effect of great businesses have tailwind or time is the friend of the great business something to that effect?
If I could boil down the best advice from Buffett, it would be that by the great companies and understand the simple fact that time is the friend of the great business over time. So that's really what I'm trying to point out in that I think in the blog post you're referring to, the other thing about great businesses is they're safer, they produce more value, but they're also safer because they they're better at handling adverse environments. I'm a big believer in the idea that a margin of safety comes not just from valuation, but from the quality of the business, because great businesses can adapt to change.
They can weather economic storms more efficiently. And I think we just saw this with covid is the great companies have said right now covid is unique because some of the great companies are strangely well positioned to basically navigate the waters that we just went through. And that's sort of a unique situation. But generally, I think that is true. The best companies in the financial crisis were the ones that came out the other side with more market share. It happens every recession that the best companies will invariably see some sort of cyclical volatility to their revenue at that moment.
But they will come out stronger the more market share. They'll be a better business and they will not just survive, but in some cases thrive. So the same thing that we just saw with covid has been an extreme case of this, but it happens every single recession. So I think you're better off owning the better companies. And my mistakes, like I said before, I come from the times when I get more attracted to the current valuation. So Wells Fargo's a mistake that I made recently.
Actually, about a year ago I bought Wells Fargo. And that company has a lot of issues. It's got some cultural issues. It had some management issues possible. The new manager is doing much better or will do much better. And he's attempting to change culture. But it's hard to change culture with two hundred and sixty thousand people. That's something that I've observed and I've learned. And some issues that Wells is facing is to no fault of their own.
Interest rates are extremely low. Spreads are extremely thin. Net profit margin, net interest income, profit margin of a bank are at all time lows and they're not as diversified as some of the bigger competitors. So they're struggling on that front as well. But if you observe how Wells Fargo has from a business, forget about the stock price, just look at how the business is done. In the last year, it has struggled mightily in an environment where the better businesses have done much better.
And so I think that's a microcosm of the point I'm trying to make, which is over time, the best businesses will be the best investments, and over time they'll also be safer. So, John, let's talk a bit more about mistakes. I mean, I don't think that you can have invested no money, could have invested for too long before to make their first investment mistake. I think it was was a Templeton that said that if you're right, like two out of three times, you are like the best investor in the world.
Let's talk about being wrong, because that is a challenge that we face as an investor. And I'm curious to hear your thought process about those investment decision, because it's a tricky situation, because you might not be sure that you actually made a mistake and you don't want to second guess yourself and incur a lot of extra cost by selling. But you also don't want to pay the opportunity cost of being invest in the wrong business. That's exactly true, opportunity costs are a big thing to consider, Steg, and so a lot of my mistakes have come from not investing in something I should have invested in.
But obviously the mistakes of commission where you buy a stock that goes down or buy a stock that doesn't go anywhere when the mistakes that actually cost you money, those are the mistakes that you need to correct quickly. And my method for selling in general, there's three reasons to sell a stock. One is you come up with a better idea and you're fully invested in it. So you need to raise cash. And that's a tough decision to make because you're never quite sure if the stock you're about to replace, the stock that you're about to buy and replace something with it is actually, in fact a better value.
But that's one reason. The second reason is the stock reaches fair value. Then the third reason is the easiest. And that's just you made a mistake. And so I've never had a problem selling. When I realized mistake has been made, the process to come to that conclusion varies. Each situation is unique, but I think you need to know how to separate the noise from actual negative changes in a business. And that's part of the skill that's required to play this game.
And then I think that skill needs to be coupled with the ability to be completely honest with yourself. And this is the most important character trait for an investor, I think is being honest. It helps you mitigate mistakes before they get worse, and it also helps prevent mistakes in some cases. So I think I think all of those things are critical. Not everyone can do that because it means admitting to yourself that you were wrong and that can bruise the ego and so forth.
But this game is not about being right or not about achieving the best batting average. It's about creating the most amount of return with a minimum of risk. And so that can come from a variety of ways. It can come from a high batting average, but it can also come, as John Templeton says, from a hit rate of sixty six percent. And just ensuring that your winners are greater than your losers, you can actually have a hit rate of less than 50 percent and still do quite well.
I think Saurus used to say that he was only right a third of the time or something, but his winners were so big that he could still make 30 percent a year. So it's all about mitigating mistakes, making sure your winners are bigger than your losers. But when it comes to making mistakes or identifying mistakes, I think one of the things I try to do is I have a list. Number one is I write an investment thesis for every stock that I buy so I can look back at that and I can look and see what I was thinking in real time.
And that makes it easy to see if the thesis has changed. And I think it's really important to not adapt your thesis to the new environment. I think it's important to recognize that if your thesis has changed, not to try to fit it to a new narrative, but to just admit a mistake. And it's more often than not, there are exceptions to that. But more often than not, it's better to just when you realize that the game has changed, either you made a mistake in analysis or the company has deteriorated in some way.
It's better to just sell. And so I keep a list of a few key variables that I track for each company, each investment, and then I can easily tell if one of the variables or multiple variables have changed or starting to degrade, then you can recognize that in real time and you can adjust. And oftentimes that means selling and sometimes it means selling at a loss. So mistakes are part of the game. You probably will make one mistake out of every three or four investments, but that's just the nature of it.
So I think mitigating those mistakes are critical part to success.
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I think a lot of unique things, obviously, we've never had a situation where, at least in the West, where Western governments have shut down their economies. And so that obviously is the most unique thing about this. I was watching what was happening in China, and I remember reading a lot about SARS in 2003. And I have a book that talks about that. And it's remarkable what they did then. And I saw a lot of the same things happening earlier this year in the winter.
And it looked very much they were following a lot of the same playbook that they used to battle SARS in China. And that means locking down apartment buildings and stationing a guard outside and shutting down cities and so forth. And so I just never thought that the rest of the free world would do that to the extent that they did. And that has been a remarkable, unique aspect of this crisis. But there are always similarities. And I said this in a recent blog post, but I can point to for a very broad general similarities that happened almost without fail every single crisis or every single recession.
And the first thing is everybody brings up the nineteen thirties. So whenever there's a downturn in the stock market of substantial size, 15 to 20 percent or so, whenever we reach bear market territory, everyone starts to bring up the nineteen thirties because there's always something bad that's happening in the economy at that time if the stock market is down that much. And so it always looks bad. And the second thing is every bear market has unique aspects, which is also scary because there's no playbook.
And so people think the worst people think the current crisis there is unprecedented. And we've heard that word a lot. And that is true with a lot of it has been unprecedented. But because of the fact that every single time is unique, whether it was the 1970s with the oil embargo crisis where we were worried about acquiring the energy we needed to sustain our economy, nineteen eighty seven was was sort of a flash crash. We were worried that that could spark another Great Depression.
When the Dow dropped twenty two percent in one day in October of eighty seven, the two thousand dotcom bubble was extremely unique. And of course, two thousand eight was a financial crisis that we haven't seen the likes of in one hundred years. So every single economic crisis has unique aspects to it, and people always fear the worst. The third thing is people sell because they fear prices are going lower. And that's just natural human behavior. You want to sell because you fear that tomorrow the stock price is going to be lower.
And the idea is bring to the fourth point the ideas you buy back. When there's more clarity, everyone thinks you'll be able to buy back cheaper or the experts are advised to wait for more clarity. But Buffett says if you wait for spring, the Robins have already gotten the worm or something. I think I just put you that quote. But basically, if you wait too long, prices will already reflect a much rosier outlook. So in regards to the 1930s, this covered a lot of people, started a Great Depression, too.
And what's very interesting is if you study history, we live in a time where we are doing things as a country, as a government in this country. And this this also goes for central banks around the world. The Western world attacks financial crises in a completely different way than they did in the nineteen thirties. So especially when it comes the United States in the 1930s, we had no unemployment insurance, we had no Social Security, we had no FDIC.
So it wasn't safe to keep your money in a bank. Your bank went under, you lost your life savings. We had no safety nets for workers, retired people, depositors, and we did things that would be considered by most economists today to be exactly the wrong thing. So in nineteen thirty, we tighten fiscal policy instead of loosening it. We flooded the system with money earlier this year. We did the exact opposite. In 1930, there's a famous tariff called the Smoot Holly Tariff and that nineteen twenty nine was a stock market crash.
We had the banking system had liquidity issues. We exacerbated those issues by slapping tariffs on our trade partners. So we sparked a trade war with Europe and with Canada, and it was done with proper motives. We wanted to protect domestic producers, but it sparked a trade war and it and it accelerated the Great Depression and made things much, much worse. We also tied monetary policy in the 30s instead of loosening it. So we actually raised rates, the Fed raised rates under Hoover instead of cutting rates.
And we we had a hard currency policy back then. We had the gold standard to a certain extent. And we obviously have no gold standard today. So we had less flexibility to print money and we were much less willing to do the things necessary. It wasn't until FDR came into office in nineteen thirty three when we began recovering his Fed engaged in QE. Basically they started buying bonds and putting cash into the system, took us off the gold standard.
They printed money, they instituted social safety nets. It was very, very controversial. A lot of the things that that we. Essentially take for granted today, like Social Security were initiated as part of the New Deal legislation that was passed in nineteen thirty three in the early 30s. And so all of those things brought that confidence. You can debate the merits of those various regulations and various laws that were passed, but they did lead to increased spending, increased investment, and we slowly recovered.
But the point is, we did the exact opposite of what we needed to do to break the panic in the nineteen thirties. And it was the exact opposite of what we're doing now. So I think that's just something to keep in mind. I don't I don't make investments at all based on any sort of macro outlook that I have because I have none. But it is something to keep in mind that when people bring up the nineteen thirties, it's really like comparing apples and oranges.
We live in a completely different world and we've learned a lot. Doesn't mean we won't have depressions. I think in this case where by the technical definition of a depression we had one. Of course the upside of the balance sheet was matched with an equal or maybe even greater force with three trillion dollars of new money coming in. So it doesn't feel like a depression, but we will have a depression at some point. Again, we'll have numerous recession.
Doesn't mean things can't get bad, but it's not going to look like the 1930s.
Let's talk more about portfolio management. I can't help but wonder, do you optimize for expected returns only or do you also consider the correlation between your stocks in your portfolio?
I think about each investment as a piece of a business, and I tend to think I do look at the portfolio overall from a top down view because I do want to have certain diversification. But other than that, I think of each investment and I want each investment to stand on its own merits. And so I think of SABR Capital as a holding company in a sense that owns stakes in a select few high quality businesses that happen to be publicly traded.
And I think of each stock as a separate company that I'm a part owner and that we're a part owner it. And so that's how I think about it. Again, I do have certain diversification requirements, but I don't try to optimize anything and I don't really look at correlation at all.
Do you hear a lot of pundits saying that the key to investing is asset allocation and not so much picking individual stocks, which is what you do?
And so for that reason, I wanted to hear your thoughts on how you feel about being 100 percent invested in equities, considering the condition we have right now, or do you consider diversifying into other asset classes? What are your thought process about that? First, you and perhaps also a few thoughts for the retail investor. I think every investor has to make that decision, the decision on asset allocation based on their own risk profile, their own risk tolerance and so forth.
For me, I have all my money invested in stocks and I have a very simple philosophy on this as well. It's it's that over the long run and part of this depends on your age and so forth, but over the long run, I think stocks as an asset class will continue to be the best asset class to own. So Jeremy Siegel wrote a book called Stocks for the Long Run, I think was the title. And he goes through there's a simple chart in there.
And this is a book that's, I think a number of years old. But there's a simple chart that shows various asset classes, stocks, bonds, gold, cash, anything you get, throw any sort of currency, any sort of other asset class in there, or whether it's art or real estate or anything else. And over time, there'll be lots of years where this won't be the case. But over the long run, over, say, a ten year period or more, it's I think you're almost always going to be better off betting on stocks.
There will be exceptions to that. If you're in the midst of, let's say, a ninety nine style bubble where the S&P is trading at 40 times earnings or something, but those situations will be very rare. So you're almost always better off owning stocks. And my philosophy is American business is the best asset class in the world to own. And again, there will be economies that grow faster. That won't always be the case. But for me, it's where I live.
It's within my circle of competence. So for me as an investor, it's the best asset class that I can own. And so American business is going to outperform all those other asset classes. Then you ask yourself, well, how do I get exposure to that asset class? And I think American business is going to provide a baseline return that you can achieve by simply owning the S&P. Five hundred. And so that means owning a Vanguard fund. And I think it's my approach is my profession to try to achieve a result that hopefully significantly beats that baseline result by picking stocks from within that index and not necessarily within the S&P.
I will invest in lots of different stocks outside of the S&P as well. But the point is, if American business offers you a baseline return and the S&P 500 is the way to get that baseline return, I think you can do better than that. By instead of selecting five hundred stocks, you select the five or 10 best companies that are within that index, for example. So that's a general philosophy. I think the best way to get exposure to to that return is through ownership of high quality companies.
Amazing, John. We covered a lot of ground here in this interview. And and I can't thank you enough for your time to time, your busy schedule to be speaking with us here today. We would like to give you the opportunity to talk a bit more about where the audience can learn more about you and see capital management. Yes, a SABR capital runs a fund called Sabre Investment Fund, and it's modeled after the original Buffa partnerships. There's no management fee and there's a twenty five percent performance fee over a six percent compounding hurdle.
So that's above its original structure, which I thought was a good fare structure for LPs. And so SABR runs a fund that again is modeled after that structure. And you can read more about my firm Sabre Capital at the firm's website, which is SABR Capital, MGP Dotcom. And there you could find a lot of the writings that I've done over the years. A lot of different things I've had to say. So I publish a lot on that Web site and feel free to check out the work there.
And it's really great to talk to you say it's always great to talk to you and Preston and I appreciate you having me on. Well, John, thank you so much for joining us, you are always welcome to come back on the show. I know I personally always learn so much from you whenever you join us. Thank you so much.
All right. So as we are letting John go, we'll take a question from the audience. And this question comes from Tim. President Stig, thank you for taking my call. I'm very new to investing, but in this weird time where interest rates are zero, money is essentially free and inflation seems to be inevitably going through the roof, at least money supply, whether that's tied directly to inflation or not.
My question is for a semi normal person like myself who's not really a high dollar investor, it seems like one of the best moves that one could make would be to buy a real asset with highly leveraged debt at a low interest rate.
And it seems like the reason for doing this is that the real asset is going to increase in value in proportion to inflation, but the debt is going to remain fixed. It seems like you're ultimately earning value on inflation through this mechanism and wanted to see if this was a sound concept. And appreciate your guys this time. I've already learned a lot from you.
Thanks. The short answer to your question is no, do not some leverage your position, and there are multiple reasons why I would suggest that you do not do that. And I really want to start up my response with a Yogi Berra quote. And, of course, this.
In theory, there is no difference between theory and practice.
In practice, there is. And what I mean is that in theory, you are right, in case of high inflation, low interest rates, you can effectively erase your debt and keep the real asset, say it could be gold and then maintain your purchasing power, which in theory would be very profitable. However, even if you are right, the volatility of what will happen between now and whenever your desired scenario plays out could wipe you out. And that really makes me think of recurring.
Recurring was a very successful value investor who was involved with Buffett and Munger in the early days of Berkshire. And the way Warren Buffett explained what happened was this.
He said that him and Charlie knew that there were always going to be incredibly wealthy, but there were not in a hurry to get wealthy. So what about Rick?
Well, Warren said that Rick was just a smart, but he was in a hurry. So in the seventy three Sandiford downturn, Rick was leverage with margin loans and the stock market went down almost 70 percent in those two years. And so he got the margin calls and he sold his Berkshire stock back to Warren. Actually, Buffett bought Rick's Berkshire stock at under four dollars apiece at the time. And now is Berkshire Hathaway's assets at trading more than three hundred thousand dollars?
If you look at the track record of Warren Buffett and Rick Warren, they're not that much different. But how the leverage themselves was very different. That was eventually why Warren Buffett prevailed.
The time it takes for you to be right might bankrupt you. The second reason is that you could be wrong. Even the great investor John Templeton, said that he was wrong one third of the time. And looking back of his track record, I mean, he was one of the most successful investors ever and arguably the most successful international investor in the 20th century. So if he's wrong one out of three times and he even said that might be on the low side, we would likely do no better.
So that's another reason why not to leverage your bets. And you also sit there in your question that you are not a high net worth investor.
I don't know if that also implies you don't have a lot of experience, which could also be an issue if you're working with the I mean, you do have investors like Ridell you who takes leveraged bets from time to time, but really knows a high net worth investor.
And he knows exactly how to structure a few leveraged bets here and there and only for a small part of his portfolio. So even if you want to test it out, which I would strongly suggest that you do not do, you really should be doing this for very small amounts of your portfolio. But really, to sum up, I completely understand where you're coming from, and it is an interesting thesis where you might be right. But if you want my advice, please do not take leveraged bets on the expected inflation and interest rates.
So, Tim, just to piggyback on Stig's recommendation, which I completely agree with, in theory, you got it. All right. Like what you're talking about is as far as borrowing money and then paying it back with money that's worth way less is a very non-intuitive idea that people I don't necessarily as we move forward in the coming few years and I think things are going to get very interesting. People that have a lot of debt are going to find that it's actually advantageous if they're paying it back with money that's significantly worth less.
Now, here's where this all gets a little bit tricky. So the environment that I kind of expect we're about to step into is going to get very depressed. My expectation for how the economy fundamentally is going to perform in the coming three years is not good. I suspect that there's going to be a lot of people that are struggling for work. Ray D'Alessio is on the record as saying that we're entering into a depression at this point. Believe it or not, that's that's the quote that he actually has and how he's described this.
If that plays out, you might have had all the logic exactly right as far as borrowing and then owning some type of hard asset. But it really comes down to your personal skill, skill sets in the demand of those skill sets going through a very challenging economy. That's the thing that's really important. So if you have let's say your house, let's say a person would go out and buy a house, that's that they're taking out a lot of debt.
They're highly leveraging themselves because they're wanting to play this this idea that you're talking about. If that person's skill set in the environment that I just described, which is going to be a very, very shaky economy, doesn't hold up and that person's not going to be able to keep that same rate of pay and salary that they were receiving when. The economy was where it's at right now and before now you're putting yourself in a bind to even make the payments back on that debt.
So is it OK to have some debt? Of course. How much really comes down to your own personal tolerance? It comes down to your personal skills and how those skills are going to endure and perform in a in a very challenging economy. And I think that's where people might not be accounting for how bad things could potentially get moving forward. And my anticipation is it's it's going to get a little crazy. So something to think about. You definitely understand the fundamental idea of what's about to play out here, and that's that the people that are lending money are, you know, they're not going to do so well.
The people that are borrowing it are going to have an advantage. But the challenges, are you going to be able to sustain the salary and the pay each month in order to continue to just make the the minimum payments on something like that? Very interesting question. Very smart question, but I would tell you to be very careful with that. So, Tim, for asking such a great question, we're going to give you free access to our tip finance tool.
This is on our Web site. And you can do intrinsic value calculations. You can look at the momentum status for all these publicly traded companies. It helps you manage your portfolio. It shows you the correlation between all your stock picks. And we're going to give that to you completely for free and for anybody else out there. If you want to get your question played on the show, go to ask the investors dotcom. And if the question gets played like Temes, you get a free subscription, the tip finance.
All right, guys, Preston, I really hope you enjoyed this episode of the Masters podcast. We will see each other again next week. Thank you for listening to Te IP to access our show.
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