Stig Brodersen  6:35  

So Toby, what you’re basically saying is that we don’t really pick the companies that we think will perform best. We’re basically looking at a stock screener or simply flow through a formula, and we know that these will simply perform better than the stock market in general.

Tobias Carlisle  6:50  

So that analysis that the bond failed did was just to show that there is some fundamental improvement. On average, when you’re looking at those three, there are a variety of value metrics that you can use that have phenomenally good performance, remarkably good performance for how simple they are. And really, you can use almost anything. The humble price-to-earnings formula works very well. Press the cash flow price to end fundamental, will perform very well. In quantitative value we rigorously tested all of the formulas to sort of determine which one works the best.

We found that it was the enterprise multiple, and we tested it using earnings before interests and taxes and earnings before interest, taxes, depreciation, and amortization. So that’s EBIT and EBITDA. The denominator there is enterprise value, which very simply is market capitalization plus the debt that you have to take on because that’s what acquirers of companies take–the liabilities of the company. And then, you net out of that cash. But you have to add in anything like minority interest. 

So you’re really looking at the full price that you pay and then you compare that to the operating earnings that you’re getting on the other side. And we found that those two outperform when we apply some fairly rigorous analysis to it. So we look in a very large universe, and market capitalization wait then. So, it’s not a phenomenon of just being very small companies outperforming. It’s actually the very big ones that does select the companies that outperform. 

So, when I actually got to apply that formula, the best way to do it is using this *inaudible* that I call the acquirer’s multiple. Basically, it’s substituting operating earnings, which is a metric that you construct from the top of the income statement down. So you take revenues, you take out cost of goods sold, and then you take out selling goods, SG&A. And the reason that you get a better result when you take it from the top rather than the bottom is that you’re missing out on any of the special items that aren’t necessarily part of the operating business. And then if you use that metric, you’re really selecting for the kind of companies that a large acquirer can take over. And so, they tend to perform quite well. And they also attract catalysts in the form of activists and private equity firms.

Preston Pysh  9:28  

You know, Toby, the thing that kept popping up into my head as I was reading your book was, a lot of people are just so focused on Warren Buffett and the way that he does business. And the one person that we’re really focusing on a lot these days and paying very close attention to is Ray Dalio. I know I sent you an email just the other day, when we were talking about something kind of off topic to what we’re discussing right now. 

But Ray Dalio, from what I understand, is implementing a process that is very similar to what you’re talking about here as far as using nothing more than quantitative data to make decisions in the stock market. He’s not really doing anything like Warren Buffett *inaudible*. He takes a lot of this qualitative feel. And when you look at Ray Dalio’s returns based on where he’s at and his lifespan, his returns are actually more impressive than Warren Buffett’s for where he’s at right now, as far as having larger returns. 

And to me, I was reading your book, and I’m thinking to myself, I really think that Ray Dalio is taking a very similar approach to what you’re talking about here in the way that you’re analyzing stocks. Would you agree with that? And I know this isn’t one of the questions that we were planning on going over. But I’m very curious to know your response to that.

Tobias Carlisle  10:39  

Dalio is one of the number of guys who are quantitative in their approach. I think probably the most famous is O’Shaughnessy Asset Management or it could be any other firm that sort of came out of the academic research. So LSV Asset Management is Lakonishok, Shleifer, and Vishny, who wrote one of the great papers, Contrarian Investing, which everybody should read. I did cover that in the book, *inaudible* have a firm. And the reason I like O’Shaughnessy is he’s been very generous, sharing exactly the process that he goes through what works on Wall Street. 

And the idea is basically, without sort of knowing precisely what Dalia is doing, and I know, in addition to stocks, he looks at various different asset classes. And so there’s an asset allocation function to what he does, which is part of his return profile. Whereas, Buffett’s known more as a stock market investor, in size, it’s O’Shaughnessy, for that matter. I’ll speak to O’Shaughnessy because it is the same point. He has shown us that he has sort of looked at all of these different fundamental metrics for analyzing stocks. 

And he has also looked at some momentum metrics. Momentum is a very powerful force. I don’t use it in my firm, but there is quite a lot of academic research that shows that it does work. Momentum is basically price performance over a period of time. So, the most popular is 26 weeks, which is half a year. You can also use 52 weeks, but it seems to be slightly uncorrelated to value. So you get, combined together, a very good return. So I assume that Dalio is using some combination of value and momentum to generate his returns.

Preston Pysh  12:23  

All right, well, we do have the next question here. Let’s go to this one. So Toby, Warren Buffett has a really famous quote, and the quote goes like this, it says, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it’s the reputation of the business that remains intact.” 

And so, I guess my question is this, because you provide hard facts in your book that shows that the really ugly businesses when you measure return on invested capital, the ones that have had a really bad past performance, are the ones that are actually maturing and turning into a much better investment over a short number of years right after you would have selected it. So, can you describe this to our audience this idea and how you came across this contrarian point of view?

Tobias Carlisle  13:07  

Let me first say that I don’t necessarily disagree with Buffett’s quote there. I do think that the management is sort of tied to the underlying performance of the business. And this is one of the big differences between Buffett and Graham. Benjamin Graham read security analysis and he was Buffett’s teacher, one time employer, and lifelong friend. And Buffett says that he’s sort of 75% Graham, the other 25% is Phil Fisher. 

He called one of his sons, Graham. And so he’s got a huge regard for Benjamin Graham. One of the points that Graham makes in security analysis is that, when you look at a business, it’s very difficult to separate whether it’s in fact a very good management or whether it’s just a business that’s enjoying a particularly good period. And he says that if you’re looking at that and saying, that’s a great management. What you’re missing is the fact that you’re potentially double counting. That’s the way he describes it.

Buffett’s big departure is that he has come along and said, Well, there are these managements that are worth paying up for because of the way that they behave. And the two things that you want from management is this sort of relentless focus on the *inaudible* and maintaining that very high return on invested capital, by doing so. So you keep the return very high, but you also have to look after the capital that’s invested in the business. 

You don’t allow too much cash to build up on the balance sheet. You’re very careful with the acquisitions that you make. You pay out a dividend, when it’s warranted. You buy back stock when it’s cheap. And to the extent that they don’t do those things, they’re sort of destroying the intrinsic value of the business. So, that’s one of the points that I make in the book that, often, activists and private equity firms, the simplest way that you can improve the intrinsic value of a company is when you come in and you find that they’re not performing that capital allocation function properly. So there might be two elements. There might be the sort of operator function of the management, which is running the business. And then there’s the capital allocation function. And to the extent that they’re not doing that, that’s an obvious place where activists and private equity firms add value.

Preston Pysh  15:22  

And that’s where you see. And you even mentioned this in your book where a guy like Carl Icahn comes in and just unlocks that value that’s just stored on that balance sheet. He comes in, he can see it there, and he just basically hits the management over the head and makes them unlock it. And it’s a pretty amazing story that you had in the book about Carl Icahn because a lot of that stuff I’ve never read before is really good. Go ahead, Stig.

Stig Brodersen  15:46  

So, Toby, I came to think of a thing here, how does tax play a role? If you pick stocks, like Warren Buffett, you have this compounding effect which is clearly very powerful and this is one of the key things in finding wonderful businesses. And even in bad times, you know they don’t have to pay the capital gains. I might be wrong, but using, let’s call it your approach, I guess that you will wait until those stocks will return to the intrinsic value, but then you have to liquidate them to increase the capital gains tax. So, what are your thoughts on that?

Tobias Carlisle  16:22  

I don’t think that one is any better than the other. I just think that, part of the reason that I wrote the book is that Buffett is so successful. He’s been so generous with his writings over 50 years. He’s spoken publicly at every Berkshire general meeting, and he’s interviewed all time. So, Buffett’s method of value investment is the way that everybody thinks about value investing. 

But really, Buffett’s targets are so few and far between. They’re a very small portion of the market. Those sort of companies that can sustain that high return on invested capital with the mode. Really, the vast majority of companies are cyclical. And they are subject to the forces in the industry that are sort of exogenous external to their own businesses. 

So, I don’t necessarily think that one is better than the other. I just think that you have such a larger universe to work with if you work with these companies that are a bit more cyclical or subject to those forces. So that is one of the problems with investing this way. You are more likely to incur capital gains tax. But that’s also true. Many of the Buffett companies, they don’t really, you can’t remain invested in them for. Many of them for 50 years. 

Often they’re sort of a five or 10 year proposition. And then they just run out of growth potential, the market becomes saturated, can be any sort of number of those issues. With the companies that I look at, I’m still thinking in terms of three to five year to 10 year periods. It’s just that I’m trying to get them really out of business and idea, then they work through those issues. And so they have a pretty long runway with it. They’re getting back to the peak.

Stig Brodersen  18:08  

So, how do you determine the growth potential? And the reason why I’m asking is that, please correct me if I’m wrong, but you’re not looking so much for the quality of those companies. And you’re not so much look in terms of, say, your circle of competence. You may be looking at numbers and what might be at the bottom of the business cycle. So how do you determine when to sell?

Tobias Carlisle  18:31  

Well, often the decisions made for you by some sort of catalyst occurring, either it reaches intrinsic value or you find a better opportunity that’s at a bigger discount that tends to be the way that the portfolios operate. The question, I think, and the point that I make in the book, I use Joel Greenblatt’s magic formula, as the means of describing this point. But Greenblatt has this magic formula where he looked at Buffett’s letters, and he said, “How can we quantify this? And if we quantify it, will we get good returns?” Because we don’t have Buffett’s genius for finding these modes, and there’s no sort of real statistical way of finding these modes. So we’re certainly not looking at the financial statements. 

So, he said, “Well, there are two things. He looks for quality, which he defines as a return on invested capital, return on tangible capital. And we look at value, which he defines as…and he’s for interest in taxes on enterprise value, what I call the “enterprise multiple.” 

And then, he just simply ranks every stock on each factor, and then he sums the ranking. So, the best combination of both, is a magic formula. Stock and then he buys a portfolio of 30, rebalances on an annual basis. And that outperforms the market. We’ve independently tested that in quantitative value and it’s been tested a variety of other times outside of us. It definitely outperforms.

Preston Pysh  20:02  

And Toby, the thing that I was really focusing in on was the time period that you had. Three years before the t zero mark, and then three years after. Were you really seeing that you got the best results over that six-year window? Did you guys play around with expanding that to maybe an eight-year window or a four-year window? Like, what gave you the best return? Was it six years? Is that why you use that in the book?

Tobias Carlisle  20:27  

That’s the debunked file research, which we didn’t test specifically for Windows. But we did look at holding periods. Sorry, we looked at the holding periods and an average of years in order to select the stock. So you look at the cheapest on one year’s earnings, two years of earnings, average of three years. I think we went out for eight years. Look, this isn’t quantitative value. And we found that there’s really no advantage to expanding the number of years that we considered, which I found really surprising, because one of the things that I was expecting that that would be a big advantage because there aren’t many people who sort of go to that. When they’re analyzing companies to the extent that they’re thinking about, they’re looking at only a few years of financial statements. 

So I thought that would be a big advantage. It turns out it’s not. And so, that sort of perplexed me at the time. And I’ve thought about it a lot since. The reason is that when you look at the companies that it selects on a one year basis, I should just say, it might be that five years is a better average. Then six years wasn’t very good. And then seven years was quite good. So, there might have been ones that outperformed an individual year, but there was no sort of rhyme or reason to it. So, they’re just sort of random.

Preston Pysh  21:43  

So, how about on the backside after it’s selected, you had in the book that three years later, and whenever I look at that chart where basically, they all come back into a normalized state. It was usually about a three-year period. Did you find that three years of holding usually brought it back? or if it didn’t, it was just kind of an outlier. Was that three-year period pretty common? Or did you try shortening that and and seeing how that worked? 

Tobias Carlisle  22:07  

You definitely continue to get. So, holding for a year gets you the bulk of the return because the gap between intrinsic value and price is widest at that point. And then it sort of gets closer and closer and the return disappears a little bit because the discount is not so great. And when, this is one of the things that I tried to get across in Deep Value, the discount from intrinsic value really is the driver of returns. The bigger the discount, the better the returns. So, as the discount diminishes, the return diminishes too. But, you still get it I think after five years, after seven years, I think you’re still getting pretty good performance out, as far as that.

Preston Pysh  22:52  

So, the key would really be, what is my capital gains tax and let me get past the largest hurdle that, let’s say, the biggest capital gains will be a year. So you’d want to sell it. And basically rebase line everything after that one year mark, because that’s where you really move completely into a different capital gains bracket, here in the US at least. Is that what you’re doing on your business, individually? 

Tobias Carlisle  23:16  

It tends to be one year and one day that gives you the best combination of capital gains and tax diminution.

Preston Pysh  23:27  

All right, Stig, you got the next question.

Stig Brodersen  23:29  

So, Toby at your talk at Google in November 2014, and just a quick shout out for that talk, we will definitely link that in the show notes. That was a fantastic and really inspiring talk. You can see this guy’s *inaudible* job is almost blushing right now.

Preston Pysh  23:46  

Hey, and I want to throw in Glenn Somia was the person who sent us the link to your talk at Google. And we would just want to thank Glenn for giving us that handoff. But go ahead, Stig. Sorry to interrupt.

Stig Brodersen  23:56  

No worries. So, Toby, let me go to the question again. So at your talk at Google, you stated the acquirer’s multiple, which you talked about briefly before, is widely used to find the hidden value of businesses. You also find that our performance on the key ratios such as free cash flow, yield, gross profit, yield and book to market value. What is the acquirer’s multiple? If you can define it real fast, and why does it outperform the other metrics?

Tobias Carlisle  24:26  

Acquirer’s multiple is operating earnings on enterprise value, which is the full price that anybody pays for a business. So, the extent that you’re valuing a company, you’re *inaudible* the enterprise multiple is the price that you’re paying. And operating earnings is the income stream that you’re really getting that you can either direct to capital allocation. 

You can allocate it to dividends, or buying back stock, or investing in other businesses. It’s really telling you how much you’re actually paying for the business and what you’re getting in return. It’s probably the best cleanest analysis of that, which is why I think it performs so well. It has been shown to do that, empirically. Why that performs free cash flow, gross profit yield, I’m not entirely sure. I think that was a little bit surprising because if you come from the Buffet, and a lot of the Buffet investors, what they’re really looking for is that very high free cash flow yield. Not necessarily an extremely high one. 

They’re rather looking for a solid free cash flow yield, maybe 10% plus, with some growth, maybe 5%. And so combined, you’re getting about a 15% return. And then, they want that sort of very stable over a very long period of time. Whereas, the deep value guys are kind of looking for a really fat return in the very short term. And the only way that you’re going to get that is with these really ugly businesses. 

Preston Pysh  25:57  

Toby, I just want to highlight for people because when you’re thinking about risk, the reason you have a lot of these Warren Buffett people like myself that’s managing their risk based off of a very stable, predictable trend line of this free cash flow. You’re managing your risk because you’re buying 30, or call it 50 companies that are all in this very deep category. Then let’s say, five of those businesses fail, you make it up through the other businesses that have had these very large returns because they’ve performed so poorly and they’ve been penalized in the market. And that’s how he’s managing his risk. I just want to throw that out there. So the audience understands that you are managing your risk, but you’re doing it in a different manner.

Tobias Carlisle  26:38  

I do some of the Buffett investing as well. The Buffett stocks are really much rarer than the other ones. So yeah. For those ones I’m always looking for that sort of I want 10% free cash flow yield going out two or three years, so I can see it occurring two or three years time with about a 5% growth rate, pretty stable returns, good capital allocation. Now, that’s a very traditional Buffett style stock. 

To the other ones, I look at 20 positions and you need to get more for the risk that you’re taking on there. So you get more in terms of an enterprise multiple. And the multiples that I’m looking at, I want to buy three times or four times. So that’s like a 25% to 33% yield. That’s a really fat yield.

Preston Pysh  27:28  

That thing is ugly.

Tobias Carlisle  27:31  

At any given time in the business cycle, whatever is the scariest thing, is the sort of thing that you buy. So, you know, oil and gas. It’s probably on or minus. There’s no secret to the speed for multi level marketing. The sicker you feel when you look at the portfolio, the better the portfolio is going to go.

Preston Pysh  27:51  

All right, Toby. So, many investors look at the PE ratio and use that to quickly determine the expected yield of an investment. Continuing with our previous question, if you could quantify how much better the performance was when you were using the acquirer’s multiple, versus just the standard PE ratio. And then also talk about Joel Greenblatt’s magic formula, where that kind of fits into this. What would you say the performance might be for an index of stocks as far as the yields that you quoted in the book?

Tobias Carlisle  28:22  

When we looked at the very large capitalization universe, we looked at companies with a market capitalization bigger than $1.4 billion as at December 31 2011, because we wrote it in 2012. And we market capitalization way to the positions in the portfolio, which you wouldn’t ordinarily do when you construct a portfolio. You either equal way, or you’d wait towards your best opportunities to the most undervalued opportunities. 

So we did that because that penalizes bigger companies and they’re often little ratios that sort of work to find small stocks that aren’t really particularly good at outperforming the market. Itgave us about, on average, a compound over a sort of 32-year period, about 15 or 16% per year. And the PE ratio from recollection, I’m not entirely sure, but it was sort of around 11 or 12%. So it’s a fairly substantial margin over 32 years. That’s an enormous outperformance.

Preston Pysh  29:34  

All right, Stig, you got the next one. 

Stig Brodersen  29:36  

So, Toby, how have the hard facts about pure quantitative models find the best stocks change your own approach to a stock selection?

Tobias Carlisle  29:46  

So, when you’re investing there too, I like to think there are two broad approaches to investment. One is the Buffet style business owner investment method where you look at the business and you look at the qualitative factors in the business, what’s going to allow it to outperform to protect its returns on invested capital. 

And you look at management’s attitude to capital allocation as evidenced by what they’ve done in the past, and perhaps, to the extent that you can talk to them, what they tell you that they’re going to do in the future. The other approach is to look at it like the statistician or the casino owner, maybe? It’s kind of like a probabilistic approach. 

And so, the quantitative approach is to the statistical probability. And in that approach, you look at a period of data beforehand. To protect yourself from all of these little biases that can creep in you, you have to approach it. I think you come up with an idea that you test. So, does value work? It seems we test them using any number of different ratios. You find a good ratio and then you have to apply that without fear or favor to the stocks that it selects code, because what you’ll find is that it pulls up all of these things that they don’t ever look like a really good idea. 

And what you’ll find, if you go through and try to cherry pick those ideas out is that you tend to underperform the screen. And the reason is fairly well known region of research, little less well known in investing circles, but quite well known outside. It’s this idea that experts tend to underperform these simple statistical models. And the reason is that they use their discretion to sort of override the model too often. That’s what is known in the research as the broken leg problem. 

So the idea is, you have some sort of algorithm that tells you that Peter goes to the theater on Friday night, and you’re trying to predict, “Will he go this Friday night?” And you learned that he’s got a broken leg. So surely, you’re able to factor that into your algorithmic model to determine that he’s not in fact going to go to the theater. And the answer is no. And that’s really surprising. 

The reason that you can’t use it is because you find way too many broken legs. You will apply it more often than the model would. And so, the model has this error rate, it’s a known error rate whereas, experts, when they’re making decisions on an adhoc basis, they have this unknown fluctuating error rate. So what they found in these lots of different unrelated fields is that the statistical model x is the ceiling on performance. And anything that you do to the screen sort of underperforms it. So, when I’m in the quantitative mode, I just run what is in the model and I put that in the portfolios.

Preston Pysh  32:54  

I’m going to add on to what Toby said. But in the book, he shows that in Ben Graham security analysis, he talks about this idea of using your own intellect like using the screen, or to bring you to a batch of stocks and then to basically use your own intelligence and your own qualitative field to extract the ones that you think would be the right ones. And so then, Toby talks about how Ben Graham changed his mind very close to his own death. 

I think the year was like maybe 1975 or 1976 that Graham came out openly and basically came back on what he had put in security analysis and said, “I don’t really necessarily know that I agree with this anymore. I think you should just take the batch of stocks that come up from the screener and you just invest in those from what you got that you don’t use your own biases to select the right ones, because I think that’s going to cause you to actually underperform.”

And so, Toby puts that in the book and he talks about how ahead of his time Ben Graham was even right up to his death, to be able to identify something like that without having access to computers, to basically validate that extra 2% gain that you actually get, that Toby has statistically proven in his book.

So with all that said, I’m going to go to the next question. So if you could only pick one investor outside of Buffett, Munger, and Graham that people should study, who would that be? And do you have any books that maybe that person would have wrote or anything like that?

Tobias Carlisle  34:21  

I’m going to give a shout out to Joel Greenblatt because I’ve learned so much from Greenblatt’s work. Starting with his very first book, which was, You Can Be a Stock Market Genius, which I think, and everybody says this but I’m going to say it again. I felt a bit bad. It’s a terrible name for a really, really good book. And it’s all about special situations, which is how Greenblatt ran his fund, initially. And it’s just such an awesome book. When I was a corporate advisory lawyer, I read that. It just made perfect sense to me. 

And so, that was the way I started out as an investor. In 2006 I found his, That Little Book That Beats The Market, and that was similarly an eye opening experience when I read that. Look at what Buffett did. His business analysis was just too hard for a guy, like I was, a corporate advisory lawyer. But I think in terms of the financial filings and writing those filings, raising money, and buying shares like that was the actual business part of it. I just didn’t have the tools to analyze. 

And so, when I saw that Greenblatt was saying that it could be done in a quantitative fashion, that sort of appeal to me as something that I could do. One very interesting thing that I saw pretty soon after that was a paper written by James Montia who’s another guy who I just love to death. Montia was the guy who did the analysis of The Little Book That Beats The Market, initially. He said, “If you take away the quality metric, you actually do better, which is completely counterintuitive.”

And so that was one of those things that I thought maybe there is something more to this. This is an area that I can study really closely. So, that was the analysis that we did in the first quantitative value. And that was really the genesis for Deep Value–to dive into that idea and explore why it is that, not looking at the quality or ignoring the quality factor, why that could lead to not only better returns, but better risk adjusted returns, which makes no sense at all. 

And I think it’s this idea of mean reversion. That the quality is the quality factor that Greenblatt uses. The return on invested capital is really selecting for those companies right at the pinnacle of their business cycle and ignoring it you do a little bit better.

Stig Brodersen  36:52  

So, Toby, I can’t help wondering, now you’re saying that we don’t have to look too much about quality. But say that through our stock screen, we found 10 grid companies based on the acquirer’s multiple, do you make any kind of analysis in terms of, it doesn’t look like that they will make money next year because they have some things happening or is it just pure numbers? Is that what you mean by what you were saying? Quality? Or do you also, again look for the next 12 months?

Tobias Carlisle  37:23  

There are lots of different… Quality is, I try to keep on defining this return on invested capital because it can mean a variety of different things. In a business quality sense, if you’re Buffett, he doesn’t really care what the return on invested capital was last year. He’s looking at a company that’s able to sustain a high return on invested capital in the future. And he’s using his sort of phenomenal mind and decades and decades of experience looking at these companies to determine which are the ones that can do that, which are the ones that can’t. 

So, I’m not talking necessarily about that method of investing. I’m just saying that when you’re looking at the deep value ones, one quality metric that you might like to look at is earnings quality. It’s definitely you’re paid to find companies that are actually generating earnings that are actually generating cash flow that matches the accounting earnings. 

Any company that’s not gotten matching cash flows for its accounting earnings over a period of time is not a good company. That’s an early earnings manipulation indicator. And that’s something that could potentially become a fraud. So you want to avoid those companies for the most part. But the thing is, when you’re buying these, operating these acquirer’s multiple, [it’s] cheaper on the acquirer’s multiple basis. 

The reason that the metric works so well is that it is looking for a very cash rich balance sheet. It sort of favors companies that have got a lot of cash on the balance sheet. So you’re not paying a lot for the actual residue of the business that you’re buying. So you’re not paying a lot for the market capitalization. There’s probably no debt there. 

And then there’s very strong operating earnings in relation to that residue that you’re actually paying for. So, you’re sort of already self selecting for the kind of things that got plenty of runway, if they’ve got cash on the balance sheet so they can withstand a down period. And then, they perform quite well at the other side.

Preston Pysh  39:19  

Because the assets are all liquid at that point. Go ahead, Stig.

Stig Brodersen  39:22  

Yeah, and just one thing to say, I just checked Toby’s website before the interview and he’s going through this formula. So, if you think it’s quite hard to understand acquirer’s multiple, we’re talking about cash, we’re talking about liabilities. I think the best things really to go into to beside and take a look at this phone though he explains like how it derives this number. So I just want to put that in.

Tobias Carlisle  39:44  

acquirersmultiple.com. A-C-Q-U-I-R-E-R-S multiple.com.

Preston Pysh  39:49  

So, real fast, just so people understand. When you’re talking acquirer’s multiple, so if you are a guy like Carl Icahn and you can go in and buy a very large chunk of a business, he’s not looking at the market capitalization, which is basically your share price times the number of shares that are outstanding. 

He’s not looking at that number because that’s not really telling him what he’d have to pay to own the business. And that’s a big misconception that a lot of people have. What is the real number is this acquirer’s number that Toby’s referring to. And that’s your EV or your enterprise value. That’s where you’re taking that market cap that everyone thinks is the number they’ve got to pay. 

You’re adding in the debt, and the minor interest, and the preferred stock, and things like that, and then you’re subtracting out the cash, and that’s giving you the real number that you’d have to have if you were going to buy every share of the business. 

So he’s saying using that, compared to the earnings before income tax is a much better representation of the PE ratio than the PE ratio. So that’s what he’s saying and all this. Anyway. Toby, I think that was our last question. I just want to turn it over to you. If people want to learn more about you, or your book, or your websites, how can they find out more about you. And whatever you tell us, we’ll make sure we have in the show notes so people can access it quicker.

Tobias Carlisle  41:05  

I have a blog called greenbackd.com, which is g-r-e-e-n-b-a-c-k-d dot com. And I put all of my research up there. There’s 800 posts going back to 2008, when I started writing it publicly. And you can sort of see all the research that I’ve canvassed, then of course, there’s deep value and quantitative value where we’ve got all the research together in a coherent fashion and written about it, so it makes sense. 

And then, I have a website acquirersmultiple.com where I just run the screen. It’s updated every 15 minutes and it will just show you the best opportunities in a very large capitalization universe and in all capitalizations. All investable, I call it, which is sort of the largest two thirds of US stocks and then small and micro cap. 

And I have another server called Singular Diligence, which is a research service looking for Buffett style stocks. So, we focus on a single stock every month, and then we write 12,000 words about the business across nine articles. And where there’s lots of charts showing the very important ratios are the most important relationships for that business and we produce that once a month. And so this sort of best for buy and hold investors.

Preston Pysh  42:27  

Absolutely amazing. Alright, so this is the point in the show where we’re going to play a question from a member of our audience. And this week, we’re going to play a question from Steven McNeil. And we’re also going to invite Toby to help us answer Steven’s question. So here’s Steven’s question right now. 

Steven McNeil  42:43  

Hi, my name is Steven and I’m a big fan of the podcast. My question is, is there ever a time where a high PE ratio, say 30 or 40 or higher, is justifiable to the value investor? Does a number this high signify too much speculationm or can a higher PE ratio sometimes be okay. Thank you. 

Preston Pysh  43:07  

All right, Stephen, thank you so much for the question. And we’re going to have Toby take it away.

Tobias Carlisle  43:12  

That’s a great question. I’m very happy to take that. I know lots of value guys. Most of my friends who are value investors, running little firms, they tend to be Buffett-style guys. And we have these debates all the time. So it’s kind of interesting to talk to somebody about their process. 

So my process, like I was saying before, if I run the model, and I look at the companies that are in the model, I feel sick because they’re buying oil and gas. That’s just a terrible idea at the moment. I don’t know where oil and gas oil is, but you know, it could just as easily be cut in half again from where it is now. 

And I know that Dan Loeb came out yesterday and said that it’s just all the tourists who are buying the oil and gas companies. So, I’m a tourist buying oil and gas companies. So that’s my process. I just ignore the businesses that are in there, just buy them and don’t worry about it. So this friend of mine who’s a Warren Buffett style guy, his processes, he goes through and he does his full valuation. 

And then he doesn’t look at the implied PE of his intrinsic value calculation. He gave me an example of something that was on 40 times earnings. And he said if I looked at that, and I saw that the implied PE was 40 times, then there’s just no way that I could buy that company because that’s way too high. 

So, his little trick is not to look at the implied PE. I think the answer is that, yes, you absolutely can buy those companies if the valuation is warranted. As a deep value guy, I’m sickened anytime I hear a number that high. But he definitely doesn’t.

Preston Pysh  44:54  

I think you can always provide the example of a company that would have a high PE that then shoots into the stratosphere even further, like Apple, for example. You go back into the 2003 timeframe, somewhere around in there, or whenever they really started taking off and people were trading them higher, I think maybe 2004 or 2005 or whatever. But, that would be an example. That would be an outlier to a lot of the stuff that we’re talking. But I think, your research is done on a large quantity or volume of data points. 

And the data points definitely prove that a higher PE ratio performs much worse than a lower one. So, I think it really depends on your approach. If you’re buying onesies and twosies, and you think that you have the acumen like Warren Buffett to go ahead and and find that diamond in the rough that’s a great business that might not have people really looking at the value, the hidden value that’s actually there through competitive advantage and stuff. 

Well then, go ahead and do that. But if you’re investing across an index of stocks or a larger portfolio, I think Toby’s book will really be eye opening for a lot of people when they look at a high PE ratio type pick.

Tobias Carlisle  46:07  

The other point to make too is that when I’m looking on an acquirer’s multiple basis, I don’t know whether they’re actually any earnings that are falling to the bottom of the income statement there. So, it’s entirely possible that they have quite a good operating earnings figure. And it’s just eating up through some other part of the income statement. And so, the number that falls to the bottom is not really representative of the operating earnings that are coming in. So, even though it’s cheap, it might be three or four times on an acquirer’s multiple basis. It could be because the E is so small that it could be 40 times or it might just  be riff. If you look on your Excel spreadsheet, and there are no earnings, you get the hash riff. That’s how I know it’s going to be a good one when I get the riff for the P number.

Preston Pysh  46:58  

Toby, I got a question for you. So, have you ever spent much time looking at the look through earnings piece of Berkshire Hathaway and trying to find other businesses that have that piece of it, that look-through earnings piece, because I think a lot of people miss to value Berkshire Hathaway simply because they do not understand look through earnings.

Tobias Carlisle  47:18  

I haven’t spent a lot of time looking at Berkshire’s look through earnings. I’m interested though. What’s the analysis that you’re doing? 

Preston Pysh  47:26  

So here’s the idea, whenever I was looking at the the cash flow of Berkshire Hathaway, the amount of money that shows up on the businesses that he doesn’t have a controlling share, and so Coca Cola is a perfect example, the only money that actually shows up and that’s reportable on his income statement is the dividends that are paid. 

But whenever you look at the actual earnings that Coca-Cola is making, it’s on the magnitude of, basically, taking that dividend payment and probably multiplying it by three as to the real earnings or the look through earnings, that Coca-Cola is really making. 

He doesn’t have to list that anywhere on his balance sheet or income statement. Now it’ll show up eventually, on his equity line of his balance sheet as unrealized gains, but when people are trying to look at the value and they’re forecasting future cash flows, I would imagine 99.9% of the people out there do not include that extra money that’s not being shown up anywhere until it actually materializes. 

So what I’m trying to do, and what I’m trying to do more research on, is I’m trying to understand look through earnings for other businesses outside of Berkshire Hathaway. Because whenever I look at Berkshire Hathaway’s reported earnings, their PE ratio, Berkshire right now might be, I don’t know, like a 17 or something like that. 

When you account for look-through earnings, its PE goes down dramatically to maybe a 12 or maybe an 11. And that’s something that I think everybody misses the boat on. And I think that’s why Berkshire Hathaway has continued to be traded at such a low multiple, when you look at the price, the book, and things like that. 

But I think if people actually understood look-through earnings, they would see a lot more value in businesses that are similar to Berkshire Hathaway as far as holding companies. So I’m trying to find a person out there that understands what I’m talking about. And I can see by your reaction, both you and Stig are totally catching what I’m talking about. You guys understand what I’m saying. 

But I just haven’t had the right person to have the quantitative analysis, the skills that you have with, obviously, in your book, to kind of dig into this and discover more about it. So maybe it’s something we can talk about offline. But I just want to bring that up because most people I talk to look at me like I’ve got crabs crawling in my ears whenever I talk about that kind of stuff.

Tobias Carlisle  49:49  

It’s the sum of the pot style analysis where you’re looking at the underlying businesses that the business that you bought, the company that you’re buying holds. So, I can think of AGCO is one of the moments’ cheap on an acquirer’s multiple basis and it’s got an Indian subsidiary that’s not included at all in that calculation. And so, it’s a lot cheaper than it looks. Those are the sort of things that deep value guys love to find because that’s a business that’s saleable, that has some value there that is not at all included in everything that’s visible in the financial statements. So yeah. I think that’s a great analysis. 

Preston Pysh  50:29  

It’s really interesting because it’s a shortfall of gap. It really is. It’s an accounting issue, where because it’s a non controlling share of a business, he doesn’t have to report it. And that’s really where the gap kind of falls. And I think, a lot of people miss the mark. And when you look at Berkshire, I mean, he has such a large amount of his business. He’s in a non controlling share of all these other business. 

I want to say it’s an excess of $100 billion for Berkshire. I mean, that’s what one third of its overall market capitalization value is owned in a non operational subsidiary business. Let’s just say that the mark is $100 billion, and his dividends on that hundred billion would probably be around the 3 billion mark, okay? I would argue that there’s probably another $6 to $7 billion that he’s actually making, that he doesn’t have to report anywhere or show up because they’re non operational subsidiary. 

So there’s a lot of value there that no one’s seeing. And I think that’s why you see its price the book at like, 1.3, or whatever it is right now. But anyway, Toby, thank you so much for answering the question from our member from the audience. Thank you so much for coming on the show. And I’m telling you, I will treasure this book. I am really enjoying this book. 

It’ll be one of the ones that I keep on my shelf right next to Security Analysis. It’s causing me to really rethink a lot of the different things that I’m doing and it’s going to give me some opportunities to test some new stuff out. So everyone in our audience, thank you so much for joining us. We’re going to send a free signed copy of the Warren Buffett Accounting Book to Steven. 

And we’re also going to send a free signed copy of our book to Glenn for recommending Toby for coming on the show today. So, Toby, thank you so much. And we’ll see everybody next week. 

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Outro  54:05  

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