Stig Brodersen  1:12  

John, my first question to you is about investment ideas. Investors generate investment ideas in different ways. They might start with a stock screener, they might speak to a mastermind group where everyone pitches a stock or it might be on developinvestorsclub.com. This is just to mention a few options. How do you generate your investment ideas?

John Huber  1:36  

It’s a great question. I get this question a lot from prospective investors that people want to understand the process. To me, investing is a negative art which means identifying what not to do is often as important as knowing what to do. A lot of investors think of investing ideas like an assembly line where you simply piece together certain inputs and out spit the finished product, in this case, that would be an investment idea. It’s my observation that the world doesn’t work that way

Great ideas involve a lot of preparation, hard work, diligence, and patience. Serendipity plays a role as well. You need to position yourself to be open to those serendipitous moments because they come from unexpected places and sources and they come at an unpredictable time. We know this business requires great investment ideas. If that’s true that great investing ideas come from unexpected places, 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. 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 necessarily the right way to do it for everyone but for me, the process is to think of myself not as an investor but more as a student with the objective to learn about a variety of subjects. 

My wife is always wondering what it is I do all day. She’s never quite sure how to describe my job to other people so I tell her the easiest thing to say is that I’m a professional student, which also causes more confusion. I think of myself more as a non-fiction writer who’s working on a book. My work involves a lot of reading, note-taking, phone calls to learn from people who know more than me about a specific topic, and then a lot of time thinking about everything that I’ve been working on. 

The goal for me is simply to learn. 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. I read a lot of the primary sources, annual reports, write up: Sandvik and other places. I do find it 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 okay to spend a lot of time reading about a topic that might not lead to a specific action within the portfolio at that moment. The thing about it is, even to boil down my process is to try to produce a watchlist of companies or build a watchlist. I think of my job every day is coming in to work on building my watchlist of companies that I know well and then just waiting for the market to give you a price. 

That process involves a lot of reading and patience. If you have a goal of finding an investment idea this week, month, year or try to find a couple of new ideas every year. If you’re trying to manufacture an idea, I think that’s where investors run into problems.

Preston Pysh  4:51  

John, we all learn from Warren Buffett that we’re all supposed to invest in so-called wonderful companies. If only it was that easy. Could you please provide some examples of qualitative and quantitative factors to help define what a wonderful company is?

John Huber  5:10  

The best investments in the long run come from the best companies. 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. For long term investors, it’s really simple: the best investments come from the best companies over time. The question is: how do you find them? Peter Thiel gave a talk. He called competition is for losers. This was at Stanford maybe 6 or 7 years ago. You can find the talk on YouTube. 

I had 2 takeaways from this talk. There are 2 types of companies: monopolies and non-monopolies. He says monopolies make money while non-monopolies don’t. He’s got an observation that I think is quite accurate. He says monopolies are always trying to say that they’re not monopolies. This is sort of relevant in the current news. We just had The Big Five tech CEOs on Capitol Hill at the hearing on antitrust and they’re all trying to say that they’re not monopolies. 

Google says their competitors are just a click away and all of them are trying to say they’re either in a small piece of a big market or they’re in very competitive markets. See, if the monopolies are always saying they’re not monopolies. The non-monopolies are always trying to say that they are monopolies. It’s just sort of an interesting observation. It’s not exactly black and white. I think it’s a good mental model to keep in mind that monopolies are the businesses that make money.

I’m using the term loosely. I don’t think it’s as black and white as Peter Thiel suggests. Some companies can produce profits that are not monopolies. Again, you have a really simple choice as an investor. There are 2 categories to look at: The first category is company monopoly and the second category is the company is building towards becoming a monopoly. It’s not Sherman’s definition of monopolies. It’s not the antitrust laws but it’s looking for a company that produces high returns on capital and can produce economic profits. 

What are some attributes that these monopolies or future monopolies have? There are some common denominators. The business has to make money. A wonderful company has to generate high returns on capital. That’s where economic value comes from. The goal of investing is to simply produce high returns on your capital. The same goal exists for businesses, it’s to earn high returns on the capital that investors funded it with. High returns on capital are a definition of a great business. That’s the result. 

There are some characteristics attributes that can lead to that result. The first one I’ll mention is adaptability to change. It’s extremely important nowadays because change is constant. Now, Buffet likes to say that he invests in companies that are resistant to change but the critical question today is to ask whether the company is adaptable to change. I’m not sure there are many companies, even the monopolies that are resistant to change anymore. The world moves and changes so quickly.

Barriers to entry are generally so much lower than if you’re not willing to embrace change, then change is going to embrace you and that won’t be good for your company. Management is important but also the employees at the company human capital are much more valuable today for many companies in the physical assets that they own because people and the ideas they generate where much of the value gets created. 

It’s important for the company to be able to retain and attract talented people and it’s important to be adaptable to change. Stig and I did a podcast last year on Facebook specifically. I think Facebook’s an example of this. This adaptability to change. Zuckerberg in my opinion is a great CEO despite all the hate he gets. I think he’s very adaptable to the change. It’s a quality that is valuable. 

Facebook IPO when the company was facing what I would call an existential crisis, 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 it would soon die.

Part of the solution there was famously buying Instagram which was a mobile-first application. Part of it was reassigning engineers and staffing them with the task of killing their golden goose. Essentially, to figure out how to find a way to fit advertisements onto an app made for a phone so they were able to do this. That was probably the most significant. 

The company also had to make a shift when it became clear that Snapchat had found an interesting idea of vanishing messages. They tried to buy Snapchat and they got rebuffed. They created Instagram stories which have been a massively successful product both in terms of adoption and in terms of collecting revenue. 

The company adapted from desktop to mobile, from text to photos, and then video. Now they’re trying to adapt again with the latest trend: the addicting videos of TikTok. They just announced this week that they just launched their product called Instagram reels which is a TikTok clone. We’ll see if that will end up being successful. I’m not sure if it will or it will not but it’s another example of how forward-thinking the company is and how flexible their culture is which I think are good. 

Another example of an attribute that I tend to look for is high gross margins. This is one that is not necessary. Not every company has to have high gross margins. Many great companies have low gross margins. In general, I’m attracted to high gross margins and we can keep talking about Facebook for a second because of their increased business model in which users generate the content. 

Facebook doesn’t have to spend money acquiring content and advertisements are self-serve. They’re essentially automated so Facebook doesn’t need nearly as large of the sales staff. They don’t need the sales staff that a traditional advertising firm would require because the ads are automated. Snapchat is an example. Snapchat has 47% gross margins. Facebook has 81% gross margins. Those are large because of those 2 differences. 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. There’s still a lot of money left over for shareholders. 

Another thing to look for is economies of scale. A lot of great companies exhibit this characteristic. This is simply a business that has high fixed costs but very low marginal costs. This does 2 things: the high fixed cost makes it hard for new companies with little or no revenue to enter and low marginal cost, Copart is a great example of this, the company owns a large percentage of the auto salvage auction market. If you total your car in an accident, the insurance company takes it and then sells it to a buyer at one of Copart’s auctions. 

Copart invested a lot of money over the years to buy the land and build this model that they have: the junkyards where the vehicles are stored temporarily. Copart doesn’t buy cars. It just takes a commission for connecting the buyers and sellers so there’s no inventory risk on each sale that runs across its network. The auctions are all done online. Each sale is very high margin and each incremental dollar is nearly not quite pure profit but it’s very high margin. 

The business has high fixed costs and low marginal costs. It’s difficult to replicate the assets and the network that Copart has built. Another example is Amazon. A well-known example. Amazon developed its warehouse network in the early days. High fixed costs but then they allowed third-party sellers eventually to use that infrastructure. They took a commission on each sale and that meant each dollar of incremental revenue was pure profit. They built the infrastructure initially which was expensive to build and carry a lot of costs to maintain. Each new dollar has very low marginal costs. 

Now, in reality, Amazon and others like Netflix. This is another example. The company in theory has fixed costs. They have very high margins on a certain amount of revenue over that fixed cost base but in reality, they end up reinvesting those high margin dollars back into the business. This does 2 things: it adds more fixed costs, the initial base which delays 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. 

It helps widen the moat which Amazon famously tries to do. Netflix sort of has a similar strategy to buying content. The content is somewhat fixed to be spread over the entire user base. Then each incremental user that wants to access that fixed amount of content is largely a profit for Netflix. This is somewhat debatable because I’d argue that Netflix content is more variable than fixed because if they stopped making new shows users might leave. 

I do think there’s at least partially a dose of economies of scale that works in Netflix’s favor there. So those are some examples of economies of scale. Another thing that has been a theme of mine over the years in Sabre’s portfolio is a toll road. The toll road is 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.

A great example here is Verisign. This is a company we have owned in our fund for several years. Verisign owns the “.com” and “.net” domain names. Anyone who has a website address ending in “.com” or “.net” pays an annual toll to Verisign and the company has 162 million domain names. It collects $8 a year for each one. It’s a great business. It costs virtually nothing to serve a new website. Every time you sign up for a new website it’s essentially a pure profit for Verisign. Electrons are essentially costless.  

VeriSign has essentially no cost to add an incremental new “.com” domain to its user base. It’s got a 65% gross margin or 65% operating margins. It’s an incredibly profitable business. It does have leverage for those reasons I just described. That’s a toll road. That’s about as close as a toll road as you can get, metaphorically speaking. Another example is the companies that aren’t exactly toll roads. 

MasterCard is an example of a business that is essentially a toll road on global commerce. They did $108 billion transactions last year and ran across Mastercard’s network, a $4.8 trillion volume which grew 13%, transactions grew 20%. The $90 trillion economies; they’re still runway ahead but Mastercards position along with Visa, they’re toll roads on global commerce. If you want to participate in the global economy you’re likely going to have to pay Mastercards toll. 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 intangible. I’ll give you an example. NVR is a home builder. Homebuilding is a tough business. You have to sink lots of money into the land which you need to build homes on and then you sell the homes and then you have to replace the land. The land is expensive. 

Since builders don’t generate huge profits they never have enough money to pay for the land. They financed the land with debt. They finance most of it with debt. This leaves them vulnerable when the next downturn comes. They’re left with lots of land and inventory that’s hard to sell. Then a bunch of interest charges that don’t go away. NVR escapes this by using options to tie up the land that they need. They put up a small fraction of the cost of the land and the seller finances the land for the cost of the option premium. 

NVR finds the buyers when they want to build a house and only then do they exercise the option to take down the land. They’re not left holding the bag. If a downturn comes the worst case is they lose their option premium. NVR has no debt, requires much less capital, faster inventory turnover, and all of those lead to better returns on capital with less risk. It’s such a great model for home buildings, more or less a commodity industry. Why wouldn’t other builders copy it? Some are trying to do that but it’s very hard because of the way most builders incentivize their CEOs. 

If you go through all the proxy statements of NVR competitors, almost without exception, you’ll find that the bonuses and the compensation structure that exists are often linked directly to the total volume of a home sold, 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 regardless of whether the growth creates any value. The easiest way to grow homebuilders’ revenue and profits is to go out, buy more land, build more homes, and homebuilding. 

That means taking on more debt and not sharing the profits with a land developer. They’re incentivized to make as much as they possibly can and they’re using other people’s money to do that. They’re incentivized to go out and create gross profits without any regard for the return on invested capital. The NVR as a model is very hard to copy because of the incentives that exist in the industry. I’ll give you one more example of an intangible miscellaneous advantage that I just noticed recently. I was reading the  S-1 filing for Rocket Mortgage or I think it’s called rocket companies. 

Rocket Mortgage and Quicken Loans are their brand names. They’re one of the largest mortgage companies in the country. This is interesting because I just read an earning press release from a company called Mr. Cooper. Mr. Cooper was touting this stat they call industry-leading and the stat was their recapture rate. A mortgage company collects money by making loans and also collects money by servicing loans. Which means, collecting payments and passing the cash flows along whoever owns the mortgage. Usually, an institutional investor who owns the security that the mortgage is inside of. 

The servicer collects a small fee for each monthly payment that they process. It’s only a few bucks on each payment but spread across thousands of mortgages over many months and then you have a nice residual stream of cash flow. The problem for servicers is that their customers might refinance. This means they might find a new mortgage company at a better rate. That would mean you lose the stream of cash flow. Mortgage companies are always trying to keep or recapture these clients when they refinance. 

Mr. Cooper was touting the 30% recapture rate which means for every hundred people that refinance, they keep 36 of those refinances. That’s above the industry average of 22%. Interestingly, Rocket Mortgage has a recapture rate of 76% which is three and a half times the industry average. So why does Rocket Mortgage do so well at keeping the customers when they refinance? The answer could be a variety of things. It could be because of their sales culture. It could have to do with their technology. They might have a really good user interface. 

It’s super easy to get a loan from Rocket 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 the MSRs (Mortgage Servicing Rights) that you own, are more valuable than they would be with someone else. Those are a few attributes I look for when seeking out wonderful companies to invest in.

Stig Brodersen  21:20  

Thank you for a fantastic response, John. I think along those lines of identifying moats I have to say that I love the quote on the front page of your website where you say, well, I probably shouldn’t say your quote. Buffett might have a different opinion. The famous Warren Buffett quote is “I don’t look to jump over 7-foot bars, I look around for 1-foot bars I can step over.” I just absolutely love this. It has been my signature on our value investing forum for years now. With everything you just said to us about identifying moats, my question for you is: which investments in the past have been 1-foot bars to step over?

John Huber  22:07  

That’s a great question. 1-foot hurdles are a central piece of my strategy. It’s a pillar of my investment approach that sometimes even the biggest most well-followed companies can get mispriced by the market. 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 2020. I’ve done this over the last 4 or 5 years. I do this about once a year. 

You can look at the variance between the high and the low price of the biggest stocks in the market, whether that’s the S&P 500 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. It’s remarkable how much their stock prices change in any given year. 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% for the mega and the fluctuation of their actual underlying value does not change by anywhere near that much. That just tells you that there’s from time to time opportunities to capture value even when the company is well followed. The idea that “you have to have an informational edge”; I’ve never bought into that theory because a lot of times the biggest companies in the market get mispriced. 

When you look at 1-foot hurdles, they often come from this category. Not necessarily the biggest companies but for companies that are well followed. There is no information edge but from time to time for whatever reason, the stock is mispriced. An example of this which happens to be the largest stock in the market is Apple. It’s a stock we’ve owned for several years and I think it’s been a 1-foot hurdle on a couple of different occasions. 

Back in early 2016, the stock was trading at eight times free cash flow. 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 being normal earning power. It was a remarkable situation where the market was doing 2 things: one is they were valuing the company and Apple always used to get value this way. It’s gotten revalued in recent years; the market has started to value it more like a consumer brand like 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. The idea was you’re Dell. Your margins are going to revert to the mean at some point or if you’re HP or any of these commodity hardware companies, any sort of economic profit you create is going to be fleeting. That was the narrative around Apple in early 2016 because Samsung had a phone that was competing and Google was starting to compete. Amazon was even competing at that time. 

People were worried about Apple’s margins. I think the other thing was just simply that Apple’s iPhone sales had temporarily stalled. Even when a majority of market participants were agreeing that Apple’s long-term future was still good and they still have a bright future, people worried about the next 3 months, 6 months, 12 months. People would say things like stocks are dead money. No one wanted to own the stock, the stock got cheap. That’s an example of a 1-foot hurdle. 

 The broader point to me is very much worth paying attention to is very high-quality companies that for one reason or another can get mispriced. Apple from that point has compounded at 40% a year for the last four and a half years. It’s a remarkable situation. In a stock where there are 200 analysts, there’s absolutely no informational edge. 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 but nowadays where information is much more of a commodity because of the barriers to entry, the ease, it’s much easier to acquire information so it is becoming more of a commodity. The edge now is called the “time horizon edge”, looking out longer-term, being able to look out 3 years, 4 years, or 5 years. When the market has a hard time most market participants are not willing to look out past the next year so I think that’s a good example of a 1-foot hurdle.

Preston Pysh  26:32  

John, when we create our investment thesis and make our growth projections for our 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. When you’re listening to the corporate management talk about how much of the addressable market they plan on capturing they’re incentivized to blow it way out of proportion and it’s not something that I put a lot of credence in whenever I hear management talk about what they’re going to address in the addressable market. I’m curious how you look at this and just some of your thoughts on it.

John Huber  27:14  

I’ll go back to Sunday, Peter Thiel said in that same talk that I referenced earlier, he has this equation, he says, “great companies create X amount of value and then they capture Y percent of X”. That’s the equation: X is the value created, Y is the share of that value. You can think of X as the market size and Y as the share of the market. 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 a monopoly like economics with a tiny share.

There are a lot of exceptions. You can, there are some great companies. For example, Geico had a 1% market share and it had phenomenal economics. Now it’s got a 10% market share. There are a lot of exceptions to this but 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 latter company will usually have much better economics and much better returns on capital. 

Ideally, you have a company with a big share of a big market. That’s when you get the true mega-cap monopolies like the Googles and the Amazons but I think most investors and especially most startups are much too focused now on the size of the TAM (Total Addressable Market) and they’re not focused enough on building a strong position in whatever market they’re in. 

It’s easier for companies to build a strong position in a small market first and then expand from there. Theil talked about the Amazon. The 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 AWS (Amazon Web Services).

Preston Pysh  29:02  

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?

John Huber  29:17  

I have a friend who specializes in buying and selling single-family homes in the $250,000 price range near a local military base and he made 37 investments last year. He focuses almost exclusively on a single asset class in a very small submarket at a very specific price point. He even specializes in how he sources these assets generally from the courthouse. He’s built up this business over the years and he has come to be extremely good at it. 

He’s got a fairly sizable payroll. He cuts out the third party vendors so his staff does all the repairs and the maintenance on the homes and he slowly has built-up his painting crew. Then one day it dawned on him that he could start painting for other real estate investors and then other homeowners. Now, he’s got a paint company that’s booked through the fall. He’s doing very well with it. He plans on doing the same thing for property management. Using what he’s created for his own business and subcontracting it out to other people that want that service. 

I told him that he’s like a mini Amazon. He’s developed an expertise for his properties and then he sells that service to third parties which is a nice high margin revenue for him. It’s a great little business. Now, the TAM is tiny and the total value of his company has a ceiling but he’s created a significant amount of economic value for himself because he didn’t start by saying, “Hey, U.S. real estate is a $22 trillion asset class”. He started 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”.

This makes a lot of sense as a general business strategy, as well. How do we identify the TAM? It’s hard to know but I first look for companies that are in strong positions in their markets and then working toward building a strong position. Secondly, look at TAM. The world is filled with mediocre companies in massive markets. One last point I’d make here Stig is at the very best companies often figure out how to expand the markets that they’re in. The best management teams tend to expand the TAM. 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. Facebook’s market wasn’t the size of the digital advertising market when it started or even the advertising market overall. It was the advertising market that they would help single-handedly create and there are lots of other examples as well. *Inaudible* 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. I think Tim Cook just said in the antitrust hearing the other day that it started with 500 apps 12 or 13 years ago. Last year, it did $500 billion in total volume. The total amount of commerce that went across that app platform, the App Store is estimated to be half a trillion dollars. Incredible business. An entire generation of developers has created businesses because of the App Store. 

Instagram doesn’t get started without the App Store. Most likely, Uber might not exist without Apple. There’s something to keep in mind. The very best companies can expand their markets. Generally, I spend a lot more time thinking about the competitive position than I do thinking about the size of the market.

Stig Brodersen  32:52  

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 car industry. I know this is an ungrateful question to ask but how do we pick winners in the industry?

John Huber  33:16  

That’s a great question. It goes back to what I said before about adaptability to change. Companies now have to have an element of flexibility and malleability. They have to be able to change with the current environment. The reason for that is because of the speed of information, technology, and evolution in the business world is so great that companies can no longer rest on their laurels. 

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, Facebook, and Google. It’s easier to reach customers and acquire customers. 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. 

It’s very difficult to pick winners. I don’t have a good answer to the question Stig but I would focus on companies that are building strong positions in their market. Like I said before, focusing less on this may be the size of the addressable market. Don’t worry about the $22 trillion U.S. real estate market. Think about how I can dominate the small niche in Lillington, North Carolina. 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.

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. 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 flexibility on the investing side as well. You have to be willing to adapt your thesis as things change and businesses get attacked and grow. That’s part of being an investor these days.

I like that you didn’t have a fixed set of rules on how to do that. The question that I asked him, not even Buffett said he had a recipe for that. In continuation, we do know that the mighty fall and companies have shoulder and shoulder tenure in the S&P 500. Disruption of existing business models is just happening faster than ever and it seems like it’s accelerating. Keeping that in mind, what are the implications for individual stock pickers like us?

 It’s a great question. The S&P 500 index is active in a sense because it’s a great investment vehicle, it allows you to own the best companies at any given time. The best companies meaning the biggest; those 2 don’t always equal the same thing. 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. As you say, you have to be aware of that as a stock picker. You have to adapt as companies adapt and companies change.  It’s the same theme that I’ve talked about. 

The important thing is focusing on companies that currently have competitive advantages and then finding durable companies. Durability is a very important feature or attributes that I look for when I’m looking at companies. Companies that can withstand these changes and attacks. They have good economics now but they have some competitive advantage that gives them durability. There are a lot of things I talked about earlier, maybe it’s a toll road business, maybe it’s a company that has high fixed costs that provide a barrier to entry. 

Again, the most important thing not to beat a dead horse but 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 great ideas come from. That’s where you can create a culture that can adapt. Humans can adapt to change if they’re in the right environment. The companies that will do best going forward will be the ones that can change and navigate these waters that you’re talking about.

Preston Pysh  37:41  

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’ve focused too much on what I’ll call optical valuation. That means the current P/E ratio (price-earnings ratio). For example, the current price to free cash flow as opposed to focusing on what the business looks like, 5 to 7 years down the road, sometime in the future. The longer your holding period the more important it is to own great businesses. One of my philosophies is that the tenant of our approach is that great investments come from great businesses. It’s also true that the longer your holding period the more critical it is to own quality companies because, in the short-run, valuation drives a lot of stock price reactions. 

It’s 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 5 years, 7 years 10 years. You’re much more efficient with what that company is going to look like. Buffett says the tailwind, effective 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 to buy the great companies and understand the simple fact that time is a friend of the great business over time. That’s really what I’m trying to point out in that, 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’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 the quality of the business because great businesses can adapt to change and they can weather economic storms more efficiently. We just saw this with COVID. The great companies have survived. COVID is unique because some of the great companies are strangely well-positioned to navigate the waters that we just went through and that have a unique situation. Generally, I think that is true. The best companies in the financial crisis were the ones that came out on 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 with more market share, there’ll be a better business and they will not just survive but in some cases thrive. The same thing that we just saw with COVID has been an extreme case of this, but it happens every single recession. You’re better off owning the better companies and my mistakes, come from the times when I get more attracted to the current valuation. 

Wells Fargo is a mistake that I made recently. About a year ago, I bought Wells Fargo and that company has a lot of issues. It’s got some cultural issues, management issues but possibly the new manager is doing much better or will do much better. He’s attempting to change culture but it’s hard to change culture with 260,000 people. It’s something that I’ve observed and I’ve learned.

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, and profit margin of a bank are at all-time lows and they’re not as diversified as some of their bigger competitors. They’re struggling on that front as well. But if you observe how Wells Fargo has, from a business, forget about the stock prices, just look at how the business has done in the last year. It has struggled mightily in an environment where better businesses have done much better. 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 overtime to also be safer.

Stig Brodersen  41:39  

John, let’s talk a bit more about mistakes. I don’t think that you could have invested no *Inaudible* could have invested for too long before they make their first investment mistake. My thing was the Templeton that said that if you’re right, 2 or 3 times, you’re the best investor in the world. Let’s talk about being wrong because that is a challenge that we face as an investor. I’m curious to hear your thought process about those investment decisions, it’s a tricky situation because you might not be sure that you made a mistake. 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 investing in the wrong business.

Preston Pysh  42:23  

That’s exactly true. Opportunity costs are a big thing to consider Stig. A lot of my mistakes have come from not investing in something I should have invested in. The mistakes of omission where you buy a stock that goes down or buy a stock that doesn’t go anywhere are the mistakes that cost you money. Those are the mistakes that you need to correct quickly.  

John Huber  42:44  

My method for selling: there are 3 reasons to sell a stock. One is you come up with a better idea and you’re fully invested in so you need to raise cash but that’s a tough decision to make because you’re never quite sure if the stock you’re about to replace, this stock that you’re about to buy and replace something with is, in fact, a better value. That’s one reason. 

The second reason is the stock reaches fair value. The third reason is the easiest, you just made a mistake. I’ve never had a problem selling. When I realize a mistake has been made in the process to come to that conclusion varies. Each situation is unique. You need to know how to separate the noise from actual negative changes in a business. That’s part of the skill that’s required to play this game. 

Then that skill needs to be coupled with the ability to be completely honest with yourself. This is the most important character trait for an investor: being honest. It helps you mitigate mistakes before they get worse. It also helps prevent mistakes in some cases. All of those things are critical. Not everyone can do that because it means admitting to yourself that you are wrong and that can lose 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 risk. 

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 66%”. Just ensuring that your winners are greater than your losers you can actually have a hit rate of less than 50% and still do quite well. Soros 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% a year. It’s all about mitigating mistakes, making sure your winners are bigger than your losers. 

When it comes to making mistakes or identifying mistakes, one of the things I try to do is 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 see what I was thinking in real-time. That makes it easy to see if the thesis has changed. It’s really important to not adapt your thesis to the new environment. 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. 

More often than not there are exceptions to that but it’s better to just, when you realize that the game has changed, either you made a mistake and analysis or the company have deteriorated in some way, it’s better to just sell. I keep a list of a few key variables that I track for each company, each investment. I can easily tell if one of the variables or multiple variables has changed or starting to degrade. 

You can recognize that in real-time and you can adjust and oftentimes that means selling and sometimes it means selling at a loss. Many mistakes are part of the game. You probably will make one mistake out of every 3 or 4 investments but that’s just the nature of it. Mitigating those mistakes is a critical part of success. 

Preston Pysh  45:48  

I find that stock investors learn the most in very volatile and unexpected market conditions but from your perspective, what has been unique in what has not been unique about all this COVID stuff.

John Huber  46:03  

I think a lot of unique things. We’ve never had a situation where, at least in the West, where Western governments have shut down their economies. That 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. It’s remarkable what they did then and I saw a lot of the same things happening earlier this year in the winter. It looked very much that they were following a lot of the same playbook that they use to battle SARS in China. 

That means locking down apartment buildings and stationing a guard outside and shutting down cities and so forth. I just never thought that the rest of the free world would do that to the extent that they did. That has been a remarkable unique aspect of this crisis. There are always similarities, I’ve said this in a recent blog post, but I can point to 4 very broad general similarities that happen almost without fail every single crisis or every single recession. 

The first thing is everybody brings up the 1930s. Whenever there’s a downturn in the stock market of substantial size 15 to 20% or so whenever we reach bear market territory, everyone starts to bring up the 1930s because there’s always something bad that’s happening in the economy at that time. If the stock market is down that much and it always looks bad. The second thing is every bear market has unique aspects which are also scary because there’s no playbook and so people think the worst people think the current crisis there is unprecedented. 

We’ve heard that word a lot and that is true with COVID. A lot of it has been unprecedented but because 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 in 1987 was a flash crash. We were worried that that could spark another Great Depression when the Dow dropped 22% in 1 day in October of 1987. The 2000 dot-com bubble was extremely unique and of course, 2008 was a financial crisis that we haven’t seen in 100 years. 

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. That’s just natural human behavior. You want to sell it because you fear that tomorrow the stock price is going to be lower. The idea is we’ll bring to the fourth point, the idea is you buy back when there’s more clarity. Everyone thinks you’ll be able to buy back cheaper, the experts advise to wait for more clarity but above it says if you wait for spring, the Robins have already gotten the worm. I just butchered that quote.

If you wait too long prices will already reflect a much rosier outlook. In regards to the 1930s this COVID a lot of people started talking about the Great Depression too. 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. 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 1930s. Especially when it comes to the United States in the 1930s, we had no unemployment insurance. We had no social security, we had no FDIC (Federal Deposit Insurance Corporation). 

It wasn’t safe to keep your money in a bank. Your bank went under and 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. In 1930, we tightened fiscal policy instead of loosening it, right? We flooded the system with money. Earlier this year, we did the exact opposite in 1930. There’s this famous tariff called the Smoot–Hawley Tariff and that 1929 that was a stock market crash. 

We had The banking system had liquidity issues. And we exacerbated those issues by slapping tariffs on our trade partners. 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 accelerated the Great Depression and made things much, much worse. We also take monetary policy in the 30s instead of loosening it. 

We raised rates. The Fed raised rates under Hoover instead of cutting rates and we had a hard currency policy back then we had the gold standard to a certain extent, and we have no gold standard today. 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 1933. 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 we essentially take for granted today, like Social Security was initiated as part of the New Deal, legislation that was passed in 1933 in the early 30s. All of those things brought back confidence, you can debate the merits of those various regulations and various laws that were passed. They did lead to increased spending, increased investment, and we slowly recovered. 

The point is, we did the exact opposite of what we needed to do to break the panic in the 1930s. It was the exact opposite of what we’re doing now. That’s just something generally kept in mind. 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 1930s 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 were made by the technical definition of a depression. We had one. The side of the balance sheet was matched with an equal or maybe even greater force with $3 trillion of new money coming in. It doesn’t feel like depression but we will have depression at some point. Again, we’ll have numerous recessions. It doesn’t mean things can’t get worse but it’s not gonna look like the 1930s. 

Stig Brodersen  52:17  

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?

John Huber  52:31  

I think about each investment as a piece of business. I tend to think that I do look at the portfolio overall from a top-down view because I do want to have certain diversification. Other than that, I think of each investment and I want each investment to stand on its own merits. I think of Sabre Capital as a holding company in a sense that owns stakes in a select few high-quality businesses that happen to be publicly traded. I think of each stock as a separate company that I’m a part-owner, we’re a part owner in. That’s how I think about it. Again, I do have certain diversification requirements but I don’t try to optimize anything. I don’t look at correlation at all.  

Stig Brodersen  53:15  

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. For that reason, I wanted to hear your thoughts on how you feel about being 100% invested in equities, considering the mental condition we have right now. Do you consider diversifying into other asset classes? What is your thought process about that? First you and perhaps also a few thoughts for the retail investor?

John Huber  53:43  

I think every investor has to make that decision. The decision on asset allocation is based on their risk profile, tolerance, and so forth. I have all my money invested in stocks and I have a very simple philosophy on this as well: over the long run, part of this depends on your age and so forth, stocks as an asset class will continue to be the best asset class to own. 

Jeremy Siegel wrote a book called Stocks for the Long Run. He goes through a simple chart there. This is a book that’s several years old but there’s a simple chart that shows various asset classes, stocks, bonds, gold, cash, anything you can throw any sort of currency, any sort of other asset class in there, or whether it’s our real estate or anything else. Over time, there’ll be lots of years where this won’t be the case but over the long run, say, a 10-year period or more, it’s 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 1999 style bubble where the S&P is trading at 40x earnings or something but those situations will be very rare. You’re almost always better off owning stocks. My philosophy is American business is the best asset class in the world to own. There will be the economies that grow faster, that won’t always be the case but for me, it’s where I live and it’s within my circle of competence. As an investor, it’s the best asset class that I can own. 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?”. American business is going to provide a baseline return that you can achieve by simply owning the S&P 500. That means owning a Vanguard fund. 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. 

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 saying 500 stocks you select the 5 or 10 best companies that are within that index. That’s a general philosophy, I think the best way to get exposure to that return is through ownership of high-quality companies. 

Stig Brodersen  56:15  

Amazing, John. We covered a lot of ground here in this interview. Preston and I can’t thank you enough for your time to take *Inaudible* your busy schedule to be speaking with us here today. We would like to allow you to talk a bit more about where the audience can learn more about you and Sabre Capital Management.  

John Huber  56:33  

Sabre Capital runs a fund called Sabre Investment Fund and it’s modeled after the original Buffett partnerships. There’s no management fee and there’s a 25% performance fee over a 6% compounding hurdle. That’s off its original structure which I thought was a good fair structure for LPs (Limited Partnership). Sabre runs a fund that is modeled after that structure and you can read more about my firm Sabir Capital at the firm’s website which is sabercapitalmgt.com. 

There you could find a lot of the writings that I’ve done over the years, a lot of different things I have to say. I publish a lot on that website. Feel free to check out the work there. It’s great to talk to you Stig. It’s always great to talk to you Preston and I appreciate you having me on.

Preston Pysh  57:21  

John, thank you so much for joining us. You’re always welcome to come back to the show. I know I personally always learn so much from you whenever you join us. Thank you so much. 

Stig Brodersen  57:31  

All right. As we’re letting John go, we’ll take a question from the audience. This question comes from Tim.

Tim  57:39  

Preston and Stig, thank you for taking my call. I’m very new to investing. In this weird time where interest rates are at 0, 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 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. 

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. Appreciate your time guys, I’ve already learned a lot from you. Thanks. 

Stig Brodersen  58:54  

The short answer to your question is no. Do not leverage your position and there are multiple reasons why I would suggest that you do not do that. I want to start up a response with a Yogi Berra quote. And the core is this: in theory, there is no difference between theory and practice. In practice there is. What I mean is that in theory, you are right. In the case of high inflation, low-interest rates, you can effectively erase your debt and keep the real assets. 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 would happen between now and whenever your desired scenario plays out could wipe you out. That makes me think regardless of 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 Charlie and he knew that They’re always going to be incredibly wealthy. They’re not in a hurry to get wealthy. 

What about Rick? Warren said that Rick was just as smart but he was in a hurry. In the 7374 downturns, Rick was delivered with margin loans and the stock market went down almost 70% in those 2 years. He got the marketing calls and he sold his Berkshire stock back to Warren. Buffett bought Rick’s Berkshire stock at under $40 apiece at the time. Now Berkshire Hathaway’s ASCS at trading more than $300,000. If you look at the track record of Warren Buffett and Rick Guerin they’re not that much different but how the livers themselves were very different. That was eventually why Warren Buffett prevailed and the time it takes for you to be right might bankrupt you. 

The second reason is that you could be wrong. Even the great Ambassador John Templeton said that he was wrong one-third of the time. Looking back at his track record, he was one of the most successful investors ever and arguably the most successful international investor in the 20th century. If he’s wrong one over three times and he even said that might be on the low side, who likely does know better that’s another reason why not to leverage your bets. 

You also set there in your question that you’re 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 that. You do have investors like Ray Dalio who takes leveraged bets from time to time but Ray Dalio is a high net worth investor. He knows exactly how to structure a few leveraged bets here and there and only for a small part of his portfolio. 

Even if you want to test it out, which I would strongly suggest that you do not. You really should be doing this with very small amounts of your portfolio. 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 leverage bets on the expected inflation and interest rates. 

Preston Pysh  1:02:13  

Tim, just to piggyback on Stig’s recommendation which I completely agree with. In theory, you got it all right. What you’re talking about 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 don’t necessarily, as we move forward in the few coming years I think things are going to get very interesting, people that have a lot of debt are going to find that it’s advantageous if they’re paying it back with money that’s significantly worthless. 

Now, here’s where this all gets a little bit tricky. 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 3 years is not good. I suspect that there’s going to be a lot of people that are struggling for work. Ray Dalio is on the record saying that we’re entering into a depression at this point, believe it or not, 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. It comes down to your skill sets and the demand for those skill sets going through a very challenging economy. That’s the important thing. If you have, let’s say, your house, let’s say a person would go out and buy a house that they’re taking out a lot of debt. They’re highly leveraging themselves because they’re wanting to play 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, that person is 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 than before. Now you’re putting yourself in a bind to even make the payments back on that debt. Is it okay to have some debt? Of course. How much comes down to your tolerance? It comes down to your skills and how those skills are going to endure and perform in a very challenging economy. 

That’s where people might not be accounting for how bad things could potentially get moving forward. My anticipation is it’s going to get a little crazy. Something to think about. You understand the fundamental idea of what’s about to play out here. That’s that The people that are lending money are not going to do so well. The people that are borrowing it are going to have an advantage. The challenges are you going to be able to sustain the salary and the pay each month to continue to just make the minimum payments on something like that. 

Very interesting question, very smart question but I would tell you to be very careful with that. Tim, for asking such a great question. We’re going to give you free access to our TIP finance tool. This is on our website 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. For anybody else out there, if you want to get your question played on the show, go to asktheinvestors.com, and if the question gets played like Tim’s you get a free subscription to TIP finance.

Stig Brodersen  1:05:55  

Alright, guys, Preston and I hope you enjoyed this episode of The Investors Podcast. We will see each other again next week.

Outro 1:06:02  

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