Clay Finck (02:01):

Now, Adam, I had a chance to read your book Where The Money Is over the past few days, and I’ve really enjoyed it and just loved the frameworks you put in place that we’re going to be discussing during this episode. In your book, you walk through why the game has changed for value investors. You mentioned that no subset of investors has had a harder time adapting to the changes brought on by the digital age than value investors. Walk us through what your process is on this.

Adam Seessel (02:31):

Well, Clay, I mean, I really wrote the book to help value investors like myself think through the dramatic changes that have occurred in the world over the last 10 years. And as I say in the book, 10 years ago, only two of the top 10 companies by market cap in the world where tech, and today eight are. And depending on how you slice it, half to 2/3 of the incremental value of the stock market over the last five or 10 years has come from tech even after this big latest correction. So it’s come quite suddenly and quite dramatically. And what I found is that very few people are talking about how to reconcile value investing this century-old discipline created by Ben Graham and then propagated by your fellow Cornhusker Warren Buffet, how to reconcile it with tech. Because tech, ever since it began its ascendancy, has been looked very expensive by traditional metrics. And value investors are used to looking at these stodgy old economy companies and looking at them at a lens that basically says, “How cheap are they?”

Adam Seessel (03:38):

And as I convey in the book, this is not an abstract concept for me. This had to do with me and my record and my livelihood. I was a successful value investor for, geez, 15, 20 years, but sometime in the middle of the last decade, my system of looking for low PE, low price-to-book stocks just stopped working. And so I was forced with a sort of fork in the road. Either I stick with this system or I say, “Well, maybe some of the metrics are broken.” And I’ve decided that it’s the latter, that value investing needs to evolve, to widen its aperture, to increase its scope, to include these new economy companies.

Clay Finck (04:19):

You mentioned that you had to make that decision of, is your strategy broken or is it just out of favor for the time being. And I think a lot of value investors are falling into that same conundrum of being in between a rock and a hard place where I hear many value investors just say reversion to the mean is a thing. And eventually, these strategies of the past, they’re going to come back. It’s just a matter of time, but you’ve heard that for the last say five years or so, and it-

Adam Seessel (04:45):

Yeah. Well, I just think that’s false. I just think that’s absurd on its face as the lawyers would say. And I think that if you asked any 12 year old, they would be able to talk as intelligently, if not more intelligently, than us in the value community, because we’ve been so set in our ways. And value investing has worked, particularly as you say, reversion of the mean has worked. But let’s just talk common sensically. Like brick and mortar retail, what’s the reversion to the mean of brick and mortar retail? It used to be when I was coming along on Wall Street in the ’90s, that retail would grow with GDP, brick and mortar retail. Is that going to happen? Is it somehow Macy’s going to go back to reverting to the mean of 3% growth every year? Or is there something wrong with the business?

Adam Seessel (05:37):

Likewise, is Amazon going to revert to the mean? What’s reversion to the mean for Amazon? Amazon has 1% of worldwide retail sales. They have maybe 6% of US retail sales. Where’s the mean? This digital revolution has thrown all those relationships out of whack. So I think reversion to the mean, sure. For some companies that are durable, manufacturing, some chemical companies, yes, reversion to the mean works. But for many, many industries, it’s like Bruce Springsteen said, “Those jobs are going, boys. And they ain’t coming back.”

Clay Finck (06:17):

It reminds me of who you mentioned my fellow Cornhusker Warren Buffet. Buffet’s been hammered for not buying tech, even though he has understood many of these really good businesses, but he did eventually buy Apple in 2016 in very large size. And to be fair, I guess Apple was trading at a pretty good price back then. Walk us through why Apple is the only tech company that Buffet’s really come around to.

Adam Seessel (06:45):

Yeah. Look, I, like you, have a tremendous amount of admiration for Buffet. He is the Mozart of our industry and there will probably never be as great an investor like him. So he is a brilliant guy, but he’s also 91. This tech revolution happened when he was, I don’t know, 75? So he can be forgiven if he’s not quite up to speed on everything that’s going on. I mean, he famously says he doesn’t read email and so on and so forth. So he is not exactly swimming in the tech ecosystem. But I think the reason he liked Apple is that it reminds him of an old line consumer product company which he has invested in for many, many years with great success. It reminds him of Coca-Cola basically. Something that’s daily, something that’s habit forming, something that consumers form a very strong bond with.

Adam Seessel (07:40):

So I think that the famous story now is that he started to see how powerful a product Apple was when he took his great grandchildren to Dairy Queen in Omaha. And nothing excites little kids more than ice cream, but he couldn’t even get them off their phones to tell them what they wanted, because they were so engrossed with their iPhones. And he said, “Well, if an iPhone can trump Dairy Queen,” which by the way he also owns, “then it must be a pretty big product.” And then he got into more complicated reasons, but equally valid reasons like, well, wow you have all your music on Apple, you have all your photos on your iPhone. The switching calls to use the formal business term are so hard that it’s going to be very hard to get Apple’s billion users off that platform. So those are all the attributes.

Adam Seessel (08:29):

And then I think what distinguishes Apple from Google and Amazon and some of the others that he hasn’t bought, is that it’s a much more mature company and it acts much more like a mature company, which he’s much more familiar with. He came of age when leaders in Cola and beer and soap were clearly established and the root to success was just sort of grinding profits out slowly higher. That’s the way Apple is. Apple basically has a billion users and most of their growth is not from new phones. They’re just replacing old phones when the upgrade cycle comes. It’s from the services. It’s from the app. So it’s sort of a mature product.

Adam Seessel (09:10):

And they’re much less ambitious than, say Google and Amazon. I think I say in the book that their R&D budget is about 1/3 as a percentage of sales versus Facebook and Google and Amazon. So that’s a lot. To spend 33% only of what Google and Amazon spend on R&D is a big delta. And of course they have a huge share of purchase program, which he loves. He loves them returning excess capital. And he’s nervous about companies reinvesting the capital. And that’s precisely what most tech companies are doing now. Amazon, Google are reinvesting all their profits. They’re not bringing them down to the bottom line. They’re not showing a dollar of profits today because they think they can turn it into $3 of profits in five or 10 years. I think that’s a wise strategy, but it’s one that Buffet historically has been very nervous about. And that’s why he owns Apple and not Google and Amazon if you ask me.

Clay Finck (10:10):

Yeah, very good points. We have these two schools of thought. We have the value investing side where you’re trying to buy something for less than it’s worth. You’re sticking with what you know and really understand. And then you have this digital technology revolution where a lot of these tech companies aren’t going to be going anywhere. There’s a phrase “They’re just eating the world.” How can we combine these two schools of thought and apply it to our investment strategy?

Adam Seessel (10:38):

Well, it’s a good question precisely because it puts its finger on one of the great red herrings of the investment business, which is there’s a difference between growth and value investing. Now, I happen to have looked into the matter and I can tell you that that whole style box was created by Morningstar. When the mutual fund craze started, when the baby boomers started to have to figure out how to retire in the ’80s and ’90s and they got invested in stocks, they didn’t understand which fund would did what and which fund did this. So Morningstar said, “Well, these funds are growth funds because they invest in stocks that are growing faster than normal. And these stocks are value funds because these stocks invest in old, beaten up businesses that are statistically cheap.”

Adam Seessel (11:23):

So that’s how it started. But if you think about it, growth and value investing, there’s no distinction. And I’ll explain why. All things being equal, growth is a component of value, correct? Like if I showed you two businesses, but one was going to grow 5% for 10 years and one was going to grow 10% for 10 years, which would you choose?

Clay Finck (11:47):

Yeah. All else equal to 10% growth.

Adam Seessel (11:50):

So are you a growth investor or are you just an investor who likes returns?

Clay Finck (11:55):

Right. Everyone’s a value investor at heart. They just want to buy something for less it’s worth.

Adam Seessel (12:01):

Well, but that’s right. Growth is a component of value. And Buffet has been beating this drum for 30 years. In his 1993 annual report he said, “I’m sorry folks, but buying stuff with low PEs and low price-to-book ratio does not constitute a value purchase, nor does buying stuff with a high PE and a high price-to-book constitute a bad investment. It all depends. It all depends.” So the reason I wrote the book and the reason I think it can be of value to your listeners is these tech stocks are value stocks in the sense that they are valuable, but they just don’t look valuable on traditional metrics. So why have they gone up so much in the last decade? Has it all been a hoax or is there something that the numbers aren’t showing us? And I think the answer is clearly the latter. Unless you really believe that Alphabet and Amazon are going to go the way of pets.com did in the dot-com bust, then we’ve got to reframe the way we look at these stocks. They don’t look like value purchases, but they’re exceedingly valuable.

Clay Finck (13:10):

One thing I found interesting in your process is you’re looking at price last. You’re talking about how some investors will run some filter and look for cheap stocks. So the first thing they’re looking at is the price relative to the earning. So price is like the very first thing you’re looking at. But in your process, you were looking at the business first and seeing if it flows through your checklist and if it checks all the boxes, and then you’re looking at price at the very end, which I found pretty interesting.

Adam Seessel (13:41):

Yeah. And look, this is a reversal of what I started out. I started at Sanford Bernstein, which runs a computer model to screen for the cheapest 10% of stocks in the universe, or it did when I was there. And that worked. It worked for many, many years precisely because the economy wasn’t changing. So if retail sales were cheap, they were going to go back to normal. If consumer products, companies were a little expensive, they were going to go back to normal. Well, there is no normal anymore, you know? Certain giant sectors of our economy are under existential pressure from tech. And tech is similarly growing like a weed.

Adam Seessel (14:20):

So I had to sort of rethink my price first equation. And I basically put the business quality first. Because in this era, you’re either on the sort of the right side of the digital divide or the wrong side. And so price becomes much less important than it would in an economy where there’s stasis. And you can count on things like things going back to normal, reversion to the mean. By the way, I think Buffet, if you asked him, he would probably put business quality first, then he looks at the price.

Clay Finck (14:55):

Yeah, I do think quality is obviously really important. In the digital age, you see these monopoly type companies, very strong moats, very strong network effects, and those who have been the strong outperformers especially over the last decade. Talk about some of the things you look for when looking for a quality company.

Adam Seessel (15:16):

Well, it’s precisely the concept of a moat play which you say. That’s Buffet’s term. Other ways to say it is, does the company have an edge? Does the company have special sauce? The business school term is competitive advantage. So most companies, whether they’d be tech companies or other companies, are doomed to sort of failure, or if not failure, then mediocrity because capitalism is so competitive. I say in the book it’s like the Hunger Games. I mean, people just beat each other’s brains out to compete. And the result is usually that the consumer wins, whether it’s a business consumer or an individual consumer. All these companies fallen all over each other to lower prices, improve performance, all for the benefit of the customer. It’s a great system because the consumer ends up winning. And all too often, the companies end up sort of just barely earning their cost of capital.

Adam Seessel (16:16):

GoPro is a great early success and sold selfie sticks and couldn’t sell enough of them. But because they didn’t have an edge because one selfie stick is more or less like another, that invited competition like bees to honey. And the price of selfie sticks just went… And if you look at bondages stock chart, it will reflect that. So you need companies that can withstand that competition, that can withstand like, people say, “Ooh, that’s a great business. I’m going to go get myself a piece of it.” And they’re like, “Oh I can’t.” That’s the business you want.

Adam Seessel (16:51):

So Google is the perfect example. I mean, Google created the fastest and most relevant search engine early on. Its market share went from nothing to 65% to 95%. Bing spent 15 billion trying to compete against Google. Couldn’t do it. The search engine is just inferior. I put an example in there of a reporter from WIRED Magazine typing in some search terms. With Google, he gets great search results. So with Bing, he gets nonsense.

Adam Seessel (17:20):

It’s less well known that Amazon tried to compete in search. Some time ago, Bezos hired the search developer who had created the first search engine for Yahoo. He was there at the founding. And he gave him all this resources and said, “Go compete against Google.” And the guy quit a couple years later and he went and joined Google. Apparently, Bezos threw a huge temper tantrum. And when he settled down, he said to his employees, “Treat Google like a mountain. You can climb it, but you can’t move it.” So these are the businesses you want.

Adam Seessel (17:56):

I urge you and your listeners, when you’re looking at companies, the first thing you should ask is, “Who can outcompete these guys? How can they outcompete them? What’s going to happen?” Put them in the Hunger Games arena and sort of mentally play out what happens. And if you can’t find a scenario in which they’re beaten or even better if you’ve witnessed people trying to take them on as Microsoft and Amazon did with Google, then you’re onto something.

Clay Finck (18:25):

It sounds great in theory, but trying to apply these ideas and practice is the really difficult part.

Adam Seessel (18:33):

Absolutely. Yeah.

Clay Finck (18:34):

People can listen to this-

Adam Seessel (18:35):

Surfing sounds easy. Yeah?

Clay Finck (18:38):

Yeah. People will probably listen to this and get really excited. You can get a quality monopoly compounder that’s going to grow at 20% per year, but your conviction’s going to be tested along the way and there’s going to be bumps along the road. I pulled together the five year returns on four big tech heavy hitters. And the disparity is just incredible. I got Microsoft, the five year return is 258%. Apple, 272%. Both exceptionally well, heavily outperforms the market. And then I looked at Netflix, 13% over the five year period. And Meta or Facebook, 2%. Talk to us about why you think there’s just this drastic difference between these heavy hitters.

Adam Seessel (19:27):

Well, it’s an excellent point. And yeah, everything sounds easy in theory and everything is hard in practice. So I take your question very seriously. And I applaud you for putting the statistics around those four companies, something that an actuary would do. But yeah, look, and you’re exactly right, Clay, that your conviction does get tested along the way. My conviction is now being tested with Amazon, down 40%. It’s in the doghouse. Everyone hates it. Nope, I have no problem. Even Apple. Since the iPhone was introduced, you look at the chart, it’s like, “Wow, what a great stock.” But in reality, the fact is that every three or four years it lost 1/3 of its value. People forget that, like, “Oh, Apple’s a winner.” Yeah. Well, it didn’t feel too good when it went from 60 to 40 in 2011 or whatever it was. But to your specific question, it all comes back to moats.

Adam Seessel (20:25):

So Microsoft has moats. It’s Office tools have moats. Google has tried to compete against it, right? With Google Docs and all that. Price was free. Free. Free to use Google Docs. How many people use Google Docs? I can’t even remember what the Excel equivalent of them is called. Sheets or something? It’s a horrible program. And no one’s going to switch. So Microsoft has moats. Apple has moats for reasons we’ve talked about. It’s a great product. Everyone loves it. I have the old one because I’m like you, I’m cheap. But to get onto an Android, it’s going to be hard, hard to switch.

Clay Finck (21:05):

My family will get mad at my dad because he’s got the Android and everyone else has the iPhones and we’re trying to message each other. The messages get all messed up, sending pictures.

Adam Seessel (21:14):

Right. Yeah, exactly. So Apple has a moat. But I’ve never liked Netflix and I’ve never liked Facebook or Meta and precisely because they haven’t had moats. I look at Netflix and I was like, “Well, yeah, I subscribed to Netflix and I like Netflix, but I also like Amazon Prime Video too and it’s free. And oh my God, Disney’s starting one? Okay. And Peacock is starting one? Okay. And then Hulu and HBO Max and Para…?” What kind of moat is that? Here again, it’s like 12 year old stuff. It’s not complicated.

Adam Seessel (21:54):

So what ends up happening, to make it a little more complicated and put it in business terms, is it becomes an arms race where Netflix I think is on pace to spend $21 billion in content spend this year. Two or three years ago, it was 10 billion. So they just have to keep producing more and more content to keep going. And they got all these very deep pocketed rivals. Some of whom don’t have to spend on content because they have huge libraries like Disney. So some competitors are even advantaged relative to Netflix. And Netflix is having to just spend money on nuclear warhead, so to speak, to just keep up. And until that abates, I just don’t see them having enough moat. I don’t see them having any sort of competitive advantage. The barrier to entry, to use the business term, in the content streaming business is just too low. The barrier to entry in search is extremely high. Microsoft spent $15 billion to try to build search. Bing is a joke.

Adam Seessel (22:59):

Likewise, I’ve never liked Facebook. Never. Part of it is I just don’t like the product. I just don’t enjoy using it. And I’m not sure how many people really enjoy using it. Like, when I go to Google, I’m pretty fired up. I know I’m going to get a good search result. I have a friend who uses Amazon. I use Amazon a lot. I have a friend who uses it. He says, “Every time I get a package, it feels like it’s my birthday.” Nobody feels that way about Facebook, I don’t think, you know? They’re just on it because everyone else is on it. And when you don’t have the secret sauce, it makes you vulnerable to competition.

Adam Seessel (23:34):

So look at the history of Facebook. Here’s the history of Facebook basically. I mean, you can argue whether he stole the network or whatever. That’s immaterial for our discussion. But it’s certainly true that when competitors began to arise, WhatsApp and then Instagram, rather than try to make Facebook a more awesome product, he just bought them. And there are emails from Zuckerberg saying it’s better to buy than to compete, which by the way, I don’t understand why the Federal Trade Commission has not been able to make it a case against Facebook for buying its rivals because it’s illegal in this country to buy a competitor to put them out of bus.

Adam Seessel (24:17):

So he bought potential rivals and put them into the Facebook fold. And then when it became obvious that this was a pattern of his and he couldn’t do it anymore, and the next awesome app which is much more interesting to people than Facebook, TikTok came along and started sucking off viewers from Facebook, what did Zuckerberg do? He changed the company’s name and he made a $10 billion a year bet on the Metaverse. Now I don’t know about you, but where I come from, when someone changes their name and just starts staking out a huge claim to an unproven technology, that’s a bad sign. That’s a warning sign. And look, the Metaverse might be awesome and it might be highly monetizable and Facebook might be the first mover and Facebook might claim the lion share of those spoils, but I don’t invest in maybes. I invest in products that already are demonstrated to have a moat. And Facebook, by their behavior, has shown that they themselves don’t think they have a moat. So that to me is a long winded answer describing why Microsoft and Apple have held up, but Facebook and Netflix have not.

Clay Finck (25:30):

Really good explanations. And sticking to the big tech theme, you talked about Amazon and Google in your book and why we’ve seen a difference in return on those companies specifically. You pointed to Amazon’s superior returns to just their really good management and their capital allocation decisions. And interestingly, when I dug into the numbers, it appears that Google’s return on invested capital, to my surprise, has actually been better over the past decade. So I was surprised to see the difference in the actual stock performance versus the return on invested capital we’re seeing. So I’m curious why Google’s return on invested capital has been better, but it actually hasn’t flowed through to the actual stock price. I’m curious what your thoughts are on this.

Adam Seessel (26:20):

Well, to your question about Google versus Amazon, it’s true that on the reported numbers Google, or Alphabet the parent company, has a higher return on capital than Amazon. But this brings up one of the critical points, which is in the digital age, you can’t really rely on reported financial statements. Now, that sounds like Paris, right? Like here’s a financial guy saying you can’t rely on the audited financials. Well, I’ll explain what I mean by that by way of example. So in 2020, which is the year in which I based my analysis of Amazon on their financial statements in 2020, their eCommerce business had a profit margin of 2% reported, 2% profit margin. Walmart’s profit margin was 6%. So if I’m to believe that 2% number, I implicitly ascent to the assertion that Amazon is 1/3 less profitable than Walmart. Or put another way, Walmart is three times more profitable than Amazon.

Adam Seessel (27:28):

Now, here again, a 12 year old would tell you that that’s crazy. Walmart has 5,000 stores to keep up. Amazon has 1,000 distribution centers. Walmart has 1.5 million people in its stores and has to worry about shoplifting, which Amazon does not. Amazon gets paid immediately on credit card for all its purchases, which Walmart does not. Walmart takes cash. Amazon has a $30 billion a year advertised business where they just charge people to get product placement on their website. They can do that because they have nearly a 50% share of all eCommerce. One of every two retail visits to the internet begins at the Amazon. So $30 billion a year of revenue, that advertising revenue should be pure profit. But you know how much the entire company reported an operating profit even including the cloud business in 2020? $25 billion.

Adam Seessel (28:25):

So if you say that their ad business was all profit, that’s $30 billion of operating profit, then everything else operated at a loss, which is nuts. You can tell I get quite animated about this because here again, economic reality is increasingly unhinged from the Gap Financial statements. And I go into it a little bit in the book where the Gap was created in the 1930s in the wake of the depression to standardize accounting and rightly so, but it was based on an economy where General Motors and US Steel dominated. So the rules were written for the industrial age. They were not written for the technological age.

Adam Seessel (29:08):

There are really important differences between a tech company and an industrial company. The most important of which is, the tech company spends most of its money paying software developers to build products. And as I say in the book, many of those tech expenditures have a useful life of more than one year. But Gap would have us believe that every dollar Amazon spends on its eCommerce website has a useful life of 365 days. And every dollar that Google spends on to improve its search engine evaporates after a year. This is crazy. So that’s why Amazon reported return on capital is much lower than its actual return on capital, because there are all sorts of distortions in its income statement that make its return on capital look very low, specifically it’s profit margin. It’s profit margin is not 2%. That’s what Gap says. But as I say in the book, Amazon’s lost money on a reported basis for about 1/3 of its public history.

Adam Seessel (30:10):

So if Bezos relied on the financial statements to run his company, he would’ve shut that thing down a long time ago. But he knows it’s not unprofitable. He just knows that the Gap Financials are distorted. So that’s a big part of what I say in the book, is we, as investors, have to adjust the financials to account for economic reality. At some point, I think that the accountants will get involved and adjust them for us because they’re aware of how economic reality and Gap Financials are diverging. Something’s got to be done. But in the meantime, we’ve got to make adjustments.

Adam Seessel (30:43):

And by the way, this is not something like crazy magical thinking like Ben Graham, the Father in value investing said, “Look, there are a lot of estimates in financial statements. You’ve got to make intelligent adjustments.” Buffet says the same thing. The whole concept of owner earnings is basically adjusting the Gap Financials to economic reality. So I’m just sort of continuing in that vein.

Clay Finck (31:07):

It’s sometimes easy to just look at these big tech names and focus on those. But to find a company that is smaller that might eventually become the next big tech name, where are some places we should start? Or maybe talk about some names that you like.

Adam Seessel (31:24):

Yeah. I mean, look, it’s a great question because we tend to focus on the FAANGs and the Mega caps, but there’s a whole another level down and then another level down from that of companies that have secret sauces, that have a moat, that have a competitive advantage, that aren’t nearly as well known as the FAANGs. These are potentially more exciting because they’re less well known and well understood.

Adam Seessel (31:49):

So I own a lot of Intuit for example, which it’s an interesting company because it basically dominates two software platforms. It dominates TurboTax, which helps 1/3 of all Americans do their taxes. And it owns QuickBooks, specifically QuickBooks Online. TurboTax is kind of a mature Buffet-type consumer product. 1/3 of all Americans do their taxes through TurboTax, where it’s hard to see that number getting materially bigger. So that’s sort of a grinded out, slowly churn out profit kind of product. Dominates its niche for sure.

Adam Seessel (32:25):

They take all that cash flow, the profits from that, and they put it into QuickBooks Online, which is far from mature. I mean, Intuit thinks they got 1% of all their ultimate customers around the world that would use QuickBooks Online. It’s this software program that helps small businesses keep track of the beans basically. And they say that their biggest competitors are Excel and the SHOEBOX. SHOEBOX’s full of receipts for small business people. So it’s a very slick online product in the cloud. You can put in your invoices and put in what you’ve been paid and put on what you owe. It basically runs your back office for you. It’s an excellent product and affordable product.

Adam Seessel (33:06):

QuickBooks Online has three times more subs than it’s nearest competitor. They spend 12 times more than their nearest competitor in marketing and in research and development to make the product better. So to my mind, it’s sort of like in inevitable. It’s like what Buffet used to call Gillette and Coke. They have three times more subs, they spend 12 times more on marketing and R&D than their next nearest competitor, no one’s going to catch them, but they only have 1% of their ultimate addressable market. Whoa, that’s cool.

Adam Seessel (33:36):

And I encourage your listeners to look for products like that. These products might be stuff that I don’t know about and you don’t know about, but they know about it because it’s in their line of work. So someone in marketing might have an insight into Salesforce that I don’t. Either they’re they have moats or no they’re extremely vulnerable. Someone in HR might understand that Workday is, no one’s going to catch Workday. I don’t know that, but they might. I have a friend who is an auditor and he loves Alteryx, which is a small tech company that dominates the market for manipulating large data sets. He swears by it. So these are the companies that we should be looking for, companies that we’re familiar with personally, that we are convinced have moats, or are convinced that in 5, 10, 15, 20 years are going to be much bigger and more profitable than they are now.

Clay Finck (34:34):

You mentioned a little bit earlier this common theme that tech companies have looked expensive for years at least using those traditional metrics, but some have still managed to produce just extraordinary returns. Amazon’s a prime example of that. Our network actually had Bill Miller on our show. He had an interview with William Green. He bought Amazon at the IPO and bought even more during the tech crash after the 2000 tech bubble. How can we do what Bill Miller did and see through these traditional metrics and recognize we aren’t overpaying for a high quality business? I guess for Amazon, for example, you mentioned that you would adjust the retail profit margin from 2% to say a 6%. So is it just a matter of saying, if this was a mature business today or maybe a few years out, how would you adjust those profit margins or how are you making those adjustments and determining a fair value?

Adam Seessel (35:34):

Well, another excellent question, because while you begin with business quality and moats, you must end with valuation. I wouldn’t have the right to call myself a value investor if I didn’t believe that the price I was paying was an essential input of the value I was ultimately getting. I say in the book I can show you a fifth avenue penthouse with beautiful views and lovely rooms, but if I ask you to pay $25 billion for it, you’re going to tell me to go pound sand. At some point anything is too expensive.

Adam Seessel (36:09):

So to answer your question specifically, you have to start sort of big picture and then you kind of have to go more granular. So as I say in the book, there are examples of mature software companies that have already had the majority of their growth. Like Oracle for example, a database company, fine company, but kind of grinding it out now. They’re operating profit margin approaches 50%. And that’s about four times higher than an average American company. And it makes sense because one of the reasons software’s tech companies gotten so big so fast is their business models are inherently better. Let’s begin with the fact that they have no cost of goods. They don’t have to buy sugar, lumber, anything. They don’t have to buy titanium like Apple does. They just put a bunch of 0s and 1s together and off they go.

Adam Seessel (37:05):

So a gross margin of a software company can be 80 to 90%. So they start with 30 to 40 percentage points, head start over just any other company because they have no physical costs. So you start with that mindset, “Okay, software companies are very profitable inherently when they’re at steady state, when they’re mature.” Then you go, like when I say in the book, I looked at Google in 2015, ’16, their operating profit margins reported was 25%. So that’s half of 50. So that’s a big gap, right? So potentially their profits could be two times higher, right?

Adam Seessel (37:41):

But then I started looking around at comparable companies. So I started looking at Alibaba which operates an asset-like platform like Google, and their profit margins were in the 40, 45% range. And then I looked at Facebook, which as you know I’m not a big fan of Facebook. And one of the many reasons I’m not a big fan of Facebook is they’ve been short term greedy. They’ve been trying to monetize their network right now. So they put too many ads on there. They didn’t make the experience great. They milked the business too quickly. But their profit margins were in the 40 to 50% range as well.

Adam Seessel (38:15):

I don’t know what Google’s ultimate margin is, but I know it’s high because it’s a network. They have no cost of goods. Once they’ve built the network, every incremental search query that comes in is basically 100% profit, right? So their margins are probably not 25%. They’re probably close to 50. So I just sort of said 40. Now, this is a rough exercise, but it’s what Buffet used to call directionally accurate. He still calls things directionally accurate. And it’s very important to be directionally accurate. And I say in the book it’s important to be comfortable with the fact that these are not precise calculations we’re making. We are not actuaries. We are not rocket ship engineers where a millimeter here or there is going to destroy the rocket. We’re just trying to sort of get a sense for whether this is a value purchase.

Adam Seessel (39:06):

So what I did with Alphabet or Google is, I said, “Well, let’s adjust their margins from 25% to 40%, because that’s sort of in line with their comps and mature software companies. And then let’s just project their revenues forward a few years” because, here again, it’s inevitable that their revenues are going to grow. I mean they still have a pretty small share of the overall ad market in the world and they are the ad market destination of choice. Any podcast, any investment manager, any hairdresser, any divorce attorney, anybody who needs to sell their service must advertise on Google. Period. So it was not crazy to just forecast their revenues three years in advance using their historical growth rate. Put a 40% margin on that. And what I found was the reported earnings for this year was 28 times multiple, which doesn’t sound like a great deal. But if you increase their margins and project three years ahead, the multiple was nine times. So I bought it and it’s worked out well.

Adam Seessel (40:08):

And by the way, that is the primary reason why these stocks have looked expensive all the way up, but they’ve gotten so valuable because they’re not trading on reported earnings and they’re not trading on this year’s numbers. They’re trading on what ultimately could be. The market is a giant discounting mechanism. It discounts into the present what the future profits will be. And so it was a similar exercise with Amazon, Clay, although it was much more granular because Amazon has many more segments, and Google has segments but only one of them really makes much money, which is search. So that was a pretty easy analysis. But with Amazon, I just took every segment one by one, cloud, eCommerce, advertising, subscriptions, and just sort of went through with the same exercise that I did with Google. What are the comparable companies trading for? Walmart’s margin is 6. Amazon’s reported as 2. Is that right? No. What could it be? I think I came up with the sort of the high single digits.

Adam Seessel (41:10):

So you just sort of have to kind of thinker and ask intelligent questions and triangulate. You’re kind of like a sailor without modern day instruments. You just have to sort of triangulate with stars. And here again, it’s not a precise exercise. And those of us who are uncomfortable with that imprecision probably should not be in the stock market. You should probably do something else. But if you’re comfortable with, “This feels about right,” then you’re going to do fine. You know?

Adam Seessel (41:39):

So I walk through. I have a whole chapter I walk through with my adjustments to Amazon in the book. These are the kind of adjustments we need to do. And then you can stress test the adjustments. Like, I think I said Amazon’s eCommerce’s margin was probably 9%. Well, let’s say you think I’m wrong and you say, “Well, no, it’s no better than Walmart’s.” Okay. So put it down to 6. It ends up not making that much of a difference. So you just have to kind of triangulate, quantify, play. And if you’re kind of in the ballpark without having to push it too far, then you’re probably right. If you’re having to push it, push it, push it to make your numbers work, bad sign. It means you’re probably wrong.

Clay Finck (42:20):

Now at the end of your checklist, you’re looking at price last and that’s after you’ve gone through, you’ve looked at the management, you’ve looked at the business and the moat. I’m curious how you’re determining sort of a hurdle rate or how do you determine, “Yes, this is an appropriate price to pay.” Are you looking at the earnings yield or what are you looking at there?

Adam Seessel (42:41):

Yeah, it’s earnings yield, Clay. Not on reported Gap numbers, but on the adjustments that we’ve been talking about. So I kind of feel, for a great business with all these moats, a 5% free cash flow yield is probably a good entry point. 20 times earnings power. I think that in my experience will yield a very good long term result. Because you have to remember with these companies that are growing, if they’re growing 15%, your multiple goes from 20 times to 17 times to 14 times to 11 times in three or four years. So the growth sort of bails you out, so to speak, of paying a high price initially.

Adam Seessel (43:29):

Buffet learned this lesson the hard way. He had his own transition from a deep value Ben Graham type investor to a more high quality business when he would buy companies like See’s Candies. He fretted about paying an extra million or $2 million for the company. I think since they bought it, it’s generated 2 billion with a B of excess profit. So he’s learned that over time, good businesses fail you out because they grow. And that’s why you begin with moats and you end with price.

Clay Finck (44:00):

We’ve talked a lot about tech, but I’d imagine that many stock investors don’t want to just invest in tech. And I loved how you touched on some of these other types of businesses in your book. Given that we know that tech’s going to play a very large part in our future, what sort of considerations should we be taking into account to ensure we’re still making sound investment decisions investing still outside of tech?

Adam Seessel (44:26):

Yeah. Well, I don’t think you should use tech as your primary filter. I think you should use moat as your primary filter. It just so happens that most of the moated growing businesses in the world, at least as I see it, today happen to be in tech. That’s why I call the book Where The Money Is. I’m not particularly interested in tech. I don’t particularly like tech. I don’t fool around with gadgets and stuff. I’m hardly on social media. But it’s where the money is. But there are also plenty of businesses, Clay, that are non-tech that have moats. We should be focusing on those businesses, as I say in the book, like Sherwin Williams, which has this incredible retail network of stores, businesses like Dollar General, which serves for better or worse the poorer Americans who’ve been left behind by our postindustrial economy.

Adam Seessel (45:18):

You just want to find any sort of businesses that have an edge, that have a special sauce. And it’s okay if it’s not in tech. You just want to find businesses that have shown that they can withstand competition. I mean, sure, William is growing twice as fast as the rest of the US paint industry. The only reason is because they have five times more retail stores than their nearest competitor. And every year they build a hundred more stores and their nearest competitor builds 10. So their moat is widening, their moat is growing and that’s the kind of company you want to look for, tech or not.

Clay Finck (45:57):

Back to some of those smaller companies we discussed earlier, I can’t help but think about the environment we’ve seen in the last couple of years. You see many of these companies take this roller coaster round trip where the COVID pandemic hit and the easy money came along and these high flyers just took off. And then now the Fed has put enormous pressure on those companies and now they’re back to where they were pre COVID. So just as an example, Roku is a company, I think, potential to be a really good company. And I believe you mentioned them in the book as well. Yeah, so it’s hard for me to think about how that company might grow into the future when we see an environment of higher rates and maybe not as much easy money and credit in the system. So I’m curious what your thoughts are around that.

Adam Seessel (46:45):

Well, I think you’re making a logical error, Clay, in the sense that higher rates have nothing to do with moats. Higher rates have to do with valuation. So when interest rates are higher, every financial instrument including, and especially equities, gets less valuable. So from that point of view, this correction is quite rational. When the discount rate for financial instruments including equities goes up, the net present value of those equities goes down. So that’s the easy money portion. Whether Roku has a moat has nothing to do with the Fed and easy money and dah, dah, dah, dah, dah. It just has to do with, “Let’s get a bunch of teenagers in here and talk about Roku. How safe is it? How safe is it from competition?”

Adam Seessel (47:36):

So I don’t recommend or say I’m invested in Roku in the book. I say, if I had been thinking about how companies interposed themselves and make themselves valuable, maybe I would’ve looked at Roku. So Roku is valuable because I think it has a 35% market share for the devices that connect televisions to streaming services. Most of their money now is made not on selling the devices, it’s made on advertising, because they say to Netflix or Amazon or whoever, like, “You’ve got a great business here. I’d hate for something bad to happen to it. Maybe you pay me a little bit of your subscription revenues or your ad revenues and I’ll guarantee that everything keeps flowing.” So they’ve gotten leverage over those companies, which is why it was a monster stock.

Adam Seessel (48:25):

Now the question is, is it a monster from a business point of view? Is it a monster from a business point of view? How secure is its position between the streaming service and the television? I’ve looked at it a little bit because in this kind of market, you want to look at stocks that are down 80%. You want to say, “Well, because it’s classic case of babies and bathwater, a lot of these stocks deserve to be marked down. They don’t make money. There’s no prospect of them making money. They have no moat, et cetera, et cetera.” It’s exciting time because you want to figure out which of these companies actually do have a moat and are getting thrown out. Amazon went down 80, 90% in the dot-com bust. The firm I was at bought it back then because we thought it had a moat. Sold it too soon, of course. But this is what you want. This is a great time to look.

Adam Seessel (49:17):

And so I’ve looked at real cool a little bit. I’m not an expert in it, but I have a tendency not to like hardware companies. It’s why I missed Apple. Because they’re so easily replaceable. Your software is very hard to replace once it’s on your machine. Whereas Roku, like tomorrow I could swap out my Roku and buy an Amazon device. And increasingly televisions are being equipped with Roku-like devices built into them. So I’m not so sure they have a moat. But I’ll bet you, someone out there knows more than I do. And if they disagree and if they’ve convinced themselves that Roku has a moat, then I can tell you it’s a screaming buy.

Clay Finck (49:54):

You mentioned how your firm sold Amazon too early and you did mention in your book that you’re in and out of Amazon a number of times. What led you to maybe making that decision to sell? And was it an opportune time to sell or was it like you mentioned where you essentially regret selling it because of maybe you had maybe a shorter time horizon and maybe saw a better opportunity at that time? So I’m curious what your thoughts are there.

Adam Seessel (50:23):

Yeah, until 2020 and the pandemic came and I got a shot to buy Amazon, down 30%, I was really sort of flailing with Amazon because I was a traditional value investor. I understood it was a great business. I understood that no one was going to catch them. I understand that they were going to grow to multiples of their size. That I all understood, but I was still anchored to the published financials. And they always looked expensive to me on the published financials. So it wasn’t until I had this kind of, “Come to Jesus” moment six or seven years ago where I said, “You know what? The published financials might not be economic reality. Jeff Bezos is not looking at the published financials to run his business, so I better figure out essentially what he’s figured out. I better look at the economic underlying reality of Amazon as opposed to what Gap, this industrial era accounting system, is telling me is real.” And once I did that, I could see much more clearly that not only was Amazon a great business and well run, which I knew, but it was also cheap.

Clay Finck (51:33):

Well, Adam, thank you so much for joining me today. I really enjoyed reading your book. If you guys enjoyed this conversation, I recommend you guys check it out, Where The Money Is. Adam, before we close out the episode, I want to give you a chance to give a hand off to our audience, to the book, and whatever else you’re working on.

Adam Seessel (51:51):

Well, thanks, Clay. I really appreciate the time. The questions were excellent. So thanks for the close read of the book. If people are interested in the book, they can go to simonandschuster.com and put in Where The Money Is. As I said, I don’t use social media that much. I understand its power, but I’m not particularly fond of using it personally. But I am active on LinkedIn. So if people want to hit me up on LinkedIn, I’m happy to interact with folks there. And then of course, if you don’t want to go to Simon & Schuster’s webpage, there’s always amazon.com.

Clay Finck (52:24):

Thanks a lot, Adam.

Adam Seessel (52:26):

Clay, thanks again.

Clay Finck (52:28):

All right. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app so you can get these episodes delivered automatically. If you’ve been enjoying the podcast, we would really appreciate it if you left us a rating or review on the podcast app you’re on. This will really help us in the search algorithm so others can discover the show as well. And if you haven’t already done so, be sure to check out our website, theinvestorspodcast.com. There you’ll find all of our episodes, some educational resources, as well as our TIP finance tool that Robert and I use to manage our own stock portfolios. And with that, we’ll see you again next time.

Outro (53:04):

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