This conversation is part of our “Wisdom in Books” series and podcast.
I had the pleasure of sitting down with Czech superinvestor Daniel Gladiš in Brno recently to discuss insights from his new book, Hidden Investment Treasures: How to Find Great Stock Investments as the Investment World Goes Passive. Daniel is a veteran value investor, founder of Vltava Fund, and longtime member of MOI Global.
In this conversation, Daniel explains how active investors can uncover compelling opportunities even as passive investing dominates today’s market. The interview explores several themes from Hidden Investment Treasures. Daniel touches on how he finds winning ideas in an era of index funds, why capital allocation decisions are critical to value creation, and how his investment approach has continued to evolve. Daniel also dives into several real-time case studies that form the crux of his new book.
Active Opportunities in a Passive Market
One key theme Daniel discusses is the advantage for active investors in a market increasingly ruled by passive funds. With the majority of money now flowing into index-tracking investments, price discovery has become distorted, creating mispricings savvy investors can exploit.
Daniel notes that when equity markets are dominated by passive investments, it actually “creates a lot of opportunities for active investors”. He argues that investors must adapt their selection process to turn the passive trend to their advantage. He outlines how the prevalence of passive funds has made market moves more extreme and slower to reflect fundamentals, opening the door for patient, long-term value investors to find bargains.
Capital Allocation and Value Creation
Daniel emphasizes that much of a company’s value creation comes down to smart capital allocation. Several case studies in his book illustrate how repurchases and acquisitions can boost long-term shareholder value. For example, Asbury Automotive is a company growing aggressively through acquisitions while simultaneously buying back stock, leading to rapid per-share growth in earnings.
Daniel highlights buybacks as a recurring theme, but with an important caveat: not all repurchases create value. He puts strong weight on how management deploys capital, whether investing in growth, making acquisitions, or returning cash to shareholders. Buybacks only make sense when done below a stock’s intrinsic value; repurchasing shares at too high a price actually destroys value for the remaining shareholders. He prefers buybacks (when undervalued) over dividends, which he finds tax-inefficient and often inflexible. Daniel offers insight into how investors can avoid “value traps” and benefit from growth in per-share value.
Real-Time Case Studies and Investing Lessons
A distinctive aspect of Daniel’s book (and the interview) is the use of real-time case studies drawn from his actual portfolio. Daniel deliberately chose about 15 stocks he currently owns (or has owned recently), spanning a range of industries, to demonstrate that you can find value in many corners of the market. By presenting live ideas rather than only past successes, he “puts his neck on the line” to provide more credible lessons.
Each case study is crafted to illustrate broader investing principles, from an auto dealership leveraging buybacks, to a special situation in litigation finance, to an energy company with a shrewd shareholder return policy. Daniel’s structured approach to these case studies offers a view into how he analyzes businesses in different sectors, all while adhering to core value investing tenets.
An Ever-Evolving Investment Philosophy
Throughout the interview, Daniel reflects on how his philosophy has developed over the decades, and why it’s still evolving. Early in his career he was heavily influenced by Ben Graham’s teachings, focusing on statistically cheap deep value stocks. Over time, as obvious bargains grew scarce, he gravitated toward better-quality businesses and learned that “the best investments are the simplest ones”. Daniel candidly describes mistakes made when he tried to get too clever, reinforcing the value of sticking to fundamental principles.
Importantly, he views investing as a continuous learning process: “…you can always get better, you can always learn something new,” he says, stressing the need to adapt as the environment changes. Even in the passive-investing era, Daniel is adjusting his stock selection approach and remains curious how it will evolve in the next 5–10 years.
Key Themes:
Passive Investing Era – Distortions and Opportunities for Stock Pickers
Capital Allocation Focus – Share Buybacks, M&A, and Value Creation
Case Study Highlights – Real-Time Investment Ideas across Industries
Investing Philosophy – Continuous Learning and Evolution of Approach
Enjoy the converation!
The following transcript has been lightly edited for clarity.
John: Daniel, thank you so much for hosting me here in Brno. It’s a real pleasure to be where it all happens, where you manage the Vltava fund. We are here today to discuss your new book, Hidden Investment Treasures, which I can very warmly recommend to everybody listening in.
Hopefully, we get a nice preview and some insights that are in the book, but you’ve been a best-selling author in the Czech Republic before. My question to you is what motivated you to write this new book. How did it come about?
Daniel: First of all, it’s a pleasure to have you here in Brno. It’s always a pleasure talking to you, so I’d like to thank you for coming.
The idea to write this book came quite unexpectedly. It’s an interesting story. About a year ago, I was attending a conference in Denmark called Nordic Value, which is organized by my friend Ole Soeberg. This conference is not open to the public; it’s invitation-only. Every participant presents one concrete stock investment idea. In two days, you get 35 different stock ideas. This is the type of conference I like most because you can talk about various things, but the bottom line in stock picking, in active investing, is which stock you decide to buy. I find individual ideas to be the most valuable.
I was listening to those presentations and it occurred to me that it would be interesting if someone wrote a book consisting only of those investment ideas because it would be able to show readers that you can be active investor, you can find all kinds of investment ideas, and you can have fun while doing it. I tried to recall a book like that. I think I have read almost everything written about investments and relevant topics over the last 30 years, and I couldn’t remember any such books. I immediately jumped to another idea. “Why don’t I write a book like that? Why don’t I write for myself something that I look for from the others most?”
I get very enthusiastic about things quite often. That morning, if you were to ask me if I was going to write another book, I would probably have said no. In the evening, I had already sketched the list of chapters, and I was looking forward to going back home two days later and starting writing. I didn’t expect it, but I enjoyed writing the book a lot afterwards.
John: Yes, it’s quite a unique book. Maybe the reason why there are all these investment books out there but not one like yours is that a lot of folks don’t like to put their ideas out in the open, especially in real time, because people like to emphasize their winners and put the losers somewhere on the back burner. However, you did put yourself out there. As I understand it from reading the book, the case studies are indeed in real time rather than accounts of past winners.
Daniel: Yes, the book consists of about 15 individual investment ideas. When I was selecting them, the main condition was that I would only write about stocks we own. It would be easy to look at the last five years, retrospectively pick stocks that did well over that time, and recreate, ex-post a story, then and there why it was a good investment, but that doesn’t help much. I only talk about stocks we own.
You’re right. It’s not very popular among investment managers because a) you are revealing what you do, and b) you are putting your neck on the line since some of those ideas will inevitably turn out not to be that great, but I think it would have more credibility.
I also tried to pick stocks from various industries to show that you can look for value in different places in the market today. In addition, I wanted to select stocks that can be used to demonstrate some more general investment topics that could be applied to other companies in a broader way or things that are valued over time. That was my selection process.
John: You do cover a vast range of investment scenarios through the case studies you’ve picked. Did you pick them in order to illustrate the breadth, or is that a result of how you manage your portfolio and construct it for diversification?
Daniel: It’s both. There are definitely more stocks we own that I talk about in the book, but in some cases, you would be repeating yourself because they come from similar industries or have a similar investment ratio. I wanted to show the breadth of the opportunities available in the market.
Most importantly, in theory, you can write a book about investment ideas at any time, but I think this book is also quite timely because we live in a world where equity markets are dominated by passive investments, which creates a lot of opportunities for active investors. I wanted to show them and also maybe suggest how we should approach the stock selection process in order to turn to our advantage a situation where most of the money is being invested passively.
John: Yes, that’s a great point. Now, some of the case studies illustrate how share repurchases can create value. You have an example on value-accretive M&A. You have a special situation in the litigation space. We’ll get into the case studies in a moment. I think those are always of interest to everybody because they may yield good investment ideas, but let’s first talk about the opportunity for active managers like yourself in a world so dominated by passive investment flows and why that creates an opportunity for stock pickers like yourself.
Daniel: Especially in the US market, which is now more than 60% of the world capitalization, it is highly likely that the majority of the money is being invested passively, and this changes the character of the stock market in a big way.
Passive investment is a good idea in itself, but passive investors rely on the activities of active investors. Passive investors buy an index or some benchmark, and they don’t care how much they pay for individual stocks within those benchmarks or indices. They rely on the activities of active investors and hope that active investors – by their appraisal process, by their selection process, by their buying cheap stocks and selling expensive stocks – create the price discovery process. They basically make sure that stocks are approximately reasonably valued or tend to approach their fundamental values over time.
If there are a few passive investors and a lot of active investors, that works fine, but in today’s world where most of the money is being invested passively and only a fraction of the active investors do stock valuations, the price discovery process is deeply distorted.
First of all, passive investors cease to be price takers; they are now price makers. They influence the prices of individual stocks even if they don’t analyze them individually. That’s because the flow of passive money into various indices influences the composition of the indices, which, in turn, shows where the money is flowing. There are many indices, benchmarks, and ETFs, and they influence each other. Passive investors have now become price creators or price makers.
Also, the price discovery process still works, but it’s much slower because only a small percentage of active investors do stock valuation as you have a lot of algorithmic trading and momentum strategies. Among active investors, most are retail investors, and I think most of them don’t have the abilities to value stocks. People who do fundamental valuations represent only a small fraction of the market.
The dynamics of the market are such that when the money is flowing into passive funds, they have to buy stocks immediately because that’s what they do, and by definition, the sellers have to come from the active investor group. Because of passive buyers, the sellers have to be active funds. Because there’s so much passive money and so few active investors, when money is flowing into passive funds, the prices required to balance the marginal demand and marginal supply of stocks tend to go exponentially higher because, in theory, if there was one last active investor in the world, the price you have to pay to sell his or her stock would be indefinite.
Prices tend to rise exponentially in the market – in general and also in individual stocks. When money flows out of passive funds, it works the other way around because the amount of money available among active investors to buy the stocks passive funds are selling is relatively small, so prices have to go down exponentially to find the equilibrium. Market trends are now longer and more extreme both ways – up and down – both in the market as a whole and individual companies.
What also worries me is that the percentage of passive investors has a strongly negative impact on corporate governance. When you pick any single stock and look at who the largest owners are, almost everywhere, it’s Vanguard and BlackRock – passive funds. Passive funds are the biggest owners in most of the individual stocks. I think they don’t have any motivation or tendency to care much about what’s happening in those individual stocks because they don’t care how much they cost. Their business is not to manage money. Their business is to collect money and shift it to those benchmarks.
One of the smartest and most knowledgeable investors is Jim Chanos. He teaches a course on the history of financial fraud. If he says that we now live in the golden age of fraud – unfortunately, I believe that we are – a big reason for that is the prevalence of passive investors. They don’t care about what’s happening in the individual companies, and the oversight over management is very weak.
This is the environment we live in. I try to describe it in the book. I also try to describe how to approach the stock selection process if you are an active investor – not only to find good ideas but also turn the whole situation to your advantage.
John: Yes, and that’s the ultimate goal, right? I know you are finding many ways to do that. We’ll talk about some of the advantages an active investor like yourself has in a world of passive money. I believe there’s also a bigger issue around the functioning of capital markets because the whole purpose of the stock market is to allocate capital efficiently within an economy. With so much money passively invested, that function seems to be breaking down. That may not matter so much to an active investor, but it should matter to regulators and society at large.
Daniel: Yes, I agree with you 100%. You cannot measure those things, which means they go unnoticed and no one can figure out how much damage it causes. But if you are living in a world where stock markets are not efficient enough and the price incentives that would attract capital are distorted, the capital flows to different places – not to where it brings the biggest return but to where the market seems to be shifting it. This lowers the efficiency of the whole capital allocation process, which costs society as a whole a lot of money – although no one can figure it out how much that may be.
John: Yes, I think even John Bogle – the founder of Vanguard - said that at some point, if passive becomes too large, it’s detrimental.
Daniel: He said things would collapse. Of course, you will never get to a situation where all the money is invested passively. Things would get bad much earlier, but I think we’re already very far down that line. The thing is that the ability to buy an index – the passive investments, the ETFs John Bogle was instrumental in creating and all of that – is a great idea, but like almost every great idea, if it’s carried to an extreme, it ceases to be a good idea. I think this is where we are at the moment.
John: Yes. I compare passive investing to derivatives on securities where derivatives take the price of the underlying, and passive investors take the price in the market. However, if derivatives were to become the driving force, it would clearly lead to distortions. I think it’s similar with passive money.
Daniel: The whole passive investment growth is also creating certain systemic risks for those index investors – more in the US than in other markets. Other markets are less concentrated, but in the US, a handful of the top companies now make the largest percentage of the index in history – if you look at market capitalization, not earnings – and many of them are related to each other – either being in a similar business or creating business for each other. There’s a certain systemic risk. Of course, it feels great if it goes up, but if it turns around and money starts flowing out of the market for some reason, who’s going to be the buyer? I don’t see anyone.
John: Let’s talk about how you take advantage of this because everybody knows that if you have someone at the poker table who doesn’t know how to play the game, you are at an advantage. It seems to me that in the stock market, some people are falling for what I view as a fallacy – that because there’s so much passive money now, all of a sudden, active investors might be at a disadvantage since the passive money is moving things around. To me, the more “dumb money” there is in the market, the better, right?
Daniel: No, I think the environment for active investments now is extremely favorable. I’ve been doing this for more than 30 years. I don’t recall less competition among active investors than today. Some 20 to 30 years ago, it was much tougher to find good investment ideas. It’s much easier now, but you should approach it with certain qualifications.
For example, seven years ago, we noticed that passive investments were already growing very fast. We noticed there were a lot of companies in the market whose businesses were doing great. They were growing earnings. They had no troubles. They showed good business performance, but the stock prices didn’t go anywhere. For one, two, three years, the market paid zero attention to them.
We started wondering, “Why is that?” I think the main reason is that most of these companies are away from the main indices, from the large caps. Also, the passive money was not touching them at all. Maybe even worse, it was creating outflows because the concentration game was already in play. We wondered how we could use this to our advantage. I think the answer was pretty obvious. You didn’t want to get in a situation where you would buy good-performing stocks, but you would also know that nobody would pay attention for a very long time because then it’s dead money. Also, in theory, at some later point, the price may catch up with value. It may be quite frustrating to wait because the market wouldn’t pay any attention to it.
We said, “What if we find stocks that are good businesses, that are cheap, and that the market doesn’t pay any attention to, but that create the demand for the stock themselves by buying a lot of their own shares?” In that case, you don’t need the market to notice how good and cheap the businesses are and come up with a buying demand. You don’t want it. You want these companies to stay as cheap and unnoticed for as long as possible. If they can buy 5%, 6%, 7% of their own stock at six times earnings year after year after year, the final outcome would be highly favorable – probably exponential.
In the course of 2019, we completely reanalyzed the 300 companies we follow and paid a lot more attention in our analysis to the asset allocation of the companies themselves, especially to buybacks. We now basically have a portfolio where more than 90% is companies that consistently buy back their own shares.
You take advantage of the fact that passive investors don’t pay any attention to many of those companies. At the same time, you don’t need them to start paying attention because the companies are already buying themselves. If management realize that buying stocks back at six times earning is probably a much better alternative than doing anything else, and they do it year after year after year, that’s the way to go.
Things like that weren’t readily available 20 years ago. There was much more competition, the stocks didn’t go unnoticed for a long time, and managements didn’t have that opportunity to buy their own stocks cheaply for years. I think that’s one way to go.
John: As an active investor, it seems like you’re in a race with most of the competition not even trying to win.
Daniel: No, and I would – selfishly – love to see even more passive investors than today. Of course, it’s not good for society, but for active investors, it is probably the best they could wish for.
John: Yes, absolutely. I think what you mentioned on the topic of share repurchases and companies creating demand for their stock – but maybe even more importantly, increasing intrinsic value per share as they make those buybacks at a low price – that’s one way to avoid the so-called value traps. Let’s talk about that and where you look for opportunities because I know you like to look at areas that are out of favor, underfollowed, or neglected. How do you go about that aspect of the approach and idea generation?
Daniel: There’s a saying – and, by definition, it is probably also correct – that only unpopular assets can be really cheap because, if something is very popular, everyone loves it and is optimistic, so this is probably also reflected in the price, and things are expensive. On the other hand, if something is unpopular, unfollowed, underfollowed, under-researched, under-owned, boring, then there’s a good chance it is cheap. It’s not an absolute truth, but it’s a good place to start.
We tend to find a lot of good ideas in every industry, but mostly in places that are untouched by the flows of passive money, which means they’re not in the largest caps and in the most popular industries. They may be outside the US. I can’t specifically point out a country or industry or size that would seem to be ripe with opportunities.
The opportunities are definitely almost everywhere you look if you’re looking in the right places. Looking for them is a time-consuming process, of course, and that’s good because most people are not ready to do things like that. I think opportunities are almost everywhere. One of the purposes of the book was to show that you can find them in various industries, countries, and sizes.
John: You’ve been investing for decades now. How has your philosophy evolved over time, and has that evolution also been affected by the passive investment flows?
Daniel: Yes. My first portfolio was in 1993. At the time, it was only Czech stocks because we didn’t know anything else about other markets. I was a broker at that time. I was already long-term oriented, but I knew very little about valuations and stock selections. I only invested in the domestic market. In retrospect, it was very naive.
As a broker, I had a lot of hedge funds and famous investors and investment funds in the US and UK as clients. When I visited them, I listened to them, learning what they do, how they do it, and different strategies in different parts of the world. I started looking for stocks outside the Czech Republic. My horizon was broadening, but things changed a lot at the end of 1998. I think every person has certain moments in their life that they will remember forever. You hear the news or something so impactful happens to you that you remember forever what you were doing and where you were at that moment. To this day, I remember reading Benjamin Graham’s The Intelligent Investor for the first time. I know exactly when and where.
John: When and where?
Daniel: I was living in England at the time. I read the book in my study or in my bedroom. It was the last two months of 1998. I recall it very clearly because the book had an impact on me like no other book.
Today, many of its parts are a little archaic, but there are certain parts that remain fundamental – like the idea of fundamental value, the margin of safety, the Mr. Market allegory, and stuff like that. It changed my thinking completely. I started applying Graham’s teachings to my investments. I became very statistical and number-oriented after that. I had a broader portfolio of statistically cheap stocks. It worked quite well for a time, but after a while, I noticed a few things.
One, the opportunities were disappearing as the market was getting more expensive, and you couldn’t find those deep value stocks. You had to deal with smaller and smaller market caps, which is expensive and not too appealing. I was learning more about investments. I started gravitating more towards better businesses.
Then I went through a period when I thought I was already so good that I tried to do unnecessary, complicated stuff – as if I was trying to show the outside world how smart I am. I learned from that. I think the best investments are the simplest ones. The simpler, the better.
Things are evolving all the time. Over the last several years, the approach I described in a world dominated by passive investments is to change how we select stocks. I’m very curious how things will continue developing and whether – in five or 10 years from now – I would think that this was not the best and that things could be done even better.
It’s a never-ending process. You never achieve a state where you would say, “Right now, I’m a good investor, and I can just relax and stop learning.” No, because you can always get better, you can always learn something new, and you can always adapt to how the environment is changing around you. That’s what I find most fascinating about investments. Every day, you have new intellectual challenges or inputs and signals you can work on.
John: You’re running real-time experiments, but not in a controlled environment because the market is always changing.
Daniel: Exactly. You don’t have all the information. You can’t control the environment. You have to deal with uncertainty.
John: I think that’s why so many investors love investing. You can do it your whole life and keep learning, which I think is very rare.
Daniel: It is very rare. You find very few areas where you can hope to be better and better till very old age. In most other areas – business, life, sports, and anything else – you reach your peak relatively early, and then you only go down. In investing, as long as you can stay mentally sharp, you can keep getting better and better because you accumulate more and more knowledge every day, and you cannot jump over those stages. Things don’t happen faster because you want them to. You have to live through them day by day.
John: Yes, and a lot of the fallacies in markets or the boom-busts happen at least once a generation. The new folks entering the market may think they’ve discovered something.
Daniel: People who have been investing for five or 10 years know only one state of the market.
John: If you’ve survived at least a couple of these cycles, you have more of a reference point.
Daniel: Yes, you become more skeptical and more careful. The younger folks may think you are a dinosaur. They’ve been saying about Buffett for the last 40 years that he’s out of touch, but he keeps learning.
John: There the famous saying, “This time is different,” when it almost never is, but I think even a lot of experienced folks fall for that fallacy because it’s so alluring when the market is doing well to believe that maybe this time truly is different.
Daniel: The question is the definition of what is different. Some things change over time, but some things never change. People should remember that.
John: We now have AI. That’s the new new thing. It’s definitely very powerful. A lot of people will say, “This time really is different because AI truly is so transformational,” and it might be in a lot of ways. I do agree that it is, but when it comes to the basics of investing and how value is created for shareholders, that’s still the same last time I checked.
Daniel: I agree.
John: Let’s get into some of the case studies because I think a lot of the value of the book is in those case studies – both in terms of generating potential ideas to delve deeper into and of creating mental models and patterns that could lead to other ideas. Maybe we can start with the idea of share repurchases creating value. It probably applies to a few of the case studies – certainly to Asbury Automotive. Walk us through that case study or another one, if you think it’s relevant.
Daniel: Share repurchases are a recurring theme in the book. You can find it with various stock ideas. I talk about it in more detail in the Asbury Auto story.
Asbury Auto is one of the largest US auto dealers. This business has been growing amazingly fast – both by acquisitions and by stock buybacks. When I talk about growth in a business, I usually refer to growth per share because, as an investor, I don’t care how big the company gets in terms of absolute size. What I care about is how big it gets or how profitable it gets per share that I own.
Many companies grow extensively by issuing shares or making acquisitions, but if you are issuing a lot of stock-based compensation shares, the share count keeps growing and growing. Per-share growth is much slower. When I talk about growth, it means per-share growth. In the case of Asbury, it grows both in absolute terms – through acquisitions and organic growth – but also even much faster per share because the share count has been going down over time quite rapidly.
It fascinates me. You have a company that has grown maybe 20 times in size over the last 20 years or so. It will probably keep growing much faster than the market, and it keeps trading at eight times earnings. If the company can keep buying its own shares at eight times earnings, that probably is a fantastic value-enhancing transaction.
I generally like stock repurchases, but, of course, not all stock repurchases are value-creating. I tend to put a lot of emphasis on asset allocation on the side of management and on the side of how they can use the money. There’s a number of things they can do. There’s replacement capex, there’s growth capex, there’s some organic growth. You can do acquisitions. You can buy debt. You can return money to shareholders – either through dividends or stock repurchases.
I’m not a big fan of dividends because firstly, dividends are taxed, and secondly, they are usually set up in a rigid way that doesn’t pay enough attention to how efficient that allocation is. Still, I like stock repurchases if they are done on a good value.
Unfortunately, there’s probably one trillion of stock buybacks in the US per year now – a huge amount of money – but I would say at least three quarters of that is done at prices way above the intrinsic value of the stock. If management buy stock above its fair value, they basically transfer money from the selling shareholders to those who remain in the stock. If you remain a shareholder, it damages your fundamental value.
For me to like share repurchases, one of the conditions is they be done below the fundamental value of the stock. In that case, the value is transferred from those who sell the shares to those who keep owning the shares. If I keep owning a share, its fundamental value keeps going up.
We have very limited ways of judging it, but management have at least five or seven basic options of allocating capital available. We don’t know all the options available to them at any given time because we don’t see those that they reject, for example. Even if we see those that they do, very often, we cannot ex ante calculate the return on those investments. You can try to do it ex post, but not ex ante. However, if management are truly looking at all these options continuously and always trying to send money where there’s the biggest return on investment, then buying stocks at single-digit multiples often is by far the best way because acquisitions are usually more expensive. They also carry much more risk than investing in yourself, and going for absolute growth is sometimes also not very efficient.
I love stock buybacks. Some of the companies we own have decreased their share count so much that it’s unbelievable. We used to own AutoNation, a peer of Asbury. It’s another dealer, a bit larger. Its share count over the last 25 years is down maybe 90%, so your ownership of the company has gone up 10 times even if you didn’t buy any stock, and the company itself is much bigger. I like those things a lot.
John: There’s a nuance there because, as you say, if companies are buying back stock below fair value, they are accreting value on a per-share basis. With Asbury, that was the case when you invested. It still sounds cheap.
Daniel: It still is, yes.
John: Some other stories become expensive because people look at the historical stock chart, maybe when management were able to buy cheap and were cannibalizing their own shares. Now, some of those stocks get expensive and management don’t switch gears. They keep plowing free cash flow into the stock. That seems problematic, but it’s also tough for managements as their shareholders probably want them to keep repurchasing because – almost by definition – if you’re a shareholder of a company, you probably think the stock is undervalued. A couple of recent examples are O’Reilly Auto and AutoZone where I believe the stocks are now in the 30s on a PE basis. The math works differently if you keep buying back.
Daniel: Yes, these two companies are among those notorious stock cannibals. The only thing they do is buy back shares, which is okay, but if you buy at a high 20s multiple, it’s not the best use of money.
Management have to be more flexible in the asset allocation. For example, we have another stock in our portfolio you might want to talk about later. It is also mentioned the book – OSB Group. It is a small UK bank. It also does very large buybacks regularly, but the management seem to have a matrix where they compare the price on a daily basis to their notion of intrinsic value. You can see that if the stock is lower, they buy 300,000 shares a day; when the stock moves higher, they buy 30,000 shares a day. They are very price-conscious. That’s very important.
Another bank we own is JP Morgan. Jamie Dimon says that over time, they will do a lot of buybacks because they have so much excess capital and make so much money, but now – at 2.4 times price to book and maybe 2.7 times price to tangible book – it doesn’t make any sense. They might do some, but very little. I think you have to be very price-conscious because you can easily destroy value.
Another example of good allocation is Berkshire. Buffett started buying back shares seven or eight years ago. He was very active four or five years ago. They were buying back a lot of shares when the stock price was maybe 25% above book value. At the beginning of this year, it was maybe 65%, so they didn’t buy any for the last 12 months. Now it’s getting cheaper again; maybe they’ll start at some point.
A lot of managements have a short-term thinking horizon. They know they’ll be out two or three years from now. They have stock options and bonuses. Very often, it’s tied to the stock price, which I don’t think is a good criterion. They tend to do whatever it takes to keep the stock price up. Warren Buffett – of course, his own horizon is now short, but his thinking is as long-term as ever – doesn’t get any bonuses from stock price. He owns a lot of stock himself. He wants the fundamental value to keep building. He thinks long term. He knows that sooner or later, the price would get cheap enough again, and he would buy a ton of stock. Until then, he’s happy to accumulate cash.
Most investors today either don’t care – that’s the passive – or have very short-term horizons. Buybacks are not a big part of their long-term investment team because they don’t have any long-term investment team. They’re short term-oriented. As long as management keep buying shares, that keeps the stock price up in the short term, and that’s fine, but if you’re a very long-term investor and think in five years and longer terms, then the asset allocation on the side of management is absolutely essential. You can kill a good company with stupid asset allocation, and you can make an average business an extremely strong compounder if your asset allocation is highly efficient.
John: That’s such an important point with regard to buybacks because buybacks are great if done at the right price. Otherwise, they may not create value. That’s within the intelligent investor community. Then there’s the whole other category of buybacks we don’t even talk about, which are made for offsetting stock-based comp, which is a total waste of money. I think we would agree. The principle of looking at things on a per-share basis is something investors should take to heart more because if your favorite growth company is putting up 20% to 25% on the top line but the share count is growing 5% to 10% a year, you’re not ahead that much.
Daniel: I’m glad you mentioned stock-based compensation because it is a huge number in some companies. It runs in the tens of billions per year. I know why, but those companies tend to include it in operating cash flow – like they are making money – whereas I always exclude it from operating cash flow. I put it in financing cash flow because you’re basically selling stock to finance the business.
Very often, it looks like they do a lot of buybacks, but when you look at the details, two-thirds of the buybacks are buying back stocks they previously issued at much more favorable terms to shareholders. First, the free cash flow is much smaller than they show. Second, the stock buybacks are also much smaller than they show because they offset what they issued before.
Take Amazon. It has a great business, but its stock price is always a bit expensive. It’s pretty high. Amazon has been doing stock-based compensation for many years. For you as an investor, it is good to pay employees with seriously overpriced stock. That increases the fundamental value of the business.
Tesla did the same. Its stock is always extremely expensive. Many times, the company issued a lot of stock at a strongly inflated price. At times, it was questioned whether Tesla could finance itself, but because the market was awarding it a very high stock price, it was able to issue very expensive stock, which increased the fundamental value of the business. If you can issue a relatively small number of shares at five times their fundamental value – or 10 times or 20 times or whatever – it increases the value of the business. The dynamics of this is always fascinating to me.
John: Yes, it’s like the reflexivity argument. That’s also why it’s hard to short high-flying stocks because they could issue new shares at the inflated price, and that diminishes your short thesis. If they can raise a ton of money at an inflated price, all of a sudden, they can have this huge cash position that wasn’t part of the thesis before. It’s a very dicey approach, to say the least, to bet on that kind of reflexivity working out because it can also work the other way where if a stock starts going down, all of a sudden, you have to issue more shares for your stock-based comp. It’s harder to keep employees. It can also spiral downward very quickly.
Daniel: Yes, especially in the finance industry. If the stock price is depressed, the companies usually have a hard time financing themselves, so the reflexivity works negatively. There’s a negative loop.
John: Yes, definitely. You mentioned OSB Group. How did you find the idea? How does a smaller bank like that even register on your screen? You also look at bigger banks and have found value in some very large banks. What’s so special about OSB Group?
Daniel: You’ve read the book. I talk about investing in banks in general first in that chapter because I find it interesting. A lot of people avoid investing in banks per se. Some of the arguments are rational or reasonable – it’s a leveraged industry, it’s a regulated industry, there’s a lot of competition, it’s highly cyclical. That’s true, but sometimes, the arguments are less rational – like, banks are black boxes. You can even hear sometimes that there will be no need for banks in the modern world.
However, some other people have been highly successful investors and have been investing in banks for life – like Warren Buffett. There’s always something in-between. I think a well-chosen bank can be an extremely good long-term compounder. The reason is that if you look at the balance sheet of a bank, it almost entirely consists of financial items. There are no factories, no inventories, no big capex, and stuff like that. It’s all financial items. Whenever a bank makes profit, the whole profit increases the book value.
If a bank’s ROE is at a relatively high level, the book value – which is a good measure of value growth for banks – is growing very fast because you don’t have this leakage. You don’t have this capex, etc. It all grows up. Also, despite assets being depreciated at industrial companies, you don’t know what the market value is relative to the accounting value, while in banks, a lot of stuff is mark-to-market, so the book value is better.
If you find a bank that compounds capital, has high ROE, it can be a great compounder. I have two examples in the book. One is JP Morgan. When you look at banks, because of the risks I talk about, it’s probably a good idea to pick the best. It’s not a good idea to go for lower quality because it’s cheaper. You should stick with the best. I think JP Morgan is by far the best-managed large bank in the world.
Jamie Dimon took over Bank One in 2000 and later on merged it with JP Morgan. The return of the stock since he became CEO is over 12% per annum compared to maybe 7% or 8% for the S&P 500. It beats the market by far. Even if you take the JP Morgan period from 2004, it’s still better than the market. That’s because the average ROE is in the double digits, and that’s much higher than the average earnings growth of the S&P 500. This could be a great long-term compounder.
There’s another way to select among banks. That is our second example – OSB Group. It is a smaller UK bank. If you look for a bank with a special niche in the market – a segment that has been abandoned by the big players for some reason – you can also find a great compounder. That’s the case with OSB Group. It’s a UK bank with a market cap of probably 2 billion or under 2 billion pounds. It’s small, but it has a very simple, old-fashioned business – it mainly lends money to buy-to-let small businesses.
A portion of the UK housing market is occupied by people who rent apartments, and these properties are typically owned by small or medium-sized businesses. A typical owner has between one and seven properties. The bank lends them the money. It’s a very safe business. First of all, it’s collateralized by the real estate. The average loan to value is about 65%, which is pretty safe. The average cost of risk recently has been about 25 basis points. It’s very good. It’s also a well-diversified business because the loans are relatively small. There are thousands of them, maybe even tens of thousands.
There was a change in regulation in the UK market several years ago that made the large banks leave this segment. It became too cumbersome and too labor-intensive for them, so they left. This segment is now dominated by smaller players, and OSB Group has a roughly 9% market share in its main business.
The company IPO-ed about 11 years ago. The book value – if you add back the dividends it paid – has compounded by something like 17% or 18% per annum since the IPO, which is very fast growth. I would expect it to do similarly well in the next 10 years. I would expect the ROE to be at least 15% over the long term. When I wrote the book, it was trading at around 75% or 80% of book value, which I deem very cheap. OSB has been using this price to its advantage, buying all of that stock. On the top of that, it pays a lot of dividends. You could do well in a business like that.
I like investing in banks because I myself have been in the financial business for 30 years. I was in asset management brokerage. I was also on the board of a bank in Prague for a short time. I have no prejudices against banking. If you select your stocks well, you can compound your money very well.
John: It sounds like – and maybe that’s a pattern you look for – smaller banks like OSB have a strong position in a particular niche that’s maybe less competitive because the big banks don’t want to put in the effort it takes.
Daniel: Yes. In the UK, the requirement was that the bank sign off on the business plan of the property owner, which is stupid. If you’re a bank, it’s in your interest to learn about it, but why do you have to sign off on it? The big banks said, “Forget it. We’re not going to do that in order to lend two, five, or seven million to those people. We want to lend 25 million or 250 million to big businesses.” They left the segment, and smaller banks increased their market share.
When valuing a bank, you have to value it differently from valuing non-financial companies. We tend to value non-financial companies based on free cash flow. With a bank, it’s pretty much impossible to figure out what the free cash flow is. You also don’t know what a bank’s debt is because pretty much everything on the liability side is some form of debt.
However, because it’s all financial items, we tend to combine the book value and the ROE as the two key elements in valuation. The higher the ROE, the more above the book value we’re ready to pay. We tend to discount banks by 10%. If a bank has an ROE of 10% over time, we think it’s approximately worth one time book value. If it has 15%, we tend to pay above book value. We try to avoid banks with ROE of less than 10% because they can be cheap, but the correction of valuation has to happen rather fast; if it takes longer, then the low ROE has very negative effects. We tend to pick.
For JP Morgan, the return on tangible equity – which is a sibling of ROE – should be about 17% over the cycle, which is a lot. For OSB Group, I expect the ROE to be about 15% over time. If you have a 15% ROE and start at one time book value, you’re probably going to make more than 15% per annum over a long period.
John: I guess your assessment of management is crucial with banks.
Daniel: Yes, absolutely. With JP Morgan, I can’t think of a better managed bank if we’re talking about big banks. There’s a lot of smaller banks, so there’s no way you can learn about all of them, but at least you can assess the management of those you look at, and I like the management here as well. It’s a very old-fashioned banking business. You lend money to business owners. You own the loan until its expiration. You finance by retail deposits. It is pretty safe for the business.
John: Yes, that sounds very straightforward. I guess with banks it’s the net interest margin.
Daniel: Net interest margin is key. Fees and commissions. On the other hand, you have a cost of risk – bad loans and cost of your capital.
John: Another case study I find fascinating at the moment – because it’s still misunderstood even though it had some big positive news – is Burford Capital. I thought the stock was going to rerate very quickly after Argentina acknowledged there’s something there. What was the thesis when you first invested? How has it played out so far?
Daniel: It’s a UK-based company I discovered about six years ago. It’s a pioneer and by far the biggest player in litigation finance. Litigation finance is a relatively young industry. It’s a business where companies finance litigations for their customers – typically corporations or law firms – in return for a portion of the awards, if there are awards.
I selected the company for the book because, in general, I think that human capital or human work is a big value creator at the level of companies. The people create value by their work, by their ideas, by their efforts in general. It’s not always positive, but overall, it’s positive. In the case of Burford Capital, 100% of value is created by human capital.
It’s like a private equity fund where the portfolio doesn’t consist of stakes in companies but of hundreds of legal cases. They have relatively short maturity – about three years on average. When the company gets the proceeds, it reinvests them in new cases. It’s like a private equity portfolio marked close to market because it’s much shorter, and it’s being reinvested at a relatively high level. I think the IRR over the entire history of the company is in the high 20s – maybe 27. That’s the rate at which it is able to invest and reinvest the money, which is a lot. You deduct the cost of running the business, you deduct the cost of capital, you add a little because of leverage, and you come up with a theoretical expected return on equity.
I think the company is still a bit misunderstood because it’s relatively young. It’s also relatively small. It was listed in UK first and only recently in the US. The accounting is fine, but the cadence of earnings is extremely unpredictable. It’s not like a business where every quarter you book about the same revenues and profit, and it goes up 5% every year. The results of the legal cases are unpredictable, as is the timing. Quarterly results are more or less meaningless. Sometimes, they are very good; sometimes, they are poor, but that doesn’t matter and doesn’t mean much. You should take a more general, philosophical approach to that business, but this is still very cheap.
Its biggest case by far is the litigation against Argentina. In 2011 or 2012, Argentina nationalized YPF – the oil company – and expropriated the foreign investors without any compensation although it previously wrote in the articles that in case something happened, they will be compensated. There was even a formula for how compensation would be calculated, but that didn’t happen.
The two clients Burford represents went bankrupt, and the liquidators approached Burford to ask if it could finance the case because bankrupt companies have no cash. The US court has awarded $16 billion to the defendants, of which Burford would probably get about a third – about 35%. There’s still an appeal pending. Right now, the sum is over $17 billion because the interest keeps accruing. I think Argentina would have to settle sooner or later.
If the full amount is awarded, Burford would probably get about $5 billion or $6 billion. Its market cap is less than $3 billion. That’s a lot of money. Of course, the market discounts that award and believes the case will be settled for much less money. At any rate, it would be quite substantial. Besides that, Burford owns a lot of other cases. Some of them are very large. Even without the YPF case, the stock price justifies the rest of the business. We have a solid business at a fair value plus a free option for a huge upside.
I think it’s a great – almost textbook – case of a company where pretty much the complete value of the business is created by human capital and human work because the core of the business is 70 lawyers who have to be able to assess cases, express them in time, probability, and monetary terms, and decide whether they do them or not.
John: To me, it looks like a classic case of investors framing the investment thesis wrong. The Argentina case is almost like an overhang on the stock when it should be the opposite.
Daniel: Exactly.
John: As you say, the rest of the business already justifies the valuation. Fundamentally, from the IRRs it’s been able to get on the portfolio of its litigations, it’s a good business.
Daniel: The YPF case is excluded from this IRR because the IRR is only calculated from the cases already concluded and paid for.
I think there’s a lot of misconception about this business because it doesn’t initiate the legal cases. It doesn’t take them over. When a corporation approaches Burford and says, “We want you to finance our portfolio of legal cases,” it look at it and maybe does that. The law firms do the same because they don’t have the capital to finance it themselves. Burford doesn’t initiate the legal cases and doesn’t take them over. Sometimes, it is looked upon negatively, as if it’s a vulture fund that tries to feast on poor delinquents, but no, it doesn’t initiate the cases.
John: Do you think there are any legitimate concerns or risks around Burford on the competitive front? If the IRRs are so attractive, maybe some bigger law firms would say, “We will do the case.”
Daniel: The competition is much smaller. There are a couple of other listed firms, but they are probably one order smaller. There are some private equity funds or specialized hedge funds that compete with Burford as well, but it has achieved a reputation and a size that leaves it with almost no competition.
For example, it can finance whole portfolios of legal cases for a corporation. It recently purchased such a portfolio from a Fortune 50 corporation and then invested $250 million, which is a transaction that very few competitors can do.
If you look at Berkshire’s insurance business, in the history of insurance, I think there are maybe seven or 10 transactions in total where the insurance premium was $1 billion or higher, and all of them were done by Berkshire because no other insurance company can take so much risk on its books. I think there was even a case a couple of years ago where Berkshire sold reinsurance to AIB and the insurance premium was $10 billion. There’s no one in the world that could do a transaction of that size.
In its own business, I think Burford is in a similar position. It’s at a level where it has very limited competition.
John: Yes, definitely a fascinating case. What kind of timeline do you expect on Argentina? Is there a way to tell how the negotiations are going?
Daniel: No. There’s still one appeal pending, which I’m pretty sure Argentina would lose. Unfortunately, it’s not the fault of the current administration but the previous ones. It has had a lot of litigations and lost many of them, eventually paying in pretty much all of them. It tries to fight and delay, which eventually costs it more, but it has to pay.
There was also litigation regarding some GDP-linked bonds in the UK where it lost the final appeal and has to pay about 1.5 billion. There’s no further appeal. That case now appears in the documentation of IMF that’s lending money to Argentina. At some point, Argentina has to recognize this as a liability.
In the YPF case, there’s still one more appeal pending. I think the government doesn’t want to recognize it until every other option is recognized. Of course, it will become more expensive for it, but countries like Argentina and Brazil have a history of imprisoning previous presidents. You don’t want to be in a situation where the next president put you in jail because you signed a settlement and didn’t exhaust all cases.
I think the time will come – probably later this year or next year – when the appeals would be exhausted. Of course, it would be smarter for Argentina to negotiate a settlement much earlier in the process because the further it goes, the more it loses, and the less leverage it has. We’ll see. It’s an interesting story to watch.
John: Shifting gears, you also profile an energy company. That’s a whole different sector, but – from both a macro standpoint and the company-specific thesis – it’s a very interesting one.
Daniel: Yes, the company I talk about is Cenovus Energy, but there’s another chapter preceding this one that talks about the oil industry in general. I think there’s a misconception among many investors that the demand for oil will go down fast for some reason. Some agencies even project very fast declining demand for oil.
However, when I travel around the world, I see a completely different story. I see a lot of growth ambitions in the poorer 5 billion people in parts of the world where the demand for energy is very low right now, but these people have ambitions and desires to live a much better life than they do. They want to get closer to what we are used to. If they succeed, this will come together with a lot of increasing demand for all types of energy, including oil.
I see oil demand growing continuously for many years down the road. If you look at the supply and demand, the more likely scenario is for oil to go higher over time or in the next 10 years. Of course, to a certain extent, oil price and gas price are the key elements when you analyze an oil company because they are all price takers. If you try to figure out what the future cash flow is for an oil company, and if you try to build a model or even do a rough estimate, oil price is always the first line. You have to have some expectations about it. My expectations are on the upward side, not the downward side.
We used to invest in oil a long time ago – before 2008 – when there was a period of globalization and China was rising. Oil was growing very fast, but maybe two years later, we left the industry because we didn’t like the asset allocation of oil companies. At that time, it was like, “Drill, baby, drill.” They were trying to acquire as many assets as possible, acquire other companies, grow production, and whatever it took because their expectations for oil prices were very optimistic.
In this industry, you are a price taker. You have very long investment horizons. You have huge upfront costs. You work with a debt load, and it’s a highly cyclical industry. The asset allocation process was very distracting. However, things changed over time. The oil companies were being pressured to stop producing oil – by society, by politicians, and sometimes by their own shareholders. They ventured into other industries and other activities. Most of all, they stopped investing in oil production because it was unpopular.
Put yourself in the shoes of the CEO of a large oil company. Your chief geologist comes to you and tells you, “I’ve got a great discovery offshore of Brazil. It will require $9 billion to invest. We might start producing five years from now, and we will be producing for another 15 years. Probably five years from the start, we’ll recover the initial capital.” The CEO will tell you, “Forget it” because in today’s environment, he would be facing society pressure, so why take the risk?
Companies have cut dramatically their investment in new production. Instead, they are returning money to shareholders, which for them is less controversial and less risky. In the short run, it may be beneficial for shareholders. The outcome of all of that would be that the price of oil will be higher than it could be because you will not have sufficient investment. That’s the macro story.
When you think about how to express that in stock selection, there’s a lot of choice. There are many oil-producing companies. What we do is cluster them into four groups. One group are the national oil companies, like Saudi Aramco, but most of them are not publicly traded. Saudi Aramco might be the only exception, but you wouldn’t invest in that, so we put it aside. They produce about a quarter of the oil.
Then you have the supermajors like Exxon, BP, Shell, and Petrobras. We don’t invest in them as well because their size is their disadvantage. They have to spend a lot of money on developing new reserves and finding new oil, and growth for them is very difficult to achieve. Also, because they’re so big, they are in the front line of politicians’ anger or pushbacks.
On the other end, you have junior oil companies. Some of them are not even producing. Some of them rely on one or two key sources. You can make a lot of money in some of them, but it’s a very risky area. You have to be deeply specialized.
We try to look for something in the middle. We look for companies that are highly profitable, have established production, have low finding cost and low production cost, and are in predictable jurisdictions. That leaves you with only very few option – some in US and some in Canada. We picked one of the three large Canadian players – Cenovus Energy – because Canada may not always be predictable, but it is one of the more stable environments.
The company has all its oil in place, so the finding costs are very low. Its development costs are also very low because of the type of production it does. The production costs are low because the main cost is gas, which is cheap in that part of the world. The asset allocation policy is very good. The company basically returns all the free cash flow to investors by some dividends but mostly by buying back stock. I expect the share count to continue going down over time.
If my assumptions about the future price of oil are more or less okay, then Cenovus should be able to generate a double-digit free cash flow yield and will return most of it to shareholders year after year. That’s explains the position. Also, if you own all these oil reserves in the ground – in this case, it’s for more than 30 years of production – it creates a hedge against certain extreme scenarios in general, for example, high inflation, commodity shortages, or even geopolitical risks. I think a position like that has a place in our portfolio.
John: Very interesting. Obviously, it is a commodity business, not the traditional high-quality business. Cenovus in particular sounds more like a predictable production story than an exploration story.
Daniel: Yes, and it’s not only being able to produce oil cheaply. You also have to be able to transport it and refine it. Cenovus is well-connected to pipelines and has some refineries. As long as its asset allocation priorities remain as they are, we’ll be happy to own the stock.
When the modus operandi changes in the whole industry, and they start acquiring each other or start acquiring reserves regardless of the price, we would reconsider it, but as long as they keep growing at a reasonably modest pace and return free cash to shareholders, that’s the ideal situation. It’s an ideal situation for us as shareholders, but it’s not ideal for consumers because that makes the oil price higher than it could be, but we’re not going to change that.
John: Let’s talk about Berkshire because that’s the big one and an inspiration for a lot of things, including the last chapter of your book entitled “Berkshire Park.” It has a lot of parallels to investing, and I was fortunate to see it and experience it. Thank you for that.
When did you first invest in Berkshire? How do you view it in terms of the position it has in your portfolio because it’s a special company?
Daniel: I first bought Berkshire in 1995 or 1996 – years before we started the fund. In the fund, it’s been our largest position by far for maybe 13 years. It’s a benchmark stock within our portfolio because it has probably the most predictable future results among all the stocks we own. It develops in a very predictable way. It also has the least business risks of all the stocks we own. That’s because of the balance sheet, asset allocation, and quality of assets.
At today’s price, you can probably earn 10% or 11% per annum over the long run from this stock with minimum risk. When we look at any other company, we want higher return because every other company has higher business risk. We can always buy more Berkshire to a certain point, so we always use it as a benchmark. Every other stock we own has a higher business risk, but most of them – at least when you buy them – have a higher expected return. For us, it’s a good benchmark that keeps us disciplined.
I included it in the first chapter of the book because what I find fascinating is that it’s one of the best long-term stories in the world – or at least in the US. It’s been visible to everyone for decades, yet still so few people understand the company that I’m baffled. If you’re a professional investor and see a story that’s been so successful, you should learn a lot about it. You don’t have to invest in it, but you should understand why it’s been so successful. People don’t understand it.
Last Saturday, it reported quarterly earnings. You can see from the headlines that the journalists don’t really understand the figures. Our mutual friend Chris Bloomstran got angry on Twitter. He said, “I spent two hours talking to journalists, trying to explain to them what the results are, and then they misrepresent them in the story anyway.” I find it fascinating. A lot of investors don’t understand Berkshire. Many people still think it’s an investment fund.
Among the big mega caps, it’s the only one today that I consider undervalued. That’s why we still own it. It’s an example of a boring company in the sense that its development is very steady. You don’t expect there to be any excitement. Yes, every 10 years, it does a big acquisition, but then it’s a reasonably steady and boring business.
People tend to find boring businesses unattractive, which I think is a mistake. People have a tendency to undervalue the impact of long-term compounding, which is exactly what this business is about. Every company has a certain life cycle because it has a certain product that experiences a boom but is eventually replaced or dies down. However, Berkshire’s business is not some product or service. Its business is compounding capital, and that compounding can run forever and can be very fast on a per-share basis.
John: What’s most misunderstood seems to be this aspect that it’s not an investment fund. It’s a collection of operating businesses.
Daniel: A conglomerate.
John: With a great capital allocator at the helm.
Daniel: Cheap leverage. Your built-in leverage, which is non-recourse, is for free and has indefinite maturity.
John: How do you think about the fact that it’s so big now and the rate at which it can keep compounding given the size?
Daniel: Yes, it’s a disadvantage. Size is always a disadvantage in investments. I think it should be a lot more aggressive on buybacks because that takes a portion of that problem away.
It was very active several years ago. Around March or April this year, for the first time since 2002 – at least in our calculations – the stock got above its fundamental value. I understand why Berkshire doesn’t buy right now, but over time, it should get more aggressive. Right now, I think it’s about 14% to 15% below its fundamental value. Maybe it’s not cheap enough for Berkshire yet, but with that much cash and this problem growing over time, it should maybe be more aggressive.
That’s one reason why we have Markel in our portfolio and also as a chapter in the book. Another thing I find fascinating is that the Berkshire business model has been in place and visible for decades, but almost no one has been able to replicate it. That’s because it’s not easy. That’s why one of the durable advantages is the business model put in place at Berkshire. Markel is one of the very few companies that at least tries to do things in a similar way and got somewhere in a successful way.
Over the last 25 to 35 years, the stock performance might be even better. I remember when Tom Gayner joined Markel around 1990. I think the stock price was $20. Now, it’s $2,000. It’s a 100-bagger, which probably might be better than Berkshire over that period. Of course, it’s not the same quality. Markel is not there yet, but it’s going in a similar direction. Markel’s biggest advantage is that it’s much smaller – the market cap being maybe $25 billion. Size is definitely not a disadvantage for Markel. t will have an easier time growing faster.
However, it’s extremely difficult to replicate Berkshire’s model because – among other things – it takes a lot of time. There’s a great book about Berkshire by Adam Mead published a couple of years ago that gives you the entire history of Berkshire’s transactions. When you look at the late 1960s or early 1970s – soon after Buffett became CEO and started turning the textile company into what it is today – you realize how long it takes. Even 10 years after he started, it was still a very small company. These things take a very long time, and no one has the patience to keep building something for 30 years and waiting for the results. That’s why it won’t get replicated easily.
John: Yes, it’s the nature of that exponential curve which – for quite a lot of years – looks almost flat, and then it goes up. There’s that statistic around how much value or personal wealth Buffett has created after even his 80th birthday, and it’s a lot.
Daniel: Yes, I think he was in his 50s when he became a billionaire. One billion today is not a lot of money, of course, but at that time, it was. If he didn’t distribute a lot of his shares to charity, he would probably be now over $200 billion – maybe $300 billion. About 99% of his wealth was created after he turned 50. That’s the exponential curve. In absolute terms, the biggest numbers of Berkshire are still ahead, not in per-share terms or in percentage terms – that’s almost impossible – but in absolute terms.
John: Where’s the stock price today?
Daniel: It’s about $700,000.
John: How about when you first invested in 1995?
Daniel: Personally? It was $45,000 maybe. When we first bought it in the fund, it was $110,000. I don’t own it personally now – only through the fund – but for me, it would have been 15 times. For the fund, it’s about seven times.
John: Yes, I don’t think we’ll have that story repeated. As you say, there aren’t even many trying to repeat it. Markel is one, and maybe a few others.
Daniel: Yes, very few.
John: It’s truly remarkable. I wonder what will happen with Berkshire after Buffett is no longer at the helm – whether it continues as one entity.
Daniel: I don’t expect any major changes. De facto, a very large part of Berkshire has been run by Greg Abel for some time. He’s been in charge of the private part for some time. At the end of this year, he would be in charge of the whole business. He would become CEO.
The longer I watch him, the more I like him. I think he’s an extremely smart guy. Buffett is Buffett. There’s no one else like him, but Greg might have certain advantages over Buffett. First of all, he was running real businesses for some time. True, Buffett is the CEO of a large conglomerate, but he’s more of a money shuffler/asset allocator – a great one, to be sure, but Greg Abel was running businesses himself. That may be an advantage to a certain extent. Also, he seems to have less inertia vis-à-vis some of these private businesses. Buffett bought all of them, and some in the private section of Berkshire are probably not performing well enough. I think Greg Abel would be tougher on them. He has been already. He might be even more disposed to get rid of some of them.
I don’t have any problems with him running the show. Of course, I would love to be reading Buffett’s writing and listening to him for many years to come, but that can’t happen.
John: In the book, you also talk about a couple of mistakes – which I think is also instructive to include – and their different nature.
Daniel: I mentioned two specifically. I mentioned CVS as an example of a company we should have never bought and Microsoft as an example of a company we should have never sold. I don’t have much emotional attachment to those mistakes, but I try to analyze them in an intellectual way and figure out what the mistake was, why it happened, and how to make sure it won’t repeat very often. I think it’s important to be learning from the mistakes.
John: What was the mistake with CVS?
Daniel: CVS used to be an extremely popular stock until about some time in the middle of the last decade. It made the huge acquisition of Aetna – a health insurance company that was hugely overpriced – and the stock started to go down. CVS incurred a lot of debt and had a lot of interest to pay down. It had to stop buying back shares and had to continue reusing the debt. The valuation kept getting lower and lower because the market didn’t like what the company did.
Then it replaced the CEO. The one responsible for Aetna was gone. CVS brought on the one previously running Aetna to be its new CEO. She said the priority would be not to do acquisitions anymore. The company would buy back stock and focus on improving the business.
After COVID, the stock was pretty cheap. We said, “This looks like an attractive opportunity.” We based it on our faith that the asset allocation would be okay. For a while, it was okay, and the stock was moving higher, but the company did two acquisitions in short succession that were a complete waste of money. It wasted maybe at least half of the purchase price. Again, increase the debt, stop buying back shares, and the rest. The market didn’t like the acquisitions, and the stock started going down.
We realized that if a company has a history of poor asset allocation, the fact that the CEO changes – especially when she comes from within the company – is not enough. We sold it because there’s no point in owning a company that is doing reasonably well but from time to time destroys the value by paying too much for a large acquisition. That was a mistake.
I talk about base case versus case rates. We knew that expensive acquisitions are the red flag we want to avoid, but we tended to overweight the case rate – like believing things here would turn out to be better – but that was a mistake.
In the case of Microsoft, it’s a stock we should never have sold. We bought it in 2010 or 2011. It was extremely unpopular. It’s hard to imagine that today when it’s one of the Mag Seven, but back then, people saw Microsoft as a business of the past that had nothing to do or nothing to say for the future. It traded at 10 times earnings.
We had a different opinion of the company. We bought it and had to explain to our investors for two years why we bought a stock that everyone knows is on its way out of business slowly. Then it started to go up and we didn’t have to explain anymore, but the thing was that it started to do much better than anyone thought.
Our mistake was when we paid 10 times earnings for an unloved stock. That was our anchor price or anchor valuation. The earnings started to rise. The multiple started to go higher. After several years, we felt it was expensive because we bought it at 10 times earnings. Now it’s several times higher, but these multiples are very expensive, so we sold the stock. We made a lot of money, but the stock went up much higher after that.
On CVS, we lost maybe half a percent of the fund – almost inconsequential because we initially bought it very cheaply. It doesn’t bother us that much. It’s a good lesson, but it doesn’t really matter. On Microsoft, we made a lot of money, but we left so much money on the table by selling it too early that I’m still kind of bothered about it.
We try to be more general about letting the good stories run because, usually, when you have something working very well, you just let it go for a while more because when good companies start running, they tend to go for longer than people think. Also, the market rewards them with bigger multiples although this is a sensitive theme because you don’t want to get caught in the growth trap. Sometimes, you let go, but it was a mistake no one forced upon us. We decided to sell.
John: What is a growth trap, in your view?
Daniel: People talk about value traps a lot. A value trap is a situation where you find a cheap stock – the value opportunity – but over time, you realize that the value in the business is not as high as you thought. It may be lower. It may be going down, and the stock keeps going down with it. It keeps being cheap relative to value, but because the value keeps going down, you are trapped. In the end, you might sell the stock – still at a discount – but you know that the discount is not really there because the value is questionable.
There’s a mirror situation which I call a growth trap, where you pay too much for too high potential future growth, then you realize the growth won’t be there and you overpaid, and the stock collapses dramatically. In value traps, it’s like a continuous process. It’s only a matter of how fast you come to the realization that this is the case. With growth traps, it tends to happen very fast.
We’re living one case right now with a Danish company called Novo Nordisk. A year ago, the stock was above $1,000 because everyone was extremely bullish about the potential of the obesity drugs. Then came the realization that the growth might be there, but way more modest, and the stock is now 70% lower, which is highly unusual for a very well-known, large company like that.
This is probably a typical case of a growth trap. A lot of people got trapped in their expectation of potential growth. The stock was trading at 50 times earnings at its peak, which is a lot even if you are growing fast. Now, it’s priced at 12 times earnings over the next 12 months, which are much lower growth expectations. The future will tell what the case is and whether this is a value trap or a value opportunity. It’s certainly not a growth trap anymore.
John: Yes, it’s very tricky, and that’s where judgment comes in on this issue of selling too early a company like Microsoft. It certainly hurts a lot, but as you say, some companies turn into growth traps. For Novo shareholders, it would have been smart to sell at some point, maybe even a little early. I think that’s where valuation does need to come in although as value investors, we often underestimate how high valuation can go on those growing companies.
Daniel: Yes, it can. We were buying Microsoft at 10 times earnings. You could say that at that time, it was a great opportunity because it’s a very strong, established company. Its growth after that was much faster than people expected, but now you’re paying a high 30s multiple for a stock like that. Can it grow fast enough to justify this? I don’t know. The market thinks it can, but I’m not convinced. It’s not growing that fast. It’s decent growth, but not super high growth.
You can find companies growing at least that fast at much lower multiples, but I didn’t expect 15 years ago that the stock would go to 35 to 37 times earnings. No one did. Otherwise, the stock wouldn’t have traded at 10 times earnings.
It’s easy to explain and justify everything ex post, but we don’t know whether the multiples for Microsoft or Novo Nordisk today are too high or too low or just about okay. That’s the good thing about investing. You can never arrive at a situation where you would say, “I know this is the way it’s going to be.” It’s always assumption, estimate, uncertainty, incomplete information, dynamic environment. Everything is changing. It’s very stimulating.
John: If you were to synthesize it all, what’s your advice for finding hidden investment treasures in today’s market?
Daniel: I’m not very good at making bold statements, but I try to explain two things in the book – that the environment for active investors today is very favorable if you understand it and approach it in the right way and that there are opportunities out there.
There’s plenty of them although the US market may be at one of its highest valuation levels in history. It’s partially held up by a handful of top stocks. If you go below the surface of the market, you can see a lot of opportunities everywhere – in other countries, emerging markets, and other developed markets. I think you can have a lot of fun and make a lot of money if you do the work. It requires a lot of effort. That’s true. Those opportunities will not present themselves every morning, but they’re there.
John: In parting, tell us what lasting principles you want readers to take from your book.
Daniel: As we said earlier, some things change, but some things don’t. Something that doesn’t change – and that I think will not change in the future – is that you should look at investments as a transaction where you exchange money for some value.
You have to always think in terms of price and value and always try to make investments where the price is much lower than the value. It doesn’t apply only to stocks. It applies for any type of investment. Many people don’t think about these things at all. If you have the discipline and select investments in this way, you can have a much better combination of return and risk than the market offers today.
John: Yes, people seem to know price versus value intuitively in the rest of their lives, but not in the stock market for some reason, which is interesting.
Daniel: Yes. When you do your regular shopping, you wouldn’t pay an exorbitant price for something ordinary or just good. You’re always price-conscious. However, when some people look at stocks, they forget about it completely. That’s a mistake.
John: Thank you for this conversation, Daniel.
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