Introduction

Patrick: [00:00:49] My guest this week is Geoffrey Batt and the topic of our conversation is how to earn transformational returns in very hard markets. In his case, that means Iraqi equities, which we cover in detail. He now runs a large pool of capital in Iraqi Stocks through his firm, Euphrates, but the journey was arduous to say the least. This is one of my favorite boots on the ground contrarian investment stories thus far in the podcast. I hope you enjoy the story and the lessons that Geoff has to offer.

Transformational Returns

So, Geoff, this is going to be certainly one of the more unique equity investing discussions that I've ever had, centered on investing in Iraq specifically. But before we spend a lot of our hour together on that topic, I want to frame this with the notion that we talked about on the phone. I think we'll call this episode the nature of transformational returns. In several places, you've talked a bit about what it takes to earn the kind of 25, 50X returns that massively change an investor's life. And however wants that, but the actual experience of getting it is massively hard and uncomfortable. So maybe you could frame our entire conversation with this simple idea of what it takes to earn transformational returns.

Geoffrey: [00:01:53] Well, just looking at the history of markets and the asset classes that have produced these sorts of returns. The first thing that stands out is that it requires an extraordinary amount of patience. Time is a major component of it. By time, I mean these sorts of historic equity re-ratings that produce these returns can take 10 to 15 years to generate those results.

If you take the case of Japan, post-World War II, from saying their bull market more or less began right at the beginning of, say 1950, 1951, and it lasted until 1989. And it's still below its peak today in 1988. But that's almost 40 years. And I think it produced a 100000% return in dollar terms. But over that 39, 40-year period, there was maybe a decade when the market did nothing. People in the West were questioning your sanity if you were talking about Japanese equities in a constructive or positive way.

Now, that's an extreme example. I don't think anybody could really hold on to an investment for that long a period of time. But you look at other markets that have done, maybe not a hundred thousand percent, but at maybe 3,000 to 5,000%. And what you typically find is that there's this lengthy period where sort of nothing good happens to your investment, but at the same time, you're enduring a great deal of volatility in the country, whether it be political or economic. And you can get to certain situations where things look really dire, and you start to question whether you've made a terrible mistake.

You have to be able to have the temperament, and the conviction, and the analytical ability to see through all of the fear and emotion, and really try and figure out what's happening and whether the investment is still makes sense. And accept the fact that you might have a decade-long period where you have nothing to show for your investments. So it's incredibly challenging, and most funds the way they're structured today and the expectations that most investors in hedge funds and mutual funds have.

I'm not sure that it's possible for funds to capture those types of returns given the constraints that they face. You have some funds that are reporting performance on a weekly basis.. I guess mutual funds are reporting performance on a daily basis. But if your hedge fund is a long-term investment for you, it might be six months, maybe a year. And if your LPs are fund-to-funds or people who themselves are having to report performance to their investors on a short-term basis, they usually pull their money from you at the first sign of trouble. And it just makes the structure of your fund very unstable. And that kind of instability makes it almost impossible to ride out those periods of volatility or those long periods where nothing happens.

Patrick: [00:04:43] I want to come back to both the fundamental story and the price story behind these massive transformational long-term returns like re-ratings and countries. So we'll spend time on that. But first, given that you're somebody that invests in a hyper-volatile market, and you have LPs, how have you attacked this problem of LP instability that matches the volatility of the underlying investment

Geoffrey: [00:05:06] If I have had any insight that's a value to other people thinking about starting a fund, is that early on in the history of Euphrates, I realized that this sort of investment was not going to appeal to institutional investors. Even if institutional investors were interested in what we were doing, it wasn't the sort of money that we wanted to manage, precisely for the reasons that I just mentioned. There are certainly institutions that take a long-term view that will give you five years or so to generate a good return for them.

But I would say they're more of the exception and not the rule. In fact, what you're dealing with, with institutions are investment committees, these groups of people who make group decisions and they're faced with extraordinary career risk. If you sit on the investment committee of some institution and you're allocating capital on their behalf, and you bring the idea of Iraq to the committee, they're going to look at you like you've lost your mind. So there's very little upside if it works-

Patrick: [00:06:05] You don't get paid off.

Geoffrey: [00:06:05] You don't get paid off on it, right? And if it doesn't work, you're probably going to lose your job. Or at the very least, you're not going to get promoted and it's going to be a demerit for you and your career. What I realized very early on is that that type of investor was just not at all what I needed. What I needed was a fund structure that was going to be as stable as possible. I thought of the fund as a bank pre-FDIC, pre-Great Depression, that the stability of my LP base was going to determine whether or not the fund itself is going to have a chance to succeed and capture those types of returns.

And that meant that I had to seek out high-net worth individuals in family offices, where the people you were speaking with had agency. They were able to determine themselves without consulting anyone, whether or not they wanted to make the investment. I guess, critically, they didn't care at all about looking foolish. If they put money into my fund, and then a year later there was some kind of major political event that freaked everyone out, they didn't have to go to a committee and explain why they made this terrible decision or what appeared to be a terrible decision.

If anything, if the market reacted in an exaggerated way, if it sold off more than was justified by the event, then they would be inclined to add. And so by targeting those sorts of investors, what I've ended up with was pretty unique in the fund management business. Namely, I have a countercyclical fund, whereas most funds are pro-cyclical. So when you're doing well in most funds, money comes in. And when you're doing poorly, money comes out. Which is far from ideal.

The practical consequences of that is you're getting more and more money when there's less and less attractive assets for you to buy when you're able to deploy it without necessarily getting a very good return on it. And when the opportunities are abundant and the prospect of generating significant returns over time are at their best, people are pulling from you. You become forced sellers. It's almost like a margin call. So you become forced sellers most inopportune point in a market cycle. And I don't have that. So by focusing on these sorts of contrarian-minded, high-net worth individuals in family offices, what I found is that we woke up one morning and read that ISIS had taken control of Iraq's second-largest city, Mosul.

Patrick: [00:08:36] Not a good headline.

Geoffrey: [00:08:37] Not a good headline. No. The only briefly positive thing about that headline was the price of oil went up. But that happened to be a peak and then collapsed afterwards, which was sort of a double hit over the head with a sledgehammer twice. But the market pretty quickly collapsed after that news broke. And it was probably the most difficult two weeks of my professional life trying to figure out what was going on and what this meant for my thesis.

But once we figured out that the way ISIS has capability was being reported in the mainstream news was greatly exaggerating their capabilities. And we were able to determine that there was zero chance that they were going to take Baghdad. And more importantly, from our point of view, that they had no chance at all of penetrating into the South where the oil is. We were able to go to our investors and explain very objectively what was happening. And they added, we added net inflows into our fund after an event like that. Which is pretty-

Patrick: [00:09:34] Commendable.

Geoffrey: [00:09:34] Yes. I would say that if you want to capture these types of returns that you can find in frontier markets or in an emerging market that's going through this extraordinarily positive transformation, the transformation is going to take a very long time to unfold, and there's going to be all kinds of setbacks along the way, you need to have an investor base that can be there with you when things look awful. And I just don't see institutional investors in that way. I see institutional investors as a very skittish group.

And I don't mean to speak so pejoratively about them, it's just structural. Yeah, it's just not right for me and what I'm trying to do. So I think that for people who want to get these types of returns, it's either they have to do it on their own, or find a fund that won't take institutional money or will take very little institutional money as a percentage of AUM.

Patrick: [00:10:25] That last point is interesting that it should be a consideration of the LP as well, Not just you the GP, to make sure that they're not getting into a fund that's going to get wiped out because others are pulling their money. I never thought about that.

Geoffrey: [00:10:36] That's adjacency risk, right? You're invested alongside all of your other LPs. If you look at most funds, when they start, there's some big seed investor. That seed investor maybe puts in 50 or a hundred million dollars, and then you have other LPs coming in for like a million or something. So you could have one LP that is half the fund, or more than half to fund it. That LP pulls, game over.

Patrick: [00:10:59] I don't know who that is and how they act.

Geoffrey: [00:11:00] Exactly. You get steamrolled by the largest LP pulling. I found that our LPs are very sophisticated people. They tend to be fund managers themselves. And many of them ask that question, but I'm not sure the average LP would think to ask that question. But It's critical.

Patrick: [00:11:17] I'd love to tell the whole story of how you got interested in this market in particular as a means of explaining the basic ideas behind transformational return? So if returns basically come from either dividends, fundamental growth, or upward rerating of the stocks in PE terms or something like this, how did you get interested in the Iraqi stock market? What were the antecedents to this interest? And then I want you to even tell the story about you testing that market with local brokers and stuff in the early days.

Geoffrey: [00:11:43] It depends how far back you want to go, I guess.

Patrick: [00:11:44] I like going all the way. Whatever you think is appropriate.

Geoffrey: [00:11:47] I guess I'll start with this. I was a student, I was studying philosophy and I had no interest in financial markets whatsoever. I was hoping to become an academic. And I think I took a graduate seminar, something on Leipnetz. There is this guy in the class, everyone in the class was smart, but this guy was smarter than everyone. And you could just tell that he was a unique thinker and it was just very interesting. And we would talk after class and I got to know him better.

I later found out after about a year of knowing him that before he started doing his PhD in philosophy, he co-founded the first fund that invested in post-Soviet Russia called Firebird along with Harvey Sawikin. His name was Daniel Cloud. He asked me if I'd be interested in leaving philosophy for a little while and coming to work for him and learning about financial markets.

So that's how I got involved. And I learned how to search and seek out these sorts of transformational situations by working with Dan. Dan, after he graduated college, I think this was in the early eighties, he went straight to China and was teaching English as a second language in China, and then got a job at a broker, some British brokerage firm, W.I. Carr, I believe, that was trying to get involved in what were the emerging markets of that period in Hong Kong and Taiwan and Thailand and so on. They were just starting to boom.

So Dan got involved in the financial markets that way. The guys who were running the brokerage firm that he was working for. They were making their money investing in frontier markets of the sixties and seventies like Japan, for example, or South Korea. So you had this older generation that taught him what to look for. And then I was fortunate enough to meet him and he taught me what to look for.

So after working with him for a while, I decided that I wanted to go out and find the next big thing. And to try and find what that is, the first thing you want to look for is a place that everyone thinks is awful. And in 2007, and when I decided to do this, that was Iraq. The war, the way it was being portrayed in the mainstream media was going horribly. It was hard to turn on a television or pick up a newspaper and not see coverage of Iraq that was extremely negative.

Now, it may be that that's justified. If there's very negative coverage of say North Korea or something, it may be accurate, but what you want to do is test the accuracy of the claims that are being made. So I thought, all right, well, Iraq is about as negative of places you'll find, or perceptions of Iraq are about as negative as you'll find, let's see if that maps onto reality. I started looking at very basic macroeconomic data and also data on security, how many people were dying in the war every month. And there were agencies that were keeping track of this sort of stuff.

What I found just sort of lept off the page. You have this country that's being portrayed as a failed state, it's fighting a civil war, and that it's just hell on earth, but oil production is increasing. How on earth is that possible in a failed state? Failed States typically don't increase oil production. Oh, like I see the CPI inflation, which was 75% year over year, a year ago is now five or 10%. That's pretty interesting. How did that happen? The currency, oddly enough, is appreciating against the dollar. Civilian fatalities from the civil war maybe peaked at, say 3,000 a month, but we're now down to 200 a month.

So what I found in the data was very much at odds with the way Iraq was being portrayed. There was this very significant incongruity between the portrayal of the country and what the data was telling you about the country. The data was telling you that there was some really awful stuff happening, but it seems like the worst part of it was behind them and that they sort of turned the corner.

So that's when something becomes very, very interesting in my view. And that's what I was taught to look for, these situations where there's this huge gap between perception and reality. And we're questions about how do you really know what reality is? And how do you know you're looking at it accurately? And I would say that you can never really be certain, there's always a skeptical point of view available. And it's possible that some bias that you have is going to lead you astray, but the data is a rarely good initial approximation of what conditions are like in a country.

Patrick: [00:16:15] Before we get to the equity market specifically, which is obviously the next step of your investigation, I want to make sure I've codified what you learned from Dan and what to look for in these countries as completely as possible. So we've got this idea of very negative perception, sort of the classics value idea that you want. Ideally like pure consensus that something is bad because that gets imputed in prices. And then you've got economic fundamentals which are contrary. Are there any other factors? I'd be curious about what other markets you considered or countries or places you considered at the early stage of this investigation, or if you just found Iraq immediately?

Geoffrey: [00:16:49] Yeah, you have to go to the country. And I know that when you started the podcast with Harvey Sawikin, you asked him your most interesting travel story or something. And I was thinking about that, what would my answer to that question be? And my first time in Baghdad was pretty interesting. I have this idea sitting in New York City, analyzing this country.

Patrick: [00:17:10] Being a philosopher.

Geoffrey: [00:17:13] Sitting in New York City, analyzing this country from a distance. And I'm making this claim that the New York Times, and the Washington Post, and CNN, they're all wrong. And I'm this guy who's been studying philosophy and I've got it all right. So just, "Okay, well I should go there and see if that's true or not." The data's telling me that this is a much better and I got to go see for myself. That's when you really can start to tell though.

The danger is that you go to a place one time and you think you've got it all figured out because you've been there, you could easily become overconfident. You certainly want to avoid that. But when you get there, part of you is not really sure if you're right. Maybe I've lost my mind. Maybe I've made a horrible mistake. Maybe this is the most dangerous thing I've ever done in my life.

And as you're landing in Baghdad's airport and taxiing up to the terminal and getting out, I don't know, are bullets going to be flying everywhere? The bombs going off? This is what was going through my head, like I was entering a war zone. And what was most fascinating about it was, you get in a taxi and you drive away from the airport to your hotel. And it's just normal. It's completely normal. It's a messed up city and a messed up country, don't get me wrong, and especially then, but I can't get this one image out of my head. It's so mundane here, but it seems so out of place to me there.

As we were driving, first of all, there were tennis courts along the road. And there was just two guys playing recreational tennis in the middle of the afternoon. They're kids kicking a soccer scribble around and you get to the more commercial district and you see women window shopping. And then you can start to see it, wow, this is the same sort of thing that people do everywhere else in the world. To the best of my knowledge, no one's shot at us yet. And I haven't heard any explosions.

When you're there, you do see how dysfunctional it can be, like traffic lights might not work properly, the water in certain cases might not be potable and you don't even want to shower in hotel and so on. But that's completely different than say, this is a country in a civil war and this is hell on earth. People aren't playing recreational tennis in hell on earth and when there's bullets flying everywhere.

Patrick: [00:19:20] Were there other things that you were searching for? Were you trying to visit companies? Were you-

Geoffrey: [00:19:23] Yeah, visit companies, definitely go to stock exchange to meet with as many companies CEOs as you possibly could, meet with brokers. But also then just sort of be a tourist. Go to a restaurant order some food. And how easy is it to hail a taxi? And how much does it cost? If I go into a store, is everybody paying in dollars, which is actually very telling, or are they paying in local currency? If they're paying in dollars, that's not necessarily a good sign. If they're paying in local currency, it suggests there's some measure of confidence in the local currency, which is good.

But mainly when you go for the first time, you just want to see, is the reality on the ground, at least as I see it, match more with what the media is telling me or more with what the data is telling me? And in this case, it really mapped onto what the data was telling me. So I would say that's a critical feature at a critical part of the process, spending time in the country and seeing for yourself what it's like.

And it's really through that experience that you see you're dealing with these incredibly complex environments or a complex state of affairs. What you find is the news media is just not set up to convey complex messages to their audience. They just can't do it. The risk for them is too great. The moment you try and explain complexity to your audience, you're going to lose them. They're going to change the channel. And they don't want complexity, they want-

Patrick: [00:20:46] Sound bites.

Geoffrey: [00:20:46] Yeah. They want sound bites. They want their own views reinforced. That's why there are people who are loyal to a particular newspaper, The New York times, they want a specific message from The Times. If The Times were to deviate significantly from that, they risk alienating their readers.

Patrick: [00:20:59] Progressivism as a service.

Geoffrey: [00:21:00] Yes, exactly the same with journal, right?

Patrick: [00:21:02] Sure, yeah.

Geoffrey: [00:21:03] If Cornell West had a weekly column, op-ed column, at the Wall Street Journal, I'm not so sure that readers would be happy about that. Just like the people at The New York Times were unhappy when Bret Stephens started writing for them. But yeah, you find the mainstream news media simply isn't structured to provide this type of service for you. And that is very much at odds with what we're taught to believe that. This is how you become informed as a citizen in a democratic society.

And you also find that the experts are actually completely unreliable. You might find out of like 20 or 30 experts, maybe one or two that are useful. But often what you find is that the experts are think tanks. They don't have any skin in the game. And it doesn't matter to them whether they get it right or wrong. In fact, if you look at their track records, they've gotten almost everything of consequence wrong, yet they still have these lofty positions in a way they face career risk.

If they were to write, "You know what? Actually the Iraq war is going much better than is being reported." If you're at the liberal think tank and you say that, you're going to be immediately accused of being a neo-con or something, like this is some kind of betrayal for you to suggest. And even if you're trying to be apolitical, if you're trying to say, this is the reality, you're going to be attacked for it and your career might suffer as a result. So I found that you really can't rely on anyone other than yourself and your own research to figure this stuff out. And so going to the country is critical for that reason.

Patrick: [00:22:30] Any most memorable meeting with a company on that first trip?

Geoffrey: [00:22:35] Yes. I go back to Berkshire Hathaway and I promise I'll tie this in. He asked me about a trip to Iraq and I mentioned Berkshire Hathaway, but I believe it was in the early-nineties when they had made their first investment in Wells Fargo. There's this very memorable section of their annual letter where they say banking is no favorite of ours. Anytime a banker or an industry is levered up at the time, I guess 20 to one, managerial skill is paramount because they make a 5% mistake with their assets, it wipes away your equity.

And so we're usually trying to buy companies as cheaply as possible. But with a bank, we're more concerned about managerial quality. So we'll pay up for a very well-managed bank. We don't want to average banks at great prices. We want great banks at even slightly unreasonable prices. Because, again, managerial skill is everything in that regard.

So I kind of was thinking about that as I was meeting with these bankers, and are there any Iraqi bankers who could fit that bill? The first bank I met with, I'm not going to name it, but the CEO, I asked him about something. I think he was lending to taxis. It was like unsecured loans to taxi drivers or something. "Why aren't you requiring the taxi itself to be collateral?" And he said, well, that makes people less likely to want to take out the loan and so on and so forth.

And then he said to me, "But between you and me, I'm a bit of a cowboy." And that's not what you want to hear from a banker. No. And that bank pretty much blew up. We didn't own it, which is good. But yeah, that was pretty interesting encounter to hear a banker explicitly and candidly say to you that he's a cowboy at the time I was just beginning my due diligence on the companies. And they had a lot of these, what are called mixed-owned enterprises, which are hybrids of state-owned companies and privately-owned companies or publicly-owned companies. So half would be owned by the state half would be owned by the public.

They were like these sort of seductive companies in a certain sense because they maybe had market caps of like 10 million bucks and they had $150 million worth of land or something. At least that's what it looked like. Trying to figure out if that was true, there was no real operating business, but is it really selling for 0.1 or 0.2 times tangible book? And if so, could we buy a big stake in it and then sell the land? Exactly. Is that even possible? You'd meet with the CEOs of these companies, instead of wanting to talk about their business, they'd ask you if you could send them CDs, like, "Do you have Good Fellows on CD? I really loved that movie."

So it's pretty easy actually. You meet a guy, you want to talk about his business and he wants you to send him CDs when you get back to New York. You can sort of cross that one off the list. So that was my first trip there. I was getting stuff like that from some of the companies. But then you also meet CEOs who are the exact opposite you find. And this is what makes this sort of country or this sort of transitional situation interesting.

What I found is that pretty much anywhere in the world you go, you're going to find entrepreneurial people. There's going to be smart people who love business, they love solving hard problems, and they're very driven. And what you find in places that have decades of terrible experiences is that the entrepreneurs there are in a way more resourceful out of necessity than they would be in a stable environment. These guys, the really good ones, are as impressive as you'll find anywhere else in the world for that reason.

And when you meet guys like that, then you really have an extraordinary opportunity because you can forget about this sort of old Ben Graham security analysis investment, where you're buying something at a discount to its liquidation value. Here you're talking about a company that's got a capital allocator, a guy who knows how to allocate capital at very high rates of return. And at the same time, a stock might trade at three times earnings or four or five times free cash flow. The top and the bottom line is growing at 20% a year on a per share basis.

That's when you really think to yourself, I've found something. You meet these CEOs who are daffy or just they were put there because their cousin was some powerful person in the party or something, and stay away from them. And then you meet the person who is, I don't want to say like a Bezos or a Malone or something, but the Iraqi equivalent of a great-

Patrick: [00:26:55] Great allocator?

Geoffrey: [00:26:55] Yes. That's when this informational asymmetry that you have. I see things that no one else is seeing because no one else is really bothering to look. They've just believed what they've seen on TV and they don't want to bother with it anymore. I've found this gem here, and it's just me. If I'm the first person from America this person has ever met, then things become extremely interesting.

Iraqi Equity Market

Patrick: [00:27:18] Talk about at that time in the late-2000s, what the size and nature of the Iraqi equity market was like? Literally, what are the stock exchange look like? How big was the market cap in U.S dollars? How many companies were there? Was this something sizable or was this a tiny little blip?

Geoffrey: [00:27:35] So first of all, they only traded three days a week, from 10:00 AM to noon, local time, on whiteboards.

Patrick: [00:27:42] This is 09-08?

Geoffrey: [00:27:43] Yeah, 08-09. This was like you read these stories about Jesse Livermore going to bucket shops or something, just writing numbers on a board. And that's kind of what it felt like. Except it was legitimate. It wasn't a bucket shop, so to speak. It's how you would imagine the U.S being a hundred years ago. There were maybe 60 or 70 companies listed, but maybe 20 of them were suspended from trading because they hadn't produced an annual report in four years or something.

The market cap was, I believe, 1.8 billion, which at the time was smaller than the Palestinian stock exchange market cap. Which is sort of fascinating, because here you have this country with 150 billion barrels of oil. Palestine has nothing like that. Palestine doesn't really have an economy. They have a very informal economy, but nothing like Iraq has. And their stock market is larger than Iraq's. That doesn't seem to make much sense. It doesn't seem like a rational pricing of the assets here.

But what you find in these markets, and Iraq was no different, is that there's a very limited number of companies that you consider investible for a variety of reasons. There might be a high growth company that's super opaque and you can't really figure anything out about it. And the CEO won't meet with you. And you just don't want to put money into something like that. Because how do you know if it's real or not? And then there are a bunch of these other companies where they're just effectively state-owned enterprises, but they're not profit-driven. They're constantly having rights offerings just so they can continue paying salaries and things of that nature. But then maybe you find five or 10 companies that are-

Patrick: [00:29:12] Are investible.

Geoffrey: [00:29:13] Yeah. And then when I started, I had the exact opposite approach of what I have today, which is, I'll just equally weigh each of these names because I'm still learning about the companies. And since I can't really say that I have that much more confidence in one company over another, I'll equally weigh. But now one of the benefits of being involved in this for as long as I've been doing it is that you develop very good relationships with management. We sit on the boards of companies now. You really can tell which companies are run by the talented entrepreneurial person, which companies are transparent. You have 11 years of history with them. Really, what's great about that is you can tell if they're dishonest or not over the 11-year period. And the guys who've been honest with you for 11 years, are probably-

Patrick: [00:30:04] Allocate a little more.

Geoffrey: [00:30:04] Yes. And especially if the business is a really good business and the business itself has what you believe is a bright future, then you want to take very big stakes in those companies. Going back to Buffet, in the early days of his partnerships, he would have 25, 30% of his assets in one stock. And that's what we find ourselves doing now, do we want to have more money in companies that we have less conviction about just for the sake of diversifying or do we want to put less money in those companies and concentrate on the ones that we have the most confidence about? I'm not saying that there's a definitive answer to that question, but from our point of view, that's worked out well for us.

Patrick: [00:30:44] Is there an allocator that you could talk about that embodies a lot of what you've said? Or you've come across somebody that, maybe it's not John Malone, but it's someone with real entrepreneurial talent and business savvy, one of these guys that ran in the rocket company?

Geoffrey: [00:30:57] Our largest holding is a company called Baghdad Soft Drinks, which is the Pepsi bottling and distribution business for Iraq. It actually was, in the nineties, created as mixed-owned enterprise through the thing I mentioned earlier where the government had a stake in it. And it was terribly inefficient as a result and unprofitable. But this local businessman looked at the company and it's prospects. I guess as an important paramedical, Pepsi is by far the dominant soft drink in Iraq, which is the opposite of most places.

Coke usually has 60, 70% market share and Pepsi's 20 or 30 or something. But Iraq, Pepsi is 70 to 80% market share in Baghdad, and maybe a little bit less than the rest of the country. But it's by far the dominant soft drink brand. And this guy looked at the way this company was being run and he saw mismanaged company, but that had a great deal of potential.

I think Baghdad's soft drinks was going through some period of financial distress. Pepsi floated them a $30 million loan, I believe after Saddam was overthrown. And by 2008 or 2009, they weren't able to service the loan anymore, they were about to do a default on it. So this businessman, not entirely sure this story is accurate because you're never really sure in that kind of place, but as I understand the story, he went to Pepsi and said, "Look, I've got a couple of backers. I want to take over the company."

So he bought the loan from Pepsi and converted it into equity. Took a controlling stake, fired management. They had 3000 employees when they needed 1000. So he fired 2000 people, which doesn't go over very well in a country where they have guaranteed employment. And after he did that at their main production facility, he went the next day and there were these 2000 people basically writing, demanding their jobs back. He had to bring down private security to get them to leave.

And the other thousand people who were still employed were very unhappy because he had instituted a performance-based pay system. Which was a radical concept in a formerly socialist country where you get paid even if you don't show up to work for a month. I think he stood up on top of some piece of equipment with like a megaphone and was shouting to them, "Look, you have to understand. Give me a year to do it my way and you'll see that you'll all be better off. You'll make more money if you do things my way in a year. If I'm wrong, fine, I'll go back to your system. But if I'm right, then follow me."

A year later, the company was fully certified for quality control and quality assurance for Pepsi, which they hadn't been before. I think production tripled. They had their first profit. It was an example of private capital in Iraq taking this ailing franchise and transforming it into the strong, very profitable business that we find today.

Patrick: [00:33:44] What's this guy's name?

Geoffrey: [00:33:45] I probably shouldn't say his name just because he tries to stay away. He still has a stake in the business, but he's not running it anymore. And he just likes to stay out of the spotlight. But the guy running it now is actually better than he was. He sleeps at the factory. Although, I guess Elon Musk's sleeps at Tesla. So I'm not sure that's necessarily a good thing. But I guess that doesn't necessarily mean that you're going to have an efficient operation. But we found that there were examples like this, that these guys were profit-driven, they were really looking to capitalize on the economic turnaround that was taking place in the country. And they were looking for these sort of distressed, but very promising companies. And they were putting private capital at work to transform it, and doing it in a way that very much resembled what you would find in the West. It's one of the great success stories in the Iraqi stock market.

Patrick: [00:34:37] You mentioned Ben Graham earlier, and I've seen in interviews with you elsewhere, this idea that maybe the voting weighing machine thing holds true in the West but may not always hold true, at least on the same time scale in markets like this. So even with a company like the soft drink company where there's an Epic turnaround, does price accurately and over some period reflect this?

Geoffrey: [00:34:57] No. Not in our experience. Not yet at least. Our existence as a fund has been characterized by completely inefficient pricing of these assets. You have very severe mispricings of these stocks. A stock could be mispriced by being overvalued or undervalued. Fortunately for us, it's been strictly undervalued. You want to stick around long enough to get to the point where mr. market gets manic and has a very optimistic view and starts assigning very high multiples to companies' earnings.

But to just explain the concept of voting machine is this idea that in the short-term, stocks are driven by popularity and sentiment. Which is not a very good or efficient way of pricing and asset. But over the long run, Ben Graham, I guess, believe that fair value of an asset would be reflected in the stock market. Because market participants are going to accurately weigh its value.

We've just been stuck in the voting machine phase, where we have just local investors who are more interested in rights offerings and stock dividends than they are about company fundamentals. And very few foreigners have come in to follow us. I don't mean to say this in an insulting way, but the fact of the matter is you have an unsophisticated group of locals who are more or less determining the price level on any given day. And they're not relying on fundamentals to do that.

So it's been a bit frustrating in that regard because Baghdad Soft Drinks, it's revenues have I believe tripled in the last 10 years and cashflow from operations per share has compounded at about 20% for the last decade. But the stock has maybe doubled. If Baghdad Soft Drinks was called like Pakistan Soft Drinks, it would be trading at 25 or 30 times earnings. It would have had a significant rerating.

There was even a point in time in Nigeria when you would find companies like this trading at 20 or 30 times trailing earnings. And what's frustrating from our point of view is Nigeria, in a way, is more screwed up than Iraq is. They have a problem with Al-Qaeda or an Al-Qaeda affiliate called Boko Haram that controls the Northeast part of the country. Their oil production has been declining for a decade. Their GDP per capita is well below and Iraq's. And Iraq got a measure of macro stability that Nigeria really never has. And people get really excited about Nigeria because where product companies was... There's-

Patrick: [00:37:24] Huge market.

Geoffrey: [00:37:25] Yes, huge market. Exactly. And it's new, it's relatively new. So they get excited about the potential growth, but the risks in Nigeria are in a way greater than the risks you face in Iraq. But because Iraq has this sort of enduring negative perception, people just stay away from it. It's really becoming the leper of the frontier and emerging market investment universe.

Patrick: [00:37:51] How would you compare the sentiment about Iraqi equities today relative to when you started? And then the second part of this question is kind of like a John Malone question. One of the great geniuses was inventing new ways, EBITDA is the popular example, and then convincing Wall Street to value his companies a certain way, basically creating a narrative, he rebuilt the voting machine. He built his own machine. To what extent do you feel responsible as a major Iraqi investor to almost do something like that, where it's not like waiting, but actually doing the work to convince others, whether it be Western investors or whatever.

Geoffrey: [00:38:24] I tried doing that early on, I went to conferences and presented, went on TV a few times and... I'll give you a better example. This happened a month ago. So I have a Twitter account. I think I created the account in 2012, but I never used it. And I made my first tweet about the Iraqi market in February, I believe, of this year. And it went viral. I think there was over 3 million views or something for my first tweet. I know all my other tweets like nothing.

I said, Iraq has come a long way since Saddam was overthrown in 2003. And I lay out the case. It turned into this sort of political Frankenstein, where the right like prominent Fox News personalities were re-tweeting what I was saying as evidence that the Iraq war was-

Patrick: [00:39:08] Confirmation bias.

Geoffrey: [00:39:08] Yes. And then on the left, you had people accusing me of being like a warmonger and the neo-con. I'm not a neo-con. And I don't really affiliate with any political party and I'm not eager for war anywhere in the world. And I definitely don't think that war brings democracy to other places. The recent history pretty much demonstrates that that's invalid. But I realized from this experience with this tweet going viral was that it's so politicized in this country. There's almost no point to trying.

I just feel like it's such an intractable problem that I don't think there's anything that I could do to change people's view. I think what is just required as time. People would just have to get far enough away from it where they don't think of it that way anymore. But in the early days I would go on TV and I'd go to these conferences all around the world and present the case to investors and contrarians would buy it. But most people want no part of it. And when you went on TV, crazy people would call you and threaten you. So it just became-

Patrick: [00:40:09] The wrong kind of.

Geoffrey: [00:40:11] Exactly.

Patrick: [00:40:12] Back to the first part of the question, which is, if you look at it today, and maybe this is measured through something like P/E ratio of the market or something however you choose how to measure it, how much has that perception changed? Another way of asking this is, is the opportunity today, in your view, as interesting as it was in 2009 when you first started buying securities there?

Geoffrey: [00:40:30] Yes. In a way, it's more interesting because when I first invested there, the civil war had just ended and they were going through this period of stability. That wasn't going to last for very long as I unfortunately found out. They had the rise of ISIS started really in 2013 and really reached this peak in 2014 when ISIS took major cities in the west and the north, and about a third of the country was part of this so-called caliphate.

But the reason why I would say that today is more interesting is that these were really important tests for the country. You have a regime change, an external regime change, the U.S comes in and overthrow Saddam, imposes this new system on the country, it's not received well by key minority parts of the population, they rejected, and you have a civil war. Then that civil war ends. You have some measure of stability, politically. And things go to hell again, four or five years later. The country rallies together.

There's this incredible sense of nationalism and patriotism that we have to defend our country from these really menacing jihadists that are trying to impose a medieval califate on us. They rallied together and fought them off and liberated the cities. Now there's still major problems, of course, but when I look from a bird's eye view, I look at Iraq's durability. Going through crises like this or like these ones and coming out intact on the other side, suggest that there's an underlying strength to this society that really I wasn't aware of before.

So in a way, the more battle-tested something is the more information you have about it. You can say, okay, they've been through this before and the political system didn't completely break down. They still had elections. They still had a legitimate democratic election during a war. Not only that, but the political party that had dominated since Saddam was overthrown finally, last year, lost its control of the premiership. They have a new prime minister now from a completely different party. Politically, although there are periods where it might not seem like this is the case, over the long run, they seem very much committed to their political system and to doing their best to make it work.

So the fact that they've endured these very traumatic events and came out on the other side intact, and in some sense stronger than they were before, tells me that they are going to make it. It's like a bank going through 2008 not needing tarp money or something. Now you know, wow, this bank is incredibly durable and strong. I guess, in a way, reputations were made. If you survived the financial crisis in 2008, 2009, and you came out on the other side stronger, people saw you in a much different way. Jamie Diamond was running the fortress bank. If there's going to be one bank you wanted to have a lot of money in, that was JP Morgan because of the way he carried himself during that crisis. I look at it Iraq that way.

Patrick: [00:43:33] So what does it look like today in terms of market cap? It was 1.8 billion, five investible companies, and three trading days a week. What's changed?

Geoffrey: [00:43:40] And that was five days a week, still only two hours Sunday through Thursday. And the market cap is around five or 6 billion today. They had a couple IPOs that were pretty important, the mobile telecom IPO's. One of them is a company, AsiaCell, which is majority owned by Qatari telecom company. And has an enterprise value of about a billion dollars against about 700 million or so in EBITDA. That trades as a 14 and a half percent dividend yield. But forget about EBITDA, just look at free cashflow. I think there's a free cashflow yield of like 33% or something.

Patrick: [00:44:14] So if you were the first U.S investor that a lot of these CEOs had talked to, how has that changed? Are there are other us investors operating there?

Geoffrey: [00:44:21] We started to see foreign money come in 2013. The market did very well in 2013 and some Intrepid frontier market investors came in. And then the moment things went to hell with ISIS, they were gone, never to be seen again. Now we're starting to see, for the first time since the problem or the war against ISIS, more interest from foreigners. And also from a major bank. I won't name the bank, but there's an analyst, the head of Emerging Market Research at a major American bank, asked if we could arrange a trip for him to go to Baghdad and meet these companies.

So we're starting to get some momentum in that regard. But I would say the key problem we face now is custody. They don't have a third-party custodian, which is kind of appalling considering that like Jamaica has a third-party custodian. And that countries that are more screwed up than Iraq, and not to say that Jamaica, but like countries in Africa that are far, far worse off than Iraq's, have custodians from HSBC or something and has custody. Iraq just doesn't have a custodian. We're working on getting one. But the absence of a custodian really makes it hard if foreign money wants to come in a style like it was when Firebird was buying Russian vouchers, you just had custody of yourself as the fund managers or maybe a local broker did on your behalf. But these days, that's just not going to fly. So the exchange itself is essentially the custodian.

Patrick: [00:45:41] So you right now will basically keep your shares on in absentia.

Geoffrey: [00:45:44] Yes. And actually it turns out that it's very safe. In fact, you could make a case that it's safer than having a large international investment bank. But we get a daily report every day from the custodian that tells us exactly what our positions are and what we've done for the day in terms of trading. And in the 11 years or so that I've been doing this, I've never seen one discrepancy, and we've never had one issue.

So it works... They don't do anything else either. It's just simply a custodian. Since there's no margin trading, it's a completely cash-based market and settlements T+0. There's no short selling. There's very little risk of anything happening to the shares. There's no failure to deliver. A person can't sell me stock unless they have the stock. And I can't buy it unless I have the cash funded in my account to pay for it that day WHEN the trading sessions over.

So there's very little settlement risk and the custody has been very solid. But the reality is that there are funds that have expressed interest, but they just can't do it unless there's a custodian. So that's one area where the exchange has not made progress, that's been most disappointing for us. In terms of valuations, 2015, 2016 earnings were depressed pretty significantly as a result of the collapse in the price of oil and the work in stasis. But there's been a recovery in 2017, 2018, and into this year. And we're looking at stocks that traded four times legitimate earnings or banks that have anywhere from 10 to 15% dividend yields trading at a fifth of their tangible book value, very liquid balance sheets. It's cheaper today than it was when I first invested. And the companies are a lot stronger today.

Frontier Market Opportunities

Patrick: [00:47:25] Obviously, you're all in on this trade, so to speak. As you think about the types of return that are possible, we'd started by talking about huge reratings in countries like Russia or Taiwan or Japan. And you look forward, first, I'm curious how you think about the scale of potential return. Is it 30% of years, at 20% of years, at higher than that? And also, whatever that number is, how much of that do you think is coming from fundamental growth of the businesses versus rerating of four-times P/E multiples to 10-times P/E multiples or whatever.

Geoffrey: [00:47:56] I don't know the exact numbers for Sberbank in Russia, but I know, at least if the Bloomberg data is accurate, Sberbank, I believe in 1999 was trading at a P/E of about one. Which I would say it's pretty cheap. I think by 2007, it was trading at 20 to 24 times earnings or something like that. The earnings went up significantly along the way. So that's the beauty of historic reratings, is that a country, the case of Russia, was leaving behind the Soviet model of plan the economy in terribly inefficient markets. And they were embracing their own form of capitalism, I guess you could say, and unleashing the potential of these companies really for the first time in their history.

So you could reasonably expect that the best companies would grow the bottom line 10, 20 times in a 10-year period. And if there was going to be multiple expansion, you would see, in the case of Sberbank, I think you saw a thousand times your money, you made a 1000X or something on that. Something crazy like that. That's an outlier. In Iraq's case, I think in the next five to 10 years, the companies we own could be orders of magnitude larger than they are today in terms of their balance sheets, their sales, and the cashflow that they generate. The question really comes down to what's the multiple going to be. And it's impossible to predict. But by definition, a rerating is going to be some kind of expansion.

I would say that in extreme cases, the multiple expansion becomes a huge part of the return. Even without it becoming extreme, you can still make a lot of money. Something goes from four-times earnings to 10-times earnings. And profits grow significantly along the way. That's still enough to get you a fantastic return. It's just a matter of how much it's going to be.

Patrick: [00:49:51] So a couple of closing questions for you. The first is, for anyone out there that is an aspiring young investors, the equivalent of what you were coming out of school, studying with Dan, and is interested in this style of investing, we'll call it frontier just in general, it doesn't need to be a geography, but something sort of at the edge, what would you recommend they do today? Anything different than you did and that we described earlier about look for something that seems awful, check the data against that, and then investigate further. And if it's that simple, that's the answer. But anything beyond that, that you would counsel younger, aspiring investors to.

Geoffrey: [00:50:23] That's an interesting question. I don't think I answered this. You asked the question earlier. I looked at Iraq, was I was looking at anything else in 2007? I looked at Iraq and really nothing else because everything else had gone up so much by then. So we are nearing the end of that bull market, which was pretty unique. People were saying things like global synchronized growth for the first time in a century or something. So emerging markets were all on fire, and develop markets were on fire, and commodities were on fire. It was very hard to find anything that hadn't gone up many times during that cycle. Even Palestine had a big bull market.

So Iraq was the only thing I could find that didn't. And maybe we're in a situation like that today, I'm not sure. Although I would say the process is more or less the same and maybe there are even more opportunities than they were when I was looking at it in 2007, because people look at the Middle East today just generally in a very negative way. The Arab Spring terrified people. The U.S constantly has a sort of belligerent attitude towards Iran. And there's always a question if we're going to go to war or not. And the civil war in Syria with a nightmare, and Yemen is a nightmare. We have protests and Algeria now that hasn't been getting much coverage, but that could become quite significant, maybe you have Arab Spring part two. And it's completely under the radar for the moment.

But when you look at what's happening in these countries, it's easy to say it's just the Middle East being in the Middle East. It's chaotic. It's screwed up. And I want no a part of it. But there's another way of looking at it, which is that it turns out that democratic transitions take a long time and they're really messy. This idea that we're taught in school, that it's benevolent men create a new society for the benefit of everyone in posterity and so on. It's just nonsense, that really if you look at the history that like democratic transitions, you can't point to a single one where there wasn't incredible violence on a massive scale.

Even in this country. We fought a war against England, and then we have our independence in 1812, the British are burning down the White House. Then we have a civil war. Western Europe, I guess from the Magna Carta until the late 18th century, is fighting a series of wars and things are incredibly unstable. Maybe that's what's happening in the Middle East. Maybe these dictatorial regimes that have been in power for decades are on their last leg. And democracy will come to some of these places.

I would say to a young investor that that's at least a point of view worth considering and testing. Using that as a framework, you should take whatever the prevailing wisdom is and try and come up with an alternative model to view reality through and to help explain reality to you. And see if that doesn't lead to interesting results. I think today maybe you'll end up with some really interesting opportunities.

Patrick: [00:53:15] My closing question for everybody is for the kindest thing that anyone's ever done for you?

Geoffrey: [00:53:19] I played basketball in high school and it turns out that I'm the same age as Kobe Bryant and his high school was like a mile away from mine. So we were in the same league and we played a lot. My school played as well. We were on the same court as his team. And I'm sure it wasn't very competitive. People knew back then that he was going to be-

Patrick: [00:53:36] Great.

Geoffrey: [00:53:36] Yes. He was practicing with the Sixers in the summertime when he was a junior in high school. And you could just tell that he was going to go places. So our junior year, we're playing and the first time we played his high school, I had a terrible game. It was at home and I was like humiliated. He just owned the team, but I took a shot and I think he threw it to the other side of the court or something. I just played poorly. I had a lot of turnovers. I don't think I scored very much. And I was really down after the game. And I stayed in the locker room. Everyone had left the locker room and I was just kind of in there feeling sorry for myself.

And as I was leaving, he was coming out of the visiting team's locker room. And he could see that I was not in the best condition. And he came over to me and said some very encouraging things. He said, "You're a good player." which I'm not sure that's true, but he complimented me. He said, "You're a very good player. Don't be discouraged. I'm sure the next time we play, you're going to have a much better game."

Even though we were peers, he was already looked at as a superstar. It was sort of like Michael Jordan telling that to you. Even then, he didn't have to do that. He was already becoming a famous person. And he could have just walked right by me and not said a word, but he really went out of his way to encourage me and to say very positive things about me when I was feeling very down about myself. And the next time we played them, I did well.

I'll never forget that because sometimes you feel obligated to do nice things. And I guess that sort of diminishes the value of the positive thing you've done. It's still positive, but when you really don't have to do something to help someone else, but you do it anyway, even if it's small, to me, I think that has a great deal of value and stood out to me. Because I was feeling really bad, and this guy who I was looking up to came to me and said some very encouraging things. And it made a difference. So that was a really cool thing.

Patrick: [00:55:26] Well, that's definitely one of the coolest ones I've heard in a long time. So your thought fade off. I appreciate it. Great answer and fascinating and really unique interview. So thanks for your time.

Geoffrey: [00:55:34] My pleasure. Thanks for having me.

Transcript by @ScarrottKalani