Introduction

Patrick: [00:01:24] A very short introduction today, because my guest is anonymous. Suffice to say, he manages a large pool of private capital. He goes by the pseudonym, Modest Proposal, and his Twitter presence is one of the reasons I first got on and now stay on that platform. He's levelheaded, smart, and skeptical by nature, all of which made for a great conversation. We discussed how difficult the market has become for active investors, thematic investment opportunities, and the potential sources of market mispricings. Please enjoy our conversation and let me know what other anonymous accounts you'd like to hear from.

Value Investing

So the framing of this conversation is going to be value investing, weird overreactions, mispricings in what has become a very competitive and difficult market. Maybe just start by giving your impression of how value investing specifically has changed. Maybe what you view as the drivers of the historical out performance of value, and whether or not those same conditions or that same opportunity set exists at all today.

Modest Proposal: [00:02:16] Yeah, I mean, it's something that I've thought a ton about. I came into the business working with a guy who was a traditional deep value, loved net nets and discount to cash. So steeped in that mindset and spent probably far too long studying the early days of value and all that. So I come to this point where I look back over the last 10, 15 years and say, "What happened? Why are we at a point today where people are questioning it? Does it still work?" Obviously, if you're doing that, there's the chance that right now is the moment to get in, but people have been saying that for five years. So what I look at is I love how Jeremy Grantham talked about there was career risk to owning value stocks, particularly if you're a discretionary manager, right? If you're, in the 70s and 80s, telling people you were buying whatever it was you were buying at the time that was out of favor, there was real career risk. Buffet has talked about this forever.

I think the seminal moment was '98 to '02. If you go to that period of time, you have value managers being called the dinosaurs, left out. They don't get the new economy. So for two years, most of them dramatically underperformed. That's when the comments, "I'd rather lose half my shareholders than half my shareholders' money," and all those famous soundbites came to be. Then what happened is obviously growth imploded. The S&P was down '00, '01, '02, and value mentors flourished. So in a sense, not only did the career risk of owning value go away, but it was almost like value became lionized. Henceforth, everyone says they're a value investor. You never hear anyone anymore say, "I like to buy really expensive stocks that are going to go up a lot more."

There's more career risk today, I think, in saying, "I'm a momentum investor," or "I like to buy really expensive, good companies," than there is to say, "I'm a value investor." So you had that career risk angle change, and simultaneously, you had a ton of academic research throughout the 80s and 90s that really showed there was a value premium and it worked. So then folks like your father and other smart people said we can systematize this. On the one hand, you had discretionary managers say, "Hey, this worked. I can buy it. These people came through the crisis unscathed, the '00 to '02. Let's do that." You also had lots of capital pouring into the quantitative side saying, "Well, if we build screens that screen for value, that will work." So I don't think it's a coincidence that that period of time, from there on, growth has basically outperformed.

There's some small episodic periods and historically, that's how it is. Its value has these short bursts, but they've become short and they've become shallow. I do think that there is something to the idea that what did work, the idea of buying discount to the present value of future cash flows, that's still works. Value investing though, as defined in either the Graham and Dodd tradition or even how it migrated over time with Buffet in the 80s and 90s, I think has become a lot harder, a lot more efficient. I don't want to say it doesn't work, but I think as a overall, just mindlessly buying the ETF, I think it's going to be a lot harder.

Patrick: [00:05:44] We just are, I guess, depending on when this airs, will have just published a big 50 page report on value factor investing. Maybe the most important finding may seem obvious, but we really show it in some detail, is it works because people overreact. They see recent bad results in earnings and cash flows, and then those tend to continue through a holding period of a year or a year plus. But ultimately, there's this stabilization and recovery of fundamentals, and all of value investing is just multiple expansion. To expand multiples, you need recovery in fundamentals, which means people overreacted. You said pricing this cashflow is always going to work. Obviously, if you buy something that's cheaper than it should be, it's going to produce good results. How do you apply that lens to the market today? So if you came up in that tradition, and I think you believe in overreaction as a source of opportunity, what does that mean today?

Modest Proposal: [00:06:40] I mean, I'd love to read your paper because that's a perfect setup for how I look at the world, which is, to me, the last remaining anomaly is human behavior. Every other anomaly gets exposed and arbitraged away. I say, as long as humans are participating in markets, there will be roles for active management. It will just become probably fewer and far between and waiting for those episodes. Josh Wolf was on, and he had that 100%, 0%, 100%. Like I say, I'm 100% sure people will overreact. I have 0% ideal when or why, and I'm 50% confident I might be able to exploit that. But what's interesting about the overreactions and why, as we'll talk about some of the sectors that I pay more attention to, is if you look at some more prosaic old-line industries, a general overreaction might be like a 3% sell off on earnings.

In small cap, consumer internet, if someone misses earnings, they might be down 25%, right? So the idea is, and it's exactly what you said, is people linearly extrapolate the recent result. I think Seth Klarman, in his end of year letter this year, said overreaction emanate from initial right idea, but then get taken too far. Because whether it's humans and then algos jumping on that, or something to that extent, today, I find that the biggest sources of opportunity are sitting on your hands most of the time, because day to day, the market is just super efficient and believing that you can go into the market today and just point to a stock and say, that's mispriced, without some either big narrative overhang or some, whether it's earnings, or M&A, or something that's causing a specific dislocation, I think to systematically out-perform that way is extraordinarily difficult.

Patrick: [00:08:34] A guy just said on the podcast by the name of Mike Zapada, who was a Navy Seal for a long time, has this fascinating analogy he uses from that life and what he does now, which is value investing, which is that the key thing is tons of preparation to understand either an individual company an industry, a trend. Whether it be retail that's online versus physical, which we'll talk about, and just waiting, right? Just sitting around and waiting for the perfect opportune time when people have screwed it up, and you recognize that because of your preparation. So maybe talk about the areas in which you prepare most, the trends that you are most interested in today that you sit around waiting to see overreactions with a lot of preparation.

Modest Proposal: [00:09:12] I wish I was smart enough five, seven years ago to have known what to prepare for. The preparation has almost come by virtue of where I've gotten involved and then continuing to pay attention and learn more and more and more. There's a huge value to that because when something happens, there are instances where a stock, like I said, can be down 25%. You may have a week. You may have three days to jump on that. Other times you might have months, but ... So there's a huge advantage to having that database and knowledge of all the companies or the general issues going on. The areas that I find today are most interesting are clearly at the intersection of technology and older-line industries, specifically, what's going on in media and video distribution, commerce, e-commerce retail. Essentially, I remember a quote Mark Andreessen had where he said, "I study value investors to learn from them, and I study VCs to learn from them."

He was essentially saying we're betting on the future, they're betting on the past. What I like to do is say, I'm betting that the future may come a little slower than everyone else. What I've learned is the technologists are almost always right about the end state, but the frictions between here and there are often way greater. So if you can figure out, reverse engineer what the expectations are that are embedded in some of these change situations and say, "Wow, maybe they're right. Maybe everyone will watch TV on a one-to-one stream, directly pulled down, what content you want, where you want it." That might be the end state, but it might also take a lot longer to get there, and this specific instance might be over pricing that reality. So it's essentially having to understand and study the future. But because I can't predict the future, all I can do is take what the technologists are saying and writing and investing in and study that, and then say, "Okay, what are the chances that that disrupts this business tomorrow or five years or seven years? What is the market today pricing in for the cash flows of the legacy business?" Then a second instance is within, this is more consumer internet, is oftentimes, because these verticals end up being winner take all or take most, if you can find an instance where the number two may still prosper, they can be priced extraordinarily cheap. Now, the right thing to do is probably just to go by the number one and hold on, but that would be too easy.

So instead, you find these instances where maybe the profit pool is large enough that it can support two players or three players, like online travel, or an online real estate. Some of these huge and markets that support multiple players, as opposed to a single dominant player. There, you can also say, "Okay, this is trading at eight times cash flow, and I think the market's large enough to support huge opportunity."

Price in Value versus Growth

Patrick: [00:12:18] It seems like everyone forgets about the key price component in all this. That these technology narratives, I'll use that word narrative deliberately, are so powerful, and the end state often is correct. The opening anecdote in the paper we published was asking whether or not people would prefer to buy a basket of New York City taxi medallions or Uber stock today. When I asked this question ... I've started asking this question, like big investing audiences when I give presentations, and it's 95% Uber. Because no one thinks about price and stabilization of cash flows, which I came across this idea because of a really bright investor, who we mentioned the paper, named Andrew Milgrim here in New York. They've stabilized, right? It's a classic value versus growth story. Let's use that lens to go through each of those stacks. Maybe we'll start with media. Maybe you pick the company that's a jump off point. Maybe it's Disney or something like this, but talk about the relevant players and the key trends that you look at and where markets may be overreacting in your estimation.

Modest Proposal: [00:13:13] Sure. I think it's important to go back a little bit and just frame that ecosystem, which is historically, there's this tug of war between content and distribution. People are always saying who's going to win and who's got the upper hand. Essentially, what you have is you have five or six big media companies that sell a package of networks to video distributors. Those video distributors mark it up 50% and they sell it to us. One of the world's great all-time business models is you got paid a monthly subscription fee from 100 million households who may or may not watch. Most likely do not watch your networks, and then you got advertising revenue on top of that, and that was phenomenal. Cord cutting became an issue in the investment world, starting in the mid 2000s. People were already talking about this.

So this is really the third go round with fears of cord cutting, and what if people start watching over the internet? Then it was YouTube, and ABC was putting free content on iTunes because Steve Jobs convinced Bob Iger that was a good idea. Today, though, the reality is it's happening, so you have to be a lot more careful. I think you need to split the world this way. There are media companies that are inexorably tied to what we will call the linear TV bundle. Those companies have a very challenging future. If they are pure aggregators, meaning they're doing syndicated reruns, that's a terrible place to be. If you are doing your own original content of discovery or scripts, they own all their content, they do original programming, it's possible that that content resonates in the next world. But the problem for anyone trying to make the leap from linear to a direct to consumer model is the economics are inferior. That's because again, you had 100 million people paying you, and maybe in the next world, you'll have 15 million people paying you. If you just think about it, you are getting three bucks. Now you need to get 15 bucks and you have all the costs associated, so difficult challenge.

The second bucket then is sports news, essentially live, the kind of content that needs to be consumed live. For now, that's a handful of big companies, Fox, Comcast, NBC, Disney, ABC. I think there's real questions about what the ultimate sports end game looks like. Is there a single sports aggregator of rights? Are there a handful just because the expense is so high? But whomever controls sports rights going forward will probably have a pretty prosperous future just because it's the only way you can aggregate 25 million people at a time anymore, and so advertisers will want to be there.

So that's the framing. What you asked about Disney, and Disney is a funny one because from the time I joined Twitter years ago, which is how we met, I had this notion that Disney was completely misunderstood. Everybody said, "Oh, they're uniquely positioned for the direct to consumer world." Then they said, that's absolutely ludicrous. They're getting paid $7 a month for ESPN by 100 million households. There's absolutely zero chance they could replicate those economics in the next world. It was just taken for granted, and Disney was the favored media stock for a long, long time. Then August of 2015 was just a seminal event for the pay-TV world, which was Bob Iger announced that ESPN was losing subs. Surely anyone who had paid attention to the media world should have known that cable companies are losing subs and satellite companies are losing subs. The whole pay-TV ecosystem is losing subs. Why wouldn't ESPN be losing subs?

The entire media world got just rocked and has never really recovered from that. But what's also interesting is if you look at 2015, that was the year that the cable networks business of Disney peaked, or recently peaked as a percent of operating income. Going back a few years, that number might have been a high as 65% of the companies. So you said, "Wow, this company is a pay TV, linear TV company." So I had been negative on them for a long time, but then that played out because the multiple compressed and their earnings were flat-ish, and the other IP part of the business did whatever. Then late last year, they made this really interesting announcement, which is they're going direct to consumer with a Disney branded product, Disney Flix, DisneyNow, whatever it will be.

I got interested. Oh, I pay attention to this because I pay attention to the whole ecosystem. But what's so fascinating to me is the framing is wow, this is Disney's attempt to migrate their linear TV business to the online world. I said, no, that's horribly incorrect. Disney's linear TV businesses is ESPN and then some smaller ... Disney channel is really the only Disney IP cable network. They're not taking that business with them. That business has to do its own thing, and that's what ESPN+ is. Who knows? Someday, like I said, there'll be some one or two aggregators of sports rights. Maybe ESPN has a role in that. Maybe they don't. They probably do just because they're there and inertia is a big thing. But what Disney was doing was saying, we're going to take our own IP, which even as I was skeptical of Disney for many, many years, I would have to admit they have the best owned IP in the world. I have a young child and..

Patrick: [00:18:41] Me too.

Modest Proposal: [00:18:42] ... we put on ... He wasn't old enough to watch it. We just put on the Pandora station with Disney singalong, and he shut up in the car. I turned to my wife. I'm like, "We're subscribing to this product," now up and down the stack age-wise with Lucas and Marvel and all that. So I don't think there's an argument that they have some of the best IP, if not the best IP. What they're doing is they're taking that IP, which plays off of the studio and the parks and the consumer products, and they're taking that direct to consumer. That is actually super interesting because as we'll talk about, customer acquisition costs kill you in any online business. Well, A, you start out with the brand awareness. B, you have multiple touch points with consumers. C, you can leverage them into bundles, which is another huge topic of interest.

So I'm actually really interested in how that evolution is going to go, because going back to overreactions and narratives, the narrative today is you can't read a story about Disney without reading about the death of ESPN and all that. I'm like, no, no, that played out. They're now down to probably 20% of segment ally. So yes, that's happened. Now, the question you have to ask, and I don't know yet but it's what I'm paying attention to, is wow, can they leverage these assets online in a really powerful way? If so, that could be really interesting.

Patrick: [00:20:10] How do you think about structuring this or expressing this via investments? So as a discretion, deep discretionary guise, kind of how I would categorize your thinking, you've got this insight or a set of insights. We just talking about one company, but there's a whole bunch of companies that are part of this ecosystem. Without giving the actual positions, how do you think about structuring this and expressing this?

Modest Proposal: [00:20:30] It's really opportunistic and episodic, is I can only judge what I see and what I think will happen and compare that to the market pricing today and what I think is embedded. So Mike Mauboussin, who you had on, he does this expectations investing. Over time, the way I've migrated away from traditional value investing is traditional value investing, you say, "It trades at 12 times PE. I think maybe it can rerate if some good news happens." So that's the what. The what evaluation is, it's 12 times earnings, so it's eight times EBITDA. For me, the more important question is the why. I need to be able to understand why is XYZ trading at 12 times or 8 times? Then you compare that why to the future and say, "Hey look, 99% of the time, the market's right."

If you look at an earnings overreaction or an earnings reaction, a lot of the time, the future earnings power might've been impaired. The slope might be lower. Something real might've happened and the market gets it right, and you move on. So what I'm looking for is trying to reverse engineer the embedded expectations, and compare that to what I think is a reasonable base case of what might happen and say, "Okay, that's now interesting." If you do that at a low starting multiple, even though I say...

Patrick: [00:21:51] A reasonable, multiple.

Modest Proposal: [00:21:53] ...a reasonable multiple, and you have this embedded expectations that you think are wrong, you, you said it's basically multiple expansion. Well, the multiple expansion comes from the fundamentals coming through, but also the reversal of this overhang or incorrect analysis. So on the downside, you have a belt and suspenders of low expectations and a reasonable price.On the upside, you have fundamentals improving or outperforming relative to expectations, and then the psychological shift. That's how you make big money in these situations, is when the multiple goes beyond where you ever imagined, I've probably sold too soon, but that's what you're hoping for.

The Unbundling and Bundling of Media

Patrick: [00:22:35] Are there other parts of the media specifically, and video distribution ecosystem that you find particularly interesting to that?

Modest Proposal: [00:22:42] For much of the middle 2010s, I was completely out of media because I think ... I'll say here that the distributors as well, the cable companies, satellite companies and telcos to some extent, just because I think it was pretty well internalized what was happening and the market was right. Right now, because of the acceleration in cord cutting, and we can specifically talk about what AT&T is doing with DirecTV now and some of these other entrants, the pace of traditional household subscription decline has accelerated. That's undeniable. So what's happened with that is that companies that I thought the market had properly assessed as broadband distributors first, and then also happened to sell pay TV, which are cable companies, have gotten caught up in this cord cutting maelstrom. These aren't unique insights. Anyone who covers the TMT space knows this.

But in general, a cable company is actually, first and foremost, they sell broadband. If you look that revenue, if you look at their gross profits, and you look at their EBITDA, these are broadband first businesses. They do happen to sell pay-TV because that's their heritage. Some of them make some money on it, but the idea that if all the pay TV business in the world went away tomorrow, which is not going to happen again, for the initial reasons we've talked about, these businesses would actually still be okay. If not better, in some regards, they'd have higher returns on invested capital because they've had lower cut backs. Their margins would be higher. They'd be very attractive businesses.

The problem is a lot of people don't want to really stay to find out what the world looks like for a cable company without a video business. Is that just a low single digit grower where you're wholly reliant on pricing power in a business that everyone, at any time, could take a skeptical view of? So there's a lot of reasons to be skeptical of them today, but that is one particular piece of the ecosystem. If I step back and I look at the various players, we already talked about the people who have content that is inexorably tied to the linear TV ecosystem. Challenged. You have folks like Disney, where you're being painted with a brush of your linear TV, but the reality is now 50% plus of your operating income and a very bright future is divorced from it. Then you have distributors satellite. Satellite is a dying asset and those businesses have no real future. I mean, they're harvest and cashflows today, but the terminal value of satellite TV is zero, in my estimation. And then, you have these other distributors of pay TV, who actually are broadband providers, but are caught up in it. So, if you look at those four different subsets, two of them are interesting because yes, they are currently getting hurt by cord-cutting and the decline of the Linear TV system. But the future, there is a real future besides that. And so, that's where the type of opportunity is today. There's a lot of deal action going on right now and that's sort of clouding the investment case. But I think if you step back and you look over three, four years, it's not perfectly analogous, but there have been other examples in the past where people have overreacted in this specific space.

And I think there is an opportunity there for patient people to try to sort amongst the various players and say, there are some survivors, there are probably some winners and then there are definitely some losers, who I don't want to specifically name names, but there are some smaller free radicals they've been called, that their challenge is, if they merge together to create scale. And the idea is we get bigger, so we can fight back against the big distributors. Well, the problem is now you are 15 networks. You're going to that MSL with, and they're like, "No, we want your five good networks."

So the bigger you get, the bulkier your package gets. And the more likely distributors today are to push back. If you stay small though, what's your relevance in the next world? Then how do you participate? So they're kind of in this very difficult position there, some of these folks have launched, I think it's called Philo, it's like a $15 bundle of... People have called it, the losers bundle, but I maybe it will get traction, maybe it won't, but it's very difficult hand for them to play where some of the bigger guys who own sports, who have news or who have the branded IP that really resonates regardless of the distribution mechanism. I think those guys are positioned to prosper.

Aggregation Theory and The Hold on Attention

Patrick: [00:27:35] Talk about the, this massive trend. We've talked about Ben Thompson's Aggregation Theory before, which I'm fascinated by. Mostly I'm fascinated by how the market prices this idea. And whether or not the market has properly reacted to attention aggregators in this cycle. So, if you look back at Facebook's history, for example, and you compare historical price to today's earnings, if you look at it's PE to today's earnings in the first three or four years, it's like five, six, seven. I mean, it was remarkably cheap, as they were sort of aggregating an audience. Talk about Aggregation Theory and kind of how you think that interplays with how you think about the investment operation and all this stuff.

Modest Proposal: [00:28:11] Yeah. It's a great question because I tweeted this one time and I was having a conversation with someone the other day about it, which is maybe the idea of eyeballs wasn't wrong. And it's one of the most [mismatched] ideas coming out of the tech bubble was, "Aah price to eyeballs." And "Oh, those people were idiots." Hmm, turns out it, maybe it's not eyeballs, but it's attention. And that was right.

And what I think is different is back then you didn't have the monetization engines to properly capitalize on it. And you didn't have scale of mobile. The mobile scale is something that I think people just... It's now internalized, I think people understand, which is why these companies are five, there are 800 billion. But, Facebook has over 2 billion users. 10 years ago, you would have looked at Verizon and AT&T and said, "Wow, these guys have 70, 80 million wireless subscribers. Today they have a hundred million wireless subscribers, that's huge. Wow. Comcast has 22 million video subscribers or twenty-five million broadband subscribers, that's huge. These are monopolies. We need to regulate them." Facebook has 2 billion. Google has six products, seven products with a billion. Instagram's about to cross a billion. This is scale that we've just never seen before. So yeah, clearly people were slow to pick up on the fact that there would be hyperscale by virtue of mobile, that, that hyperscale by aggregating an audience of that size would be able to monetize dramatically. And that, that would squeeze out a lot of other media types.

So today, if you're trying to sell programmatic display on your site to gets 10 million uniques a month, great, good luck have fun. That's a very, very difficult business because what scale means today is so much bigger. And look at Netflix. I mean, it's hard to have a conversation in media without talking about Netflix, but Netflix is on its way to... The market is pricing in 250, 300, 350 million worldwide subscribers. So, it's nice that once there was a hundred million pay TV households, but that's, it's going to be a rounding error in the next world.

And so you look at, what's Google going to do with YouTube? What is Facebook and revolve Facebook Live? I mean, these platforms have so many users, that they certainly are positioned to capture more and more audience. With Facebook, I question is that the use case of the Facebook Feed? Or of the Facebook App? Is blasting that up on your TV and spending three hours. Whereas with YouTube, you can look at it and say, "The use case of YouTube is consuming video." It shouldn't be that much harder for them to then pivot that product into sort of a much more all encompassing, hold on your attention.

Patrick: [00:31:06] We talked about overreaction, which said differently is over extrapolation. And the things that people are worst at extrapolating is non-linear trends. And I'm curious if forced to go into your head, you had to structure a long short portfolio, a market neutral portfolio, and the whole time was five or seven years. Something seen or something pretty long dated. Is the play then in your mind, long Netflix and like short everything else? Because it's got the kind of weird non-linear potential? Or as the market already figured that out? You said it's pricing in an insane amount of subscribers. How do you think of that?

Modest Proposal: [00:31:35] I look at Netflix and I say, to me, there's only one question I think for Netflix beyond, it's clear it's pricing in 250 million plus is, what is the ceiling on content spend? And the hope there is obviously that they, 15 billion, 20 billion, 22 billion, that they don't need to spend above that and almost physically can't. And if that's the case, then you get nice margin expansion and all that. But I think the back of the envelope math I did, was 500 million subs and they get to a 30% margin and ARPU goes up, which doesn't make any sense because the next a hundred million subs are coming from India at three bucks. I think you got like an 11% IRR from here. And so, the non-linear outcome has probably happened there. I actually think it's a no coiner, I'm a no Fanger. So if I look at Fang, I could actually be kind of dispassionate about evaluating them.

I have the hardest time penciling out a really exciting IRR there. In Amazon you still have the non-linearity of AWS, it might still be early days there. Facebook, Instagram, it's about to cross a billion users that seems like a unique property. Google, you can make the bear case, but it's the world's most efficient marketing machine and more and more dollars are going there. So, I don't have a strong view on each of those valuations. I think the, Facebook it's pretty clear what the risk there is, is that young people stop using it and they have a hedge and that everyone goes to Instagram, but yeah, that's a real risk. Google, the risk is that AI or something like that actually answers the questions you want without having to click on an ad. Benedict Evans says, "The great irony of google's businesses is that search doesn't actually give you what you want. You're clicking on ads instead, maybe someone actually figures out how to give you what you want."

And then Amazon, which is sort of my obsession because of the e-commerce stuff is, you have to separate AWS because that's sort of in a different world. But on the retail side, I am curious and I spend a lot of time thinking about over 10, 15, 20 years, how can that bundle that they've created be then unbundled again? And the bundling unbundling bundling cycle in tech is just so fascinating because right now you're seeing it apply to so many old-line industries. CPG is just being radically unbundled, and you're seeing it in media where these groups of eight networks are finding out that maybe too matter in the next world. And maybe even networks don't matter, maybe shows matter and so then shows migrate to Netflix because they package them all together.

So with Amazon, Amazon is a curious one, if you leave a side, AWS of... They look infallible, I do wonder if, okay, shipping does AVS, does automated vehicles somehow bring two day, one day, same day shipping capabilities to everyone neutering that? Amazon's not the cheapest already. So there are folks selling cheaper than them. Does someone figure out how to aggregate as much supply? Does Walmart decide, Hey, maybe we need a much bigger third-party marketplace and we can marry that to our logistics and then eventually add on autonomous delivery. It's such a fascinating question to me because it's clearly today the best run company in the world, the most interesting, most exciting company. And so, as a contrarian and a crank, why not spend all your time instead of owning it, figuring out how to deconstruct it.

And what does that mean for other players? You joke, but you talk about where overreactions come? Over reactions come from wherever Amazon gazes. And there are times where a significant portion of what I'm doing is essentially saying, "Is Amazon really going to kill this in the next five years?" And I actually, I say, "It's possible Amazon kills every company in every vertical that they look to." But I don't think they'll do it simultaneously, so if you can find the areas where they're less able to leverage their existing infrastructure and their existing capabilities, but the players are getting penalized as though they're going to, that's really interesting. And yeah, I mean that's been a source of real opportunity for the last two, three years.

Customer Acquisition Costs

Patrick: [00:35:56] It's a perfect segue to a line you said earlier which is the idea of Customer Acquisition Costs just killing internet businesses. Let's talk about CPG Retail, Physical Retail versus online, and your thinking on this kind of interesting part of the market.

Modest Proposal: [00:36:12] Well, if I can go back to start, the first internet company I ever invested in was Expedia. And this was in 2011 and it had blown up for one of its many times where people overreacted their earnings. And so I started doing work on it and the online travel space is actually a great intro to the consumer internet because it's an enormous and market, trillion dollars plus, so it supports multiple players. You have suppliers on one side desperate to fill up their incremental room night, incremental seat on an airplane. So really value finding customers. On the other side, consumers hated picking up the phone and making a phone call to a travel agent or to a hotel. So online travel solved a real problem, it aggregated audience on one side supply on the other, and it's been a home run.

But at the time you're studying it and looking at it like, "wow, these companies spend 40 to 50% of their revenue on customer acquisition costs." And there are seven players in the market. That's probably not sustainable because Priceline, which is now booking.com, as they grow faster and faster, they're going to have more marketing dollars to spend. Expedia as they grow faster and faster, they're going to have more marketing dollars to spend. What about Orbits? What about Travelocity? These guys can't hang. And so, what I learned from that experience was, wow, there's a massive advantage if you can outspend your competitors, acquire all the customers. But then the realization was, not every end market is this big and if I have to spend like that and I can't access a profit pool that, that's big, wow, I'm really screwed. And so if you apply that to the e-commerce framework, the problem is, in e-commerce, for the most part you're selling fungible goods, meaning they're found on multiple sites, at low gross margins most of the time in the thirties, and now you have to acquire customers.

And so there's a reason there are almost no standalone profitable e-commerce companies is because you either dedicate yourself to a niche and you stay subscale, you just enjoy the fruits of that small niche. But nobody wants to do that, you want to grow. And once you take on the institutional imperative to grow, the way you grow is you go and you acquire customers. And once you do that, you go to Google search, you go to Instagram, you run TV ads, you do whatever you can. And all of a sudden, I call it sort of this law of diminishing returns in customer acquisition, which is your first cohort is your most profitable...

Patrick: [00:38:48] ...And cheapest to acquire.

Modest Proposal: [00:38:49] ...Yeah, because you had a product, you hit product market fit, everybody loved it. This small group of early adopters, they told their friends. Great. You get to 50, 100, $150 million. So now you've raised a bunch of money, you're worth a billion dollars on paper, but you got to grow. So what do you do? Oh, well, we'll go out and we'll buy some Google search words. Okay, look, the ROI is okay. Or maybe the ROI is not okay, but we say we'll spend to a $0 profit on our first purchase with them, but they'll come back. And so now you start fudging the LTVs, and the other problem is your cost to acquire is increasing because other people are doing this too.

And so, you can look across the landscape. Marketplaces are different. So eBay has very high margins, very different, but first party seller of goods. This idea that by getting rid of stores and getting rid of the fixed cost infrastructure, all of a sudden you are going to have this wildly profitable business has just not borne out at all. And it's actually interesting, even Amazon has migrated to a third-party selling model, where the vast bulk of whatever profits they have in their retail business, come from the marketplace business.

So I think it's just, it shown that online customer acquisition is a very challenging way to scale whether it's just a niche brand, which you're seeing a lot of, or a broader store idea. So people have hit the wall, they've tried to sell themselves, the ones that haven't, have basically got out of business and I talked about this looking at Andy and Don had this old post about various ways to fight Amazon. And if you look through the various ways to fight Amazon or avoid Amazon, almost none of them have worked. At the end of the day, whether it was flash or daily deals or subscription boxes, you get some adoption and then you hit that wall where you just cannot acquire your next customer profitably and you're kind of done.

Patrick: [00:40:50] When we first got together, we were talking about physical malls and retail and things like this. So talk a bit about that idea and the, this funny thing that like the unbundling bundling cycle everything's coming full circle, and the Warby parkers of the world are opening stores. So talk about physical as customer acquisition costs.

Modest Proposal: [00:41:06] This sort of speaks to the opportunities and how I look at the world. In November of 2016, something happened in the United States that caused consumers for whatever reason to pause their spending for a little bit. They also, for whatever reason in February of 2017, didn't spend as much as expected either. Some people think it's delayed tax refunds. And so, the numbers that Physical Retailers reported were horrific, just eye wateringly bad. And also as a result of that, a bunch of them filed bankruptcy. Now you can say, many of them had improper balance sheets because they were owned by private equity who had levered them up and not expecting perhaps the election to cause distress. But for whatever reason, a huge swath of retail filed bankruptcy and closed a bunch of stores. And so you started seeing stories about retail apocalypse and death of the mall and all this. And, so my spidey sense goes up and again Amazon's killing them all. So first response is, Wow, I got to go look at this, if Amazon's responsible. And see maybe there's an overreaction.

The problem is, if you build the worst business from scratch, if you just whiteboard, what is the worst business look like? And when you're done tallying it up, you've built a retailer. So I had no interest in actually exploring retail because the ones that had prosperous business models (TJ Maxx, Costco) they hadn't been impacted. They were still trading as though they were great businesses because they are great businesses. The ones that were trading as though they were crap businesses, are crap businesses. And so maybe I could catch an apparel cycle or something like that, that I have no expertise in. So I said, "No, can't do retail."

Why Costco is a Great Business

Patrick: [00:42:54] Real quick before we go on, just enumerate what makes, say a Costco, a good business and a traditional retailer such a bad business if you're whiteboarding it. Just to not to take that for granted?

Modest Proposal: [00:43:04] Sure. Well, I am not an expert on Costco, but they have a model, that's a subscription model in the physical world where essentially their operating income is subscription revenue. And then they provide an enormous amount of customer surplus. Their customers love them. They sell it, I think it's a 10 or 15% markup. They have nailed the rollout of stores. They know where to go. They know how to do it. They know how to merchandise because they merchandise a limited assortment. Their suppliers want to be there, work with them, so unique. Walmart for years and years won on their supply chain, TJ Maxx wins on the buying meaning they're buyers they're open to buy is out, they're able to source goods and their customers have a treasure hunt experience that can't be replicated online.

So there are various players that have figured out models that work. The generic retailer has high fixed costs, high working capital intensity, low differentiation, they take fashion risk, they need to acquire customers. Essentially, you're selling at a 40% margin with high fixed costs underlying that, you have SG&A, you need to comp two to 3% a year to not de-leverage your fixed costs. You have inventory risks that if it rains in May, all of a sudden you're on the conference call say, "Well, we didn't move through our spring t-shirt line." So it's just, it's a horrible business. It's why there are very few persistent over time performers. You'll have someone come five, 10, 15 years, they overexpand, they become stale and now they're stuck with an aging store base. So that's on why I had no interest in retail.

So as I looked around, I was reading about the death of the mall and at the time there was a paper circulating that was the next big short was with mall CMBS. And I read it and it was actually very interesting and there's some embedded correlation risk in the CMBS product that made it. I could see why people would want to do it, but that's a great headline to have, right? The next big short is out there. And so I started looking and said, "Okay, there are 1200 malls, that sounds like a lot, wait, about 900 of them make up, maybe 10% of the value in the sector. So yeah, those are probably going to die, but what if you don't own those?" And so you sort of said, "Okay, there are 300 malls, they make up 90% of the industry value, they're owned by five public companies."

Let's start taking a look at that. Some of them have assets overseas. So that made it less interesting to me because I don't particularly have a strong view on what's happening in the rest of the world retail. And you can sort of narrow it down and come to the idea that some of these might be really interesting because, A, you had this overhang of retail apocalypse, mall apocalypse. B, you had what I thought would then be an improving retail environment, because again I think that late 16, early 17 was sort of an anomaly in, yes, the trends in retail are bad, but they're not that bad. So I thought you would get some improvement there. And then, if you really get into the nitty gritty details, the a mall properties in general did not suffer negative and a why in '09. And their occupancy in the 2000s was call it 92, 93%. Their occupancy today is 94 to 95%, but it's down from 96.

So if you think about extrapolation 2014, 2015, the best malls in the country were operating north of 96% occupancy. Which is kind of crazy if you just think about the general churn in and out, it's very difficult to run an entire portfolio at 99. So maybe 96 is the upper limit. And so that had come down to 94. And so Wall Street linearly extrapolating is like, "Well, the next stop is 92 and then probably 90." And so, again reverse engineering, you could sort of look at it and say, "Wow, it looks to me like we're assuming net operating income." Which is the key metric here was going to go negative kind of in perpetuity because otherwise, if you just thought that NOI would be flat or up, these were fairly attractive.

So then you say, "Okay, what has to happen for NOI to go negative?" You say, "Okay, well, it didn't happen in '09, so we need consecutive 09s." And you can start to say, "Maybe this is interesting." So it really started to do a lot of work there, but it ties in nicely with, like you said, Warby Parker which is... Warby Parker is not going to open a thousand stores. Gap today has 1200 Old Navy's, 1000 Gap. That model is dead in my estimation. But what you will probably have is folks who launched online, built that initial fan base, decided we have a big enough business today that we can start to scale this. We know, and this is really powerful, that when we put a store somewhere, our online sales go up. Our stores we can operate them profitably, because we don't need a 10,000 square foot store like they used to have. We can have a 1500 square foot store. We can operate it profitably and it's a source of customer acquisition. And it benefits our online business. Okay where do we....

Patrick: [00:48:29] ...And it builds a brand. It's genuine.

Modest Proposal: [00:48:30] Build a brand. It's kind of like Madison Avenue, high street retail. That business is challenged today because everybody was running those at a loss, but they needed it for brand building. Well, what if you can build your brand profitably by not putting it on Madison Avenue, but it in a really high traffic, urban mall. So I think the future looks a lot less malls and retailers that are not e-commerce or physical, but they're just retailers. There are people selling you stuff and their brands selling you stuff and they probably want to have locations in San Francisco, New York City, Miami, Washington, DC, Los Angeles. There are however many urban locations that you're going to pick and whether that's 200 or 300 or 350 you can go through the demographics of all that. But that seems like a model that's going to work because online only, is not working and offline only, is not working. So some hybrid clearly makes sense. And who figures it out, how it works, it's definitely an open question, but my guess is whoever it is, is going to want to be in these specific locations.

The Ecommerce Internet Journey

Patrick: [00:49:41] So I'd like to go back a little bit and tell in some more detail, this consumer internet story. It's a couple a thesis that's a couple of years old now and has in many ways played out. But it's a good example of our overall conversation, which is over extrapolations, overreactions. So maybe go back a few years and describe what you saw there, what you were thinking about as it pertains to those businesses and why there may be an opportunity that's been mispriced by the market. From there, we'll also go deeper into this no Fanger idea about why and how maybe these businesses won't disrupt as much as everyone is talking about, but we'll start with this idea around consumer internet companies.

Modest Proposal: [00:50:17] Sure. And I was not unique in the insight that the consumer internet's going to be great, but I think at given points in time, particularly in the small and mid cap space, there's been tremendous opportunity either because one of the big guys was allegedly pointing their traffic gun at that area, or just general competition was increasing. So there've been episodic opportunities to look at some of the businesses. But I think if you go back to the late nineties, you had sort of this web 1.0, and then starting in the mid two thousands, you had this next gen, which were more technologically savvy, much better able to pivot to sort of the mobile world. And they're I'm thinking of the Zillow and Trulia's in real estate, Seamless was started early on and they sort of dominated their category. And as you started to look through each of these verticals, you had couple billion dollar companies that were steadily accumulating the type of aggregation that we talked about earlier, but within a niche, that niche could be huge.

Zillow has the vast majority of real estate browsers in the US are going to go there and they accumulated that via putting this estimate out, building traffic, and then subsequently becoming essentially the de facto. Seamless and GrubHub came at it the same way. They just steadily built supply, aggregated both sides of the marketplace. But what I think was under appreciated was similar to folks not appreciating, wow, Facebook has 2 billion users, they're probably going to make a lot of money off that, was that there was an opportunity within these verticals for each leader to extract real economics. And the reason was the CEO of Groupon once said something that's blindingly obvious, but has stuck with me is that the folks who have won in the internet have made the experience better.

So if you look at online travel, calling an airline was horrible. Calling a travel agent was annoying. Booking your travel online is just better. And so all of these various winners calling a restaurant to get your delivery each night is an inferior experience to going online, hitting I want dumplings and, whatever, and getting it delivered. So these businesses took friction out, made for a better user experience, aggregated the customer side, went out, built the supply side that wanted to access that. And did essentially what we talked about with the big platforms, but for specific use cases.

So at various times from 2011 on, you had opportunities to pick up some of these companies that had extremely attractive prices and one particular in late '15 and '16, and early '16 much of the stock market was on sale. But there was just a unique opportunity where you look at GrubHub, Amazon announced they were coming in with their restaurant delivery, uber eats was getting press. And a friend of mine says, "Small focus always wins." Because every day they wake up and it's life or death for them. And for Amazon signing up restaurants and figuring out how to deliver food to customers is nice. And maybe there's some tangential association to Prime, but for GrubHub, every day, the most important thing, the only thing that matters is making sure that consumers get the food they want when they ordered it.

And so whether it was match had just come public and that stock got down to eight times EBITDA. And today, if you look at match, it trades at closer to eight times sales. So people have figured out that, "Hey, internet dating is probably a real business." But there was a good four or five months stretch there where you name it, in small and mid cap, most of the leaders were being treated skeptically. And I think they're up to 250%, 200%, something like that from the bottom. But I think the more interesting case is when an Amazon does announce they're going after someone or Facebook does announce, or it actually used to be with Apple at WWDC, you'd see they'd make some announcement of, "Hey, we're pulling in this service into our OS and the stocks would be down 20%.

Now it tends to be more Amazon or a couple of weeks ago, Facebook announced, right? They're getting into dating. And so the knee jerk reaction is...

Patrick: [00:54:50] Everyone's screwed.

Modest Proposal: [00:54:51] Right. They have 250 million... Literally, right? They have 250 billion single profiles. People spend 40 minutes a day on the platform. Why isn't this obvious? And who knows, they haven't launched the product yet. We need to see how it evolves, how they iterate it.

But again, Match has multiple brands who wake up every day with one goal in mind, to make the user experience better to connect daters. Facebook to me, if you were to say, "Given what's going on with privacy and all that, would this be the right time headline wise dating product?" You'd probably say, "No." So you sort of ask yourself, "Okay, why are they doing this?" And I have no idea if this is causal, but if you look at the last 15 to 24 month data, the sort of 18 to 30 year old cohorts time spent on Facebook by third parties is said to be declining at 25 to 30%, if you want it to re-engage that cohort on your platform, an interesting way to do it might be to try to launch a data product.

So I always take a first principles approach, can Facebook get into dating? Of course, they can. They have billions of dollars and they generate billions of dollars, that they can do it, but why are they doing it? To what end? Is this a consumer proposition or is it to solve a need of Facebook? And so in this instance, it looks to me like they're trying to solve their end of problem of declining engagement amongst a certain age group that might be invigorated by dating as opposed to solving a customer problem, which is, "I want to meet someone. I want to have a good experience." I think match was down 25%, I see who owns 80% of it was down 22% and we'll see.

I mean, they got to play their hand, but you see that time and again where if you know these companies, I think it was two and a half years ago, Amazon announced that they were going to get into a business of a small little company called Shutterfly. If you have kids you know Shutterfly, because you probably make photo books for grandma and grandpa, you put their faces on mugs. Amazon said, "We're getting into this business." And look, the first reaction is, "Oh, crap." This is the big behemoth. They have 60 million Prime households, same exact demo of moms buying stuff. But then when you see actually how they launched the product, if you've ever gone to Amazon's homepage, you know it's nearly indecipherable to find anything. So the click flow to actually get to the site. Then when you got to the site, it kicked you to a third party because they were white labeling, basically an outside provider. You saw that essentially the only thing they had going for them was they were charging a lower price, because it's Amazon.

And that had a large user base that they could potentially tie to, but the experience was inferior. It was not anything that they really cared about. And so the stock has more than doubled since that announcement. Going back to these overreactions, if you know these businesses well, because they do dominate their category and take the lion's share of the profit. If FAANG decides, "Hey, we want to go do this." You think hard and you get scared and you go, "Oh, crap, they're coming." But then you sort of analyze the situation and say, "Hmm, maybe not."

Patrick: [00:58:11] We were talking before we started about, I'm going to mispronounce his last name, but one of the original PayPal mafia guys, Keith Rabois or however you say his name, had an interesting point on Twitter about post '95, any company, especially in niches that has any sort of traction really hasn't been killed by one of the big incumbents. And that's very counter the narrative out there, which is that the Fang stocks basically, as you've just described, could go after anybody and wipe them out. But that really, that hasn't happened. The underlying question is, so why isn't Amazon or Facebook or whomever, why isn't Facebook going to win in these niches? When I think it could grow their businesses tremendously? Is it a lack of focus? Is it an investing truth that focus in niches are just to work better than do everything platforms? How do you think about that looking forward?

Modest Proposal: [00:58:59] Again, I don't think the question ever should be asked, "Can big tech get into something that a portfolio company of yours or someone you work for, can they get into it?" Yes, they can. The no barriers to entry on the internet is true, but uninteresting because it definitionally is. So the way I think about it is I try to say, "Okay, what are they trying to do?" It's unlikely that they're just saying, "We're going to set up a me-too service and try to grab some of that profit pool." Usually it's to further some core mission of theirs. So with Amazon, if you think about it from the consumer side, Prime is the center. Prime is the universe. So if there's something that can be added on to Prime as a service, you should think long and hard about that because they can integrate it, they can give it away now as part of the subscription at 60 plus million households.

So you kind of need to start from first principles of not can they do this, but why would they do this? Facebook is an interesting example because if you were to go back 18 months and you were to say, "Has Facebook ever made an incursion into another category and won?" Everybody would laugh and say, "No, of course not. Everything they've launched and tried to do has failed. But then they took on Snap and stories with Insta and had lots of success there. And so recency bias now everyone says, "Oh crap. If Facebook comes for you, you're screwed because they're going to leverage their 2 billion user base."

But I think that to answer the question, it's one, usually they have an ulterior motive other than just winning the category. Two is, again, these niche companies, even though they can be $10, $15, $20 billion companies, they wake up each day with one purpose and that's to serve their customer for whatever specific services they're providing. They work on the UX of that, they're building the supplier base on one side. They're just constantly iterating that. If you are a global platform or aggregator, you have lots of goals, you're doing lots of things all over the place. And so you've dedicate an engineering team and maybe one day you use your homepage or your ability to drive traffic to it. But then the next day you're onto something new.

Google has Google photos, which is by far the best photo repository site. And they do that because they have phenomenal machine learning algorithms and it helps them to really develop internal talent and expertise. One day for no apparent reason they decided to offer photo books on their front page. And so again, people go, "Oh, shit. Google's making photo books." And you don't like to see that, but you sort of say, "Okay, are they going to build out printing functionality? Are they going to build a good user experience or are they doing this to prove that their machine learning algorithms are really good at picking out seven photos of your baby over a month at a time?" And that's probably the goal that they're aspiring to.

So I think you have to look at when a small focused organization with one mission in mind is fighting a very large organization with unlimited resources, but not focus. I think Keith's point is that you should probably bet on the guy who this is all they're doing all day and it's been a huge opportunity to make money because again, from time to time, one of these platforms is going to say, "Ooh, I like that. Let's go do that."

Patrick: [01:02:25] You mentioned this idea of the distrusted 50. I'd love you to describe this list kind of its derivation and why you find it interesting because it fits nicely in with this kind of journal idea.

Modest Proposal: [01:02:34] Well, yeah. There's a research shop, Empirical Research, and they do wonderful, fundamental quantitative research. So probably mirrors a little bit of your investing style. And I'm not a quantum, just a general fundamental guy and their research nicely lines up with a lot of what I see. And this notion of the distrusted 50 essentially is that free cash flow tends to be undervalued. And that there are groups of companies that have great businesses, generate relatively high free cash flow margins and free cash flow yields. And the market's sort of systematically under prices that either because they think that the capital is going to be squandered or that it's unsustainable. And so in the paper that you talked about we're putting out, this idea that value is essentially multiple expansion. And in these cases, basically you're getting a nice yield. Maybe you go in with a 5%, 6% free cashflow yield, maybe higher.

And so you essentially clip that coupon. But what you're really hoping is that at some point it goes from distrusted to trusted and you get the rerating and a lot of what we've talked about is, so I have these ideas of the future and all that, but in reality, I'm not predicting the future. I'm reading the VC blogs, just like everyone else. I'm listening to your podcasts with them. What I'm trying to do is find a view of the future that differs from the markets today. And then my belief is that over time, the market's belief will accrete to my view, that view doesn't actually have to come true. I just need the market to come to believe that. So a little bit of these distrusted fifties and the general notion of buying sustainable free cash flow is that if you go in with a high yield, again, we're not talking double digits here, but call it 5% to 8%. That is pretty good protection because each year that's accreting to the entity. And then what you're hoping is at some point, and you want to have a view of what that point might be, but at some point that the market then, whether it's they don't destroy capital by doing M&A or doing something stupid or that, durability, the franchise is proven out that you rerate that down to a 4%, 5% yield. And now you've made a lot of money and you'd go find the next one that's distrusted.

Capital Allocation

Patrick: [01:05:00] So part of that distrust is whether or not the managers of that business are going to do a good job with their capital. I'd love to talk a little bit about how you think about capital allocation and maybe even some specific hot button issues within that topic. So let's maybe start with buybacks. So this has become the whipping boy in the media, and it's a hot topic. There was just a story yesterday in the Wall Street Journal about how the instances of insider selling, there's an abnormal rise of that, following buyback announcements, which tends to lead to a pop in price, or has tended to lead to a pop in price. How do you think about something like buybacks as a starter when it comes to capital allocation?

Modest Proposal: [01:05:35] Sure. the great luxury of today is that many of these businesses we've talked about generate enormous excess capital. And that is a blessing and a curse because Buffet pointed this out many, many years ago is you spend your whole life working really hard to become CEO, or in these tech companies case you founded it in your dorm room, and then one day you wake up and now you're responsible for allocating $6 billion in excess capital and you have no experience in that. So, yeah. This is one of the key issues for many, particularly in the tech and media world that generate just enormous excess cash is, what do you do with it? To buybacks specifically, I think it's pretty simple. If your stock is reasonably discounted to what you think you or a private market buyer would pay for it, buy it back.

If it's not, don't. The single worst thing, and when I talk to a management team, I say upfront, I go, "I'm going to put this out here. This drives me more insane than anything else is if you say we buy back stock to offset dilution, I will go bonkers." Because if you think about that, they're two entirely separate decisions. We issue stock to pay our people because in some industries, that's how people choose to get paid. Don't make the second offsetting decision for no other reason than you want to buy that stock back. If the stock's not cheap, don't buy it back. That's just like issuing stock. If you have a very expensive stock and you issue it to do an acquisition, great, that's smart. If your stock trades at 25 times EBITDA, and you're issuing stock to your employees, you're acquiring them cheap. But if your stock's cheap and you pay out SBC, fine, that's fine, but go buy back your stock because you're increasing the per share value of my stock.

And so much of this gets back to is the goal to grow the size of the enterprise? Or is the goal to create a value per share? And that is often lost on people because folks are empire builders. Folks have delusions of grandeur, but per share value is what we're trying to maximize. And again, the calculation is simple. If your stock's cheap, buy it. If it's not, don't. But I don't think that for most management teams, this is sort of the thought process. Now there's a separate big buyback debate that I've engaged in on Twitter for four or five years, which is, has buybacks come at the expense of, whether it's corporate investment R&D any of this, and there I just think the evidence is very poor that buybacks have come at the expense of something else. Because if you think of the uses of capital, right? There's internal reinvestment. And we know that R&D is rising and has that is not a problem.

So then the other uses of capital are going to be CapEx, are going to be buybacks, dividends and M&A. The metric most people point to is free cash flows, use, dividends, buybacks, and I'm like, "But that's already net of R&D and CapEx." So the real remaining criticism then is that CapEx has been under-invested in. Well, I think the argument for that is that global demand growth has been slow. There was a lot of excess supply coming out of the great financial crisis, and we've had to work through a lot of that. In certain industries, take tech. There's massive CapEx going on. The problem is when you look at the ratios of CapEx to say sales or anything, these companies are growing so fast and are so big that Amazon spending $25 billion in CapEx looks like a drop in the bucket relative to their P&L.

So I think that there's a societal question of are buybacks bad? And they're I would say no. I think that actually they're completely legitimate. They have not come at the expense of other things. Then there's the financial question of, are most of these buybacks being done value accretive? And they're at situational and you have to look at that.

Patrick: [01:09:34] Yeah.

Modest Proposal: [01:09:35] I wrote something a few years ago where I said this idea that we want tech companies to just be throwing all their money into whether its M&A or R&D is crazy because you want the experts doing that. And a lot of tech companies have built a product in a certain cycle, earned enormous cash flows off it. And now the expectation is, "Go throw that capital in and build the next thing."

Patrick: [01:10:02] Do it again.

Modest Proposal: [01:10:03] Right. And the base rate of success of that is extraordinarily low. And so if you're a shareholder, or even if you're just stepping back somewhat observing society, you would much rather that capital go back to its owners and then that capital deployed elsewhere into the next guy who has a better chance of building that next new thing.

Patrick: [01:10:22] It sounds so funny. It's so funny to me, because it's almost like people were saying that somehow these CEOs or whatever can allocate capital better than markets can, which it just makes no sense.

Modest Proposal: [01:10:30] Right. And some investors are presumptuous enough to try to tell management teams how to do their job. I generally don't think I'm smart enough because I've never worked for a big company or even a small company to tell them how to do their job. I have ideas, they laugh, we go onto the next topic, but on capital allocation, if you're an investor, this is literally what you do. And so there, I do think that an informed conversation with management is warranted because you are constantly dynamically allocating capital to its highest and best use, and that's what companies should be doing. But for various reasons, oftentimes they either don't think of it properly or they just aren't doing that.

Patrick: [01:11:07] Talk a little bit about international equity markets from your seat. So a popular topic has become China, largely because there's many now recognizable huge names in the tech world specifically, but how often does your opportunity set creep outside of the US? Is it something that you care about or think about all that often, are you kind of agnostic to where a company is domiciled or headquarters? And do you see any differences, I guess, in international markets relative to the US that makes opportunities to earn alpha more or less attractive?

Modest Proposal: [01:11:37] I would say in general, I mostly do US listed equities. There have been times where some of these quirky overreactions, a few years back ABI, which is a European listed company, but has the majority of their earnings from the US and Latin America, was getting sold off on the European crisis. And I think they had 8% of their sales at the time in Western Europe. So I situationally look for episodes like that. In general find the lack of access to management, the financial statements sometimes are in different languages or using different accounting standards, to be difficult. But sure, always looking, we started out talking about value investing. I think every value investor worked their way, has at some point paid their due. In Korean preferred's and Japanese discount to NAV, those are always on the common, they're going to work next year.

But so you look for those, but I think in general, it's been possible to get really nice international exposure via US listed companies. With the Chinese companies you asked me about them and tech. I think it's interesting because they've gotten to this massive scale and they're clearly so successful in their home markets. So there's a notion that they should be able to expand out and I don't have any great insight into them, but I do wonder once you enter a fully competitive market without the backing of the home team, and you're up against the local incumbent and then the US platforms, that's just a different competitive operating environment. They bring a lot of advantages, which is massive scale, massive balance sheets. Some have tried, Alibaba had a US site that they were trying to build up e-commerce wise. I don't think they had great success.

There's notion sometimes that they may buy their way into the US, they have a stake in Groupon. They may someday link up with eBay. Someone people have talked about, Tencent, they're global via their games business, things like that. But I think it's a different competitive environment when you have to go head to head without the finger on scale, and you're not a name brand. So whether the assets you're bringing to bear are enough to sort of overcome some of the structural frictions and reasons that category winners win. I don't have a good view on that.

Asset Management

Patrick: [01:13:58] I'd love to talk a bit about the industry itself, the asset management business, the investment business, and your take on it given a fairly unique seat and having watched it for a long time, just like I have with a lot of interest I think. One of the themes of our conversation is the episodic nature of big opportunities. We talked about three examples in consumer internet, sort of the overreaction maybe to cord cutting, things like real estate and malls. Obviously, those are discrete sets of opportunities which may play out over some period of time. One of the things I've been thinking a lot about, especially for fundamental active managers, is that by giving money to a fundamental active manager, you're sort of implicitly assuming that the opportunities are fairly evenly spread through time, but that doesn't actually seem to be the case. How do you think about that? What do you think the kind of future of what's your assessment of active management, generally speaking, and any thoughts on where you think we might be going would be fascinating.

Modest Proposal: [01:14:52] I think if you're a dispassionate analyst in our business and you step back and you analyze the nature of the money management business, you would probably say, "Wow, this is not a place I want to put my capital and likewise, maybe I don't want my kids going into it." I think you're at a point where you have some of the smartest, hardest working, most driven folks, all competing in... I don't want to call it zero sum because some markets have positive sum, but in very competitive situation. And you can look at any number of ways of slicing and dicing the data. But it's clear that the excess performance generated by even superstars has been diminishing and reducing in persistence.

So the amplitude of outperformance has come down and the persistence of it has basically disappeared. So I do think that there are a handful of folks who have demonstrated over many, many, many years that they are truly elite, like you would in any other profession. But I think Michael Mauboussin talks about the paradox of skill and our profession is now cursed by the fact that there are a lot of really good people doing it. And that luck probably plays a larger and larger role in outcomes and that generally isn't a persistent characteristic.

So I think the notion of these episodes, why that appeals to me is because as I've done this longer and longer, market efficiency is something that I originally came into the industry scoffing at and today I think they're mostly right. And most people sort of use an example of a stock goes down 25% on some news and everyone goes, "Ha ha ha! EMH." And you're like, "No EMH says you can't systematically take advantage of those mispricings to outperform. And we know that's definitionally true because very few people are doing it.

Patrick: [01:16:47] Right.

Modest Proposal: [01:16:47] So I think the idea you can go in day in and day out and find wildly mispriced securities and systematically out-perform, that is, crazy is your word. There are folks doing it and so I don't want to knock them. And I'm not an expert on every strategy.

Patrick: [01:17:03] Maybe we'll go back later and say, picking who might be able to do that is crazy.

Modest Proposal: [01:17:07] Correct, yeah. It's very difficult to identify the persistent out performer, but it is clear that from time to time, whether it's a thematic narrative, there's a macro overhang, look, it's easy to say in retrospect that the fall of '15 and early '16 were great buying periods. But if you bought a lot then, that worked and that generated out-performance for a few years. So I think the way that performance is evolving is it's who can sit on their hands, be patient, and wait? And that's always kind of been the case, but I think the waitings, it's getting harder, you're inundated daily with data. You think it matters. You see your competitor's performance numbers. There's so much news flow, there's the urge to action. And it's almost made it harder and harder to sit and wait and say, "What are these fat pitches? When should I put significant capital to work?"

And then as far as a business, if that's the right way to invest, I have no idea how you structure that as a business. Folks in distressed debt have managed to figure out how to pull down opportunity funds and that has worked for them. They know when the time is right to deploy that capital. Certain folks have earned the right to go to their investors and say, "We see something or we will see something." But I think for the investing is a game of multiple Sigma's out. No one's really interested if you're operating at the 95th percentile because there's a lot of people then to your right. It's how do you structure your business to sustainably generate out-performance? I think you need to have this patience, this mentality, and this capital all aligned so you can do it.

On the other hand, I will say, I look at a lot of pitchbooks and this idea of time arbitrage has kind of been universally gravitated towards as why active managers should exist. So I think you have to be careful not to just say, "Ah, we're arbitraging time. It's the last available sources of alpha." Because guess what? Everyone's pitch book says that. So I think you need to be careful in not just saying the tried and truism, you need to actually mean it that look, I do nothing for 18 months at a time and then opportunity presents itself and I pounce.

And I think behaviorally, it's really difficult. Business-wise, it's really difficult. So I'm not sure that folks can actually do that, but that is in my estimation, I think, again, the idea you can just go into the marketplace and beat people day to day is not for the traditional fundamental investor.

Patrick: [01:19:38] The combination of patience and conviction, the kind of classic Buffet, Munger thing is popular. How do you think about the allocation of a portfolio in between periods of conviction? So in between the opportunities to do something that seems like a broad mispricing that's happened, cord cutting for example, how do you think about positioning the portfolio when there's nothing to do? Are you just long? Are you an SPY? Markets are mostly efficient most of the time, how do you deal with it?

Modest Proposal: [01:20:05] I'm going to differ from I actually do at my day job, and from what theoretically might be, I've spent a lot of time thinking with friends about this is, what if the right thing to do is just put it in low cost index fund, not charge money on the capital in the index fund, just charge on the actively managed assets and when the opportunity presents itself, you'd invest SPY and you go buy alpha? Look, I can't speak for allocators. I don't know how they view the world. I think that would probably be very a difficult pitch to make to a lot of people that, "Wait, so we have this guy, he's 80% in the SPY right now and at some point in the future."

Even though that's probably a smarter thing to do than leave it in cash and wait until an opportunity fund draws it down, because most of the time the market goes up, from human behavior my guess is that wouldn't work. I think your question is though, on a day-to-day basis what does an active manager do when there's not a lot to do? And I think that's where a lot of mistakes are made is people try to reach. And I think that's where discipline and respect for the market is really important.

Patrick: [01:21:08] What are some other investors that you've... I was going to use the word respect, but I'll change that a little bit and say, not just investors, just other thinkers that you've learned the most from that have most impacted the way you think about markets?

Modest Proposal: [01:21:20] Look, I think it's cliche, but anybody who says they, haven't learned a bunch from Warren Buffett is a fool. His shareholder letters over the years, still to this day, if you go back and read, I once posted on sort of franchises versus businesses, and it started a multi month conversation around this idea of what's a franchise and what's a business and a franchise is truly special. He talked about in the early nineties, essentially the death of media. That you owned a local newspaper, or you owned a local TV station, you were King, because you had a local monopoly, said, "The future might be bright." And look, it was for the next 15 years, but he saw the writing on the wall, and so I think set aside your views of how he's earned his money lately, or if you don't like what he does with banks, any of that.

If you just look at the 50 years of writing, you have to have learned from him. Mike Mauboussin has put out some of the most fascinating work on actually the mechanics of investing. And I think he's really helped folks think about adapting and this idea of expectations investing, which is you don't go to the track and you bet on the favorite, you go to the track and you bet on the mispriced horse, right? And investing is the same. A lot of people feel comfortable owning the best businesses. Well, that's fine because it is nice to sleep well at night knowing that your company is great and a leader and all that, but is that the right way to outperform? Unclear, at certain points in time it is, and at other points in time, it isn't. So this idea of understanding and becoming sort of a market psychologist, I think is very underrated.

Who else? There are so many folks out there, but those are two that I would definitely point to. And then the ones that I would love to have access to their brains are active managers who have thrived over the last 20 years by evolving. And how have they gone from being just high yield bonds to running a multi-platform or multi-asset class business? Because that sort of mental dexterity is truly, I think, what has separated that elite 0.001% from a lot of the people who may be for a five, 10, 12 year window were in their cycle where their style of investing prospered, but when the cycle changes, the persistence goes away. And then there are a handful of managers that I don't want to name them, but that I personally look at in awe from the outside, because you see that they've managed to rotate capital into strategies that are working at the right time and therefore prosper over multiple decades.

Patrick: [01:23:54] It's amazing looking back, you talked earlier about the '98 to 2002 period being so important for our business and the lifespan that a lot of value managers were able to survive despite bad performance because of how well they did in one specific period, but then maybe haven't evolved. And I just think that highlights, look, from an allocator standpoint, it's so hard. How the heck ahead of time are you going to identify the ones that can and will evolve?

Modest Proposal: [01:24:18] So I think I will name one person because I'm fascinated by his performance. He puts out great letters. He's given speeches on this, is Bill Nygren at Oakmark. And if you were to go back to '04, '05 and look at the cohort of value mutual fund managers that were sort of revered for their ability to come through the '98 to '02 time period, he was definitely listed amongst them. If you look to today, he is one of the very, very few who has not only survived, but generated significant out performance. And so the question is why? And it's well, he bought Amazon in 2014, at 200 bucks and he owns Google and he's said, "I know what we were supposed to do. When I came into this business, I looked at the list of statistically cheap stocks. I picked amongst them, I don't like that balance sheet. I do like this one, let's buy them."

But in recent interviews he said, "Look, that doesn't work anymore." And today, I remember when he made his case for Amazon and he essentially said, "Look, if you look at their price to gross profits, it's as cheap as it's been. I get that they're not earning any money right now, but they're about to inflect and we think it's being underpriced." And he was right. So I think he's done a really good job of adapting the value investing style. And again, value investing is simply buying future cashflow at a discount, right? But value investing, as many people learned it, was buying statistically cheap stocks. And he adapted, others maybe haven't. And you mentioned from the allocator's perspective, it's really difficult to say, is that person adapting or does that style drift?

And if someone goes through a period of under performance, is that person dogmatically sticking to a failed or a historical process? Or are they sticking to their process and on the verge of performing again? Because we know it for outperformers generally you underperform 30% to 40% of the time. So I think one of the constant tensions in money-management is markets evolve, markets adapt, investors need to as well, but how much is it adaptation? And then when do you go too far into style drift? And late in a cycle, everybody wants to own momentum driven growth companies. So you see people pile into that, which is typically a late cycle behavior, or is it just people saying, "You know what? These businesses are still undervalued. The market's getting it wrong, I'm going to buy them." And that's the tension that you have to weigh.

Adapting to Evolving Conditions

Patrick: [01:26:52] This adaptability idea is becoming, I don't know, maybe the thing I think about more than anything else, because that tension is fascinating to me as an investor, to thinking about companies like Jeff Bezos or whatever brilliant manager's ability to adapt to evolving conditions. They're investors too, right? They're allocating capital too, and those will be the winners, right? The right balance of sticking to some set of core principles. You use the term style drift. I think you probably need some, whether it's customer centricity for Amazon, you need some true North to orient yourself, but then constant adaptability is really important for business managers and investors. How do you think about that personally for you? What are the ways that you try to force yourself to adapt to new conditions beyond obviously, just thinking a lot and reading a lot, are the things that you're deliberate about to make sure that you don't get caught in that snare or that trap?

Modest Proposal: [01:27:44] Yeah. If you go back to my history, starting out buying $400 million companies that had $200 million in real estate that wasn't on the books and $150 million in cash, and maybe they had a lousy management, but you would put up with it because one day they might sell the real estate and buy back a bunch of stock, to today where I look at some high-growth internet companies when they're going through challenges. So there's clearly been an evolution and here I'll, I'll actually put in a pitch for Twitter. Twitter exposed me to a broad range of investing styles that I never would have encountered.

If you are one of those crusty old deep value investors, you tend to talk to other cranky, crusty old value investors, and you try to find the least bad in a really crappy industry. And you go out and you look at the real estate that's not on the books and get really excited, by seeing that technical analysis work, by reading the thoughts of VCs betting on moonshots, by seeing growth investors talking about, "Look, I don't care if I'm paying 25 times earnings, the RLIC is 30 and they're reinvesting at a super high rate. In 10 years, they're going to be earning five times more than they are today."

So seeing that all these other styles worked, I think necessarily just made you question there's no one true way. And I do think that folks can sometimes, people can sometimes fixate on this fact that my way is right. Well, value works, or did work, and momentum works. We know they both work and that's a pretty funny conclusion is that people doing the exact opposite thing could both outperform the market. And so I've forced myself to do a lot more reading about high tech, what VCs are investing in. I subscribed to a bunch of newsletters on that stuff. I've tried to expand my circle of competence, always. I think this idea of expanding that circle, not getting content to say, "I know three, four industries, and that's it."

There's something fun and exhilarating about a new industry, but do you also have to be careful because when you wade in, there are people who know that industry really well and you just got to be careful that your ability to understand the market psychology in a new sector as you're getting up to speed, is going to be worse. And so you may think you've discovered something, "Wow, this is really novel. Look at this." But what you find out is that the industry thinks of it differently or has internalized it in a certain way, already knows there is, already priced in. And so I think you have to be careful of that, but you can't be stagnant because the market's constantly moving. Capitalism is dynamic, markets are dynamic. And if you just say, "All I do is X." The market moves away from that and now you're left with an old bag of tricks.

Patrick: [01:30:32] I'm going to close with a couple of just fun ones. Just purely for fun, you probably haven't done deep dives on these, but just fun given your mindset to get your reaction to these. So the first would be the impending investment and interest in the cannabis industry.

Modest Proposal: [01:30:45] I think my biggest challenge with it is it is a schedule one drug and it is the federal government still rules it, essentially, illegal. In all shapes and forms. Is there going to be a huge opportunity there and is there one today? Yeah, sure. I think it's very difficult as a fiduciary to put capital to play when with the change of an administration, you could just have the DEA kicking in doors. Longer-term it, strikes me it will probably be legalized. I think you don't really know the name of the richest lettuce grower. And I think that this will just be a scale business, it's farming.

So I think you'll probably have an early gold rush once it is fully legalized where everybody consolidates, but this is a very old world industry that will sort of evolve in the way that classic real-world businesses evolve, where a few players come to be the main suppliers. There are a few big brands probably. Someone's selling all the equipment to them, but it should become industrialized. In the interim, if you can find businesses and ways to play it legally, then you're going to earn the excess rent that a market that's not fully legalized and that capital isn't fully deployed to. So hats off to the people, I know people who have played real estate in it, and I know people who have gotten licenses for the dispensaries and all that, but even today on the ground it can be a hard business. If there are 10 people with licenses to a dispensary, you're running a retail store and you're out there marketing. So I think it's a very interesting opportunity, but I think it's difficult with the overhang of the federal government to put a lot of resources into it.

Patrick: [01:32:30] You mentioned you're a no FAANGer, I'm curious if you're also a no coiner and if so, are there any conditions? And I really only asked this one because the crypto world is in the midst of a pretty massive draw down now from it's highs. Albeit, very short-lived highs. Are there conditions under which you would get interested in that world?

Modest Proposal: [01:32:47] Yeah. I'm waiting for the first coin that generates a bunch of cash flow and is thoroughly out of favor to then buy. I think crypto is fascinating for two reasons. Behaviorally it was the most perfect thing I've ever seen. I grew up watching the internet bubble, actually even before that was baseball cards. And baseball cards was just this wild bubble with the Honus Wagner card and things like that in my youth. Then I saw the tech bubble and to this day, it's one of the craziest things I've ever seen was the globe.com's IPO, VA Linux. I remember seeing it scroll across the screen plus 220 on its IPO day, but crypto was just so perfect that the stretch from, I don't know, the spring of 2017 to the end of December was unlike anything I've ever seen behaviorally in my life.

And I think I once said, "If this doesn't break, then it goes against everything I hold true about human behavior and how markets work." And fortunately, it's somewhat broken, even though I think it's still up two X from when I said that. So behaviorally it's been wonderful to watch. Investing wise, through your efforts and others, I've actually tried to learn a bunch about the technology and I'm fascinated by it as anyone should. And one of the things they got me to do was I went and I bought a book called F'D Companies. And if any of you out there listening remember towards the end of the bubble, there was fuckedcompanies.com and it was a website essentially tracking just companies that were goofy ideas that died. And the guy wrote a book, God bless him to further monetize it.

So I bought this. If you look through the first 10 pages of F companies, probably seven of them have been reincarnated in new businesses now worth three plus billion dollars. So the ideas seemed dumb at the time and yes, they were fucked and they went to zero, but they weren't bad ideas in many senses. And so I did this because you talked about sort of adapting, I wanted to force myself to say, "Yes, 99% of ICO's right now are frauds and scams. It's morally repugnant to everything I believe in about markets and honesty and all that, but there's probably something here. There is something that will probably change the future indelibly and you should pay attention. Don't be the asshole in 2002 and 2003 saying, "This internet is never going to take off. Why would anyone use it? And by the way, all the winners have already been established."

So I'm open-minded on it. Bitcoin as a store of value clearly has a special use case. And I can see why people who used to like to own gold would like to own this. Ethereum and some of the newer building blocks, yeah, that I'm going to watch and learn about, because that seems where a lot of the action is. I know there's a lot of excitement around tokenizing securities, and I just think it's really early days, the world moves very fast there though. They're recreating the existing financial speed system at light speed, with all the pitfalls and parallels there. So I think it's worth watching. I don't believe I have a particular insight enough to go say, "Okay, Bitcoin 6,500. Now it's time." Could I see it at 50,000? 100%. could I see it at 1,000? Also 100%. And I do pretty well in my own investing, and so I'm going to stick to what I know.

Patrick: [01:36:19] This has been an awesome exploration of many different industries and ideas. My closing question for everybody is to ask what the kindest thing that anyone's ever done for you is?

Modest Proposal: [01:36:28] I think it's got to be on the personal side. There are people who've helped me professionally, but on the personal side, my parents divorced when I was about six months old. And so my mom had two kids under the age of four and we moved back, we moved 3000 miles across the country and she was a single mom, two kids, no job. And she started dating a guy who ultimately became my stepfather. And I always appreciated how incredibly generous and amazing he was to support us when we weren't his kids. And to take us on at that age when he was a grad student and didn't have full-time income yet. As I've gotten older and sort of experienced the responsibilities of having a family and having kids, I think it resonates even more that, "Wow, I don't know if when I was in my early thirties, I started dating a woman who had two kids, that is a big order." And for him to have done it and provide me and my siblings with the opportunity that we got, as much as I was appreciative at the time, I think in retrospect, it's just the magnitude of that is even greater where I say, "Wow, who knows where I'd be, but I probably wouldn't be here without that set of kindness.

Patrick: [01:37:44] Fantastic. So hopefully in a year when markets have evolved a little bit more, we'll get together and do this again. Thanks for all the time.

Edited by @babyxcar