Introduction

Patrick: [00:01:19] I really underestimated the impact that this podcast would have on my life. I owe a huge thank you to everyone listening, especially to those who have shared the ones they've enjoyed most with their friends. I haven't done a single thing to "market" this show. It has been a hundred percent organic word of mouth growth. So the large audience size is thanks to you all. I deeply appreciate it. But I appreciate even more, however, is that the show's success has pushed me to be more thoughtful about what admittedly remains an informal process of searching for the most interesting people I can find that will share lessons they've learned with me and with you. Were it not for the podcast, I would never have met most of the people you hear each week. Some of those guests have become dear friends, including the two in this week's episode, Ted Seides, and Brent Beshore. Ted and I flew out to St. Louis to spend a day with Brent. While we are all passionate about investing, we've had very different careers. Ted in alternatives, hedge funds, and fund to funds, Brent in lower middle-market private equity, and my own in quantitative equities. What we share is a passion for investing in general and a deep interest in where the asset management business and profession is going. This conversation starts like most episodes, somewhat structured exploration of the investing business, but moves to be a bit more fun and informal as we work our way through a bottle or two of wine. In the latter half, we talk about how to dissect an industry, common features of good businesses within a given industry, books we'd like to write, books we wish existed, and things we've learned in our careers. We spent a long time talking about Ted's famous bet with Warren Buffet, but I've removed most of that and saved the conversation for another time. You'll hear us reference it here and there, mostly giving Ted help, but rest assured we will the entire thing in more detail at a later date. I could spend all my free time having conversations like this one and die happy. Thank you again for listening and sharing because you're doing so has allowed me to find people like Brent, Ted, and many others, and lead to friendships that have quickly become an important part of my life. For show notes, visit investorfieldguide.com/brentandted.

On Hedge Fund Fees, Edge, and Competition

Patrick: [00:03:23] We begin in the middle of a conversation we are having on the future of hedge funds and the fees they charge clients. Please enjoy this conversation with Ted Seides and Brent Beshore.

Ted: [00:03:34] But there are structural headwinds that hedge funds have today that they didn't nine years ago. Most notably the level of interest rates, which imposes a cost to getting in business or really for the generation of returns and hedge funds that has nothing to do with the market. So with short term interest rates at one or 2%, you're earning nothing or negative on your cash. Whereas nine years ago, short-term rates at four or 5%, you were starting off up three or 4%. So there's a big cost at the beginning. The fee argument is a funny one because fees are certainly coming down for hedge funds today.

Patrick: [00:04:07] Where do you think they are? What's the spot market

Ted: [00:04:10] Spot market is probably still close to one-and-a-half and 20. I think that hedge funds are highly concentrated, they're still in the hands of the 200 large funds that are, call it north of a billion dollars, and that's roughly where that fee is. The incremental fee is a lot less. So a new fund starting out has to offer incentives to get in the business. And even in the last week, since the letter came out, there had been a wave of announcements of larger funds starting to cut their fees. But for the most part, you're at a downward trend starting at call at one-and-a-half and 20.

Patrick: [00:04:43] Where do you think that is? And Brent and Ted, and I have talked a lot about this in the next five, 10, look out as far as you want. One of the sentiments out there now is if you're any good at investing, you'll get rich pretty quick and you won't need to charge management fees. So the vast majority of all of the compensation when you're investing someone else's money should come from carrying above a hurdle or not but that seems to be a common sentiment. At the same time, you've got this issue of funding a business and without a management fee and a very competitive labor market for talented people and hedge funds, your advantages can get eroded pretty quickly without management fee income. So what do you think that transition's going to look like? We talked about this a little bit last time, but with Brent here too, it'd be fun to talk about the future of asset management and where we think we might be heading.

Ted: [00:05:33] Well, we know where the direction is. We know the direction is down in terms of calling it the fixed cost, the management fee. And often that gets offset either with a longer duration of capital or maybe even higher incentive fees over the inappropriate hurdle, less clear how we get there. Now, I think one of the things that have happened is if you go back 10 or 15 years in hedge funds and just think of it as a business, so it would get Brent in here quickly. You had a business with a high-profit margin and the hedge funds were making 15 or 20% markets were less efficient and the one-and-a-half percent management fee was dwarfed by the returns you were generating or whatever you're paying in dollars just dwarf by 10 of the total profit margin dollars of the business. But then as returns came in because markets got more competitive, it's gotten more and more clear that that fixed cost is just too high as a percentage of the returns. And so I don't think that's going away. What it means is that the $3 trillion, vast dollars that are already allocated to hedge funds don't require the high management fees they've had historically, but to your point, Patrick, that makes it really hard for a new entrant to get into business because they need something to fund their operations. So we know the direction, I'm not sure how it gets there and when.

Patrick: [00:06:48] Brent, from your seat where you've been doing it in a very different way in the private equity world, pretty much by yourself, outside this institutional asset management world. From the outside looking in, what seems right or absurd, what do you think the future is going to look like?

Brent: [00:07:02] I think it's interesting. I think the world is moving much more towards heads I win, tails I also lose, or at least that's where I hope moves towards in that direction. I think there's a lot of misaligned incentives. Whether it's been in venture capital or private equity, certainly in the hedge fund world where you have a relative out-performance, whether that can be tied directly to luck or to skill is part of the debate. But you end up getting into these heads I win, tails you lose. And I think hopefully those are going to evolve. I mean, I agree that Ted says is how you get there though. I mean, I think there's a lot of institutional inertia, I don't see a clear path either. Although you start seeing in the venture capital world, I wonder how much of that's going to mirror what's happening may be in the hedge fund world. You have the Andreessen Horowitz coming along and saying, "we're going to take all of our 2%, all of our management fee and apply it, instead of towards exorbitant salaries and towards enriching the partners of the founders, we're going to spend virtually all of that and arguably even more than that on servicing the businesses that we're moving towards." And I wonder if, in the hedge fund world, I don't know if it's a direct corollary, because I don't know if, you don't need to add layers of complexities we joked about. There are some hedge funds out there that just have hundreds of PhDs sitting on the sidelines for basically window dressing. I certainly hope we don't get into the world where it's mostly just window dressing, but that somehow the fees that are taken upfront on the management of the actual assets are going truly towards that and not towards the enrichment. That's not where you should make your money basically.

Patrick: [00:08:37] Yeah. It's a complicated problem, and I find it especially interesting in the private equity world too, where arguably what you do imagine you had some pot of money on those factual management fees that the return you could earn and then pass on to your investors by deploying that management fee income could be huge. But it has developed such a pejorative negative connotation in the minds of investors everywhere that a higher management fee, just in a linear fashion is worse and worse for investors.

Brent: [00:09:08] Yeah. I think that you get into this weird dichotomy between being truly an investor and being more of a capital deployer. And I think that the higher the management fee is, and the more of heads I win, tails you lose structure that you set up, the more natural tendency you'll have towards capital deployment, capital gathering, and capital deployment. And so I think everyone is trying to go... Well, everyone who, unless you can get into that game is trying to get away from that. I think that everybody who is a capital provider is wanting to put their money with investors and not capital deployers. I wonder how much of that language has been changing over time. I mean, there was a period of time where I just kept hearing over and over again, "No, you're buying a vintage of the fund. That's what you're doing." Well, that's just capital deployment. If you're just buying a vintage, then basically what you're saying is yeah, we're going to get you into what everyone else is getting into, and let's cross our fingers and hope it turns out well. I mean, I don't know how much you should make it, that's your job. I mean, I think there should be in the future, hopefully, a premium put on true investors. People that are generating, and that are real alpha as opposed to the winds and the luxe, the way the luck bounces over time. So I don't know. I wonder how those things are going to evolve.

Patrick: [00:10:19] One of the weird things is how fees tend to be in roughly the same ballpark, whether you're talking long-only where it's a percent that's coming down. The weight of the average is probably 70 bips or something like that, or in hedge funds where it's one other half and 20 for enormously dispersed outcomes. And the most talented guys, it's like in basketball like LeBron James could probably justifiably get paid $100 million a year by the Cavs, he's worth that much. Just like Renaissance Technologies or some of the outlandish results that have been delivered by hedge funds should be a lot, probably even higher fees than they charge. But you get this level playing field, and the net result is you have to have the aggregate underperformed, the S&P 500 in the long-only space. It's just math over 10 years and you effectively have this enormous tax on the world's assets for those that are deploying the capital on their behalf. Even if they lose, they're still charging 1% along the way. So there's this... I don't have a solution, I'm just fascinated by the problem as someone that believes in active management, believes in skill, believes that it's extremely hard to identify that skill ahead of time. I don't know what to do other than obviously eat my own cooking with quantitative type investing. But it's a huge problem and I don't know, I would not want to be in the seat of a big capital allocator with the career risk being don't overpay for active management because you're not only losing upfront than you're losing in the longterm. But now you've got to think about a 30 times multiple, what are the key variables that allocators should be looking at when evaluating an alternative option, whether it's a bucket they're filling up or they feel that the equity markets are just too expensive?

Ted: [00:12:00] The question is what are the underlying fundamentals of return that you get? Let's call it a long-short equity hedge fund. On the long side, we understand a bunch of stocks. What's been interesting is that even in this period of time of strength of the S&P, a number of long-short equity hedge funds have created long-only products out of their long book. And with great consistency, they have been very successful and outperform the S&P. So it's not the long side that's been hurting the hedge funds, it's been the short side. In this environment, shorting has been incredibly difficult. Part of that is what I mentioned before with low-interest rates, there's just a cost of doing the business. The other part of it is that shorting is a lot more crowded than it was nine years ago, and the volatility of single name shorting has made it incredibly hard for someone who has a thesis that a stock trading at 20 is ultimately worth 12 to not watch it go to 25 or 31st and have to cut the position because of risk limits, and then actually not be able to make the return. So it's just been really hard for people to make money on the short side, and that's going to be something to watch. I don't think that's going away anytime soon in the US. What allocators should be looking for is where there are pockets of opportunity where they still see inefficiency. What I found over this period of time is that managers participating in the Asian markets, that are fundamentally good investors like to buy good businesses, relatively cheap, short, expensive businesses that they don't like. That still worked. Asian long, short managers have delivered terrific alpha over this period. There are certain sectors in the US that are less trafficked generally by hedge funds. You could look at the data but I would define where hedge funds traffic generally is consumer stocks, financials, TMT technology, media telecom, and some in healthcare. But there are other places where it can still be interesting for hedge funds.

Patrick: [00:13:51] That's interesting. What's the story there? Is there any particular reason other than just maybe like a snowball effect, that that was what some big names covered early? Why are there certain sectors that are more traffic than others?

Ted: [00:14:02] I'm not sure I know the answer. I think that some of it probably can be described as where there're perceived winners and losers. The technology sector is the most notable example. Product cycles are so fast that in theory, you can pick winners and losers. I think healthcare and biotech in particular, similar, a lot of big winners, a lot of big losers. Consumer stocks, it feels like everyone thinks they know something about retailers. Everyone can go to stores, they shop somewhere, they have a wife that shops somewhere and therefore-

Patrick: [00:14:29] The old Peter Lynch approach, right?

Ted: [00:14:30] The old Peter Lynch approach. But there are other sectors that, think of, for some reason, consumer staples just tend not to be trafficked by hedge funds. Utilities, certainly not. Real estate stocks, not so much. And every now and then you find someone who's really an expert in those spaces and they've continued to perform quite well. So those are the pockets where I think even net of quite high fees, skilled hedge funds can continue to deliver.

Brent: [00:14:57] Ted, we covered this a little bit earlier, but is it possible to pick the best pickers over time? I mean, we talked a little bit about a selection bias issue going on there. I think that's an interesting observation.

Ted: [00:15:09] I think it's possible, and it's certainly possible to select the better ones from the weaker ones, but it's harder. And it's harder in part because the process for allocating capital to managers is more efficient. There are more smart allocators today than there were 10 or 15 years ago, and they tend to find the perceived talent, so the star number two or three guys from a big hedge fund that spins off and goes on his own. There are a lot of people that are interested in investing with them. And as a result of that, the perceived talent attracts capital quickly and gets to a size where they don't really have the advantage of being smaller than they might have. So it is doable. Again, I think it's more doable if you try to find the major league player playing in a little league or a minor league market that's less efficient. But you look, I am less confident in my own ability and the ability of others than I was eight or nine years ago and I made that clear. And I certainly think that my old shop probably did a better job picking managers than we did picking selectors of managers.

Brent: [00:16:21] How much was the size a factor when you were picking? I mean, I think there's a pretty well-known trend that as good pickers get larger in their asset volume, their performance tends to decrease, correct? In general.

Ted: [00:16:33] In theory-

Brent: [00:16:34] In theory.

Ted: [00:16:34] ... I'm not sure that's played out in practice.

Brent: [00:16:36] Really?

Ted: [00:16:37] Yeah.

Brent: [00:16:37] Okay. So you're not sure that that's actually provable in the markets and that's something you didn't obviously observe directly then.

Ted: [00:16:42] Yeah. I didn't. You see academic studies that consistently show small managers do better than large managers, and you really don't see any academic studies that show that large managers do better than small managers. But if you actually look at the studies, they usually define small as less than $50 million in assets, and that's not an investible universe. What's happened over the last bunch of years, is that the large managers by and large as a group have performed as well as a group of small managers, and they're certainly more comfortable for the marginal allocator to invest with so they've attracted more and more money. But unfortunately, it hasn't been the case. The group of small managers has at least meaningfully outperformed the group of large managers. Now you can ask why. One of the big cases I would make is that the advantage of a small manager is having a broader investible universe, which means they can participate more meaningfully in small mid-cap stocks. Well, in this period of time, when the S&P has been as strong as anything, that hasn't been an advantage. If anything, it's been a marginal disadvantage. So it's hard to know if it's because the small manager is less skilled or just their broader playing field hasn't really rewarded them for the opportunity set.

Patrick: [00:17:56] It would certainly seem, we look at a lot of this data that, that effect of... The simplest way to think about it is, take the Russell 1000 or the Russell 3000, whatever your broad benchmark is. Take the cap-weighted return minus the equal-weighted return. That dominance of cap-weighted results in this cycle has overwhelmed any sort of skill that's happening in the small to mid-cap space because the numbers have been staggering. Like 2015 was an especially crazy year when all the returns of the S&P 500 came from a small handful of stocks. And if you missed that on the stocks, you underperformed. It was terrible... I think it was literally the worst year since '89 for active managers broadly speaking. Something like 11% outperformed the benchmark. And cap-weighted minus equal-weighted is usually a pretty good proxy for active versus passive management. If we think about again, the future of edge, and this is a question I've started asking investors that I'm meeting with is, "Okay, what's your edge? Because this is what everyone asks. Why is it there? Is it structural? Is it sustainable? Is it persistent? Why won't it be competed away?" And there's the old trichotomy of analytical, behavioral informational, and you were telling us a really interesting story earlier about the informational edge that I'd love for you to share with us about how crazy it was 20, 30 years ago, and how much the fight for information has changed.

Ted: [00:19:18] Yeah. Well, I talked about the challenges of shorting right now, and that story was one about the Feshbach brothers, who were three brothers that were well-known short sellers in the '80s. They were colorful Scientologists. There was a whole bunch of noise about Matt Feshbach. One of the three brothers happens to be a good friend of mine, and they compounded a short-only fund in the '20s for about 10 years in the '80s when equity markets were up 15 or 20% a year. So the question is, how did they do that? And again, they were known for fraud busting, and they definitely had a couple of stocks they found that went to zeros. But when you talk to them, their hit rate on making money on shorting was extremely high. I don't know if it was 70, 80, 90% at times. The reason was that unlike today's market where getting an edge probably means something about thinking differently or processing information differently. In the '80s, it was all about acquiring information. And what the Feshbach's, one of their great tools was they would hire college interns and recent graduates, put them in Washington and their job would be to go to the library of Congress, look up the recently reported 10Qs, pick up a phone, go to the phone book, put dimes in the machine, which doesn't exist anymore, call the office, they were down in Clearwater, Florida and tell them what the report said. What would happen was back then, the reports would get sent to the fidelity portfolio manager would wait a week, get the 10Qs in the mail, and when he read it, the stocks would react. So the Feshbachs were a week ahead of everybody else just by hustling and realizing if you go to the library of Congress, you can see the information before other people could. So there were all kinds of things when people were forward-thinking, intelligent, motivated that hedge funds were able to do 15 or 20 years ago, 20, 25 years ago, that there are just so many smart people looking for those edges today. It's probably shifting towards computers.

Patrick: [00:21:22] Yeah. It reminds me of the location of high-frequency trading cables or computers closer and closer to the exchange using satellite photos that are used. I mean, everyone uses the examples of Walmart satellite, parking lot satellite photos, or credit card data for consumer companies, things like that. But I think because now we're looking back and laughing about that, and you could look back to something like Ben Graham and Northern Pipeline, where Ben Graham figured out that there was this wealth of data that Northern Pipeline reported to the ICC that nobody knew about. And he figured out that they had its stocks trading at 50 or whatever, and it's got 60 bucks of cash on its balance sheet that nobody even knows about. And so he has this aha moment and becomes an early activist to get this money, to unlock this shareholder value so to speak, we talked about this with Jeff Graham on the very first episode of this podcast. We look back at these what seem like quaint examples, but I'm sure in 20 years we'll look back today and there will be what seemed like quaint examples.

Brent: [00:22:20] Well, that's my question. Where are the quaint examples going to be from 20 years from now?

Patrick: [00:22:24] I think that that's what everyone, especially in the hedge fund community is trying to figure out. So if there are signals that have an alpha in them and they have a half-life, let's assume everything is got some sort of half, maybe not, maybe value investing will work forever some way shape, or form, but maybe the excess returns are diminished. That's the big question is one, what has like a half-life that's worth pursuing that's not a one-year signal that's going to work and then everyone will know about it and it'll go away. What's got a three to five-year half-life or something like that. And maybe that's the Walmart, although everyone's been talking about these Walmart parking lots for the last three years. So I bet that advantage has already gone, but I don't know.

Brent: [00:23:01] Yeah. I think social sentiment, social media sentiment is kind of an interesting area that I know there have been a lot of startups in that area. I think a lot of them have bombed out and not proven to be... Well, has proven to be more noise than signal, but that does seem to be an area. I also wonder how the change in how many companies are public makes a difference as well. I mean, you guys are more the experts than I am, but that the universe of publicly traded companies seems to be diminishing. And so, as that happens, do you continue to slice the pie thinner and thinner and thinner? I don't know. I don't know how that's going to play out. It'll be interesting to see. I wonder, with the SEC rule changes how these sort of almost semi-public companies, how those will evolve into a completely different class of companies. I mean, I think you can raise $50 million of capital and be kind of like semi-public right now without making many of the disclosures. I wonder how that's going to create almost an entirely different stock exchange. I don't know if either of you guys.

Patrick: [00:23:57] Well, I think it raises broader questions of the future of the corporation in general and these kinds of economies of scale in the industrial world. We've talked about this as well on past episodes, in particular with Alex Moazed, on kind of the platform business model. We've talked a lot about asset-light businesses, the power of outsourcing, the need for, or less of a need for big scaled organizations that you can effectively run with a pretty small group of people, a really neat business, and outsource the rest. If you can do that, maybe there will continue to be fewer and fewer public corporations that all these signals are based on. All the data, all the research that we're talking about is just a 50-year chunk of time. In the history of the corporation, it's changed a lot. And we've seen dramatic changes since 2000 thanks to kind of the availability of data, the internet, connectivity, the platform business model.

Brent: [00:24:52] Availability of capital with private markets. I mean, look at it Uber.

Patrick: [00:24:54] Totally.

Brent: [00:24:55] It's crazy.

Patrick: [00:24:55] Yeah. I mean, yeah. If you can have a business at that scale go that long without going public, what's the point?

Brent: [00:25:01] It almost seems like a different type of company that's now raising in the private markets at a huge scale that has a very different business model. It's sort of the high burn public companies are seeming semi-private now. I mean, they're still getting money from the fidelities and those types of people. I mean, they're just not technically publicly traded.

Industry Dynamics and Investment Decisions

Patrick: [00:25:20] Yeah. I think that for prospective returns, thinking back again to what allocators should be thinking about, that the price component, unfortunately, has really run away from us. And that's great when low-fee instruments deliver really strong returns, 14% returns, you said for now quite a while. And now you've got a batch of somewhat seasoned investment people who have seen nothing but... I barely saw in my career. I started right before the crash so that was my first experience. But since then, it's been kind of hunky-dory. It's been fairly straightforward in a straight line and to the right. We get conditioned on these sorts of returns. Unfortunately, with those returns come outlandish prices. And so, the question I'm asking everybody is how to think about valuation. At some point, 30 times multiple, the earnings yield on that is so paltry relative to inflation that the associated risk just becomes too much to bear. And so, it seems to me like the most important thing is to think about value today. I'm extremely biased because I'm sort of a value guy at heart and that's what the data suggests you should be. But that's why I've spent so much time with Brent, with others that you'll hear in upcoming episodes about private markets. I know there's a lot of hair there, but at least there, you can see businesses trading at more responsible multiples. Maybe we could talk a bit more about that. What we haven't done in past episodes is really explore particular industries. It would be fun, Brent, for you to maybe pick one or two that you've got a lot of experience with, that you've seen what works and what doesn't across the 1,000, 2,000 businesses or so you see a year to flesh out kind of how you think about industry dynamics when making an investment decision.

Brent: [00:27:07] I think the industry is interesting in the sense that most of the moat in any of these small businesses are going to be tied up with the owner. That's the first thing you got to remember with any small businesses. So from an industry perspective, most of the small businesses have sort of an average return on the owner's time. Now, there's always going to be pluses and minuses and easier industries and harder industries. I would say that it's almost like a sexy spectrum. The more boring, typically the higher the average returns in an industry, the more sort of naturally attractive the industry is the more the returns on average are going to be driven down. And so, you see a lot of this. The wine business is a terrible business. The film business is a terrible business. The restaurant industry on an individual basis is a terrible business because you can go and interact with any of those products and think, "Oh, wow, this is a great business to be in. I think I'm going to quit my job doing whatever and go work in that." No one has their roof replaced on their home and looks at some guy nailing shingles to your roof and says, "I really hope I get to replace that guy someday." I mean, it just doesn't happen. We're sitting here laughing, but those are the fundamentals that drive a lot of human behaviors, just what looks attractive, and what do you stumble into.

So from an industry perspective, most of the small businesses have sort of an average return on the owner's time. Now, there's always going to be pluses and minuses and easier industries and harder industries. I would say that it's almost like a sexy spectrum. The more boring, typically the higher the average returns in an industry, the more sort of naturally attractive the industry is the more the returns on average are going to be driven down.

From an industry basis, I mean, I think naturally from a value standpoint, there's definitely an incentive to get involved in less sexy industries. Now, when you get down into sort of the individual industry, regardless of whatever it is, you're going to find a really interesting chain of value where the most obvious places to participate are typically the lowest return. And then, you've got a whole bunch of providers around that obvious place that typically have higher returns. So if you talk about the real estate industry, what's the obvious thing in the real estate industry? Will be a realtor. Well, the real money in the real estate industry is not in being a realtor. It's selling stuff to realtors. I mean, that's kind of the joke that that exists. The same thing, even if you take an industry like the wine business, which I said is typically a terrible business, there are plenty of people in the business or in and around wine that make a tremendous amount of money and have extremely successful companies. One of the companies in my backyard that's an incredibly successful company supplies barrels. Missouri Oak Worldwide, it's an enormous business. And it's so under the radar, but do you want to necessarily be in the whiskey business or the wine business? Those are the obvious places. The places you make the money are in the barrels or the steel rings that hold the barrels together, or whatever the thing maybe. Or even hacking in the wine transportation business. We've actually seen a couple of businesses that could specialize in transportation. So I think that the more non-obvious the role is in the industry, the more protected it's naturally going to be.

Patrick: [00:30:02] It's a good point, which is that it's less about searching for particular industries that have favorable economics or investment opportunities, but probably every industry, even the glamour ones have subcomponents, component parts, business to business type businesses, which nobody has any idea exist. Probably never even think about when buying the bottle of whiskey or the bottle of wine, but which have the most favorable economics.

Brent: [00:30:25] Yeah, absolutely. And I think that it goes increasingly now into the software side. I mean, there's a lot of amazing software businesses that are built on helping very boring operators, like the pest control business. Well, there are software providers that all they do is specialize in helping pest control local dude in a truck, make his business more successful. I think that's the trick is to find those niches that are helping support the economy without being necessarily the thing that's obvious to get into.

Patrick: [00:30:57] Can you talk a bit about the newspaper world and the media world as an example of something that's a bit counterintuitive or at least it's starting to run contrary to the popular narrative that newspaper is a terrible business model and dead. Everything's going digital, but maybe there's some data that suggests the opposite.

Brent: [00:31:16] Yeah. Well, I know what you're talking about because I sent you an interesting study on this topic. The newspaper business, I think, is following the same arc that a number of other industries do, which is you have people shouting about disruption. You have some real disruption actually, obviously going on first being Craigslist really taking down the classified section, which was a huge area source of revenue and profits for newspapers that sort of artificially propped up the editorial side and maybe helped take the pressure off the ad side. The bottom line when it comes to media of any sort is it's all about attention. There's a lot of vanity metrics around views or likes, anything that you can come up with to show some sort of interaction. Those can be easily faked. At the end of the day, all that matters is can you affect a consumer's behavior reliably and consistently in a certain direction? That's it. And that's all about attention. And so, what you have in this interesting, the economics of the sort of digital divide versus the print divide, and you take newspapers for instances.

Most of the value, if you look at that's being driven is still being driven through print. Even though digital is growing faster, a large argument to be made digital is growing faster because the emphasis is on digital. It's obvious that you need to be digital. Of course, every consultant, every talking head is, oh my gosh, look at that media group. They got to digital late. They're screwed. They're way behind. Well actually, if you look at who is doing the best, there are some huge outliers that are print only still or the vast majority of their revenue is print only. And so, I think you get into these interesting dynamics where you have these very counter-intuitive trends that occur where everyone's shouting in one direction. And the reality is if you can afford to sort of stay the course and sweat it out a little bit and go against the grain, I think there's still real dollars to be made in the media business.

Patrick: [00:33:13] It seems like change and the pace of change is a useful variable in any investment decision. That thing that changes faster, faster product cycles for companies, industries that are changing faster, it's just harder to get it right. And that luck becomes a bigger determinant of the outcomes. Ted, do you think there's anything from the allocator's perspective, again, that kind of follows up on that theme? Are there tried and true old strategies that maybe will come back into form away from kind of the proliferation of every million different hedge fund strategies to just old-world strategies that seem to work that in the next cycle, especially if the market's due for low returns might have better returns?

Ted: [00:33:56] Oh, I think there's one big one which has to do with duration. Everything we've talked about with hedge funds and quantitative investing has to do with the increase in turnover. So whether it's manager turnover for an allocator, stock turnover for investors, certain hedge funds, higher turnover than traditional long-only managers. The whole system has gotten set up to have shorter and shorter attention spans. The companies with quarterly results and then managers trading on that, and then investors looking at shorter-term track records and certainly in hedge funds where benchmarking is more difficult than it is in traditional long-only. So if there's one opportunity set in that, it's for those few investors who have the wherewithal, the right capital behind them to just be able to look out a few years. I've seen that a number of times, whether it's hedge funds or traditional long-only managers, but managers that have a longer duration capital structure feel like they have a big advantage in looking at particular security or situation where say, there's an event that they think can play out with great certainty over two years. They just don't know when and the result of that, the security trades quite a bit cheaper than something else that has a merger with a defined date that's very crowded.

Reflections on Long Duration Capital and Changing Long-held Beliefs

Patrick: [00:35:12] On this duration idea, I'd love to hear from both angles. Let's say I'm an investor looking for a capital allocator or a capital allocator looking for an investor. What are the setups that would be conducive to a true long duration? I've started to hear from some very interesting allocators that try to do really cutting-edge, interesting work that they've got some guy in a room that just reads all day in Switzerland and picks six stocks. He's got no overhead. He just cares about the selection and nobody knows who he is. And that's the kind of guy that they want because the incentives are aligned and he's got a long duration. But of course, there are enormous risks associated with something like that. There's no institutionalization, there's no succession. There's nothing. What might be some markers of an allocator or an investor that doesn't just pay lip service to a long duration, but can actually execute on it?

Ted: [00:36:07] Patrick, you and I both know this from being in the asset management business that it's a very rare organization that has the wherewithal to see through cycles, because even if they have the ability to do it, their clients may not. So that's a very hard sort of downward spiral to break. One great example is in private equity. Today, private equity is the buzz. Private equity firms have done really well. Valuations may be higher, but that doesn't change the fact that they've done well. One of the reasons they've done well is that allocators take themselves out of the way. They give someone money. They say, "Here, go invest this over four or five years. And hopefully, we'll see a nice return in seven or eight years." That gives the absence of a mark to market, the absence of scrutiny, the absence of pressure to generate returns in the short term is a huge advantage. It's harder to do that in the public markets, but you do see certain organizations, they tend to be smaller, they tend not to be the big brand name firms that have decided they recognize the challenge in attracting that type of capital. And they recognize the challenge in knowing it's a more limited prospect universe of potential allocators that will withstand volatility, and they nevertheless set up their businesses so that they'll only be interested in attracting that type of capital. They may have a long-term lockup is the easiest example of hedge fund land. There are a few funds that'll just say, "Look, I'm only taking three-year money." That dramatically shrinks the potential size of their business, but they believe that will allow them to generate higher returns. And if in fact, they do, then they'll have a more stable business over time.

Patrick: [00:37:51] Brent, from the perspective of somebody as an investor yourself, who at some point might take outside money, what would be the most important features of a partner that you were looking for if you were deploying somebody else's capital?

Brent: [00:38:05] Yeah, I would say that long-duration obviously is, is incredibly important. Well, especially in the area that we get into, it's so hard to get into the deal. I mean, I think that's the thing that's under-appreciated. When you get into a great deal, the fact that you have to get out of it so quickly. I mean, even private equity, you talk about long lockups. And that seems short to me. The fact that it's just so funny, the language is the same, but the duration is completely different. I mean, I think about getting into a business and thinking I'm going to exit out of it in three or four years. I mean, which is sort of a normal cycle. There are so many decisions that you should be making. Well, I shouldn't say should. It depends on your time horizon. You could be making that would help the business in five or 10 years that are materially different decisions than you would make if you're planning on selling it in three or four. If you're planning on holding it in perpetuity, assuming the business continues to perform well and you have great relationships and all of that, it just seems like pure insanity to put some sort of artificial marker at the end. I would say duration definitely key. The second thing is sort of a counterintuitive application of aggressiveness is how I would describe it. I think something that would be very attractive for us is being with us in the good times or the up times. And I would say now is a good time to buy a business. It's a good time to sell a business. It' sort of not weighted one direction or the other. I think it's all situation-dependent right now. The next downturn is where we discussed earlier. It's going to feel like the mosquito at the nudist colony. It was just time to go nuts and counterintuitively, most capital providers shrink back and try to sit on the sidelines and everyone claims to... What is it? When blood is in the streets, you go and buy. No one does that. No one actually does that I don't think, or very few. Regardless of we take outside capital or not, we want to be in a position that we have the capital and the guts to go out and be able to buy when others are selling and need to sell for very good reasons. Health issues, you can't time out. Marital issues, you can't time out. None of us get out of this life alive. Things happen. And we want to be in a position when there are fewer buyers out there, that we are the buyer of choice always, but especially in those times. So I think that's an incredibly attractive thing as well.

Patrick: [00:40:23] Totally switching gears, just to have some fun for a few minutes, what do you think each of you guys have changed the most on? We talked a little bit about this last time, Brent. In the last, say two or three years, in terms of some long-held belief about investing or the world or how you conduct yourself that's very different. Brent, last time you said just kind of being more understanding of people from their perspective, putting yourself in their shoes is a popular one. So maybe I'll ping you for another one. But something that, as we're all trying to listening to stuff like this, and I listen to a ton of podcasts. I read everything and get my hands on it. I talk to as many people as I can. I look at as much data as I can wanting to learn. What are some of the long-held beliefs that you've shed in the last couple of years, or even more recently than that, that surprised you?

Brent: [00:41:12] I think that I have a newfound appreciation for how hard everyone's job is. Everyone thinks their own job's hard. And then you sort of look around and you see the highlight reel of everyone else and you say, "Oh, well, my job's hard, but surely his is easy or a heck of a lot easier than mine." It's interesting because when you fly at 30,000 feet, which is basically what you're doing when you look at other people's lives or other people's jobs, in particular, I think it's really easy to get yourself in this weird situation where the grass always looks like it's greener for everyone else. And the interesting part is we've dived into all of these companies over the years. We've gotten to interview hundreds and hundreds of executives in lots of different industries. I've gotten to work with a lot of different people. Everything is hard, and that may sound like an obvious or kind of like, well, no kidding, but I think it's highly under-appreciated. Anytime anything appears easy it's because you either don't have enough information or you got lucky. I think that's really been a driver for me of balancing my opportunity costs and understanding that most of the value that accrues in any situation is sort of powering through the dip that inevitably occurs when the newness of something wears off and you get into the weeds and you start grinding on something and you realize, wow, this is a heck of a lot harder, a heck of a lot more complicated. The dynamics are completely different than I had expected. You sort of realizing that what it feels like you should do is reverse course, turn around and go down a different path. And as I've done that in my career, every time I've reversed course and gone down another path, I've gotten to the exact same position where I'm like, "Oh, now this is hard. Well, I had no idea. Well, now I want to go back and do the other thing because I've now forgotten how hard that thing was. Why did I come down this path in the first place again?? So I'd say that's kind of the biggest realization I've had as well.

Anytime anything appears easy it's because you either don't have enough information or you got lucky. I think that's really been a driver for me of balancing my opportunity costs and understanding that most of the value that accrues in any situation is sort of powering through the dip that inevitably occurs when the newness of something wears off and you get into the weeds and you start grinding on something

Ted: [00:43:12] It's definitely in the last two years that I was introduced to Don Miguel Ruiz's The Four Agreements. The one that resonated most is the concept of not making assumptions. The number of times I've seen someone struggling with something in a business, personally, whatever it was that was based on an assumption that they knew something was about to happen or they'd get themself into a tizzy because someone was sick and that meant that this was going to happen and how difficult it was going to be. And just taking in that we actually don't know what's going to happen. That has so much applicability for business, for investing, and for life. It came to me in the last couple of years as a friend of mine who introduced me to his work. Every day, I wake up trying to question what assumptions I have and realizing that I don't know half as much as I thought I did.

Patrick: [00:44:10] Yeah, that's an awesome one. Mine would be this idea that there's sort of a mountain to climb, a learning curve, or an effort curve or something like that, where doing something interesting early on is incredibly hard and can take years. But then there's this strange inflection point past which sort of getting over the mountain, so to speak, that all of a sudden it completely reverses course. What was very hard all of a sudden you get past some tipping point and become much easier? Isn't necessarily easy, but all of a sudden the outbound effort gets compensated for with inbound help. The only way to make that rule of the universe work for you is to figure out something that you really love doing and just do it without any expectation, kind of like an assumption, but expectation maybe is the better word, without any expectation of anything coming back to you ever. Something that if you just did it the rest of your life and never saw a penny or thanks or anything from it, you would still enjoy doing, that's been the most powerful use of time outside of your day-to-day job. That is impossible to understand because I'm just beginning to understand and kind of feel it. It's impossible to understand unless you actually do it. One of the questions I've been asking people is, and it kind of runs counter to Brent's answer, but what are things that actually feel almost easy or effortless to you that look like really hard work from the outside? Because that's a great way of honing in on what you might want to do with your life and Brent, the first time said he tap dances to work, which I think is true. It just doesn't mean it's easy. Enjoyable doesn't have to be easy. But I think that that's an incredibly powerful way to use some of your free time.

Brent: [00:46:10] I actually would agree with you. To be honest, there are certain things that I can do that seemed like no-brainers, to me, that seemed to be extremely challenging, much more challenging for everyone else. My argument would be that still doesn't make them easy. And there's still a huge amount of room to grow in them. It's almost like on a curve, your sort of talent can take you so far, and then hard work's got to take you the rest of the way. And I think that talent maybe is the boost that gets you further, faster than everyone else, but ultimately it's all still difficult. And I think that expectation of you may be able to do it faster or more intuitively than everyone else, or than most people still don't make it easy.

Exploring Ideas for Books

Patrick: [00:46:50] So Ted's written a book. Brent has probably written the equivalent of a book.

Brent: [00:46:53] Is not writing a book.

Patrick: [00:46:57] If you were forced to write a second book, Ted and Brent, and you had to write a 300-page book, what would you write about.

Ted: [00:47:04] If I was forced to write a... At this point in time, I think I would write a book about transitions. I've gone through a lot in the last couple of years, personally and professionally and transitions, and have learned a lot from it and I've found that I seem to like what you're saying Patrick, people seem to come to me now that are in certain changes in their life. And I feel like I can help them, and that's just a really fun place to be having gone through some stuff. I'm not going to write that book, but having gone through the process of writing one. But that's sort of where I'm at today and the piece of information I think I've acquired that feels like it's most helpful to others.

Patrick: [00:47:44] So what are the one or two subtitles to that book? What are the big categorical useful, replicate-able, is that a word? Lessons for dealing with transitions effectively?

Ted: [00:47:57] Nothing's coming to me right now.

Brent: [00:47:59] "How to lose to Warren Buffet and still wake up and look at yourself in the mirror", or is that not too soon? Is that too soon?

Ted: [00:48:06] I've ripped the mirrors out of my house. I think, one is a concept I heard of from the Headspace app that we didn't talk about sort of the last time, which is that if you have a day where it just feels like it's cloudy inside your head, you have to remember that there's always a blue sky above that. So you might not be able to see it at that point in time, and you might not be able to see it for a while, but it's there. It's always there. And that's a big one when people are going through tough times.

And the other for me is the importance of both reaching out for help and getting outside of yourself. So, when anyone's going through a tough period, they tend to stew in their own challenges. And one of the tools I've found that is helpful is in that moment to think, who can you reach out to and call that might need your help? And just get yourself outside of yourself, realize that this is really all about being a value to other people.

When anyone's going through a tough period, they tend to stew in their own challenges. And one of the tools I've found that is helpful is in that moment to think, who can you reach out to and call that might need your help? And just get yourself outside of yourself, realize that this is really all about being a value to other people.

Patrick: [00:49:03] What's your book, Brent?

Brent: [00:49:04] What's my book? I think there are some interesting lessons around why big businesses get big and why small businesses stay small. And so, it'd probably be something around the hygiene that you need to have in sort of every major area of a company needs to have the equivalent of the floors cleaned and the toilet paper replaced and have your teeth brushed. And it seems mundane and sort of not very impactful and it's not unless you don't do it. And I think, that a lot of businesses stay small because they're not willing to do the basics, and sort of, they try to fly past them and take shortcuts. And so, I would probably say that that would be the path that I think there's a lot of value to be had there. And there's a lot of self-help business books out there, right? And they all talk about these theoretical strategies around what you need to do and how you need to do it? And I think that so much of it is just the basics of where is cash coming from? Where is cash going? What is consuming cash? What is consuming cash poorly? And just making kind of cleaning everything up. Unfortunately, I see so many businesses that we examined that are unsaleable, because they just have such bad habits deeply ingrained in them.

Patrick: [00:50:29] We jokingly call this hygiene alpha earlier.

Brent: [00:50:31] Hygiene alpha.

Patrick: [00:50:31] Which I think is a term that I've now coined.

Brent: [00:50:37] But it's like building to scale.

Patrick: [00:50:38] Yeah. It's a powerful concept. There's that really hokey titled book, How to Double Your Profits in Six Months or Less? I think the author's name is Bob Fifer.

Brent: [00:50:48] Don't Get Divorced.

Patrick: [00:50:49] Yeah, don't get divorced is a good one.

Ted: [00:50:51] Half of your assets.

Brent: [00:50:53] Oh, I'm sorry, sorry.

Patrick: [00:50:56] And apparently it is, one of the handbooks that Brazilian private equity firm 3G, hands out to its managers. And it really is about hygiene. And if you're interested in this idea of hygiene, business hygiene. It's probably the best book or the only book that I've come across that's anything close to that. And the simplest expression of the idea is that you should maximize strategic costs, which is defined as anything that might contribute to growth to revenue, earnings growth. You should want to outspend all of your competition in those areas and that you should cut every other non-strategic cost to the absolute bone. And if you can do those two things, some of which is vicious and what was your term last time that synergies are firing someone and losing less than their salary? So, it can be kind of cold and ambitious, but it is a little interesting heuristic for thinking about how to use that idea of hygiene to get a better business.

Brent: [00:51:56] Well, I think it's actually on the upside of that. So, most people focus on the downside, the synergy, the cost-cutting, all of that. I think on the upside, it's extremely spot on. A lot of people don't realize about, for instance, advertising dollars, is you want to spend until the marginal utility of that advertising dollar is virtually zero, because Uncle Sam is paying for half your advertising dollars by the deductibility of it. And you're able to build a moat around the business, through outspending, out-marketing, using different channels. And that's something that's just not widely appreciated, especially in small businesses. And this is, I would call this a layer above hygiene, but it's pretty close. I mean, big businesses understand that there's a reason why GEICO, for instance, under Warren Buffet has exploded their advertising dollars. I mean, absolutely exploded them. It's not because he's an idiot, it's because it works. And so, when you find something that works, you want to maximize the use of that tool to its fullest extent. And I think that's the exact opposite of how for instance, most business owners think about it. They think about it as like, "Okay, what is the minimum amount I can spend? Because every dollar spent on advertising is coming straight from my bottom line."

And in essence, that's the weird counterintuitive nature of a lot of these investments that people don't understand that you're actually harming the business and you're not maximizing the value of the business by not spending the dollars. Now, you have to have good metrics and you have to have a good strategy around it and you have to have talented people that are working with you on it and that's a whole separate discussion that we could have about the survivorship bias and selection bias of service providers to small business, which I think is a huge problem that goes sort of unaddressed in the nature of if you have $100,000 ad spend. The only people that you can hire to spend that $100,000 on your behalf. Probably aren't qualified to spend the $100,000. And so, there's this weird chicken and the egg issue that goes on. I think that's where a lot of these small businesses stay small.

Patrick: [00:53:52] I'm going to invert the book question and instead ask if you could somehow produce out of thin air, a book of extremely high quality on any given topic, where you haven't found that book yet, what topic would that book be on?

Brent: [00:54:08] I would say that the book that I'm most interested in, I still feel like hasn't been written is all around incentives and businesses. So there's been a lot of behavioral psychology books written, Daniel Pink, synthesize a lot of really good literature in his book Drive, which I think holds considerable merit in some instances. And we found unfortunately, it doesn't hold as much merit in other instances, and that's no fault Daniel Pink at all. In fact, I greatly appreciate his contribution. I would love to see just how different managers, different situations are incentivized that are working out well. One of my mentors and somebody I really respect, Peter Kaufman, who runs Glenair out in LA, has an incredibly straightforward structure for how he incentivizes his company and the discussions I've had with him around that. I mean, he's paying his line-workers, if you want to call them that, the people who were in the factories producing a product, considerably more than competitors and generating above-average profit margins. So when you kind of come at it from a, I'm going to call 3G mindset, you're like, how can that be? That doesn't make any sense. Well, the incredible magic that I think he's harnessed that that is underappreciated is that he's perfectly aligned the incentives between the line-workers and the executives. Everyone's eating from the same trough and the metrics are the same. And so, everyone's aligned in what they're trying to achieve. And from his mouth, he says it's a 5X, 10X gain that you get. So it's not a 20% gain. It's not a 30% gain. It's 500 to 1,000% greater. And so, I'd love to see more examples of that. I'd love to hear competing thoughts because I think there's no right or wrong answer. I think a lot of it's the art of it, but that's the book that I feel like, "Gosh," I just would love, I think you'd be like dance around it, but they don't really get to the heart of it and really get a lot of good examples, because it's usually such confidential information.

Patrick: [00:56:05] People always ask me for a good recommendation in the behavioral finance arena and there are good books, but the trouble with all of them is that it's a collection of studies, who knows how many of which we can replicate. We know this huge replication problem we're going through in the psychology literature for sure. And there's, you're right, there's never been a good book that actually says, okay, here's how you can actually use some of this information.

Brent: [00:56:30] Yeah. I mean, I would absolutely love it.

Ted: [00:56:32] I think I came up with two.

Patrick: [00:56:33] Excellent. I got two too.

Brent: [00:56:35] You got a lot more time to think about it too.

Ted: [00:56:36] I had a lot more time to think about it. The one investment book and one non-investment book. So the investment book, I think Patrick, close to what you were talking about is a book that talks about chasing returns and provides all the data over time to show in every asset class, in every security, how damaging that could be, so that there's evidence to bring to every decision-maker along the food chain, to try to understand that this is not a good thing for whoever your constituents are. So I don't know if that's wrapped into behavioral finance or it's evidence-based or whatever it is. But a fairly simple book that proves what we all know, but we all think we're the ones that are the exception to that rule, but that somehow reverses this short-term dynamic.

Patrick: [00:57:22] Before you get your second one. The funny thing about that book would be that the current answer to the question of what everyone's chasing is the S&P 500. And I think that idea, which is again, if you go stack up every major investible opportunity right now, and you stack them by trailing eight-year performance or whatever it is, the S&P's going to be close to the top of that list. And everyone thinks that it's this obvious, easy investment decision today, but it is in its own way, a performance chase. And anyway, that would be an interesting last line of that book if you updated it often like, "Oh, and by the way, here's the thing that if you buy it, you're committing this..." Maybe it won't work out that way, because sometimes like we saw in the last 10 years, you can start with a great performance and it can continue. So it might work out that way. But odds are, that the performance chase today is the broad U.S. market.

Ted: [00:58:17] Yeah, I'm not big on market predictions, but I'll make one anyway. So, one of my-

Patrick: [00:58:22] It worked, done so well for you last time.

Brent: [00:58:23] Exactly. I was going to say, who do you want to wager with this time? Let's just go and get that on the record.

Patrick: [00:58:29] Me and Brent will split it.

Brent: [00:58:29] Too soon, too soon?

Ted: [00:58:30] Too soon, too soon, too raw. One of my former partners, Scott Bessent, who later ran Soros' Family Office, has this wonderful line that he says, "When the boats tip too far in one direction, it has a way of righting itself. And it's very hard to know why this indexing movement should change. I don't think it will. I think it's a big trend. Why the S&P should roll over? I don't know, but it will. I don't know exactly when, but it's coming and we kind of can all nod our heads in agreement. So a sober reminder that I will be writing-

Brent: [00:59:01] Eventually.

Ted: [00:59:02] All right. The last book. So this is something I think the two of you were probably too young to appreciate, but that's okay. I'd call it something like building a bridge. And so, one of the things you realize when you get into your 40s, is that you'll have these frustrations with your parents, for example, for all these things that you thought they should have taught you, because they're your parents, they're supposed to teach you about life and all these things. And one day you wake up and you realize, well, nobody taught them. And there are all these lessons and you can go all the way back to what didn't I know about how to treat other people or table managers or relationships with other people or sex. Can I say that on a podcast? Or sex. All these things that you thought you should know. So someone should write a book that says, here are all the things that when you're adult you realize are common knowledge that you may not have been taught because your parents weren't taught because their parents weren't taught, but this is sort of common knowledge, and everybody should know that.

Brent: [01:00:00] Like don't make bets with billionaires. Oh, too soon, too soon.

Ted: [01:00:11] So here's a funny one. This never occurred to me. Earlier this week, a friend of mine sent me an email with all this publicity that is coming out. He said, "Do you realize how good this would have been for you if you were winning the bet?"

Patrick: [01:00:23] Oh, man. It's pretty good even in a loss.

Brent: [01:00:24] Yeah.

Patrick: [01:00:25] It's good marketing.

Brent: [01:00:26] Whata, coulda, shoulda .

Patrick: [01:00:28] So, I've got two, as well. I've had the longest time to think about it. So the first one would be very hard to put together and it would probably have to be like a bunch of coauthors, but Brent and I often... really it's one-way Brent, giving it to me, sharing PDFs or long summaries of industry dynamics of kind of what the key variables or levers are in a given industry. And let's say use GICS' classification that there are in public markets, probably 60 or 70 industries, and then maybe 124 sub-industries. I would love a book that was five to 10 pages on each of those 60 to 70 industries to understand the change, the current state, what matters, what doesn't matter, from a qualitative, from a quantitative perspective? I think, that that would be incredibly valuable, to think about the idea of Munger's idea of mental models. It's sort of like an analog to that, that just to understand the basics of how every major industry operates. It's always fascinating. And usually, it's like the most boring ones that are the most interesting, studying like, oil and gas services companies or something like that, which sounds incredibly mundane is anything but, and I think that would be, that'd be a long book, but it'd be fascinating.

Brent: [01:01:41] Well, I think that that information is, is so incredibly valuable that the only people that are currently getting it are the custom research projects that all these research companies put together where they have, it's the same information, but they twisted a tiny bit and repackage it and then sell it for $10,000 for a 50-page report or whatever it is. I think someday somebody is going to wise up and figure out that they should put together the 25-page version, that's sort of more general. And absolutely, that would be like something you keep on the shelf and come back to it. I mean, there's a book that we use in the office a little bit. That's kind of like the standard for brokers of small businesses that go through every, ...I'm going to say, every it's probably, gosh, I don't know, 900 or 1,000 different types of businesses. And it's half a page to a page and a half on them. And it'll give you the standard multiple, it'll give you kind of the big red flags. It's a pretty interesting book. Now, unfortunately, as I've thumbed through quite a bit, a lot of this stuff's pretty much you can Google it and figure it out pretty quickly, put two and two together. But I think that the blown-out version of that's more industry-specific would be, that'd be amazing.

Ted: [01:02:52] The closest thing I've seen, now Michael Mauboussin put out a piece a couple of months ago on base rates.

Brent: [01:02:57] Yeah, that was good.

Patrick: [01:02:58] It was really good.

Ted: [01:03:00] It's not exactly, it doesn't really have the dynamics of the industry, but it was really good for sort of the quantitative metrics profitability of industries.

Brent: [01:03:04] Yeah, I saw a chart of returns on invested capital by industry over periods of time. Man, that chart looked like, I have it super-glued up in my office on my desk.

Patrick: [01:03:16] So we've done a lot of this work and never published it on the quantitative side, especially I think the return on invested capital is the most interesting metric at the industry level. And it's pretty stunning the divergences between return on capital and profit margins, where profit margins are at all-time highs. But in many cases, companies have used so much debt. And debt is incredibly cheap, so the interest burden doesn't look bad. But the return on invested capital at those same businesses with so much debt employed is really not that good, sort of mediocre by historical standards. And there are all sorts of these metrics that are fascinating, but when I've spent time and I did this twice, maybe two years ago, where I did consumer staples and energy as two sectors that I explored, and it was an incredibly interesting exercise. I was doing it sector by sector rather than industry by industry, but it took forever. It was like a really intense, I was interviewing people, I was interviewing like hedge fund PMs to give me on the weekends to give me a sense for what was the dynamics that were important. It would be a hard book to write.

Brent: [01:04:18] I'll tell you what? What's really interesting, I actually tweeted about this, I think yesterday or the day before is I feel like there's an incoming purge that's going to occur as interest rates rise, where there are so many businesses. And we see this all the time, smaller businesses where the margins on those businesses are so low and with interest rates artificially, well, they're just low, regardless of artificial or not, right? They're just low. And as interest rates climb, the ability of the business to make up that margin, it's just not there. And I feel like there's just going to be this giant purge. I'm actually curious what you guys think if it's going to be a big purge or it's going to be kind of quiet. But I mean, I think there's going to be a lot of businesses that aren't around by the sheer nature of what they're providing to consumers that have been masked by the ability to get cheap debt.

Patrick: [01:05:03] I think that's totally right. And it won't stop until interest rates or the cost of capital rises significantly, because why not start those businesses? Especially if you're doing it with other people's money. You're basically, you're building yourself a fantastic option, that's free and not free, but very cheap, and why not? And I think that they'll be carried out feet first and you will have a massive purge when interest rates rise across a lot of different industries.

Brent: [01:05:31] I wonder who's holding that debt? You look at the people that are sort of supplying that. I wonder how that's going to ripple through the credit markets? It won't be pretty.

Ted: [01:05:41] No, I mean, and it'll go in every way, but there are these ETFs that hold high yield bonds that have a massive liquidity mismatch. So you could see pockets where you expect the pain to come sooner. The rates go up, all this money in bonds is going to hit hard to know exactly what the short-term impact is on stocks, but it's not going to be good. And then, all the private equity funds who have levered continuous sort of re-investment, what's going to happen when it's not too easy to refinance the debt.

Patrick: [01:06:10] So I thought of another one, which is a similar theme and these books would all sell like 500 copies each. So these are not going to happen. But the second one and Brent started the ball rolling on this one, is sort of a catalog of mental models. Mental models being this idea that everyone talks about, but again, there's not like a good central repository for, okay, what is opportunity costs? Why should I think about it? Why should I think about incentives or pick your... as Brent put it, "Mental models that have the most freight or carry the most impact." I think that that sort of collection, again, as a sort of collection, would be much less interesting than a big narrative, which is what makes books actually sell. But that would be extremely useful for a college student or someone early in their career. I didn't learn about a lot of this stuff until I finally wasn't embarrassed to ask, because I just assumed everyone knew what opportunity cost was and I needed to pretend as if I knew it. So, that sort of collection would be interesting as well.

Brent: [01:07:09] You know what's interesting about that. I think if you'd asked me three or four years ago, I would have said, "Yeah, it would be amazing if it was 200 or 250 deep," right? And you can get into these sort of, they're still applicable mental models, but you're so infrequently used. And now I think at least where I've kind of evolved to is that you need to have the 30, maybe 40 that are just constantly applicable and you need to pound them into your head in, and the nuances around them. Opportunity costs, you just brought that up as being an example. That's pretty easy. You can talk to most people and pretty quickly they're like, "Oh yeah, of course, if you do something, you can't do something else." Well, the nuance around opportunity cost is tremendous. There are 10,000 examples of how opportunity plays out in the world that are fairly subtle, but once you identify them and you kind of understand how to look for them, they're so obvious and they help control everything we do. And so, I would say that book would really, honestly, I'd say, 20 chapters that are fairly lengthy and then 20 chapters that are half or a quarter as long, sort of the 20 most important, and then the next 20 most important. And I think Munger's uses the one, the ones that carry the heavy freight. And he said, "There's only 20 that he thinks that carry the really, really heavy freight." And I think that's true.

Patrick: [01:08:27] If you had to write a chapter in that book, which chapter would you write? Which mental model would you choose?

Brent: [01:08:34] Oh gosh, that is brutal. What's my one, my one mental model?

Patrick: [01:08:39] I could start. So I would definitely choose compounding. I would choose it because it would be incredibly fun to do the research on the manifestations of compounding in non-investing settings. And business would be the first obvious one, but, in all sorts of weird, different parts of life, Peter Attia and I in a previous episode, talked a lot about health as the key biological manifestation of compounding in the other direction, right? Where your health span looks like an inverted investing chart where it's kind of declining steadily and then all at once towards the end of your life. And, I think that you could probably find some of the most interesting, fun, cool people and examples of how little things done consistently every year, every day, every week could have non-linear effects in multiple years or decades into doing those things. It's a big, huge part of my personal philosophy for living and so I think a deep investigation of compounding outside of investing would be just a really fun exercise. So, that'd be the one I chose.

Brent: [01:09:49] I would probably say the circle of competence would be such an interesting one. If you look in history at those that have done really, really well, they have fairly tightly... Well, they have figured out what their circle of competence is, continually pushed it out. Circle of competence being the area that you actually know more than most people, that you have a good firm grounding in and you have first principles that you can sort of judge things by. And, I think most people, unfortunately, including me, I have this tendency to sort of veer outside of my circle of competence and be overconfident in what I know about the world. When it's just, we are sense-making creatures. So I would say, studying what's occurred when you stay inside your circle of competence, showing lots of examples of people that have maybe stepped outside their circle of competence and how to push the edges of it. I'd say that would probably be the most interesting chapter for me.

Ted: [01:10:44] The one that I'm most curious about is some combination of the 80-20 rule and this sort of instinctive blink, which kind of go hand in hand-

Patrick: [01:10:53] Intuition.

Ted: [01:10:54] ... intuition. To some extent, they're opposite ends of the spectrum, but there is something that intuition and where it applies and when it doesn't apply and how people make mistakes based on it. That is just sort of fascinating and you see, come up over and over again.

Patrick: [01:11:11] I think intuition is one of those ideas that is almost like a value investment. It's something that's very out of favor in an algorithm-driven, systematic process-oriented world, where everything is solvable. And that all intuition is a really finely tuned algorithm that we just don't know what the equation itself is, it's just rooted in tons of... All it's really saying is gather an enormous amount of experience and let your subconscious process it. I don't know how much we could study it, but it would sure be fascinating to understand the dynamics of it.

Brent: [01:11:47] Yeah. That's one of the things actually probably in recent years that I've paid more and more attention to. And, I sort of went through a period where I paid more attention to it and then paid less attention to it. I think it's kind of trying to follow the trends, right? It's like open offices, the worst idea ever, everyone loves it. And, the way I think about it now is that it's like pinging every potential experience you've had in the past, the thing you've read, sort of everything that's it's somehow in you, all at the same time and then rendering an immediate result. And so it is the algorithm, we have no idea how it works, but it feels in most cases, other than the obvious ones where you have psychological biases at play. And I mean, there's all the literature around that. I really do feel when you get a good circle of competence and you get a deep fluency in something, that intuition you just can't replace. I mean, I think about some of the businesses that we own now and the people that lead those businesses and they often times can't tell me exactly why they're doing what they're doing, which used to scare the crap out of me. I mean, we'd asked him, "Why do you want to spend $500,000 on that again?" And they're like, "I just think it's the right call." And it's like, "Well, I'm glad you think it's the right call. Now you need to tell me why you want to spend $500,000." And, what I found over a sort of a fairly lengthy period of time in lots of these instances was, they're almost always right. If it's in their area, their circle of competence, and if it's in sort of where you can allow your intuition to work. I think it's incredibly powerful and that's one of the things, frankly, that we struggle with the most. One of the things we see in all of the seller packets that we get if there's an intermediary involved is, "Oh, the replacement value of the owner is $150,000 a year." Or whatever it is. And it's like, well, sure, technically we could hire somebody to come in at that cost and sit in the seat and try to make decisions, and then they'd probably make fairly decent decisions. Trying to replicate that intuition, I mean, it just it's almost impossible. It's hard to put a price tag on it, which then goes back to, not to keep harping on sort of the core thesis that I have, but it's most of the moats that we look to buy are inextricably tied to the owners' personal relationships and intuition.

Personal Investing and Retirement

Patrick: [01:13:56] Couple more questions and then we'll wrap up. If you had to each put your money with some other person, management team, ETF, pick your location and you could never touch it again. What would you do with it?

Ted: [01:14:12] So, this one actually has come over time and let me explain what and why, and then I'll say who and what. So, the world's gotten tough or capital markets are expensive, we've talked about that. So, if you're going to put capital somewhere over time, you want to own things that are going to compound. You want to do it with people you can trust, you want to do it with someone that's off the radar screen, playing a game that's less efficient and is structured in such a way that they're not going to have external pressures to behave differently than how you'd want to compound our own capital. There aren't many places where you can do that and I think a lot of capital allocators search for that but don't find it. And, when they do find it, there are institutional constraints that prevent them from making that investment. One of those people is Brent. And so, I'm not trying to blow smoke next to the guy who's serving me wine right now. However, if you have an opportunity to take someone with a decade, more experience, buying tiny companies who dedicate their time to do that and understands how to improve them, that's rare. It's a rare skill and I sit here envious, watching Brent, talk about all these really fascinating things. But if I could partner with Brent, that's something that I would happily take my kids' retirement funds put them there for a couple of decades and I'm sure the outcome would be quite good.

Brent: [01:15:37] We'll see here, I can't invest in Ted's betting. So no, too soon?

Ted: [01:15:43] No, too late.

Brent: [01:15:44] Too late?

Ted: [01:15:45] Too late.

Brent: [01:15:47] Exactly. That's very kind of you, Ted. That's what happens whenever you feed on somebody's wine for a while. So, I have to say... So, I'll tell you what I'm doing for my daughters, we've put a little bit of money away for my daughters and it's going to go exactly with what we've talked about. And, I'm sure you guys are going to give me these dirty looks, but it's the S&P 500, it's Vanguard, it's an index. And I think that's a reflection of my lack of... Frankly, all public markets to me are outside of my circle of competence so I own no public equities. Personally, I have tried over the years to be involved. I don't have the intestinal fortitude nor the personality, nor I think the intelligence to be able to do it well, or at least better than the averages. And, so I have kind of determined that I'm going to buy the future of American industry for my daughters and let it compound over a very long period of time. I think that it's hopefully a foregone conclusion that in 20 or 25 years, whenever they access that money for the first time, that it will be higher than it is today, which it may not be much higher depending on how things go. With that said, I would hope that they would do something with it for themselves. I think the best place to invest is in yourself. I mean, that's one of the things that I think people very much underappreciate is in their own education and their own knowledge and their own relationships. I think that's where you get the most compounding and so I don't know how that would look, but I think it would be more on a personal basis than anything.

Ted: [01:17:21] Hey Patrick, how about you?

Patrick: [01:17:22] Well, Brent kind of stole my answer, which is, I think some of the most interesting investments are in... And I won't name the people because they won't mean anything to anyone, but in people that I've gotten to know, either I've known for a long time or have just recently begun to know, Brent would fall in this category, that have incredibly deep... The circle of competence seems like the wrong term to me because competence isn't right. It's something much deeper than that, It's an area... I've started to meet these people who just know whatever it is they do at three or four levels of depth beyond everyone else. And, there's something really magical that happens when people do that kind of investigation for themselves. Start to apply that knowledge so it's not just an academic exercise, but they're actually taking that deep learning and applying it somewhere with deep work and that kind of scales across. I can think off the top of my head of about five different people, whether they be kind of investment managers or upstart entrepreneurs, or people within a division of a larger company that I would just figure out a fun way to allocate money to them. To people that have this kind of deep knowledge that apply it, applied deep knowledge. I was asked, this is like a classic dinner party conversation. If you could somehow, and this was a short-lived idea with Erin Foster, I think it was the running back that did it, if you could somehow buy equity in another person and participate in that person's upside career earnings over time. I just think that's such a great question and a fun way to think about people and people that you want to meet, people you want to add to your network. And so that would be my answer that I would kind of just like you spread it across five hedge funds. There are probably five or so people in a variety of different places where the common theme is incredibly deep knowledge in a very particular area. Something far beyond competence who has also demonstrated that kind of that go, that they apply that knowledge. And, it may not necessarily be all financial return I think that some of these people we'll just discover amazing things and that's a good investment as well. So, sort of a hybrid answer between the two.

Brent: [01:19:31] I got one for you guys. What does retirement look like?

Patrick: [01:19:34] I don't think I'll ever retire, I mean, I'm a fiend for research. When people ask me what I do, I just say I'm a researcher. And, at various times that's a methodology or investment data or industries or people or travel or whatever. I just love researching and so that will never change. And, I think there will always be some sort of... I think that Bill Gurley had a great quote talking about venture capital or something that, "You haven't done anything, you haven't accomplished anything until you're liquid." And by that, he meant that there is a market that is willing to pay you for your stock in the example he was using. But I think that the price system and mechanism is an incredibly powerful one and that until you can get people to pay you for what you're doing, you haven't discovered anything of real value. And so I would always temper that research mentality with the real price that people are willing to pay for what it is I'm doing.

Ted: [01:20:35] I've tested it out a little bit over the last-

Patrick: [01:20:37] How's that working out for you?

Ted: [01:20:40] Not that well. I'd say for a couple of months it takes some adjustment, but there is a notion of finding the middle and being engaged with smart people, people you like spending time with, and then having plenty of time to do leisure activities. So for me, that's always been athletic. I don't know if it were a permanent thing, I'd probably have to tweak a few things, but it works. It just takes some time to ease in to.

Patrick: [01:21:05] Maybe I'm going to revise my answer a tiny bit. The closest thing to retirement might be some sort of pilgrimage of sorts. I've always had this internal struggle between growth and adding stuff and adding knowledge and more and more and more, and all of the... I think the most compelling philosophical literature on subtraction, that the only way you actually get any better is by taking things away, and there that price mechanism wouldn't be helpful at all. So, maybe I'm totally wrong, but I think I could stand when my kids are older and safe and happy with their own families. I could see myself taking three years in India or something like that too... Whether it's an inward pilgrimage or a physical pilgrimage or some sort of very removed contemplative period. That might be like a mini-retirement, but I don't know that it would last. But that would be my one caveat to my never retire answer. How about you Brent?

Brent: [01:22:08] Oh, I don't know. I'm curious about this because we deal with people all the time that are retiring and so I'm kind of always around retirement as a concept. And, being in my mid-thirties I don't think I'll ever retire. Right. I think that's the answer that I hear from most people and then I just wonder if you get to a point in your life where you're just done. Look, what I want to know is, are the people that are retiring today did they always have retirement in their head as a concept? And, was it something they were driving towards, or is it something that evolves over time? Because I do hear people, we have somebody in one of our companies, it's like, "I am retiring at 65." Like, "That is my goal. My goal is to retire at 65." And, kudos to him. I wonder if that was something if it's sort of a time thing like that was a moment in time, it was kind of the open office of whenever it was the 1970s or whatever. And, it was just like always stuck with us because I don't feel like I want to retire. I mean, I truly, I don't like every day, but I love what I do. And, I hope to continue to be able to do it for the rest of my life but I think it's an interesting concept. I just wonder how that evolves over time.

Ted: [01:23:13] You could circle back to a mental model related to this, and something I heard in a speech a couple of years ago. A lot of high achieving people strive for success. Success can be defined in a lot of different ways, but let's assume that's tied to financial rewards and that may or may not be tied to fulfillment. So, there are people who achieve success, reach some financial goal, and then they say they're going to retire and the rest of their life they're going to search for fulfillment or whatever that is. The challenge is for those people who do that and then don't achieve success at that level and are a little bit lost, then trying to figure out, "Wait, I thought I was going to do this and then feel fulfilled." And, so the notion of finding those two things together, which you both have done in your lives, but a lot of people struggle with that sort of concept, of how do you get in the flow? How are you doing work that you just enjoy, that you can do better, that's easy for you, but hard for other people, is all part of that? And, that if you can find both of those things in your day-to-day work, there's no need to be thinking about, "Oh, I'm going to put this down and go do something else." It's rare to find people who have had the good fortune to work their way into a career that is both,... can meet their sort of financial objectives to live the life they want and feel fulfilled on a day-to-day basis.

Brent: [01:24:33] I think that's the key, it's good fortune, because I look at the different career paths I could have had. And, it's sort of somehow along the way, I feel like I grabbed the bus that was driving 60 miles an hour down the road, and I somehow latched onto it and went for a wild ride because, play out the Monte Carlo simulation and it doesn't always end up this way and I feel very, very blessed because of that.

Patrick: [01:24:54] Very last question, just to leave everyone with something neat. If you had to share a book, an article, a person that you've come across with interesting or new or unique ideas, let's say in the last six months, what would you share with people?

Brent: [01:25:09] You know, I'd have to say this is a little bit cheating, but this is a past podcast guest of yours, which I was the one that recommended is Peter Attia. I haven't been able to listen to the episode quite yet, but if you... Yeah, I have no doubt it's awesome. Peter is somebody who I have gotten to know over the years and have the utmost respect for his thinking and the way he goes about analyzing, taking nothing for granted in a space that I had no idea... Health, how much was taken for granted? And in many ways, I think Peter's turning things on their head and shaking up a lot of ground in the process and doing it in a way that there's this sort of, there's no other way to do it other than experimenting on patients that need the help or want the help and are doing it in such a way that's just incredible. I think it's the future of medicine. I think that whenever you see what Peter's doing, it is what medicine's going to look like in 30, 40, 50 years.

Ted: [01:26:10] I'll go with one of each and we've talked a lot about the bet, but it's been an incredible blessing for me to have gotten to know Warren and Ted Weschler and Todd Combs through this. And, people can be skeptical about Warren for many reasons, hard to argue with his success. But having had the good fortune to spend some time with him, he's just a remarkable, humble guy, and just feel very lucky that despite looking like a fool in the media and all that kind of stuff, I've been really fortunate to have built that relationship. I recently have read a book called The Book of Joy, which is a series of conversations with Bishop Tutu and the Dalai Lama talking about what creates joy and happiness in life. And, I didn't really have expectations of the... In fact, the head of the lower school at my kid's school recommended it and it is just extraordinary. Really gets you outside of yourself and one of the things I talked about earlier and learning these two men who have been through such difficult times in their life, and yet walk around with a smile on their face and watching them turn difficult circumstances into positive perspectives is just something I highly recommend.

Patrick: [01:27:24] So, mine is going to be a... Brent and I have shared this book and there are very few books that actually change my behavior. I usually find nuggets that are interesting, and maybe I'll remember for a while and apply every so often, but there's a book called The System's Bible by John Gall. Who was actually, I believe a doctor, passed away a number of years ago talking about sort of the philosophy of systems. And, it's called The System's Bible, I picked it up expecting to read a book about how to build great systems. And, I'm a very systematic guy and my bias was that all systems are good or mostly good and the book is the exact opposite of that. It basically says don't build a system unless you absolutely need to. If you're going to build one, make it extremely simple and let it evolve from simple roots to more complicated structures. And it was just one of those books that were a total ...just a mind-bender because again, Robert Shore has a great line. I can't remember what the interview is with. It might actually be with our friend Morgan Housel that he said this, but he said, "You have to remember that very often, your thoughts are not your thoughts." Meaning what you think or what you spew when asked your opinion is not something you've actually chewed on and considered and gotten that deep knowledge on. And when you realize that and you start watching yourself, it's kind of a disaster because you realize that you are regurgitating digestible, common opinions without having really considered them. And this book was the starkest example of like, Oh my God, I've never actually thought about whether it's good to build a system. And this seems to be extremely compelling, theoretical evidence, and some really great examples of why systems can be evil and very quickly can become perverted. And so that book is for anyone that's in business because business is a collection of systems. Anyone that's a routines or habits person, which are just themselves systems, I think can totally change the way they think about how they conduct themselves or their business by reading this book. So, it's obscure and it's goofy and kind of a dry sense of humor, but man, did that book knock me off my chair?

Brent: [01:29:32] I have to say, I got one more to add and I think it's one that I definitely recommended to Patrick a few times. Trying to get him to nudge, to read it at some point is Making Sense of God by Tim Keller. And regardless of wherever you are in your faith journey, I think it's a book that lays bare the alternatives to faith and to make sure you're fully understanding sort of the cohesive worldview that you have accepted or that you are accepting. And I think that's something that it's a book that I wish I had been able to read 15, 20 years ago, because I think it would have given me a lot of clarity around the choices that I made. And, it's one that I would highly recommend again, regardless of your faith, regardless of where you are in your faith journey, or maybe you've settled on the issue. I think it's certainly one that's going to challenge you and give you a lot of insight into at least how maybe the other half thinks and lives. And I got a tremendous amount of value out of it.

Patrick: [01:30:26] Well, this has been a real blast guys, more informal than most, but a lot of really interesting topics that we've covered. So, thank you both for your time and now let's go drink the rest of that wine.

Brent: [01:30:35] Cheers.

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