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Value Investing with Legends
Django Davidson - The Capital Cycle: Finding Opportunity Where Others Aren't Looking
00:56:12
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- [00:02]
A
Welcome to a new episode of the Value Investing with Lanes podcast. I'm Tano Santos, the Robert Halbron professor of Asset Management and Finance at Columbia Business School and the faculty Director at the Halbron Center. I'm here with my co host, Michael Mabusen, an adjunct professor at Columbia Business School and a faculty member as well at the Hellbrunn Center. Michael, how are things doing?
- [00:21]
B
Very well, Tano. And I'm super excited by our conversation today. We're going to go through some very interesting analytical frameworks that should be of great value to our listeners.
- [00:30]
A
I love intellectual and conceptual conversations. Cannot think of a better way of actually finishing our Value Investing with Lanes podcast season. This opportunity comes to us through a couple of our students, Christian Walter from the Value Investing program and Alexander Nelson from the Executive Education program and whom I met last week in London, both absolutely brilliant and who were probing me about the interesting investment philosophy of our guest today. And per usual, my answer was, well, I'm not so sure or I don't know. So let's have a podcast. This is one of the advantages of having a podcast is that you get to invite smart people to tell you things you don't know and explore the deeper issues in asset management. We're happy to welcome in the program today Django Davidson, who is a partner and PM at Housekeeps Partners, which is an asset management company founded by Jeremy Hosking in 2013. Django, who joined Mr. Hosking at inception, came from Gebris, I don't know if I'm pronouncing that correctly, the investment firm founded by Davide Serra, and before that, I believe after graduation from university, Django worked at Deutsche bank for seven years. Hoskin Partners, as I said, was established in 2013. It's an investment management company and it has about under $8 billion under management. So, Django Davidson of Hoskin Partners, welcome to the Value Investing with Legends podcast.
- [01:52]
C
Thank you very much for having me on, guys. It's an honor, Django.
- [01:55]
B
We typically start these conversations getting to know our guests a little bit. And so before we get into investment philosophy and even your professional career, tell us a little bit about your background, a little bit where you grew up, a little bit about your family and what you studied in school.
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C
Well, I grew up in a very unfashionable area of the uk Leicester. It's a kind of Midlands town. You know, an American equivalent would be a kind of flyover state. But I was from a very kind of non conformist background. My father was a Musician. My mother was an academic and looking back on it wasn't a particularly economically bountiful upbringing, but in terms of ideas, tolerance for difference of opin and kind of learning to think independently. I was super lucky and I look back on it now and think there's probably a real advantage in having an unconventional background. It's been amazing to be able to deploy that into the investment world. That's been a great thing.
- [02:44]
B
So it looks like you studied geography at university. A, is that correct? And B, do you feel that that helped or hindered you as an investor? And if so, how? In either way.
- [02:53]
C
So geography is. It's an academic discipline in the uk. In the US it's only probably a few eyebrows are raised when they see that on CVs. One of the benefits of doing a kind of UK geography undergraduate degree is this idea of being a kind of informed generalist. With geography you are looking at lots of different disciplines, whether it's geology, economics, sociology, politics and kind of weaving them together with the kind of anchor that is placed to try and come to some sort of informed view. So it was actually quite a good training for investing because it just allowed you this kind of breadth of disciplines and kind of always looking to, to mold in other ideas from other places which Michael, I know you're a great advocate of given your work with the Santa Fe.
- [03:42]
B
So can I ask you about your first job right out of university? It looks like you joined the city and went to Deutsche Bank. Is that where you learned about equities and equity research?
- [03:50]
C
Absolutely. And the kind of forging moment of that seven years at Deutsche bank was the financial crisis where I was working on the bank's team. And what I learned was that in the land of the blind, the one eyed man is king. I knew just a tiny bit more about banks than a lot other people in this period of stress. It was just a great piece of luck to be doing banks at a time when everyone wanted to know about banks and suddenly started kind of asking what a capital ratio was. That was a very lucky period to be doing that.
- [04:20]
B
So after Deutsche bank you joined Algebrist. Tell us a little bit about that team and why you joined it.
- [04:25]
C
Algebrist was one of three funds that Chris Hahn at TCI seeded with his back office and support. And Algebras was a single sector fund focused on financials and it was a great time to be doing it. I learned a lot. I think one of the things, if you are kind of curious and interested investing long term is that focusing on a single sector is just a bit limiting. You always have to have a stock that you like and a stock that you don't like. You've got to like one UK bank and be short one UK bank. And the idea that I kind of was wrestling with was maybe just UK banks aren't interesting. And turned out that was kind of right for the next decade. And I'd been reading a lot of the. They were called girs, these global investment reviews that Marathon would put up for free on their website. There was just such a draw to learn more about this generalist capital cycle approach to investing, which I was lucky enough to get an introduction to Jeremy. And that was where that journey started.
- [05:20]
B
Now, in that early career, you also were exposed to some of the letters of Warren Buffett and some of the Buffett thinking. Talk a little bit about that. First of all, how did you run into that and what impact did that have on you as you went through those letters?
- [05:33]
C
Well, this was a terrific piece of generosity and it's something I hope to pay forward and have done so. But when I look back on it and it was a great piece of luck, there's a nice man called David Fear who ran a fund here in London which was Ziff Brothers. It was the UK arm of Ziff Brothers. And I'd been talking to him about various bank ideas during the financial crisis and said that I was interested in becoming an investor. And his immediate response was, well, have you read all of the Buffett Partnership and Berkshire letters? And then I hadn't. I was 27. And he said, well, you wanna read these before you make that choice. And he kind of slid across the desk, this incredibly heavy stack of letters. And it really was one of the greatest gifts you could have given someone in their mid to late 20s. And I went away and I did read them and it just blew my mind. And, you know, like so many people have told this story before, I don't wanna take up any airspace with it, but it was a great benevolent career gift and I'm forever thankful to him for that.
- [06:29]
A
It's interesting because during the financial crisis, which is such a formative moment for many of us as investors, even when we don't do it professionally, right? When you realize that the market is kind of in full panic mode. But, you know, one of the things that was reflecting. I was recently in Omaha and I would love to get your reaction to this Django. It's a little bit of an aside, but I've always thought that Warren in particular was a Bit shy when it came to deploying capital during the global financial crisis, that it takes a little bit, a lot of courage to deploy capital when everything is falling around you. And I'm wondering about your own. Take your own psychological makeup when it comes to that. It's interesting that you were inspired to become an investor precisely during the global financial crisis, which is when opportunities arise. Can you tell us a little bit about that?
- [07:23]
C
I'd like to hear Michael's view on this, but my thought would be the reason for the reticence of deploying capital of Buffett during the financial crisis was there was a significant period when literally no one knew what was going on. And I think that would probably include Buffett. I remember very senior bankers telling me that they thought that cash points would not be able to distribute cash. I'm not sure if that's the time to be making significant bets. I would just point out just how stressed the system was and how close we were to. I don't think the word is overused, collapse. And then. Sorry, Tanner, the second part of your
- [07:58]
A
question, the second part of my question is exactly about that psychological makeup that one needs in order to actually invest during the times of crisis. That famous line from the 1986 letter that we are greedy when others are fearful and we're fearful when others are greedy type of thing, which is exactly the right type of mental framework to have when it comes to investing in crisis. And whether you personally, given that you were to some extent drawn to the asset management industry during the global financial crisis, appreciated that kind of insight, that kind of mental model that one needs to have to invest in crisis.
- [08:34]
C
I think what was distinct about the GFC was we all learned, and this is a great point that I hope we can come back to about these kind of what Nick and Zach called deep realities of businesses. One of the deep real banks and the financial service companies was just how fundamental trust is to their operation. And that absence of trust really was a foundational pillar that got knocked away and as we just mentioned, could have had calamitous results. So I think when Buffett, if you look back at all of the things that Buffett was doing and all of the things that all the very sensible policymakers were doing is they were trying to rapidly restore trust in the system. And once trust returned, you could use the being greedy while others are fearful framework to deploy capital. But until that fundamental trust was reestablished, I'm not sure that model worked. That's a period in which that model was suspended, albeit briefly, when you move that model into businesses where you're not levered. Royal bank of Scotland at one point was levered 70 to 1 on an assets to equity ratio. It was insane. It had a balance sheet of US$4 trillion, which was larger than the entire GDP of the UK at the time. So when you move out of financials and out of highly levered banks, and look at, I don't know, take the lumber industry, it's much easier to be greedy when others are fearful there, because the systemic impact of one lumber company going bust is probably not going to bring down an economy. But what I took away from that and what I have learned, I've actually sort of seen this idea, albeit expressed differently in some of Michael's work, is this idea that there are these kind of central truths to certain businesses, certain industries. And it is very important as an investor to weigh that information appropriately and not to accumulate additional information which will cloud that fundamental truth, deep reality, call it what you will. And it's very important as investors, we learn to identify what they are and weigh them appropriately.
- [10:36]
A
That's a wonderful insight that there's always with every company there's a core aspect of it that one has to keep in mind, so to speak, and the world is not distracted. But you're right that sometimes that ancillary information can introduce noise in the decision process. So, Django, before we get into what we really want to discuss, which is this powerful idea of the capital cycle, why don't you tell us a little bit about Hoskins Partner when you joined them, what was the firm like? How do you think the firm has evolved since you joined? What kind of environment did you find? Then tell us a little bit about it. Describe the company as it is today too, please.
- [11:14]
C
Hosking Partners is a continuation of the investment philosophy and ideas that were built on Marathon, which was a firm Jeremy founded in the late 1980s. And what we do at Hosking Partners is take a lot of that intellectual foundation. But we've kind of tweaked and distilled some of the ideas to create a process which we can get into, which we think is pretty unique and difficult to replicate.
- [11:39]
A
How many of you are now in the company? How is it structured? Can you tell us a little bit about that particular structure of Hoskinpana?
- [11:45]
C
So we have five portfolio managers, we call them multi counselors in deference to the original capital model. I'm sure you guys have read Charlie Ellison, the History of Long Term Investment Excellence, where he describes that early capital model where the portfolio managers were called multi counselors. It was much more akin to the setup of a local dentist or doctors. There were a lot of professionals sitting in a room together. There was the ability to talk to your co counselors to get a second opinion on a stock. We set this up kind of in opposition to this all seeing stock jock kind of emperor portfolio manager approach because we have a different view on things like concentration and diversity. And that's the kind of reason for this multi counselor idea.
- [12:34]
B
So Django, let's jump into this and talk more about the capital cycle and we'll spend a few moments on this. In particular, I'm also interested, I think the capital cycle idea grabs people or doesn't for whatever reason. I mentioned your view of why more investors don't use this, but let's take a step back and just describe for the audience exactly what you're trying to do. And by the way, you tagged a moment ago this Bill Miller 10 bagger idea. I'd be curious how that fits into it as well.
- [12:58]
C
You know, it's always interesting to go into the history of ideas and then you kind of understand them a little better. So where does this idea of the capital cycle comes from? Well, Jeremy, in his early 20s, is sent out by the firm he works for called GT from London to San Francisco and he inherits a portfolio of 80 busted PC shares. It's a technology fuft. Most of the shares are down. The portfolio on average is down 50%. Some of these things are down 90%. And as a young guy he has to kind of sit back and go, a, wow, this is a hell of a thing to land on my desk. But B, how do I make sense of this? The germ of the idea of the capital cycle came from this. These PCs were on everyone's desks. The productivity gain of this fantastic new technology was obvious. It was changing the way people worked. And there's obviously a clear analogy with what's happening today. But the returns to shareholders were abysmal. And the central kind of insight was to take classical economic theory and apply that to the industry cycle. Too much capital had been raised. The valuations at which this capital had been raised were very, very high levels, such that the returns on capital required to make any kind of meaningful return on that capital were just never going to work out. And so there was this intersection between a kind of traditional, mean reverting return on invested capital framework, which anyone who's got elementary economics would understand. But overlaying that and where this gets more interesting is the role of the stock market in extending or amplifying, if you will, these capital cycles. So on the way up, if I'm a promoter and I can raise a dollar of capital from the stock market and have it valued at $5, I'm going to raise a load of capital. The capital is mispriced, it's underpriced. And very often when you get these great new technology booms, these new waves of innovation, very clever promoters will massively over capitalize an industry such that the forward looking returns, it's just very difficult to see that capital earn an adequate return. And on the flip side, and this is where it gets interesting, when valuations are low, when a dollar of capital is valued at $0.50 in the stock market, when that capital is very expensive, the rational thing to do is to reduce that capital stock, to shut down factories, to return capital to shareholders. And so what this capital cycle framework does is kind of meld two ideas, the industry return framework, but also the role that the stock market and promoters and various actors do in amplifying these cycles. On the way up and on the way down.
- [15:45]
A
How do you guys go on identifying this capital cycle? Do you actually, for instance, keep track of the actual capex of the companies in a particular sector, in a particular industry? And you know, there's some evidence coming from academia, it's kind of interesting, I think very, very consistent with this story, which I think is very sound, that somehow industries that see a lot of capex, you know, the returns, the financial returns of that industry turn out to be very low exposed. How do you operationalize this exactly? How do you actually keep track of that capital cycle? And how do you use it as a screen to identify good ideas?
- [16:28]
C
Taking a step back, the way that we use it every day is it's kind of like a lens, it's like a pair of glasses, a way of seeing the world. And what the capital cycle kind of framework will do is give you some kind of guardrails for contrarian thinking. Successful investing, broadly speaking, is about being right and having people agree with you after. And so how do you do that? Well, it's not easy. But what the capital cycle will do, Tano, is give you these frameworks. What it will do is it will say, let's just take a really vivid and powerful example today it will say if I look at the S and p Today, about 50% of all the dollars invested in the S and P, in fact it's probably a bit higher now are in semiconductor names, the MAG7S hyperscale, let's just call it tech, broadly speaking. And about 1.5% of the s and P is in metals and mining shares. So, using the capital cycle framework, I am probably going to find some interesting ideas in that 1.5%. Why? Because I'm being super simple here. But just to give you a vivid example, those valuations are low. There's not going to be much capital formation. In fact, there might be supply and capacity constraints as new mines are not invested in, for example. And on the flip side, If I've got 50% of all of the capital in the S and P in this one area, my goodness, there's going to be some capital formation, whether that's in America itself, whether that's in China with firms that want to compete with companies that are making those profit pools. There's a great Willie Sutton quote, who is a famous American bank robber, comes out of the courthouse and some sort of journalist says, hey, you know, Willie, why'd you rob the banks? And he just kind of looks him dumbfounded, goes, well, that's where the money is, right? And so all the capital cycle is, is it's telling you where the money is and where the money isn't. So, number one, Tano, it's just a very simple. It's that point we just made earlier about weighing information rather than accumulating it. Number one, it's a great framework to kind of point you away from things that could be overvalued and towards things that could be undervalued. That would be the first point.
- [18:38]
A
And then.
- [18:39]
C
Sorry, I keep forgetting the second part of your question. Come back to me with the second part.
- [18:43]
A
It was the issue about the. In fact, the very strong academic evidence. I think you guys are on very solid grounds here academically, because there's plenty of evidence that periods of large capital investments are typically followed by very low returns. So whether you could comment on that, whether you guys have looked at the academic literature on this, which is exactly right, I'm with you that I'm always being a little bit surprised this point. And as Michael was very rightly saying, sometimes he has a little bit of a problem being accepted among investors, even though all the academic evidence is strong when it comes to it. I don't know if you agree, Michael.
- [19:21]
B
No, of course I agree 100%. It all does make sense. I think, Django, you could correct me if I'm wrong. Part of it is it requires you to look out, at least for a longer time perhaps, than other investors are willing to look Out. And this leads to a question I'd love to ask you. I think that one of the things I always mention to my students is they tend to think about the range of outcome in too narrow range. They have a hard time seeing things go up or down a lot versus where they are today. You've got this sort of 10 bagger heuristic that you mentioned before. Like how is it that you can see that, how is it that your ranges of outcomes are large enough? In other words, a company that could Trade earns a dollar today is going to earn $10 in the future or something like that.
- [19:59]
C
On the capital cycle in general they are very long duration. So let's take some classic ones. Whether it was the canals and the railways in the uk, whether it's the railways in the us, whether it's the PC boom, whichever one of these massive kind of economy wide capital cycles, we look at the time it takes to deploy this capital and then the time it takes for that capital to finally earn a return. These are measured in decades and decades. So you are absolutely right Michael. The only way you can prosecute this approach is to have very long term capital. And everyone in our world talks about long termism being an advantage. But if you're actually going to use long termism to be an advantage, you have a massive business challenge which is you need to find people who are going to genuinely commit to you for a long term. And that is incredibly difficult to do. It's why everyone in our industry wants permanent capital vehicles. One should be honest about one's kind of advantages. Like we have a huge advantage in that a big chunk of our asset base are basically superannuation funds who each month are getting investments in. And so another topic, but why did value work so well historically? Well, there are a lot of defined benefit schemes who are getting these monthly investments. If you're an endowment with a small pot of capital that you want to compound at a rate, you're going to naturally skew to different environments. So one thing I would say about the capital cycle in order to be able to prosecute it and we, we hear lots of people say that they're capital cycle investors and I'm glad that it's getting acceptance, but you really do need long term capital for this to work would be one point. The second point about how does it enable you to look for these multi bagger type opportunities? When you kind of look through these cycles they are often extreme. What you can't do is predict the timing of them. You can roughly get the direction. Right. But the duration of these cycles. We can talk about memory semis or mining or whatever you would like. But what the capital cycle will do is highlight these under earning areas. It will point you towards areas of capacity reduction, it will point you towards better market structures, but it won't tell you where the endpoint is. It's not a treasure map in that sense. But I love the Bill Miller challenge, which is that if you are not looking for 10 baggers, you certainly won't find them. And so what I love about that idea is that it forces you to really think out, okay, well, if in 10 years this industry had three players rather than 15, if, if, if, if, if, what would the returns be? And that does allow you to think more creatively than perhaps a more traditional business analyst mode, which can be quite limiting and as you say, kind of limits that free thinking that those tail calculations.
- [22:39]
A
Something that you mentioned in this response to Michael about the catalysts that make the capital cycle turn from one phase to another. I read a very interesting piece that you guys have on your website that I recommend to everyone on Japan and how Japan had been these incredible, disappointing both performance, both in the economic terms, but also in the stock market until there are this kind of set of reforms that take some time to get going and then all of a sudden you have finally this recovery in valuations and economic activity. How do you guys specifically about Japan, for instance, have you guys positioned yourself to benefit from that? How do you guys think in general about this issue of catalyst in making the cycle turn from one phase to another? Tell us a little bit about that.
- [23:30]
C
The capital cycle is a great framework for looking at industries, for looking at certain companies. It's this lens through which to look for investments. It also has this kind of country level application, particularly when countries like perhaps the UK in the 80s, perhaps Japan about 10 years ago, are going through these significant structural changes. So I would sort of use the capital cycle to explain the following. The capital cycle looks at returns on invested capital and obviously there's a numerator and a denominator in there. One of the interesting things about Japan is that the denominator is distended, it's bloated, it's very large. You can go and look at a Japanese company and there might be three head offices, there'll be cross holdings, there'll be lots of cash, there'll be lots of assets that are underutilized. And so when you look at the return on invested capital of let's just say Japan Inc. It's very bloated now that leads to the low returns. And a lot of investors who maybe aren't as sensitive to this sort of capital cycle approach will just say, well, they're low quality companies, they're poor quality. Japan, I remember once famously was described to me as where capital goes to crawl up and die. And that was a great way to dismiss looking at Japan, a lot of investors just forgot about it. And as per capital cycle theory, the low valuations were a cure. The cure for low valuations is low valuations. And what's happening in Japan and why it's so exciting from a sort of country level capital cycle perspective is that this denominator is being shrunk. Those cross holdings are being unwound, those head offices that you didn't need are being sold. They're even kind of consolidating into. You're moving from these great buildings into individual offices. Some of my friends in private equity are just so excited about the opportunity in Japan because they think this is like a decade long ability to restructure these companies. Why that's so important, Tano, is that you can improve your return on invested capital just by shrinking the denominator. To actually go out and earn more profits. You've got to hire more salespeople, you've got to find more markets, you've got to raise prices on your product, got to do all sorts of things that are really difficult and challenging and require very dexterous business skills. But actually shrinking the balance sheet of these companies, I don't want to say is easy, but it's easier.
- [25:50]
A
I really like this point. I don't know if I did it last week when I was in London teaching, but I typically teach my students. Exactly the point you just made, Django, that this thing of divesting, of shrinking the balance sheet, of letting go of assets can be incredibly profitable for the investor. And the example that I always use is that of Walmart and Walmart International. They've been shedding off all these international operations now for years because it didn't work out the way they had hoped for when they launched this strategy in the late 90s. It worked out in Mexico, in Canada, a little bit in China, but very limited. And they went into Germany, South Korea, Japan, all these places and they got in autobiography, all of them. They destroy value. At the beginning, they created value when they decided to put an end to those international adventures that didn't quite pay out. Can I ask you just one more thing about this capital cycle theory? And then we jump into some specific examples, the issue of time here. One of the things that I learned in the years prior to the global financial crisis, I would tell this to everyone. The first time I started talking about housing prices being overvalued in my country of origin in Spain was in 2003. That's the first time I remember having a conversation. This cannot last much. It went on for another four or five years, effectively. And this idea that somehow I thought there were catalysts that were going to be realized. The bank of Spain was putting out reports, people were talking about it. The government itself was alerting that there were serious imbalances building in the private sector. Nothing matter. How do you go about assessing the capital inflows that sometimes you experience in some of these situations, by which I mean, hey, it's not only that a few people are crazy, but a lot of the few people with a lot of capital are crazy. So that capital is going to keep coming for a long time. Do you guys think about time when thinking about the capital cycle, do you guys monitor it, follow it getting ready? How do you guys approach this issue of time that the capital cycle suggests? It's an important determinant.
- [28:08]
C
You know, going back to this point about it's impossible to precisely time when these cycles turn. But with your kind of capital cycle glasses on, you would hopefully be steered away from the bubbles and looking for the good opportunities. One of the interesting things about your Spanish real estate example is that, yes, there were five years when Spain was clearly in some form of property bubble. Whether you looked at cement consumption per capita prices versus other European cities, it was clearly a bubble. But each year for five years, it kept going bigger. What I have learned about doing this job is that you need to have quite a wide canvas, you need to have a diversified set of exposures. Because I'm just going to put it out there, Spain had the wrong interest rate. And when were those interest rates going to change? I don't know. Spain had an interest rate that was relevant for recovering Germany, not a booming Spain. That's way beyond my pay grade or ability to take any view on when that kind of political deal was struck. It took the financial crisis for that to adjust. So if you were going to be not that we do short, but let's say you were going to be short Spanish real estate, you would need that to just be a very small proportion of your exposures. And because you cannot predict the timing of these cycles, you need to have a large number of these cycles because it's kind of like A bond portfolio. Except with a bond portfolio, you know when each bond is going to mature. You might have a ladder that gives you each year for the next 10 years. You have one bond that matures each year. With the capital cycle, you don't know when these are going to mature. But one thing that is clear is that as, as interest rates rise and capital becomes more expensive, the ability of large scale capital deployments, which, remember, always sucking capital away, every $100 billion that is invested into data centers is $100 billion that isn't being invested somewhere else. As soon as these cycles turn, they can be very violent, very rapid. There's a great quote from Robert Friedland, the great mining entrepreneur who says that in order to benefit from a rotation, you have to earn it by being there ahead of time. And I kind of feel a lot of what we do and we try not to have too much exposure in one of these cycles, but we are kind of earning the benefit of the cycle turning by wearing some kind of underperformance in that particular cycle. It's also important not just to have diversity in terms of the number of cycles, but particularly in these lower end of the capital cycle ideas. Mining, heavy industry, you need diversity within them. We all probably on this, listening to this podcast, is aware that perhaps we're a little short of copper if we want to fulfill our data center rollouts and greening of the energy infrastructure and so on. But you can have a copper mine that is the best new copper mine. Take the Cobra Panama example. Panama's. There's a $5 billion hole in the ground in Panama. It's 7% of Panamanian GDP. It's kind of more of tax receipts with this amazing new mine that was going to bring about 2% of world copper supply on. And the thing has been shut down for the last three years because the Panamanian government for a whole host of reasons decided to close that mine down. You could have been right about the copper cycle, but had just one investment. You could have been like a 1015 stock type fund. You had your one copper mine, it was owned by a Canadian company called First Quantum, but you wouldn't have been producing copper for the last three years. So one of the things, and I've learned a lot from reading Michael's work on this, is overconfidence is so prevalent in our industry. The way that you raise money is to be confident. How do you get people to trust you with their money? There's loads of good reasons for confidence in our industry, but overconfidence is fatal. And it's particularly fatal in these kind of capital cycle ideas, which is why we've got this broad spread of stocks.
- [31:59]
B
So Django, we've been talked about a bunch of spending booms, canals, railroads, dot com. The one facing us today obviously is artificial intelligence. It's a very interesting way to think about demand and supply. How do you think about AI and the spending in AI today in the context of the capital cycle?
- [32:15]
C
Just standing back, there are capital cycles, technology revolutions, and some of them are super productive and bring something amazing and kind of benefit all of humanity. Railroads, automobiles, some of them are just basically speculative bubbles. Tanner, you mentioned Spanish housing, US housing. This is one of the former. Right. So that makes everything more interesting and more challenging. So that's just an important caveat before we get onto it. And one should just be very humble that if you are facing some massive productivity enhancing technology, it could be incredible or it could be incredible. But in 10 years, the PC boom that we talked about earlier is a really good example of that changed how all of us work, how all of us interact with technology. But it was dreadful unless you happen to own Microsoft or Dell or whatever. And the ability to pick those shares, as we all know, is tricky. So with that kind of caveat out the way I would say this looks like, smells like, yeah, it's really interesting to see one happen, to live through one. I'm kind of enjoying it. We are very fortunate and why it's not so painful is we had a very traditional long run capital cycle view of the memory semiconductor industry when we set up the fund in 2013. And that was based on a very simple view that this was an industry that I think at peak had over 20 players. It had about eight players at the time. This continued consolidation, which meant that the long run capital cycle for this industry was one of better industry structure, better pricing and much more discipline about supply. We feel very fortunate that those shares have gone up a lot recently. But that was not any insight into AI. That was a supply driven investment case. One thing I would say as a good simple heuristic for people to help think about the capital cycle is demand is ultimately storytelling. How much AI adoption will there be? What will people pay for it? Who will be the ultimate winners? That's a kind of story. If you're an industry analyst, you'll have a good idea about that, but it's ultimately a story you tell yourself to justify your investment. Supply is measurable. How many gigawatts of data centers are going to be built in the US how much does it cost to build them? What have you got to earn? I've just been looking at this like U.S. utility. If you've got to earn 10, 11% return, which is what a lot of regulated utilities earn in the US this is going to have to be the most profitable industry in the history of the US by any measure of economy and so on and so forth. So this feels as if we're getting closer to the top of this. The most recent example this week, which I think really does make me feel comfortable about saying things like that, is Google, an amazing company, probably the most significant company of the last 20 or 30 years, has gone from buying back shares, significant amounts of shares to issuing shares. I mean that's a complete. And this is this point about weighing information rather than processing it, weighing information rather than accumulating. I could accumulate lots of individual data on what's happening in data center rally and lots of very various. But this totemic company at the heart of the AI revolution has gone from buying back shares to issuing shares. I suggest that's.
- [35:25]
A
Can I jump in? I think it's fascinating analysis the one you just gave us and I want to pick your guys brain on this a little bit more. So have a couple of reactions to what you were saying Django, which is the first one is I think something important, correct me if I'm wrong to remind our listeners of. Is that you can have this capital cycle framework to think about what is going on with valuations in the market and what is going on in terms of capital deployment. You have to ask yourself how that capital is going to play out once production is up and running and whether that particular technology, in this case AI comes with some type of form of customer captivity that will allow the parties that are deploying that capital to rise above marginal cost and realize those returns above the cost of capital. And that is what is not clear at this stage. Maybe the capital is justified from a social return point of view because as you were saying, this is going to be a remarkable technology that is going to change the way we do things. The question is whether the shareholder is going to capture some of the surplus created by this technology or not. That's going to depend on whether we think there are some form of customer captivity that will allow these companies to extract some surplus from the consumer and redirect some of that surplus to their shareholders. So I think this kind of capital cycle theory needs to always keep in mind that at the end we need to understand this form of customer captivity that will produce the high exposed return. And maybe sometimes there is that formal customer captivity, sometimes there's no customer captivity that will justify the initial deployment of capital. Does that make sense?
- [37:14]
C
It does, and I think you're right to highlight that. I suppose what I'm saying is I'm kind of going even simpler. I'm looking at who knows what the right number is. Let's say 5 trillion of total spend a 10, 11% return is 500, 550 billion to earn a 10% return on capital. And by the way, none of These businesses are 10% return on capital businesses. From Facebook even down to Oracle, These are teens to 30, 40% return on capital businesses. So I don't know whether they're happy with that. If they are, they're certainly not telling us as investors that they're happy with those sort of returns. That would be a bit of a shock. So even Tanner, before we get to ideas around where's the customer value and all of those really good and important business analytical points that what the capital cycle is doing, it's just kind of stopping you here. It's just going hey, where's this 550 billion coming from? Who's losing? Where's that profit? Is this all win win new economic value created? It might be, but that may take some time. That could be the PC analogy that when you're rolling out when we had 35 PC companies and they're all doing this TAM analysis to justify their IPOs, maybe there was this great productivity boom that justified but it feels we are a long way from being able to do that math. And even by the way, that's the whole thing about even if you do that math and you get to those levels of earning that is not great for the valuations of the hyperscalers. And by the way, it doesn't mean the hyperscalers are going to halve in value or anything like that. It just means that there is going to be a process of reckoning where we're not at the end of this movie.
- [38:56]
A
So if I understand you correctly, your answer is look independently what you may think about what is going to happen exposed in this market, the magnitude of the capital being deployed is going to require so much in terms of profitability that doesn't seem, even if you were to be bullish in the ability to capture some of the surplus that would justify this amount of capital deployment, at least in the short run. I think it's a wonderful point. So can I ask you a further question about this? Because I Think that the way sometimes we talk about these AI capex is kind of interesting. If I think about Google or Meta itself, I can think about them deploying capex and maybe it's a little bit too high compared to what we would like to see, but at least they have a core business that can support perhaps that capex, massive as it may be. But also you can think of AI as being complementary with that core business, whether it be the social network, whether it be the advertising business is very different than the capex of an open AI or an anthropic, for which that is the business, so to speak. So do you guys make a distinction when looking at the capital cycle at which of these different players are doing the capex? Because it's very different depending on who deploys the capital. Philanthropic this is the business, this is what they sell for Google. Well, they sell many things and AI may help them. Or Meta. Clearly AI seems to be helping with advertising business above and beyond these kind of privacy policy changes that we've seen over the last few years. What is your reaction to that?
- [40:30]
C
Yeah, I think there's a sort of hierarchy of certain AI companies are more advantaged than others and Google is probably the most advantaged in that pyramid. Would be one response to that and almost to the point that if you read the Demis Hassabis biography, which is the history of DeepMind, Google was kind of embarrassed about its success in AI and it was like, whoa, we don't want to talk about this. And then you listen to open a high and anthropic and all they can do is tell you that half of white collar employment are going to be whatever it is. And I love this Peter Thiel point about the thing about a monopoly is they'll never tell you they're a monopoly and that I think he was pointing that directly at Google. And I've used that model, that approach, to trying to understand who the winners and losers are in this. I think Google has got the best set of outcomes from all of this as you start to move further away. Google is kind of like the sun and everything else kind of revolves around it in my conception of this. But I'm not a detailed industry expert. There'll be people who know way more about this than me. Listen, I've read a few books and that's kind of the end of beginning and end of my knowledge about this.
- [41:39]
B
Django. I'd love to talk about some specific stocks. And let's maybe start with Micron technology, which is a memory and storage Company. I was looking at this just yesterday, which seems extraordinary. The consensus earnings estimates for fiscal 2027 a year ago were $13.50 and the consensus today is over $100 per share. Can you just share a little bit of Hosking Partners history with this company? From days when earnings were much lower to where we are today.
- [42:09]
C
So we just had a very simple insight and the capital cycle is all about, as we say, weighing rather than accumulating. And the insight that we weighed very heavily was that whilst this industry was subject to kind of product cycles and in the short term, by which we mean 1824 month type cycles could appear very cyclical and unattractive over the long term. The consolidation in this industry, the rationing of supply the stock, this much more full approach to capital deployment as the expense of deploying new industry capacity rose, meant that this industry was likely to see lower troughs in cyclical earnings. And so you would just have this kind of slow ladder up. And thankfully this doesn't always happen. But thankfully that just very simple capital cycle framework kind of played out. And if you look back at the cyclicality of Micron, it has remained cyclical and it will remain cyclical. I think the company is very open about this. No one is pretending this isn't a cyclical company, although that share price chart tells you something very differently. But anyone who can kind of get away from that. This is a cyclical company, but it's a cyclical company that is unlikely to go loss making anytime soon. Micron may earn 100 bucks a share, but it's unlikely to lose 20 bucks a share. Whereas 15 years ago there were a number of quarters where Micron would print losses. And that really is. Michael, one of the. Your point about long termism is so relevant here because if you are going to make a kind of industry call like that, you really get the fruits from it a decade down the line. And it does take quite a bold investor to back something like that, but they just take time. It takes a long time for these industries to heal. And for those, the airline industry is one that kind of almost got to that point and then Covid came and hasn't worked out so well. So it's not that this approach kind of gives you this treasure map to the end, but you do have to be patient.
- [44:08]
A
Can I ask you about a company that I didn't know about? I still don't know much about it, but you guys have a wonderful write up about it in your website, which is the Saga company. So why don't you walk us a little bit through that case? It's a very interesting company, a very interesting story of which I knew nothing, maybe of interest to our listeners. These little gems that sometimes we miss talking about the big companies.
- [44:35]
C
So one of the things about a global remit with a capital cycle approach, and this is really important about being unconstrained, is that you can compare investments in, say, small cap UK with mega cap US tech. And I don't know what Michael thinks about this, but I've got just an intuition that humans make better decisions when there are stark contrasts. Do you want a green smoothie or a whiskey sour? Right. And one of the things I find so perverse about our industry is this fetish for specialization. And I get that it works in a lot of these POD shops, right? You super specialized thing. If that's how your brain works and you want to work like that, I'm sure you can grind out the alpha. But I just think as a human who wants to make good decisions, I'd love to be able to contrast Meta with a small cap company, because I'm about compounding the capital. I don't particularly need to win any awards for calling a sector big mega cap sector, where there's, by the way, 150 analysts who are super bright and work 15 hours a day. Part of the advantage of having this capital cycle approach and also about structuring your firm and the way you can do things to be as wide as possible is you can compare these, these investments and you can then have less competition. When you're comparing an investment in a mega cap tech company, you're literally fighting against the best of the best. But when you're looking at a small cap UK company, there's been this massive degradation in the uk. You're really not up against the same players. And there was this fantastic example of this in a company called Saga, which is 75 years old. It's kind of part of the furniture. In the uk, everyone's parents have been on a Saga holiday. They basically take over 55s. It's more like over 60s, over 70s on holiday. And they really look after them. They've got this business philosophy which is we do things properly. And properly is such a loaded term in the uk. It's like, oh, he's done it properly and it really does mean something. And if you're true to that, over 75 years, that is an amazing brand to have. And it's exactly the sort of business that Buffett would wax lyrical about. And then something Truly extraordinary happened, which is that this business, which been around for so many five years, was sold by the founder's son, who was really the driver behind it, sold it to private equity in 2004, went away, kind of went traveling, did some cool stuff. He's a massive charitable guy. He's kind of redeveloped this kind of down a hill place in the uk. Anyway, he sold it to Private Equity and they basically mucked it up. They overcharged the customer. They started doing the things that old people on holiday don't like, charging them for things on the cruise ships. They started to cut corners, they put too much leverage, they did a massive dividend recap. Classic private equity stuff, which when your key deep reality is trust older people, trust you to look after them properly. When you do that, bad things happen. And this company, which was valued in 2004 at £3 billion, crashed to an equity market value of £150 million. And this just kind of came up on our screens and we saw that the founder had come back out of retirement, put $250 million of his own money into this company, like a proper amount of money to use the properly thing. And he had a very simple diagnosis of the problem which is that they'd lost the customer's trust and they need to win the customer's trust back. And this is how you did it. This was a kind of two foot bar like this was. So I don't want to sound sort of pompous, complex adaptive systems or mental models or whatever. There were just some very, very obvious things that meant that this was someone who is putting $250 million of his own money in. But it's not just that it's his family name. This is a 75 year old business that his father set up. This takes, it's part of our culture, this literally part of our culture. So this was a very obvious investment, 150 million, which was the market cap at the top trough. We bought it a little bit higher, but we did manage to buy some down there was approximately equal to what they should be able to earn on a recovered basis. And so it fitted that. Bill Miller, if you don't look for 10 baggers, you're certainly not going to find them. What's amazing is how much of this company we were able to buy. We own just under 10% of the company. It's subsequently done quite well. I think we're early in this journey and what's so interesting about that is the lack of competition. You know, this was a big company with A small, small market cap. This often happens. You can get really quite big companies, but because they have a small market cap, there are people that can't look at them, they've got liquidity restrictions or it's outside of their. The analysis that we did, I've just explained it to you, was not particularly complex, but we just didn't have a huge amount of competition whilst we were prosecuting it. And that's to do with how you structure yourself as a firm individual and what have you. This unconstrained approach we have just allows us to go places where there is fewer people doing the work. And I know that's an idea that will echo with you guys.
- [49:30]
A
It's a wonderful company. I'm looking at the price right now as we speak. I mean, it's really remarkable. I would recommend everyone to take a look at it also because they're positioned in a very interesting space because they cater to not seniors, but middle aged people and above essentially for their needs, whether it be tourism and so on. So they're very well positioned to take advantage of some secular trends given demographic realities over the near future. Now, it's quite an interesting story, let me tell you.
- [50:00]
C
The only people with any money in the UK are the boomers. No one else has got any dough.
- [50:06]
A
Exactly.
- [50:06]
C
So these are the guys. Of course I'm being a bit flippant, but when you look at all these stock market gains, when you look at these housing gains and you look at the difficulty that that has for a whole host of reasons about percolating down, investing in businesses that benefit from that is a good area to start looking. And actually what I've learned about peak businesses that sell to older people is you can't BS them. Once you have been on a number of holidays, you know exactly what you want and it better be there otherwise you're not going back. And so if you can build loyalty among a wealthy demographic, it's a very good business. Actually, I think people have. I certainly hadn't appreciated until I really got into the weeds of this company just how valuable serving older customers and doing it well is. It's a great business.
- [50:53]
A
Someone was telling me in this space on the senior care, home care type of business that seniors have a demand for predictability, that the way to think about seniors is, look, one of the things that goes with age is the ability to adapt, the flexibility and so on and so forth. So predictability of services is quite important. It's a wonderful case. And again, I recommend our listeners to read the write out that you guys put out on this, which is wonderful. So, Django, we're getting to the end of our conversation, this wonderful conversation. We always finish with two questions. I'll ask mine, then Michael will ask his. Which is what worries Django Davidson about the future. What excites Django Davidson or Hosking Partners in general? What is it that keeps you up at night? That whenever you have a minute free, you go and think about that trend, that opportunity, that sector, that particular pattern that you think is interesting, exciting, worrisome? What is that?
- [51:53]
C
This is more a societal question about. I got three kids and I think in the west, this is particularly acute in uk. The US has kind of got a bit ahead of the curve here, but there's a long way to go. We need to develop supply chain resilience. And that's like an easy thing to say. It's an incredibly difficult thing to do. And it requires it's not just huge amounts of capital to be invested in, whether it's energy resilience or chemicals resilience or any of those things. It requires a whole different way to approach the building of heavy infrastructure, which we are not good at here in the uk. The US is a little further ahead of the curve on that. But if I look at the kind of things that my school about the environment, for example, which I want to live in, an environment that isn't clean and all that good stuff, a lot of those ideas conflict with building resilience in Western industry. And that's a big conversation that needs to be had.
- [52:47]
A
I think this is super important actually, and I'm glad that you bring it up, that in a world that seems to be getting more and more fragmented, we're going to go back to thinking about these issues of resilience much more than we had in the past.
- [53:02]
C
It's a truth kind of bullet that hit me in the temple a couple of weeks ago. In the uk, we are about to close our last remaining salt mine. For the first time in human history, the UK may have to import salt. If we don't have salt, we can't survive for more than about 10 days. Salt is integral to every single pharmaceutical drug. It's the fundamental building block of 95% of our drugs. Fundamental to chemicals, the chlorine in our drinking water. Everything requires salt. And we are so divorced because we live in this service based economy that's maybe like forgotten how things work. It's very worrying. And I'm going back to the capital cycle. Forgive me, but we have totally lost touch with the replacement cost and the value of having spare capacity in all of these industries. We've become very reliant on potential adversaries for the building blocks of life. And that's very dangerous.
- [53:59]
B
So, Django, what are you reading or listening to these days? And is there a book or are there books that you would recommend to our listeners?
- [54:05]
C
So I'm going to give you two on that point about understanding the material world. A friend of mine, Ed Conway, wrote a book called the Material World and it really does explain all of those things so that you must listen to. The second one, which is kind of tied into it, is a book given to me by Jeremy a couple of weeks ago called the Bolter. And it's a kind of Great Gatsby style story of this extraordinary English woman in the 30s who kind of ran off and went to Kenya to go and live the high life. But what's interesting about it, and I think American readers will maybe find this a bit uncomfortable, is how just in kind of living memory, a hundred years, less than 100 years, the UK went from being this center of absolutely extraordinary wealth. If you read the lives of these people, often they were related to industrialists or whatever, but just the wealth that was present in the UK versus today. And at the start of the book you get this kind of family tree. And I kind of like vaguely know a few of the people who are like related to these and the lives that are led today versus then the difference is extraordinary. It's a reminder for Americans of just how very quickly you can lose this extraordinary wealth that comes through being the kind of apex economy. And I hope that's a reminder to everyone of just how fragile these economic systems are and how we do need to invest in them and keep and be cautious about these things.
- [55:27]
A
These are wonderful recommendations. Django Davidson from Hoskin Partners. What a pleasure. What a great conversation about the capital cycle. Thank you so much for coming to the Value Investing with Legends podcast.
- [55:39]
C
Thank you guys. Loved it.
- [55:40]
A
Thank you so much to all of you. And we see you on the other side of summer. Thank you very much. Goodbye, Michael. Goodbye, Django.
- [55:50]
B
Thank you for listening to this episode of the Value Investing with Legends podcast. To subscribe to the show or learn more about the Halbron center for Graham and Dodd Investing at Columbia Business school, please visit graham anddodd.com. thank. You.