← Value Investing with Legends
Value Investing with Legends
Ricky Sandler - Investing Through Perception Shifts and Market Cycles
00:55:33
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- [00:02]
A
Welcome to a new edition of the Value Investing with Legends podcast. My name is Michael Mauboussin and I'm an adjunct professor at Columbia Business School and a faculty member at the Heilbron center for Graham Investing. I'm here with my co host, Tano Santos, the Robert Heilbron professor of Asset Management and Finance at Columbia Business School and the faculty Director at the Heilbron Center. Hi Tano, how are you today?
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B
Doing great. How was your Thanksgiving, Michael?
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A
Yeah, was very nice in yours.
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B
Very good family, the usual chaos, stress, overeating. So perfect Thanksgiving.
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A
I can relate to all of that. Well, over more than three decades, our guest has developed and refined an investment framework rooted in identifying where market perceptions are likely to shift. In so doing, he has delivered strong results for his partners through cycles, dislocations and dramatic changes in market structure. His approach is built on deep fundamental analysis and a willingness to take differentiated positions on both the long and short sides. What also distinguishes him from many managers is that from time to time he goes beyond anticipating corporate outcomes to being an active participant in shaping those outcomes. Through his work on corporate boards, he has engaged directly in the capital allocation process, bringing an owner's mindset and a rigorous analytical framework to the boardroom. This combination of fundamental insight, long term orientation, and a willingness to engage when deemed appropriate has made him one of the most thoughtful voices in modern long short investing. We are delighted to welcome Ricky Sandler, the founder, chief Executive officer and Chief Investment Officer of Eminence Capital, a fundamentally driven long short equity investment firm he launched in 1999. Richard Rickey began his career as a research analyst at Mark Asset Management before co founding Fusion capital in his 20s. Under Ricky's leadership, Eminence has grown to an $8 billion global equity platform grounded in deep research, analytical rigor, and an investment framework based on change in perception. In addition to his role as an investor, he has served on multiple corporate boards including Ashland and entaine, reflecting his commitment to active, engaged ownership and thoughtful capital allocation. Welcome Ricky. Thanks for joining us today. Lots of stuff we want to talk about today.
- [02:20]
C
Thank you for having me. Michael Tano, I appreciate you are both legends in finance as well, and I'm honored to be here today.
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B
Thank you for being here.
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A
Thank you. Ricky, let's start at the beginning. Just tell us a little bit about where you grew up and a little bit about your family. How did having a father who was both an analyst and a fund manager sort of shape your view of markets? And were there early signs in your life that investing would be your calling.
- [02:43]
C
I grew up on Long island in a suburb of the city on the south shore of Long Island. My father commuted into the city and worked, as you mentioned, as an analyst at Goldman Sachs when I was growing up. I grew up playing competitive tennis. Being an athlete, I grew up around finance. And I think those two things very much shaped what I become today. Even though the path was a little windy, or at least at first, I wasn't sure I was going into finance. But growing up around a father that had been through cycles, I was a Little Young in 1974 to really know what was going on. But he would tell me stories later about how the banks were chasing him and trying to call him and get in touch with him and how he hid from them in the 74 market decline. And ultimately that led to his ability to kind of recover. And I've witnessed that. I've witnessed him being a fund manager through the highly leveraged transaction crisis in the late 80s and early 90s. So I'd lived through a number of and heard stories of the pain and the crisis part of investing. And that was helpful in shaping how I thought about things.
- [03:49]
B
How did playing tennis, which is a relatively lonely sport where you have to make decisions by yourself on the court, it's not a team sport. You don't rely on others.
- [03:59]
C
I bring it up because I think it has two aspects that I think are important to investing. And I think I realized this later in life when I was in the business and noticed that were a lot of competitive tennis players in the investing world being competitive at the start and trying to figure out how to win and wanting to win is one of those things that's really important in investing. This is not a intellectual debate. This is about outcomes and success in tennis, very uniquely amongst sports. It is me against you today. If I lose to you, either you beat me or I beat me. Those are the only two things that happen. All I have to do today is figure out how to beat you. What are your weaknesses? How can I exploit them? How are we playing this game? And it is a lonely sport where you're thinking alone and investing. Being independent is very important and thinking independently. They have a lot of skill sets and development between the competitive aspect and the one on one aspect and the alone aspect. And I don't have to be the best golfer in the round that day or those four days. I have to just beat you today and I got to win. Those are very unique attributes of that sport. It dovetails into my other passion on longevity and racket sports have a huge longevity factor. When you look at people who play racket sports later in life, it is a big increase in their lifespan because of the activity, because of the movement, because of the mind.
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B
It's a wonderful sport. One of the big frustrations that I have in my life is that I never became a good tennis player, even though I love playing tennis and I'm embarrassingly bad.
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C
Have you discovered Padel yet, Fidel?
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B
Yes. As you know, it's a big sport in my birthplace of Spain. So I grew up playing Padel, which is fantastic fun. I have to say.
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C
I'm full fledged addicted now.
- [05:44]
B
Great to know. So anyway, let's go back a little bit because we have a lot of things to cover. So what about your education? I know you thought at some point of becoming a lawyer. I heard in an interview you thought of becoming a lawyer. What made you stick with finance?
- [05:55]
C
My education, public school in Long island to University of Wisconsin where I was in the business school studying accounting and finance. Coming out of school my dad was in the fund management business. My brother also went into the investing business and work for a asset manager. Coming out of college this was some of my early parts of my mindset of being a bit of a contrarian. I was not going to go into that. I was going to do something different. I was going to maybe be a lawyer. It would open up my mind, I could be an executive, I could learn how to think. These were the things that I thought at the time. I studied for the LSATs, I applied to law school. Just before deciding that I was going to go, I started talking to a bunch of people who were young lawyers and most of them really didn't love what they did. And it really had an impact on me and told me let's at least push this off. I deferred my law school admissions and tried to get a job in finance from an accounting and finance background. That was sort of natural to me from coming into the business. From the moment I got in, I loved it. It was the competitive aspect of the scoreboard. It was figuring things out was being good with numbers. Ultimately I'm not a great writer and I'm very good with numbers. That was one of the things that I probably didn't appreciate when I thought about going to law school originally. But as soon as I got into this business I kind of loved it from the second.
- [07:15]
A
So Ricky, you started your career at Mark Asset Management and then you co founded Fusion Capital at a very young age. So what did those early experiences teach you about research, risk management, building a firm. And what lessons did you take from those experience as you started and built Eminence?
- [07:30]
C
Everything that happens in our lives before shapes how we are today. So those experiences shaped a lot of Eminence's approach. When we launched Eminence, we were committed to a classic Jones model approach to investing, shorting for alpha and absolute profit, independent shorts having a moderate but positive market exposure. The mark asset management experience shaped the concept of owning great companies and high quality businesses shape deep research and understanding companies and what makes them grow, and evaluating management teams. When we started Fusion, we started Fusion with a quality value mentality. So we wanted to own good businesses, but we also wanted to pay value prices. My former boss, who is an amazing growth investor, was a little less valuation sensitive. In many times that's a wonderful trade and in other times it creates certain risks that for my style and my philosophy and my temperament, I wanted to try to avoid that. Launched into Fusion with quality and value. As investors who were mostly on the long side, or our history was on the long side, we dabbled on the short side and we called ourselves long short. But we would short the bigger peer to the company that we were owning. We were hedging, we would short maybe expensive stocks that we didn't think were the highest quality. We without the kind of rigor of truly understanding what makes stocks underperform. And I think going through the 1998 experience at Fusion. So we had three really good years. Our fourth year we had a big drawdown and a subsequent recovery in the 1998 drawdown, the Russian debt crisis, long term capital management. And these were macro events that I perceived at the time had little to do with my companies and what they were doing. But they created risk in the market and de risking and a big drawdown. And I felt very defenseless in 1998. I knew I wanted to buy the companies that I own, but we had a pretty big P and L drawdown because we had not hedged really well. That feeling of not being able to go on offense when I knew that the right thing to do amidst dislocation is to go on offense, kind of shaped a lot of things about me going forward. One of which is the business model that we have at Eminence. Another is a mindset of risk managing ahead of time so that when things go wrong, your losses are within the range of your outcomes of your expectations and you have the ability to go on offense. So these were some of the principles that we founded Eminence on in the
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B
early days, you mentioned the issue of hedging and that there were some great opportunities. What do you mean by that? What kind of hedges would you have liked to have put in place to take advantage of the opportunities that presented themselves?
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C
I think I would have liked to have had a drawdown in our portfolio that was significantly less than the market. So that if the market was down 30, we were down 15 and still feeling like we could go on offense. But because of our hedges, our shorts were not as big and they tended to be maybe even bigger companies than the things that we were long. They didn't draw down as much. We had a drawdown that was as much as or maybe more than the market. And it didn't give me the room to go on offense. Or at least I didn't perceive that to myself, and I knew instinctively that was the thing to do. But the structure of our portfolio and what our performance was, I didn't perceive I had the ability to go on offense. It was less about macro hedges and more about having really alpha generating shorts that acted and behaved similar to our longs in market drawdowns and would give you the ability to be offensive in dislocation.
- [11:15]
B
That was a very peculiar crisis, one of the forgotten crisis, the crisis of that year, in a way, because everything that came afterwards was so massive in a way. But that was an interesting crisis because it started, as you very well put it, in Russia. Ltcm, it was Brazil. It was kind of a funny thing that kept on popping up in different places. It was difficult to manage in a way, that crisis.
- [11:37]
C
Yes. As a fundamental investor in companies, it was not easy to see how all this was going to really impact my businesses. Yet it impacted our performance a lot, therefore was even more of the reason why I wanted to go on offense. But feeling like I didn't have the firepower was one of those formative feelings that I didn't like and shaped how I wanted to risk manage and portfolio construct going forward.
- [12:00]
B
So let's switch then to this investment philosophy. I think it's a good place to do it. So as Michael was saying at the beginning, you define or describe your framework as identifying change in perception opportunities. Can you walk us through that concept today? How do you think about probabilities of perception shifts? How do you think about that for the long and the short? And let's go deep into this. I'm curious about your take on it.
- [12:21]
C
This has been an evolution in our framework. First, from quality and value to quality value and investor perception to what I would describe today as durable businesses and mispriced stocks. There have been evolutions in markets and evolutions in the economy that have shaped all those evolutions in our philosophy, or my philosophy rooted at the core is still buying the right business at the right price, capturing value in what you do. What I realized post the great financial crisis and as markets began to shift away from what I would describe as largely driven by bottoms of fundamental investors to markets that were driven by passive flows, to markets that were driven by thematic investors, investors who were short term oriented, what I began to notice was that the dislocations from value were persisting for longer and for wider amounts of time. And therefore early in my career it was enough to have the right business at the right price and things took care of themselves because most market participants were doing bottoms up research. And in time the gap between what we thought fundamental value was and the market's price would close and we would be able to earn that higher compounding rate of both a business that compounds and a business that re rates. And that was the core tenants of this investment philosophy that we want multiple ways to win. What I began to appreciate was that investor perception was this dynamic that created multiple compression and multiple expansion. Who were the investors that were creating it? Why did their perceptions exist and what would change? I would say to my team, you're recommending the stock at 12 times earnings because you think it's worth 18 times. And the question is why is it going to go to 18 times? It's not going to 18 times because you think it's worth 18 times. It's going to go to 18 times because other investors who believe it's only worth 12 times today change their mind and they now believe it's worth 18 times because they think the future beyond that point warrants it or the company's characteristics warrant it. Beginning to realize that the gap in value, the time it would take if you didn't understand why a stock was mispriced and didn't understand what could change that misperception. You could have something that stayed cheap for a very, very long time and then your compounded IRR might not be good enough and or you might have periods of too large of underperformance to keep your capital and keep your investors. The big change was how markets had begun changing. This was sort of the early understanding of markets changing where early in my career it seemed as most investors were bottoms up stock pickers and therefore stock prices were driven by people who were looking at individual company fundamentals how they changed and so you could just focus on that. What changed over time was the investor base. They became increasingly short term, they became increasingly passive, they became thematic. There were a lot of things that were changing in markets that caused me to realize I needed this lever and I needed to understand this in order to truly outperform on a consistent basis. And even the things that created investor perception changes have changed over time. The biggest one that has always existed is duration and short termism. I think investors have always been short term focused. They have always lacked an ability to take a longer term perspective and see through short term problems. And that is something that on a recurring basis still creates mispricings and the opportunity for perception change over time as markets have further refined. We have a whole cadre of investors today who are investing on a three week, a three month timeframe. And what they're doing has nothing to do with the business and everything to do with the stock and what's going to make the stock work. As investors have changed, the, the sources of opportunity have changed. So we have a market that is dominated by factors, by quant investors, by retail investors, by passive investors. We have a factor called momentum which is one of the most powerful signals over the long term. So a stock's 6 month return and 12 month return, excluding the last month is a factor that has worked over the long term. So you buy what is going up. As someone with a little bit of a contrarian bent, that to me didn't make the most amount of sense, but yet so many investors follow that either implicitly. Where you're a fund manager that wants to buy the theme that's working, or find a new idea and a theme that's working, or you're a quant manager and it's very explicitly part of your model, or you're a pod manager where you need to own what's going to make money the next three months. This has created even more sources of mispricing where things go even more extreme on the value. So things get more overvalued and more undervalued in today's markets. And some of these create perception changes. So oftentimes having a short term problem then being part of a negative momentum exacerbates, I'll call it investor perception. But it is really within their framework that people can own it because it has negative momentum. This is how markets have changed to both still make this perception change very critical to what we want to do and the dynamics behind it different than it even was 10 years ago. What we are shooting for is earning outsized returns. So I want these two levers. I want the compounding of the business and the rerating of the stock. And our sweet spot has been owning things for two, three, four years and getting multiple years of compounding along with a significant RE rating and then turning our capital into the next mispriced, durable business where we could identify where investor perception is wrong and how it might change.
- [18:24]
B
This is fascinating. Early in our current season we had Clif asness in the podcast and we were talking at length about the issue of the impact of passive investing in the market. And I think this framework that you are advancing is a very useful way of thinking about what is it doing to individual valuation. And this idea that you have to understand always where the other side of the market is coming from. And in this case the other side of the market is this passive investment philosophy combined with something that you brought up that to me is also very interesting. This thematic outlook and this duration narrative that came into place right after the global financial crisis that I think drove a lot of what happened in the market. This change in perception. What are you looking for in terms of catalysts that tell you, well, I'm counting on this to realize the value for me? Or are you thinking more in terms of these are the type of stocks that I'm going to be buying given this environment? Because I know that even if takes for a long time and you brought up this fundamental issue that many miss, that time is an issue for compounding returns, how do you think about that issue of what is going to change the perception to realize value for me? How do you guys think about that?
- [19:44]
C
A lot is made of catalyst investing and I specifically don't use that word because it creates the perception that there's one thing that we're hanging our hat on and if it doesn't happen or doesn't happen in our time horizon, we're wrong and we move on. Many things change investor perception that have little to do with what we think about about the business, such as a stock's momentum. So if a stock goes from negative momentum to positive momentum to some significant investor base, that's a change in perception or at least a change in how they view that stock. There are lots of things that create perception change. It is the removal of a short term negative, the emergence of something somebody can't see of a mid to long term positive. There are cycles, economic cycles or other cycles that create investor perception change. So nobody wants to own cyclical stocks going into an economic downturn, but at some point the economic downturn turns over. And buying stocks that people are selling because there's a cycle, whether that's an economic cycle or a company has its own supply demand cycles, there is a point in the future where, you know, that cycle will be different and that will change investor perception. Covid was an incredible example of where we were out in front in both being positive after the COVID drawdown, but different than everybody else in buying the COVID losers. Because I believed that at some point in the future, whether that was three months, a year, 18 months, two years, that the market would no longer look at the world as shut and physical spaces as closed. And so investor perception would come from the eventual moving on from the pandemic. There are a lot of different aspects that can come into this. It is important to understand who are the investors playing in the stock, what do they believe today, what is causing the stock to trade here? It might be a factor. It might be screening poorly on a quant basket. It might be negative estimate revisions. These are all things today that drive investors to have negative perception. And then what creates positive accelerating growth, Estimate revisions in the other direction, the removal of an overhang, whether that be technical or related to the business. There is a wide range of things that create investor perception change. And these things themselves have changed as the players in the market have changed.
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A
So Ricky, can we get a bit of a case study, perhaps the stock of a company you either own now or have owned in the past, and just explain how that change in perception unfolded for that particular company and explain in that process a bit about how you thought about the business quality as a component, just to walk people through something, how that actually played out for you.
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So I think it would be helpful
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C
if at first bucketed the different types
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D
of investor perception changes that we have
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C
available in the market, and then I
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D
can bring to life some examples through a few of them. And maybe a better and more instructive way to talk about this issue than one specific example. There are investor perception changes that happen because of micro issues at a company. There are investor perception changes that happen because of cycles that happen within industries, whether that's an interest rate cycle or a housing cycle. There are investor perception changes happen because of macro conditions where investors are very focused on the near term macro conditions, whether that could be a post Covid period. And then there are now even investor perception changes that happen around factor rotations. And so the first bucket of micro investor perception changes I'll talk about in a little more detail. Because there are several examples or different types of those. But all the last three buckets of
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C
cycle, macro and factor are types of
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investor perception changes that are happening even more often now with market structure changes. And so we're seeing more examples of companies trading peak on peak or trough on trough in terms of trough, multiple
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C
on trough part of the cycle.
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D
And in the past when most investors were bottoms up investors, those cycle opportunities happened less frequently because people look through the cycle and and look more to mid cycle. But we're seeing even more of those examples. I'll touch on that as well. But let me dive into a little bit of the micro the company specific
- [24:07]
C
ones because I think this is the
- [24:08]
D
ones that maybe your listeners will grasp the most and are most recurring in the market. There are several examples. So we often see micro company specific investor perception change opportunities where companies have short term business issues that affect the earnings in the near term but but don't affect our view of the company's
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earnings power over time.
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D
And so the market gets very short term oriented. I think one good example of this would be Vertiv which is in the data center equipment space. In 2022 we had known Vertiv from a prior investment that we had in a company. And in mid to late 2022, as a result of all the supply chain challenges that were happening and the inflation that was happening in all sorts of components to different products, Vertiv typically bids on projects with long lead times. And so they had bid on a bunch of projects, their cost structure as a result of the supply chain increased significantly and they pre announced or announced a big margin problem and so their operating margins were going to be down significantly and the stock got cut in half. So the stock was in the mid-20s and went to $10 a share. In our view, nothing had changed about Vertiv's long term opportunity to grow within the data center space. Nothing had changed about their ability to earn the type of typical margins. But there was going to be delay in that. So it took some time to work through preexisting contracts with current economics on the supply chain. And so this created an opportunity where investors were very focused on the short term, very focused on the fact that the earnings had got cut in half and weren't looking out to beyond the next nine months when we thought margins would normalize. The stock has gone on to be a huge success in part because of data center demand. But the initial recovery from $10 to 25 or $30 happened primarily because investors got very short term focused about A short term business problem. This was also true in Sea Limited where when we got involved in late 2023 actually Sea Limited was investing. They are a Asian e commerce company. They were investing in their business to develop a competitive product to TikTok, a video based service.
- [26:21]
C
One of the things that happens in
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D
a lot of these micro situations is companies are making investments or doing things that take a short term hit to the earnings but make the company stronger or better over time. Oftentimes you get a double opportunity where
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you get the opportunity to buy a
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company where the concern is front and center, the earnings hit is front and center. But then as the company executes you get the opportunity for both that concern to go away and then you have a better company that exists on the other side and even stronger company. I think even this year Google is a good example of investor perception change where only 6 months ago Google was perceived to be an AI loser based on the competition for search. We could fast forward to recently and now they're perceived to be an AI winner. And so you see very big micro investor perception changes around short term problems. Occasionally we see micro opportunities where there's an event overhang, a litigation or a transition. So in Halion's case or Reckitt Benzikers there were litigation related concerns that became front center. Investors hate uncertainty and that creates the opportunity. Time will solve that. Through time eventually that uncertainty becomes a certainty. And normally with the uncertainty, investors price in a very large amount of impact with events as well. Ferguson would be a good example of that. Where they transitioned from being a UK
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domicile company to a US domicile company.
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D
Getting out of the UK indexes created a temporary depression on the stock price. Getting relisted in the US they needed to develop some time before they could get reintroduced to US indexes. And so that was another sort of event related dislocation or opportunity for investor perception change. And then maybe the last category of micro investor perception changes or company specific can be transformations where companies bring in a new CEO and they're improving the business. And in the short term, oftentimes these businesses take a step back and investors get concerned about the short term. I think that Louisiana Pacific was a transformation from a oriented stranded OSB producer that was making a commodity product into a company that was in the wood siding business and engineered buildings products. Higher value growth product, they were converting plants. And so in the short run people believe that Louisiana Pacific is a commodity producer of wood products. And over time the company has transitioned their business to more of a engineered Business building products company which creates a significant change in investor perception. Amazon would be a good example of this. When they started investing first into AWS and built out that business, you become a different company on the other side. And so you also get the double benefit in these cases of where companies are investing in a certain area, creating a new opportunity in the short term that depresses earnings. But then as you come through that cycle, not only do the earnings rebound from that temporary depression, but then becomes a different company on the other side. So lots of examples of company specific investor perception changes around short term problems, events or I would say transformations of business mix that are often behind me. A new CEO, that's the one category. And then I mentioned the cycle where you have interest rate cycles that impact companies in the wealth space like LPL or Charles Schwab.
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When interest rates are really low, they're
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under earning on their cash, the earnings are temporarily depressed. And as that cycle works its way through, whether it's an interest rate cycle or a housing cycle, you start to get the opportunity for a rerating in that stock. Another category of macro related cycles, I think Covid was a great example of this, where lots of businesses were closed for a short term period of time that created a very short term focus on the lack of earnings and created an opportunity when that issue subsided for the business investors to perceive it differently. And I mentioned more recently factor related opportunities in investor perception. In late 2022, people were really down on unprofitable tech as a whole category for good reason because these were very overvalued stocks in 2021. But as you came through the end of 2022, the whole category of unprofitable
- [30:42]
C
tech was left for dead.
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D
And then that created an opportunity for software companies where the unprofitability came really just from investing in good high quality growth related opportunities. A multitude of different ways in which investor perception can happen from each of these different categories. And I think that sort of helps explain the different opportunities that come from this in the market and the opportunity for investor perception change to create both a big rerating in the stock. And while you're waiting for that to happen, hopefully you have this durable business where the earnings power continues to grow through that period.
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B
There are many things that make stocks enter into the portfolio. As you said, there are all these changes in perceptions. There may be something that is specific to that firm that gives you a window to enter into that position. Like in the silo case you just mentioned. Can you tell us a little bit, Ricky? How you think about portfolio construction? When I look at your 13F, it's a fascinating 13F where you have some of these tech names that you must have gotten into then in 2022. Meta, Salesforce, Tesla, you have the more classic value names. Lennar, Norwegian Cruise. Things maybe you got into during the pandemic. How do you think about portfolio construction and how you think about sizing? How do you think about shorts now and how do you embed those shorts into that portfolio construction?
- [32:03]
C
We're ultimately looking for value and for that value to be recognized. And value can come in the traditional sense in a stock that is statistically cheap, where the market is pricing it at a low multiple because the market believes either those earnings aren't sustainable or those earnings aren't durable. Our bet in those cases is the earnings are more sustainable and more durable. These are the events that will occur for the market to come to that view. The flip side is I also know that growth companies can represent value even if they're not statistically cheap today. And in those companies, the bet that within a reasonable time horizon, let's call that three years, the earnings power of this company is, and I use earnings power over earnings, will make this stock look cheap, will make this stock look like a value. What we have come to see over time is that the market tends to go in and out of favor with different styles of investing and different types of stocks. The flexible mandate to find value amongst different types of companies gives us a wide swath of opportunity to look for and look for the opportunities that the market gives us. If you are a growth investor and only a growth investor in 2021, everything that you liked or everything that you would appreciate was very highly valued. Now, you might have found this growth stock that was at a discount to this other growth stock that was ridiculously overvalued. But ultimately everything was sort of overvalued. And so by having a flexible view of value, both in growth and value, we take the opportunities that the market gives us. Ultimately, by looking for mispricings, you're looking for the opportunities the market is giving you. When it comes to portfolio construction, I don't have a preconceived notion of how much comes between each of those camps of stocks, or let's say, what will be in the middle of a quality compounder that might have a micro controversy cause that's another type of opportunity that we find. We portfolio construct based on a couple of key principles. One being the range of outcomes is a very important determinant to how big of a position we want to make something not how much can we make. Because our success over time has been based on a good batting average being more right than wrong, we need the batting average to determine our success. And therefore, if a stock has 15% downside, we think, and 60% upside, that may be a 4 to 1 risk reward, a great opportunity. And that can also be a very big position. We may find a equally compelling stock that has 40% downside and 300% upside. That has to be a smaller position so that we are getting that name wrong. And you can get every name wrong. This goes back to my uncertainty comment. There is uncertainty in everything we do. There are things we don't know. There are decisions that happen, there are things that change, the world changes. New competitors happen. To believe that you don't have risk in every investment or uncertainty is a false sense of security. High conviction. That position may be half the size of the former position. So portfolio construction around position sizing is important. And I think this is one of the reasons why, even though a lot of very successful investors believe in concentration and you have to put all your eggs in a basket and watch that basket closely, high concentration outperforms. I have come from a more diversified perspective. That doesn't mean I want high diversification, but I want several things. I want to be able to own stocks that have significant downside but even greater significant upside. So a stock that can lose 40. If you run a concentrated portfolio, you may never be able to own a stock like that. But if you think you can make 3 or 4x your money and you could size that risk appropriately, that is a very compelling opportunity. I also think having a little more diversity allows us to take this duration, not know when something is going to play out. We say we plant seeds at different times, they sprout up at different times. And so even though we're judged year to year, we're taking two or three or four year views on our stocks. We haven't had extended periods where we've underperformed for multi years because we keep waiting for our investor perceptions to change. Portfolio construction for me comes from this concept of risk managing ahead of time. And that's in position sizing. That's already knowing you can be wrong and own as much of something as you can live with being wrong. Size it according to the width of the risk reward outcome. And then having enough diversity in types of ideas, whether it be a traditional value stock, a traditional growth stock, a quality compounder, where some things in your portfolio can be working at any given point in time. And so we don't have such a narrow definition. The diversification point also gives us the freedom to sell something and say we're wrong. And I think that's another challenge in concentration. When you only own 12 stocks, you have done months, years of diligence. You have built the conviction your file is an entire file drawer. Getting you to change your mind is very hard. We've just seen with everything that's happened in the world how quickly things can change. Having being anchored to something because you've done a lot of work is also dangerous. So there is this balance between enough concentration that you can really outperform, but not uber concentration where you're not willing to walk in and say, we're wrong, sell it, we'll make our money elsewhere, it doesn't matter. Those are the principles. Risk management ahead of time, enough diversification, position sizing for range of outcomes and portfolio construction to have that duration.
- [37:37]
A
So Ricky, you grew up as a bottoms up investor, but at eminence you've built quant and data science teams. So why do you think that was necessary and how'd you go about doing that and what do you get from that that you didn't have before? Why did you think that was necessary?
- [37:50]
C
This is the evolution of the world. There's the growth of data, the ability to synthesize large, large amounts of data and help humans make decisions. I don't believe that quants are going to take over the investing world, but, but I believe that humans, aided by the benefits of quantum data science, can make better decisions. Ultimately, I think there are a couple of reasons why we have this and we think it's really important. One is table stakes. When I think about data science, everybody has access to credit card information and are trading on what the signals of that tell you. In order for us to know where investor perception really is, we have to have the same data that other people are trading. In order for us to take the other side of investor perception, it is helpful to know why they're selling something. So we often have examples of where we have a 18 month view or 2 year view of a stock and a business. What will make the earnings outperform but in the short run they're going to miss this quarter by 2 or 3%, at least according to the data. It's very comforting to buy into that stock knowing you know, why other people are selling. Part of it is having table stakes to understand decisions other people are doing for data science. Beyond that, owning the data and having the team work collaboratively with my analysts, we can slice and dice the data in ways that are really longer term oriented. We can do cohort analysis, we can do competitive analysis where we look just at the locations of stores where competition has come in. So you can do things that will tell you what will the data look like in two years based on slicing and dicing the data. Today, I think data science is really at the analyst level, using it to understand what other people are doing and using it to help inform what might happen in the future. Quant is a tool that I use at the portfolio management level. I mentioned to you before my quantium could tell me exactly how cheap growth stocks were in late 2022. We get a lot of anecdotal perspectives, Gee, there are a lot of cheap stocks in this, but just how cheap are they? And we can put a lot of rigor behind that. It also tells us about the risks in our portfolio. I mentioned the concept of risk managing ahead of time. I have to understand my risk so we can run simulations. You made a big housing bet. If rates go up by 200 basis points, how much are you going to lose? Can you live with that bet? How much do you want to take? It is a combination of understanding ourselves and understanding opportunities in the market. With a lot of rigor is why we use the quantity and why I use it. So ultimately it is about humans making better decision by being able to synthesize large amounts of data and have better perspectives using that.
- [40:28]
B
Another thing that you do, activism, you use it asparently. But when is that you actually go in and engage with management and have a more assertive view on how that company should be run.
- [40:40]
C
Activism is a spectrum. Being a constructively engaged shareholder, which is something we do nearly all the time and we're doing on a very regular basis. Oftentimes it's very light because we like what the company's doing, we like the decisions that they're making, and they don't need our help. We often give them perspectives on how investors look at things and the decisions they make and how they should understand how investors look at that. Down to when you engage with companies hoping to change decisions they're making, but you engage constructively down to places where you are more adversarial with companies. So we always want to be engaged, constructive shareholders. What I would describe as true public activism, where you are out publicly criticizing a company, hoping to persuade other investors to be critical of them because you want to change the outcome of a vote or you want to cause the board to have to make a change to management teams is a very high bar to that for us. Number one, we want to be viewed as constructively engaged. We want companies to appreciate our work. We tend to like to buy into companies that have good management teams that are doing the right things. We don't want this to be a going in decision like, this is a great idea. If we can do this, this and this. It is very time consuming. It creates issues in managing your portfolio because you get locked up. And so the bar on pure activism has been high. Most of our activism has been around corporate transactions where we were opposing things that were happening at a company, whether it was KKR trying to buy Masonite or the takeover of plural site, where we felt like if we don't stick up for ourselves, we're going to lose this opportunity. The activism that we've engaged in to change things, whether that be Autodesk, Men's Warehouse and Tain today, that's a different type of activism with a super high bar.
- [42:33]
A
So, Ricky, AI is obviously top of mind for investors, including debates about whether we're in an AI bubble. Where do you land on that debate?
- [42:42]
C
We are in a feverish arms race that has a lot of characteristics of potential bubble. I don't want to have any absolutes. I also know from history that both can be true. AI can be the next great thing. And five companies in an arms race trying to build out the data centers and infrastructure to take advantage of this. They may all or probably all won't be winners. So there will be shakeouts. The Internet was potentially similar. I don't want to draw direct parallels because I think the companies capitalizing on AI today tend to be a lot more profitable than the companies that were capitalizing on the Internet back in the day. The notion that the Internet was maybe the greatest thing developed in our lifetime, all of that was true in 1999. And yet by 2002 there was a lot of carnage. I think I land with an open mind about how this will play out and still believing that AI may be big. The other bubble part is around investor narrative and how things have changed a lot in the market. Narrative plus stock price equals the answer to a lot of people.
- [43:49]
B
And.
- [43:50]
C
And so I believe there are a lot of stocks that may be in a AI bubble where the businesses may never develop or have very tenuous prospects relative to the price you're paying today.
- [44:04]
B
So I was listening to the Odd Lots podcast the other day and the interviewee had an interesting point which is that if this is a bubble, the systemic consequences of these are going to be massive compared to previous ones because it has all the components of the previous ones. It has the technology and the biases that always come when it comes to valuations with technology. It has the real estate component because of the data centers. It has the government intervention. These companies are to some extent very important to keep the United States apace with technological competition with other countries. So everything comes together here in a very dangerous way. Should it burst.
- [44:48]
C
I would add on to that the level of investment by retail investors in the market and in the theme which has consequences for our economy and the purchasing power of our consumers.
- [45:01]
B
Absolutely. How do you think about risk managing this? You think about this when selecting names. How should the investor approach this issue?
- [45:12]
C
The only way to approach it is through portfolio construction, risk management ahead of time, whatever that means to you. To an individual investor, that might mean, don't use leverage. Give yourself the ability to come back from whatever is going to happen to our hedge fund. It might mean having a certain level of net exposure, not having excessive concentration to the theme. One of the things that causes bigger problems is even if you don't have leverage, if every one of your stocks is levered to the same theme and they correlate. So our best risk management attributes lie in having a portfolio construction that will allow us to ride through problems and not be the one that's carried out, not being the one that has to sell at the bottom. Also having an open mind to how things change. And I think maybe the last piece, there is a difference between the business and the stock. If a stock is priced for greatness and the business does good, that could be a bad, bad stock. I think investors have to understand that distinction in what they do. What am I paying for this opportunity? So those are all elements that I believe we as investors can use. Knowing that this may be real and big and play out, but that there'll likely be shakeouts before the final chapter of the book is written.
- [46:30]
A
A thread throughout our discussion today has been sort of the ability to boil things down to what's important for a particular investment. So how does one learn this skill? Is it something that's basically a result of experience or are there ways to sort of learn about how to do that?
- [46:44]
C
Well, there are two types of things to boil down investments. One is around business and one is around the stock. And I think around the business we like to do pre mortems, asking yourself, what will cause me to sell this stock down 25%? That's a very important point. You may not be able to come to a firm conclusion on that, but you better diligence that and be comfortable if see if you can track things along the way. That might give you some signposts. Doing pre mortems is helpful on the business side. And then on the stock side, I think there are always KPIs that matter very significantly. To a particular company, it might be net revenue retention. To a software company it might be organic growth. To another company it might be gross margins. In a business where competition is the tension point, the stock stuff comes with experience. It also comes with research and understanding the tension points and what investors really care about. I think you can do diligence on those. One of the things we like to do in talking to the sell side is is ask who is calling you. What questions are they asking you? I don't want your opinion, but I want to know what investors believe today, what they're worried about today, and what types of investors are inquiring about this particular company. That helps us hone in on as it relates to the stock. What are the important variables. And then we can go do our diligence and figure out whether we can gain a differentiated perspective in terms of
- [48:16]
B
AI and the demand for analysts going forward. I understand that AI is going to be complemented with your skills, your experience. You've been in the market for decades. What do you think it's going to do for the demand of analysts for entry position analysts, for instance, in your firm? What are you guys seeing?
- [48:33]
C
Typically we like to hire two to four years at a school and frankly, most of our firm are people that we hired at that point. People who had good building blocks, good, good skill sets, but didn't really know how to invest in public markets. I would think that AI is one of those tools that will be table stakes for an analyst to be able to use. For an analyst to be able to get up to speed quickly, understand the debates quickly, access information quickly, access information at scale, using it as a research tool, making you faster and more effective is, I think, going to be table stakes. I think there might be some dangers of certain views that come out of AI that may not be true. So I think it might be important to use multiple tools to make sure that we're all not just believing the same thing that ChatGPT tells us, but understanding its limitations, understanding different perspectives. To me, I think that the concept of a pyramid structure going to more of a diamond structure of an organization resonates where the analyst that is kind of building models, doing write ups is going to be moved up the curve to someone that's going to be able to do that much quicker and potentially develop an opinion. I would be careful to use these models for opinions. I would use them for facts and information. That's a big distinction that people have to understand. Ultimately, whatever the model tells you from opinion is going to be consensus because everyone's going to be using them. And this goes back to this idea that in order to get value or differentiation in a stock, you not only have to have the right outcome, but it has to be different than what the market believes. Being cognizant of that element of AI I think will be very important for young analysts as they start to use these tools and it becomes ubiquitous.
- [50:31]
B
So we're getting to the end of our wonderful conversation, Ricky. We always finish with the same two questions. What worries or what excites Ricky about the future? What keeps you up at night with worry or with excitement?
- [50:45]
C
Let's start with the worry. At a market level, the changes in market structure and how they will manifest themselves in the next downturn is a little scary and unknowable. We have an enormous growth in an industry that is using an enormous amounts of leverage in how they invest. Many of them have risk systems that rhyme with each other. When I lose money, I sell. When volatility goes up, I de risk. I worry about the size of the door and everybody rushing for at the same time and what that looks like. We saw a glimpse of this in Covid. I think it was notable that the drawdown in Covid was as big as the drawdown in the great financial crisis. We have all been around markets long enough to know that Covid was on a mid to long term basis. Nowhere near as scary as the great financial crisis. But markets drew down quicker and as much. That gives you a little signal about what could happen. So at one level I worry about the market structure and what it means and the interplay with the real economy. Because we've had so many retail investors in the market at a bigger level, but still related to the economy and markets, I worry about government debt. This is both a US issue and a global issue. We're at unprecedented levels. Nobody seems to have the will to deal with this in Washington. And at some point either the cost of capital or the value of the dollar feels like it has to come home to roost. I worry about that and whether there are ways to hedge a risk against that. Maybe at a societal level. And some of your listeners Might not like to hear this, but I worry about Islamic extremism, Western values. Some of the direction I see our country going in the education system and how we're kind of educating and training young people. These are things that are worries and passions of mine around how things have developed on a more societal level. I get excited by how the market has changed and how fewer and fewer people do bottoms up research, take longer term perspectives. That's a big opportunity. So at a very micro level, very few people can be in their industries for 35 years like me and say my business is less competitive than it was. It's different and I don't want to say it's easy but it is less competitive. People are doing what I do less and then maybe moving up bigger picture levels. I still believe we're in a country with a lot of entrepreneurial spirit, a of lot a very flexible economy. The world is changing and creating new opportunities that excites me for the future of our country and whatever the problems are, I hope we continue to have a framework that will allow us to figure out and solve those. So I'm pretty bullish on America long term notwithstanding the level of government debt we have that I described.
- [53:30]
A
What are you reading or listening to these days and is there a book or perhaps a few books that you would recommend to our listeners?
- [53:36]
C
So the things that I read and listen to and I would move everything into the second camp that I do most of my reading through audible today than reading I feel like I read so much for work and you can do a listening at different places tend to fall into a handful of categories they tend to fall into listening to or reading what great investors and great executives are saying or writing. So a number of podcasts like this or invest like the best I think are terrific. Founders Podcast is something that I regularly listen to and those are both great people and history. Reading books about history learning from previous greatness I think are really good. So great executives, great investors, history of great companies, great executives, psychology things like mindset or invisible influence where understanding things that go on in people's minds that since I'm in the investor perception change and this has maybe bigger influences on why people do things than rational people can understand. I do like Lessons of the Titans as a book I would but in the other area that I'm a big believer in is longevity and health and so the Peter Attia podcast my current Audible book that I started reading or listening to this past weekend is 1929. I'm too early in it to tell you how great it is, but it fits with history and understanding what goes on.
- [54:58]
A
Ricky Sandler, thank you very much for joining the Value Investing with Legends podcast. And to all of you, thank you very much for tuning in and we'll see you in our next episode.
- [55:06]
B
Thank you so much for coming.
- [55:07]
C
Ricky, thank you for having me. Really appreciate the conversation. Thank you for listening to this episode
- [55:13]
D
of the Value Investing with Legends podcast. To subscribe to the show or learn
- [55:18]
A
more about the Halbron center for Graham and Dodd Investing at Columbia Business School,
- [55:22]
D
please Visit Graham and Dodd.com thank.
- [55:33]
B
You.