This meeting is being live-streamed. That means it's Value After Hours. I'm Tobias Carlisle. I'll join as always by my co-host, Jake Taylor. Our very special guest today is Matt Sweeney of Laughing Water Capital. He's a small cap value specialist. So we're going to get into all the things that are ailing small cap and value. I have a pity session, though. That's been doing very well. So how are you? That's good to see.
I'm doing great. Thanks for having me. I know I've told you guys this in the past, but this has always been my water cooler session. The Value After Hours Podcast is a muscle little practitioner. I spend a lot of the time by myself. Then I flip on the value after Hours Podcast and it's my trip to the water cooler to just kick around whatever ideas might be bouncing around my head without actively being a participant. It's always
me doing the listening. So it's nice to be here live at the water cooler. That's cool. Well, it probably would have been more more substantive discussion. Ted, you've been part of it. I don't know, man. It's obviously the format has changed a little bit since Bill has moved on, but I always felt like you guys had the perfect mix of different personalities and different views on everything. I felt like I could hear
a little bit of myself in each of your different approaches. So I know it's water cooler for me. We got Billy coming back next week and I'm going to take a little break for a while, but Billy's back. Let's talk a little bit about laughing water capital. What did the name come from first? That's what I'm, that's what it's on everyone's minds.
Yeah, that is the top of everybody's diligence checklist when I'm asking. My family has a small place on the North Fork of Long Island in a little community called Laffin Waters. And kind of the joke in the hedge fund industry is your name, your fund, after the street you grow up on, but I grew up on Homestead Avenue and there's already like 20 different
Homestead funds. So Laffin Water was next on the list and it's kind of a place that I've always gone to to think about like reading a book, Lane in a hammock, you know, listening to the waves, whatever, that kind of thing, just being thoughtful about the world and that's kind of what it means to me. Nice. Nice. And what's the strategy in laughing water? What's the philosophy? Concentrated value is a short version of that. It's typically around 15 stocks. I think
I've been as high as 20 and as few as 12. Typically taking a three to five year view on a business with an intelligent business person's perspective on how the business is going to change over time. And the underlying belief is underneath all of that is if a business is creating cash flow, you're going to do okay as long as you don't overpay going in. That was one of the things. I don't want to rehash the complete discussion because I think
people should go listen to it, but you're your podcast that you did with Bill. And one of the observations that you made there was about the how much of the market participants
now are driven by really just sort of numbers today. And you were observing that and please tell me if I have this wrong, but that you know, your businesses that you have in your portfolio, you vision what they might look like in three to five years and why those numbers would look attractive to that other 80% who's who's maybe just only focused on some of the like most, you know, next quarter type of things. So maybe just unpack that a little
bit for us. Yeah. So one of the things that has been discussed at Nazim in the value investing world for the last, I don't know, a couple of years. I guess the question of whether or not value investing is quote broken. And you know, David Ionward has been a leading proponent of that theory. And I think he has a great way of coming at it. As to other people, the way I've kind of thought about it relates to a piece I read from
JP Morgan back in 2019. And the piece basically said that 80% by their estimate 80% of equity market participants these days or in 2019, it's probably higher now. But 80% of market participants were relying entirely on quantitative inputs for their decision making. So that's indexes, ETFs, any kind of quant investment platform, you know, the AQRs, AQRs of the world to buy
as you might have a few years as well. So my thought was basically in today's world, if 80% of the world is just looking at the numbers, maybe we should be looking somewhere else, right? If something looks quantitatively cheap, you know, at 50% of that purely just what market cap is, right? Like one number. Yeah. I mean, that's a huge part of it. Sure.
And I spend a lot of time in small cap where you know, I have less of that. But you know, the basic idea being that if something looks quantitatively cheap and 80% of the world is just looking at the quantitative numbers, you know, what is not in those numbers, what is cheap that is not there? Because there are definitely exceptions. But in, you know, from a high level, it's not hard to imagine that if it looks cheap and 80% of the world has
looked at it and it's still cheap, that means 80% of the world has passed. And if 80% of the world has passed, well, then who's the incremental buyer? Because on a long enough timeline, the only thing that matters, of course, is fundamental business performance. But you know, in the real world, opportunity cost is a real cost. So we can't just rely on things that are going to execute without anybody ever buying them. You want to know that there's
going to be a buyer. So I kind of, you know, just chewing on that idea a little bit in the implications of that came around to the view of, you know, what if we could find businesses that the screeners, the quantitative screeners cannot identify or cannot identify as attractive right now. So, you know, like, let's just imagine that some quant fund out there as a value factor. Well, let's not look at value factor. Let's look at things that are
optically expensive. And then have a view on the actual business and the people running it and the competitive nature of the industry and how things are going to evolve over time and how the numbers are going to change over time. So you could, you know, just a theoretical example, you could take a stock that today maybe looks like it's trading at 100 times earnings.
Well, nobody would argue that based just on the numbers, that's cheap. But then do some work on the business and understand the people and maybe the reason it's trading at 100 times earnings is because margins are temporarily depressed because of, you know, any number of reasons it could be because they are spending more money on R&D or it's not really important what it is for this conversation. But, you know, figure out why the screeners would be
missing it and figure out what's going to happen. If it is a temporary problem, you know, a temporary blip, then something that looks like 100 earnings today might really only be like 10 or 12 times earnings looking out three years when the business is running more
efficiently. And the quants, you know, in theory, if they're really paying attention to that value factor, they're going to pass on a today within a couple of years from that when they see, oh, wait, it's actually only 10 times earnings, they're going to buy it.
And that's your incremental buyer there. You have the added benefit, of course, is that the business is presumably executing, you know, they're at least in this example, they give you their, you know, grown top line and widen margins or taking cost out and widen margins. But, you know, just from a fundamental business perspective, a business with wider
margins is more valuable than a business with less wide margins. So you kind of get both sides there, the fundamental business performance as well as the incremental buyer. And your view is that the business sort of normalizes and then the market's view of that business sort of normalizes as well. So normalize business normalize multiple. And that
would be what you estimate, pay value to be around. Yeah, yeah. I mean, in theory, all businesses should eventually trade at some, you know, normalize multiple of normalized earnings, right? I mean, that never works that way in the real world. There's, you know, that idea of normal, like we might, we might pass it going around the street corner and
then we're back on the circle again and who knows when we'll get there again. But yeah, and that's, that's the basic idea is figure out what earnings are going to look like a couple of years from now and then figure out what those earnings will be worth. And that's the work. I mean, that's the job, right? That is the craft. It's figuring out what
the earnings are going to be. And the multiple part is also part of it. That's a little more formulaic where you can just look at comps and, you know, past transaction multiples and it interest rates. If you want, that is a little more formulaic, but actually figuring out the business is, I mean, that's the craft, right? It's, it's not as easy as just looking at the numbers and saying, Oh, well, this is, this is where we are. Like, you know, how
was the business going to change? I was a competitive environment going to change. What is, what are the growth prospects? And the real idea that I come back to is the fewer variables you have, the better, right? So like, you could make an argument that a business as earnings are going to be higher several years from now because they're going to spend the next seven years jumping through flaming hoops while juggling knives. And that's fine. Like,
you know, that's some people that's how they invest. That's not what I'm looking for. I'm looking for, you know, the one foot hurdle of why earnings power is going to be higher. A couple of years hence. We've been kicking around a few ideas before we started about. So it's been a, it's been a long tough run for value for smalls. And we're throwing around a few of the ideas. One of them was, uh, Schumpeter's JT. Do you want to expand on that one a little bit?
Yeah. There was, um, there was a podcast recently with, with Michael Mobison and, uh, Tano Santos of Columbia and this economist named James Besson and they were talking specifically about creative destruction and the pace of creative destruction. And what, what Besson was found through some research was that they looked at the likelihood that a top four firm as far as sales goes, how likely were they to be still in the top four in a year later
or three years later or five years later, whatever. And they measured this in a variety of ways and what they found was that the rate of disruption was rising in the 70s, 80s, 90s as you would probably expect, like we all have this intuition that like technology is speeding up, uh, but they found in the, in starting in the late 90s, early 2000s that it peaked and it's gone down sharply since then. And so the rate of disruption is like half of what it was,
you know, 50 years ago, 30, 40, 50 years ago. Um, and that may play into like why some of the big have stayed big and gotten bigger and small caps then kind of by, uh, backstrap elation then would, would maybe have a harder time catching a bit at that point if there's not as much disruption. Is that by industry, top four in each industry? Yeah. What do you think, Matt? I mean, it's hard to know, right? There's, well, one, two things. It's hard
to know one and two. I'm not sure it's actually all that relevant. If you're a stock picker, um, you know, in terms of hard to know, it's part of it. I think if you take any large sample set of however many businesses, you're going to have some that are the best, right? And the ones that are the best in theory have some sort of true competitive advantage that's difficult to replicate. And over time, more people are just going to figure out new competitive
advantages or new ways to rise to the top. And the old ones are probably still going to be there because, you know, though, if in the 80s or 70s or whatever it was, the average business, let's just say like a five or seven year life, well, today, maybe that's 15 or
20 years because for the best ones because they're, they're literally the best. So there's going to be more overlap where some existing business is still enjoying its competitive advantage period, but a new business comes up with a slightly different niche or something like that. So I guess that's my, my first initial thought that it makes sense intuitively
to me. And the other part of it is like people learn, right? So if you look at the best technology company from the 70s or whatever and I don't know, I'm just, let's just say it was IBM, like IBM has made a number of mistakes along the way. And everyone at Google or Microsoft or wherever you want to think about today, like they're broadly speaking aware of the mistakes that were made by IBM. And they're going to try their hardest to
not repeat them. Now, you know, human nature being what it is and markets being what they are, there's going to be some mistakes still, of course. But in theory, if people are getting better over time, then you would expect their businesses to last a little bit longer as well. So I mean, that was one of the suggestions for why small capital struggled that were
previously company said listed in small capital and outgrown small capital. Now they stay private for much longer because they're VC back then they don't come public until it bigger. But also part of that was there, there are many more exits by acquisition. And they listed the acquisitions and it was all Android by Google, YouTube by Google,
Instagram by Facebook and so on. Like those sort of very material, any of those companies stand alone are very impressive companies, but any of those businesses stand alone are very impressive companies. But you know, they just add to the glory of Google, or whatever
it happens to be. Yeah, I mean, it's, you know, I don't know how deep we want to go here, but if you go back and read like, you know, Karl Marx and stuff like that, he said like the problem with capitalism on a long enough timeline is that the competition goes away because the strong just keep getting stronger and they gauble up all the competition. And
you know, I'm certainly, I'm certainly not anti capitalism. I assure you of that. But you know, there are arguments saying like there, there has been too much consolidation in the world and it has not benefited enough people or however you want to think about it. But at least we're stopping the handbag retails from combining together. Jesus 10% market caps too much in handbags. Yeah, I mean, that's, I don't even know what to make of that. I mean, it just doesn't make any sense on any
plan that I can think of. So what do you think about, you guys follow this, the pod shops, do you know what the pod shops are? Do you want to explain what a pod shop is? And then yeah, I mean, as your thoughts, as if we were five years old, high level, you know, like a massive hedge fund platform where there are many different pods, each pod being a PM who typically has a, you know, sector focus or a product focus
or something like that. And they typically run net neutral. So they're not really taking a market risk. And then at the, the parent level, they're levering it up several times and then running super tight risk controls. And there's been a lot of articles over the last, I don't know, year 18 months, maybe even two years about how much money has flown to
the pod shop structure over the last, you know, that period, I guess. And there's been some commentary to around what that means for the market, which actually I think it was when Brian Barris was on just a week or two ago, he was talking about how it in today's market, if you, you know, if you miss earnings by a penny, like the stock could be down 20% or whatever, because a lot of the money is in these pod shops where a big part of the
strategy, it's typically super short term, holding period. And I know, I know some of them, I don't want to name any names, but some of them, if you're a manager on the platform, you get charged for your capital. And some of them, if you hold the position more than 30 days to the rate you have to pay, just access your capital goes up. So like you are really incentivized, I've super short term holding periods, which means you're just trying to
game the events, right? You're trying to game whatever happens with earnings or maybe it's a conference presentation or whatever it might be. And look, the model has been very successful, right? I sometimes wonder how much of the success of the model has been because of the interest rate environment, meaning that if you're, you know, you're running four to six times levered and you're not paying anything for that extra capital, well, then
you can afford to recruit more pods. And if you have more pods, you're splitting your returns even more. And then you can leverage even more in theory, right? You know, then rates go up. Like, I don't know what happens if that starts to unwind a little bit. And it's, you know, there are a huge factor in the market these days. It's probably not good. Plus, I call it till it is been just, yeah, hardly anything. Yeah. So, so I don't
know, it's definitely another, you know, factor to think about, though, as an investor. And it's funny because not long ago, it was one of the major pod shops filed as all of a sudden, like a huge older of one of my positions. And I got emails from a couple of people saying, oh, did you see they, they filed and I say, yeah, but, you know, all that means a week. There's a big seller in three months or whatever it is. And I don't know.
I have a little bit of possible of a hypothesis on some of this. Why so much is flown to the pod shops. And I think it, some of it is some, the large pools of capital, like foundations and endowments have one, they have not been getting the cash back from their private side as much as they thought they were going to. So there's been a lot of illiquidity in the privates. And what that means then is to meet their obligations that for, you know, tuition
and whatever these, the budgets at the schools, they have had to find liquidity somewhere. So where do you find liquidity? That's like your public managers, like they're much more liquid than your private. And the most, then therefore, if you're very much kind of stuck in privates, you need to have liquidity terms that are much easier to handle. And the pod shops are good at like providing easy, come easy, go liquidity relative to say,
like a long, only, you know, value manager that's looking three to five years out. So therefore more money sloshes into the pods because they know that they can get their hands on it again easier if they need to. Almost like it, not that it's a money market fund, but it's, you know, like they're treating it as kind of, yeah, it's a much shorter term investment.
And therefore, the people who are in the middle who are public equities long term have kind of gotten squeezed out by short term on one side and then private on the other that's blocked up. Yeah, that makes that makes perfect sense to me. Have you seen, I know that you're not purely small kept, but do you think that the, have you seen rates impacting the businesses of those smaller companies that you look at?
Yeah, well, I mean, sure, in some cases, right, if you own something with adjustable rate debt and rates go up, like that matters, right? It's going to, it's going to take some of the cash flow, then your term cash flow out of the picture. And one of the things I've kind of struggled with in the portfolio is businesses that are executing on every level you can imagine, and they also have some floating rate debt.
And the floating rate debt is the only thing the market seems to care about. It's like, you know, it doesn't matter if the business is executing if they have floating rate debt. I'd imagine, you know, part of that is fundamental. Again, like there's a real cash cost to
increase interest expense, you know, that matters. But if you think about the value of a business hypothetically being the discounted value or the present value of all future cash flows, it shouldn't matter all that much over like, you know, to the hypothetical true intrinsic value, but it seems to really matter. So it's been frustrating, you know, like it's a
time where you have to think about those factors. And if your base assumption is always that if this company can generate a lot more cash flow with three to five years from now, then they can today, and we don't overpay going in, the stock is going to work out. You know, like I still think that's true, but that three to five year period when rates are moving around and everyone's just focused on the macro can be a really volatile three to five
year period. And that's kind of where we've been, I think, with a lot of small cab. So then they do those end up trading based on what everyone thinks the Fed is going to do. Yeah, absolutely. It's, you know, you see it all the time. I mean, at least some of my names that I don't want to really talk about specific names, but, you know, like headline earnings report, they're doing everything right, beating expectations, raising guidance, rates are up, stock is down.
You know, like, you know, what are you supposed to do then as a manager? And the answer is, well, one, you should have patient capital, and which I do, which is a huge help. But if you don't have patient capital, you kind of have to just go along with the herd and play the rates game. You know, that's what the pods are doing. And that's what so many other market participants are doing. But it's not fun when you are just focused on the actual business value and you are just focused on,
you know, fundamental business performance and execution. It doesn't seem to matter for extended periods. But you know, you look, you can look back in history and see this isn't the first time this has happened, right? There's plenty of businesses and plenty of stock charts. You look at the big old sideways for a number of years. And then something somewhere switches and the stock all of a sudden catches up that huge sideways period that it had.
And all of a sudden the Kager goes from, you know, a three year Kager of 2% to a four year Kager of 18% or whatever it might be. You just have to stay in the game, which is, which is our. You see any demand destruction, you know, like the sales are impacted as a result of the right. So just the general, like does it give you any insight into the underlying health of the economy?
I'm not really a macro guy. And most of my businesses, like I think of that more being like, you know, maybe consumer facing stuff like that where you would see that. Most of my businesses are not really consumer facing. And I'm typically looking at, you know, starting with the bottom up, looking at a business where I have a strong understanding of why I think their earnings power is going to be a lot higher.
But also then having, you know, a top down view on some specific industry force, which is going to explain why there's going to be some tailwinds to independent. Of whatever rates are doing or the macro is doing so, I mean, just a quick example without saying specific names, but like I own a couple. Large molecule CDMOs, so basically like biologic drug manufacturers.
And I can't think of a single reason like it's basically impossible for me to believe that five years from now or 10 years from now, there won't be more biologic drugs. You know, and high level, if you think of a small molecule drug, think of like aspirin or Tylenol, that might have like 25 molecules to make Tylenol or aspirin. And then look at like a biologic drug and might be 25,000 molecules like they're infinitely more complex.
And most of the simple drugs have been figured out. So the whole world is going towards more complicated drugs. You can see it in the FDA application process, the percent of the FDA pipeline that is biologic and everything else. And you could also see in terms of, you know, drug adoption in the US versus less developed parts of the world where the US is increasingly going biologic.
And you know, Africa, for example, is still primarily a small molecule, but you know, that's going to that's going to shift over time. So like the trend behind large molecule drugs, it's almost impossible to think of how against disrupted. And if you can combine that with a single stock or a single business where they are set to increase their earnings power against a trend that is pretty much unstoppable.
You know, the macro is frustrating. And the near term and the stock trades on rates and everything else, but ultimately it's going to be fine. I hope. What about like large scale construction type businesses that's going to be somewhat impacted by the macro backdrop, isn't it? Large scale construction or construction housing. I'm just making limb back, for example, it's one that I've held in the past. I don't currently hold it.
Well, yeah, so I mean, there's something there's more than meets the eye there though. Like so there's an argument that construction can slow down and not slow down based on the macro. They are focused in the right areas. Like they specifically focus on like healthcare institutions, educational institutions. Data centers is a big area of growth, although they're not on the, you know, the new build side. They're more on the facility maintenance side.
So all of those things tend to be more recession resistant. You know, people, if you're building a hospital or you're, they're not even on the, they're getting away from the new build side and more like facilities maintenance side. If you were, they have the contract for a hospital to like minimize their heating and cooling bills. They still need to minimize their heating and cooling bills if there's a recession or not. So like they are more insulated.
But that's also part of the thesis is like historically they had most of their business focused on what they call general contractor relationships where they might be working with a GC who is actually overseeing a new build. And now they're going more towards like facilities management and you owner direct relationships with what they call.
So somebody who owns a number of buildings or even one large facility, they'll go to them and pitch them and say, hey, whatever your, your, let us take a look at your HVAC system. And we will come back to the proposal for how you can save costs, you know, save money. And when your business model is saving people money, that never really go that a fashion. Yeah, good one. Let me give a shout out to all folks at home. Senator Mingo, Dominican Republic.
Bendigo was dead cat, cutly new South Wales. Castle for the England, Mendocino, Mendocino, California, Moutain Keens, Crackow. Always jumps on me, Gothenburg, Sweden, Limerick Island, Tampa or Beck City, Rachacha, New York, Durham, Connecticut, Tomble, Texas, Atlanta, Georgia, Jupiter, Florida, still winning Clemson South Carolina. Lincoln, Nebraska, Victoria, BC, New Delhi, Carava, Finland, Portugal, Lisbon, Pettitick, V, Israel in the house.
My God, Macedonia. This is a good spreadsheet. Macedonia. I'm rising in. Have you ever gotten any information or done any work on how some of the people in the most random locations have heard of the podcast? Like, like, for example, could it be someone from New York that then moves to Northern Finland and still tunes in or is there something? No, we've done this is literally zero. We don't work. We get billboards in Macedonia.
Yeah, I just, you know, it maybe not doing work, but like, if you've ever gotten an email from someone that's like, Hey, so you know, I live in a town of 700 people above the Arctic Circle in Finland, and I love your show. Like, it just be kind of interesting to hear the story on that. If anyone wants to write in, please email Toby about that. And I think that, you know, we're previously, you sort of geographically limited feel interest.
So maybe you had a subscription to some sort of weird service. Now, you know, you, you coalesce around your interests. And so this is a, this is a very specific nation. I haven't very nation value investing podcast, but it's a global tribe. That's right. There are dozens of us. Does it. So it's funny though. When you, I'm thinking I had a meeting last week with someone from, he invests in India, and I believe he lives in Singapore. And he was coming through New York on his way home from Omaha.
So, you know, mutual connection introduced us and we sat down and, and jatted, but it's like, you know, we're talking for like 30 seconds. And it's just immediately clear, like, we speak the same language. Like, you don't have to, you don't have to spend time on the awkward pleasantries or anything. You just kind of like dive into it. And, um, no, that, that was actually a big part of my experience talking about Omaha.
The first time I went to Omaha, I was probably, I don't know, maybe 2011 or 2013. I got on a plane by myself. I didn't know anybody. I didn't even know anyone that had ever been. I just had been, you know, reading and falling along the greenbacked and, and other things. And like, beginning to see the world a certain way. And I figured, I don't know, I'll go. And then you start walking around and you realize how many other people are there doing the same thing.
And like, you don't need a nice breaker because it's like, oh, you're, you're part of the tribe too. And, you know, it's kind of, and I was like nerd prom or something, you know, everybody's on the same page. But there's people I met that first time that I still exchange ideas with now. And, you know, it's great. What, uh, what appeal to you about value investing? How'd you find out about it? Well, fundamental investing doesn't have to be value. I say value, but I mean, fundamental investing.
Yeah, I'm very much a lead bloomer. I didn't grow up around the stock market. And I managed to make it through four years of college without ever having taken accounting or business or finance or anything. And I embarrassingly, I probably couldn't, like, I probably never even seen a balance sheet till I was like 25 years old or something. And like, it's kind of ridiculous to say, but here we are.
And my, my short story is I wound up through a twist of fate with a job on the cell side that I never, I was completely unqualified for. But I don't want to get into the whole thing because I know this is a short window here. But basically as a result of 9-11, I got a job at Cannibals' Charyl because they lost a lot of people and they were hiring and a friend of a friend who survived basically called me and said, hey, we need someone. Can you come in? And I said, Cheryl, come in.
And then I wound up on a trading desk, the equity trading desk, which for a while was super exciting. It's like literally, this doesn't really exist anymore. But if you go back and watch like a clip from the 90s or the 80s of like guys running around yelling and screaming and, you know, super high energy. And I thought it was great. But eventually I realized how ridiculous it was because I was calling portfolio managers that were, you know, twice my age or more who managed a billion dollars.
I didn't know how to read a balance sheet. And I'm telling them like, oh my god, they missed earnings. You should sell. And they're saying, oh, let's sell. You know, take sell 100,000 shares of XYZ or whatever. And it was a commission generating role. So that was great. But eventually I figured it out like this doesn't make sense. Like nobody at all should be listening to me. And they are listening to me. So like I got to get up the curve. So I started just kind of reading broadly.
And then eventually somebody pointed me in the right direction and said, you know, go read Warren Buffett, read Ben Graham, read Joel Greenblatt. And then I just really got down the rabbit hole and all the blogs and everything else. And got to the point where I'm sitting on a trading desk with people, you know, whipping a football past my head and screaming and yelling at each other. And I'm just looking at, you're reading our live.
Yeah, I've told Tobias in the past, like Greenback was one of my big ones. Like, you know, reading about some obscure net net and being like, oh my God, this is amazing. And, you know, but the more you read, the more you learn. And over time, like my own style kind of developed. And I got away from the, you know, the historic quantitative value. Like the where most people start. Most people start in value investing in value investing in quotes.
And they start with Ben Graham and going back to what we were talking about before. My thesis that like the world has changed to the extent that things that are quantitatively cheap. Maybe are not cheap anymore. And maybe they are, right? It's, but it's, I think there's an argument that 75 years ago, if you found something quantitatively cheap, it had a much better chance that it was actually like a good business, a real business versus today.
If you find something that's quantitatively cheap, you have to be more suspicious. I think they tend to be just a little bit more cyclical. Now things get cheap because there's some, you know why they're cheap. Some, some, you know, energy is getting beaten up or there's a whole lot of banks are failing with SIVB or something like that. It's, there's often a reason why you can identify them. There's no mystery why they're cheap anyway.
Right. But I mean, I guess what I struggle sometimes like the more cyclical stuff is like, are they cheap? Because like so, a cyclical if it's cheap often looks like IPE though, right? Because, you know, the bottom side of the cycle earnings are lower. So it might look expensive. That kind of fits into my theory of things that are not. They don't look cheap, might actually be cheap.
So if a cyclical does look cheap, I think what the market is off and telling you is that earnings are not sustainable or that earnings might fall off. Right. And now the market obviously gets that stuff wrong sometimes because that's a time in question and you know, time in is very hard. I try to avoid situations where you have to get the timing right.
And you know, like one of the ways I try to frame investments is like if you go back to just super basics like like literally as basic as it gets. Just think of, think of a government bond and let's pretend for a second that the government does not have a spending problem and has no chance of getting over its skis. But like you think about a government bond, you know, I don't have that creative imagination. This is fantasy now. Yeah, okay.
You know, like if you think about a hypothetical country, you know, you know what the amount of money is going to be returned to and you know the timing, right? And like if you know the timing and you know the amount, well then that's kind of like your baseline for any investment and you know, of course part of the amount is growth but like we'll will roll growth into there and I've you know, I guess that's it's for a bond it's a double-edged sword right?
It's like you're you know what you're going to get but you're also not getting more. So that's sort of some people that's no good. But if you start there with the two things that matter is the certainty of the cash flow and the timing, I tend to focus more on the certainty of the cash flow and less on the timing.
No, certainty can mean different things like I don't I'm not investing in I don't know, you know, vanilla blue chips where it's Coca-Cola or whatever where you could say like wow, this is a rock solid business. I'm investing in things that are less predictable but it seems like the future is going to be a lot more attractive than the past has been. But the timing is the part that I don't know.
Again, you know, the previous example like I am very confident that biologic drugs are going to continue to take share and then very confident that that will benefit drug manufacturers. But I don't know the timing and it's not the kind it's not Coca-Cola where you could look at a CDMO over the last 20 years and say oh every year they you know they take a little bit of price and they take a little volume and that's not what it is.
It's very much a more nascent trend but it is still a very strong trend. It's the top of the hour which means that it's time for Jake Taylor's veggies. Mark it down, I live in a three on the 33 minutes. Okay. Time stamp. Time stamp. I don't think I ever realized that this was top of the hour. I thought you kind of just jammed it up. We just kind of figured out. Yeah, it's okay. It's a rough approximation. All right, so we are sliding in today with some amazing facts about fish.
So mark your calendars. So this is kind of surprising to me but fish have been around for more than 530 million years. So pretty successful as a biological entity. There's around 32,000 species of fish in the world. More than all mammals amphibians, birds, and reptiles combined. Catfish have over 27,000 taste buds while as humans only have 9,000. Now thankfully, it probably for the catfish that they don't eat each other because catfish tastes terrible. That's just fun. That's just science.
There's this little fish called the cleaner RAS. And they've been shown to not only respond to their own reflection in a mirror, but they attempt to remove marks on their own bodies when looking in a mirror. So it's like it's a sign that they're actually self-aware. Fish use tools. There's an orange dotted tuskfish which has been filmed repeatedly smashing mollusks on rocks to get to the clams inside.
And there's this one fish called the goby fish that it's survival depends upon being able to leap from one tide pool to another at low tide, without getting stuck on the rocks, which would be fatal for them. And they have this very clever solution. While they're swimming along at high tide, they're actually memorizing the topography of the bottom of the ocean. And they make a mental map. So when the tide goes out, they know where all
the pools are and they know where to jump. And the studies have shown that these little fish can remember this information up to like 40 days later, which I find to be quite shocking. So fish are quite a bit more impressive and interesting than I think I gave them credit for. But what I really want to talk about today is these things called a fishbone diagram. And I don't know if you guys are familiar with this concept.
I hadn't really heard about it before, but I read about it in Luca D'Alena's new book called Winning Long-Turne Games. And we're having Luca on the show here when we come back from break. And I'm excited to have him on. But in there, he talks about it's this visualization tool that it's used to systematically identify and present all the possible causes of a problem. So they're also known as Ishikawa diagrams after it's development by Dr.
Aureu Ishikawa, I believe it said, in the 1960s. And Ishikawa was a key figure in quality management processes, think about like the Toyota lean manufacturing stuff that was happening in Japan. And he was influenced by a series of lectures by Deming, who was one of the kind of figure heads of that. And that Deming gave to Japanese engineers and scientists in 1950 and Ishikawa happened to be a part of that. So these diagrams really helped teams brainstorm and categorize potential
causes of problems in a very structured way. And it's really getting at root causes instead of just symptoms. And they really turn complex problems into these much clearer visualizations. So imagine, they're in their part of like the Six Sigma lean manufacturing continuous improvement like Kaizen processes. So why is it called a fishbone diagram? They look like fish skeletons when they're drawn. So you take like the defect or the problem that's to be solved. And
it's shown as the fish is head. And it's typically like kind of on the far right of the diagram. And then the causes extend to the left as these like as fish bones. And so these ribs branch off of the backbone as like the major causes of a problem. And then you can have little sub branches coming off of each each main rib. And really as many levels as you want to require. So they can be used in conjunction with that five Y's exercise where you just keep asking why until you get at the
root cause of an issue. And there are these different kind of catchy collections of different fishbone diagrams that can be done depending on the industry. So I'll give you some of them like in manufacturing, they have the five M's which are manpower and mind power. So like physical and knowledge work machine equipment technology materials. So your raw materials could see rules and methods. So that's like the process that are being used. And then measurement and medium,
which is like the inspection and the environment. So those like you could if you're trying to diagnose a problem in a manufacturing context, these five M's drawn out on this fishbone diagram can help you to understand like where might we be going wrong and get at the root cause of it. There's an eight keys for product marketing. See a product price, place, promotion, people process, physical evidence and performance. And then the last one is in the service industry. There's
the five S's which are surrounding suppliers, systems, skill and safety. So these are just kind of like generic ones that people have built that like that apply more generally. But I think this is a useful tool. If next time that you have a problem that you're trying to really figure out how to solve it, drawing one of these fish diagrams can really help you to kind of unpack, especially in a team dynamic where everyone is trying to understand like where the problem is and what's the root cause
of it. And hopefully this ties together a little bit with some fun facts with fish. So good much I see. I like it. I'm still trying to figure out with catfish have 27,000 taste buds why they basically eat garbage. But yeah, I got stuck on that too. I didn't make it much past that. It's what I know exactly what you mean. I've seen like, I don't know if it's an artist or a sculptor or somebody, but you could get like if you're a fisherman as like a kind of taxidermy, you can
get the actual fish skeleton. And like you could really see all the bones. And I know exactly what you mean. And in terms of like why they call that's a that actually is an interesting way to to frame it. Yeah. And if you just do a quick Google search on like the image of a fishbone diagram or ishikawa diagram, like you'll see it and it'll just like immediately make sense. Right. I did that while you're telling story. Yeah. Did it make sense? Yeah. The match. The match.
Matt, you've identified some of the themes in your portfolio. Do you have any other sort of themes that you think are driving the future? Things that you think will see? Plastics. One word. AI. Yeah. Well, I mean, like it's it's it's funny. Just where we are in the market cycle and how the market's behaving. Before getting into like industry themes or any like that, I think the most important theme to just stay focused on for fundamental investors is that, you know, if you
increase earnings power, you're going to do okay. That's it, right? Like if you don't overpay and you increase earnings power, you're going to do okay. It seems odd and I don't think it's exactly what you where you're going with your question. But like I think right now I've heard from a lot of investors who are as frustrated as I am and know about the world where you're there's so many stocks out there right now, which they they look very cheap. They are executing very well
and they are not going up and you know, it's frustrating. I think that's one of the problems that investors have over time is that they lose patience. So if you have businesses and they are executing and the stock isn't quote unquote working, like when when do you have to give up give up on it? When do you throw in the towel and that's not a question. Do you have an answer for that? No, I don't. It's you know, like I know Monizh Fabri has said he does two years and then he throws
in the towel. I don't think it's as simple as that. I thinking of one stock in particular. I held it for about two years. It maybe went up, I don't know, three or four percent and I sold it and then immediately continued to go up four X and it's like those ones are really frustrating, right? And it's as a portfolio manager, it's tough. You can't know in advance, right? And not only can you not know in advance if you do sell in advance, it's much harder to buy back in at a higher
price when it does start to work. So you you could wind up really putting yourself in a mental box focusing on that stuff too much. So you know, for me, it's kind of constantly just reminding myself, like if the cash flow is there, it's going to matter. I don't know when, but I promise you it will. But then also spending time cycling through the world and looking for new ideas and saying, okay, if the cash flow profile, the future cash flow profile is reasonably similar,
then we need to shift to the timing aspect. Then are there ones where we can kind of pull forward, you know, that return because the cash flow will be here sooner. So it's more thinking about, you know, less so much thinking about like those individual sector themes that I think you were actually referring, but more thinking about like how predictable can the world actually be? And look, there's a ton of evidence and I'm sure Jake has done several veggie segments on how bad people
are predicting the future. But sometimes you see it and say, all right, this might be unknown, that's like an 18 month to 24 month unknown. And the other one might be a 36 to, you know, 48 month unknown. And what you should probably then move to the, you know, unknown, that's a shorter unknown, even though you're never going to be right 100% of the time where it gets tricky, though, is also thinking about the interim steps, right? Because like if the ultimate goal is more
cash flow, there's a couple steps on the way. Like one of them is revenue starts to build. And then the next one might be like operating leverage starts to kick in and then operating leverage like really flexes and, you know, but each step along the way. So it might be a situation where you're looking at something or I'm looking at something saying like, I feel like this inflection is going to happen sooner. And the two, just two hypothetical businesses, you know, similar future cash flow
profiles, but one influx sooner. It's not as easy as just saying it's going to inflect sooner, because that one might actually get to like the real cash flow sooner, but the other one might have that interim step that comes first. So I don't know, I've spent a lot of, been spending a lot of time trying to come up with a better system to understand, you know, to think through those
problems. And it's hard because none of it, none of it fits in a spreadsheet, really. It's more, it's a lot of, it's a lot of just thought experiments and trying to understand the world and how it's working and how you can try to categorize things that do not lend themselves to be categorized very easily. And then, you know, again, focusing on the cash flow. Part of the category is I mean, though, I'm part of thinking about when the cash flow might come, I guess going back to your
original question, as I understood it, just those kind of sector themes. And I mean, the biologics is one that I've talked about. And other is just like small, medium businesses adopting software, where most small, medium businesses today, they're not in the cloud, they're still running their business on, you know, sticky notes and Excel spreadsheet and quite books, maybe. Restaurant tech is another one that's been, you know, widely discussed on Twitter that I have exposure to. I think
restaurants are definitely going to have more and more software going forward. None of these answer the questions of who's going to win these battles. But, you know, they're interesting tailwinds to think about. And then if you can kind of have that tailwind against the individual companies that seem to have the distinct competitive advantages to win, it makes it a little easier to hold on through the unknown timing period if you have that, you know, that the bottom up and the top down.
Matt, do you feel like the, you said that having not overpaying for all of these propositions as well? And what it like, one, it seems like that perhaps there's a little bit of, you know, frog in the boiling pot that's happened with valuations over the last 15 years, where I mean, 20 times for earnings for a quality company used to be kind of high end and like, or at least, not low end. And you wouldn't say that was cheap. But I feel like today now people talk when they
say like 20 to 25 is relatively cheap. Yeah, it's like, oh man, this is a great generational buying opportunity at only 25 times earnings for a good company. Well, one, I guess the question, is that true? Will we do, will we see a reversion into the mean in that? Or do you think that there's some new permanent version of the world where you, like a good business should just trade for 20 or
25 times? It's hard to answer. And there's a couple different like, you know, major currents I think about, one of which is, you know, low interest rate environment, which we just had kind of reset the, you know, the normal, if you will, a lot of it, I think was basically as bond proxies, right? Like you could look at companies, especially like, you know, blue chips, blue chip companies that actually generate real cash. And then they're trading at 25 times earnings or something like
that as a bond proxy. And that has already receded quite a bit. The other part of it though, I mean, that much though, I kind of feel like not as much as I would have thought, like you put rates back up at five or six, I would have thought that you wouldn't still take a two percent earnings yield on a Costco or something. I totally agree. But the other part of it going back to where we started about, you know, how much of the world is just looking at quantitative inputs. I mean,
the amount of money that has gone passive plays right into this, right? Because by definition, the index is, you know, the S&P, for example, is market cap weighted. So I'll give you have two businesses that are exactly the same. But one of them is more expensive. Well, the S&P is going to buy the more expensive one. And I don't know. In theory, that doesn't make sense, right? Like, you know, a long enough timeline that does not make sense. That's not the way the world is supposed
to work. But the trend that that is a huge pendulum that has been swinging for a long time. And where, you know, we're past the 50% mark. I think it's like something like maybe 60, don't quote me on this, but maybe 60% of the market is gone passive or something like that. Like, you know, you're just dumping more and more fuel on the fire for that. And that helps explain. I think why multiples are elevated for some of these best businesses. I don't ever really, I
went to criticism of myself. I wish I was better at paying up for quality. I'm not great at paying up for quality. I am much more interested in things where you look at it today. It looks expensive. But, you know, looking out two or three years, it's only trading for a single digit free cash flow yield. And part of that is because, yeah, I mean, it's just margin of safety, right? Like, let's say I'm wrong. And it's not trading for a single digit free cash flow yield because the cash
hasn't inflected the way I thought it would. Well, fine. Then it might still, it's still probably, you know, if the average business should trade at 16 times free cash flow or something like that. And, you know, if instead of trading at eight, it trades at, you know, the low on the number, you could get to the same point, you know, the same price target by putting a higher multiple on
the lower number and feel comfortable with it. That's kind of, that's kind of how I come up. But I get, you know, my strategy, it's not the type of strategy that should be 100% of anybody's portfolio, although it is 100% of my portfolio or, you know, 98% of my portfolio. Because I want to eat my own cooking. But, you know, for most people, and I don't want to even call up my strategy because I
don't want that to be too close to the marketing line. But for most people, if you're thinking about allocating a portion of your portfolio to concentrate a small cap, but it should be exactly that. It should be a portion, you know, as a way to kind of, you know, find some different exposures. And you can get a little juice if the strategy is executed well. Maybe not as much juice as if you just put all your money in the video. But it's a, it's a different kind of juice.
There's been this wave of bankruptcies in restaurants, seems like restaurant chains have been going on. And there's, I saw one, I saw this story today about Boston market evidently, the bankers have seized their HQ and they've effectively seized operations. They're franchising, these that are out there that are still operating like the last soldier in the ass hole in the Pacific. Have you seen any of that? I mean, that one's gone bankrupt like how many times now?
Yeah, I don't know. I don't know that one. I mean, I'm aware of the restaurant chain. I don't know about the bankruptcy. I did see I think it was, it was a red lobster maybe. Yeah, there's a lot of stuff. We did hear that it was, the all you can eat shrimp, I guess, that went, that went bankrupt for them. But it turns out that the private equity company that owned red lobster had a shrimp company and we're just taking all their margin out basically on the shrimp that
they were supplying. That's amazing. I had not heard that. It's all the full of the locations and waste them back. I thought it was that if you, if you got all you can eat shrimp, you short the American eater and that's just a crazy position. Yeah, you don't want to do that. But I would have great hedge though. It's all you can eat shrimp, but we own the shrimp. I wonder, I mean, I have to imagine that was disclosed, but I don't know if that was a franchise model, but you feel sturdy
though, doesn't it? Yeah, absolutely. And that's why you wonder if how much was disclosed and how much the actual owners, again, I don't know if it's red lobster was franchise, but if it was, and you're a franchisee and you don't, you don't realize that that's obviously a big problem. We got to worry about handbags. We don't have time for us to have some shenanigans. Have you seen that in your, in your sort of restaurant adjacent software kind of focused business?
Is that fair? Are there a lot of these businesses going under? Or is that just a? So yeah, I mean, the businesses I'm invested in are, they're not really dealing with. There is a move towards table service, but it's more focusing on tier one quick serve. So the McDonald's, the Burger Kings, the young, all those, and those ones I think are a lot more stable.
And less like one, they're not private equity owned, which I think were some of these companies have gotten into trouble as we just discussed, putting leverage on those businesses is not necessarily the greatest playbook I don't think. So I'm not really worried about the customer base that they're dealing with. I mean, they're in theory extremely stable businesses, the end customer, the high quality QSRs are stable businesses through cycles.
You spoke a little bit about frustration with some of these small businesses that are executing and not getting recognition from the market. What do you think it takes to get that recognition? Yeah, I mean, well, part of it is, I mean, my thesis at least is basically the actual improvement that they're making working its way through the financials. And it comes back to if you're a quant, there's only two inputs. I mean, the quants are way more sophisticated than I will ever understand,
but at the end of the day, there's only two sets of inputs. And one of them is backwards looking, and one of them is forward looking. And a lot of the names in small cap world, they don't really have great forward looking earnings. In some cases, there's maybe two or three analysts who cover 45 names and they regurgitated press release and called a research report. So I think a lot of the heavy lifting for the quants on that is just looking through the rear view mirror.
But if you're talking about fundamental business change, it doesn't happen in one or two quarters. You know, it's typically measured in years. So over time, as long as they continue to execute, eventually will all be in their rear view mirror. But it's frustrating, whereas a couple of years ago, if you have, you know, forward looking things, like even improve guidance, for example, like there's plenty of times that you see improved guidance and the market just doesn't care,
because it's not in the numbers, right? Like they, eventually if they hit the guidance and it flows through, then the market can't ignore it. And you know, sometimes you see a little bit of a move, but you know, there's examples and I have a file somewhere that lists some of these weird, weird things. I don't have access to it right now, but you know, examples where they, they announce, you know, guidance, or they increase guidance by some number. And if you're looking at it
and you're just extrapolating, you should say, oh, well, the stock should be up 20%. And instead, it's up like four or something like that. And that's fine, right? Like, you know, it'll, it'll come through eventually, but it used to be at least my memory and maybe I'm fooling myself, but it used to be more like, all right, if you're guiding up 20%, you'll get a little more credit from the market for that, because there's more people that are out there actually doing the work
and understanding that you're executing. And it feels like now, you know, fine, if you're, if you're getting added to an index or something, you might get a larger jump like that, but if you're just executing without any of the flows impacting it too, you don't get rewarded with the same, you know, the same magnitude that you used to. Sounds like you're sympathetic to on-hones. You have the right. Yeah, look, I think, I think I know, well, one, I promise you, he's like
way smarter than me and done way more work than me on it. So I think his views are, are well-formed. I just think, you know, his approach is more to focus on companies that are going to repurchase their own shares. And that's fine. He, his portfolio, I think, has a lot more companies that are currently profitable and currently doing work that where a lot of my companies, they're not, they might not be currently profitable because they're investing in that future capacity or something
like that. So they might not have the cash flow today to be buying back shares because they're using that current, whether it's cash flow or balance capacity, but they're maybe they're using that to invest in the future. So the future earnings will be higher. And that's, of course, a, you know, risk that I'm taking more of than he is. Part of that, I think, is because given his size, there's fewer smaller companies that he can invest in. So he's kind of restricted to more companies
that are, you know, more mature than I am. But again, that comes back to the craft of investing. Is figuring out like, are these companies making investments for the right reasons and are they likely to be successful? Or are they lighting shareholder money on fire? And if, you know, look, they're lighting shareholder money on fire, then that's never going to, if it passes through the numbers,
it'll be in a bad way. Like the earnings are not going to inflect, right? But if it does, if they are making good investments and margins are temporarily reduced for whatever reason it might be, when we get back to quote, unquote, normal, we should be rewarded. I've heard Ian Castle say that one of his favorite setups is a company that will be profitable in a quarter or two. And you can see it coming because you can see the rate of growth. You know what the margins are roughly.
And you can see that they're about to get over their fixed costs. Not that point. They've got that enormous operating leverage when they go from losing money to making money. And then they screen very well after that as well. So they get picked up by guys like me. What do you, is that, is that, is that a, a now just what you're doing? Yeah, 100% except often if you can see it in one or
two quarters, well, like, you know, it's already picked up. Yeah, that's pretty tight, right? I mean, that by that point, you start to pay attention because that's, you know, that's pretty short term, even by pod shop standards in one quarter. So I'm typically more looking, you know, I've always sent a story like three to five years out, which, you know, now it feels like that's too long,
right? I'm consciously trying to shift more of the portfolio to opportunities that are maybe shorter dated, even with, you know, like lower duration, maybe not quite as much upside through the cash flow. But it'll get here sooner. And the market seems to care about those more. So, you know, it's a balance all right, like from a portfolio approach, I want to have, I want to be diversified along timelines
as well. I don't want to have everything's going to mature next quarter or whatever. And then I have to, you know, recycle the whole portfolio. I want to have some things that are longer dated with more upside and more variability, of course, too, right? I mean, if your cash flows are three or four years out in the interim, you're going to be a more volatile than a company whose cash flows are one year out. So, you know, want to have, have a good mix of those. But I'm definitely more focusing on
trying to bring it as forward as much as I can these days. And we'll see if that works or not, you know, two years from now or three years from now. Do you think it's easier to predict over a quarter over one year, two year, five year, or ten year? predict what? What normalized earnings would look like, let's say? Yeah, I mean, you don't want to go out too far. I mean, for me personally, like, I don't even
really bother on the quarterly stuff, you know, huge percentage of the pod shops. That's all they do. I'm more thinking, you know, in an unknown time period, looking out a little bit and typically more tied to the specific levers than a management team can pull. So like, you know, growth, everybody can just start by extrapolating and then move up and down and whatnot. But I,
that's one way to come about it. And I do have some names that are, you know, on the growth of your side, where I think I can add the most value, though, is situations where it's not necessarily tied to growth. It's more tied to the inset those in the behavior of a management team. So, I know I've talked about this in the past, but like, you know, high level easy example of that.
It's just like good co-bad co-where if you have a business line that earns a dollar share in one, or one business with two business lines, one business line earns a dollar share, one loses 50 cents of share on a net basis, they make 50 cents. The market puts a multiple on it. The quickest way to double that earnings power is for the management team to kill off that money losing business.
So, that's why I try to spend a lot of times looking at that, trying to understand like, what are the incentives of the people and how are they going to drive earnings power, rather than how is the, you know, the world going to drive earnings power like big growth. You're trying to figure out what customers are going to do, what competitors are going to do, what all these different people are going to do with, if you're just killing something off,
it's really just trying to understand the incentives of management. Now, that is a very clean cut example that only really exists here on this podcast and the real world, it's always a lot more messy. Yeah, right. Well, it's always a lot more messy, right? But if you can kind of take that mental model and then look at it through different lenses and different
permutations where it's never so easy as, oh, just just kill it off. I mean, sometimes it is that easy, but it's usually not that easy, but just understand like different levers that the management team has to pull and then also just different, no, different industry forces that might impact the business in different ways. You can kind of try to isolate it down to one or two variables instead of trying to get every variable right that is tied to growth. And I typically think of
growth as having the most variables that you have to get right. Hey, Matt, we're coming up on time here. If folks want to follow along with what you're doing or get in touch with you, what's the best way to do that? Lackinwater.com. We're Lackinwatercapital.com is the website and on Twitter, I think I'm laughing H2O capital on Twitter. I think I was just searching for you today and I couldn't find it and then I
just remembered it was H2O. I should have there you go. We'll put it up. Well, Matt, Swini, Lackinwatercapital, right as always, we'll have you back in the not to just in future. Thanks very much. Thanks for your time. And folks, we'll be back next week. It'll be a while.