This episode I chat with Toby Carlisle, a managing member at Carbon Beach Asset Management and author of popular value investing books such as Deep Value and The Acquirer’s Multiple. 

Toby’s approach to value investing evolved from his observations as a corporate lawyer in Australia during the burst of the dot-com bubble.  Watching investors target cash-rich, business poor dot-com companies confused his traditional, discounted-cash flow mentality.  But after watching these activists get their hands dirty, Toby realized that even bad companies can be attractive if they’re trading at a deep discount to liquidation value.

We navigate a wide range of topics, including uses and limits of quantitative investing in the realm of special situations, how Apple can be a deep value stock, and why using the opposite of your signal to build a short book might be a bad idea.  


Corey Hoffstein  00:03

Hello and welcome, everyone. I’m Corey Hoffstein. And this is flirting with models, the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.

Narrator  00:15

Corey Hoffstein Is the co founder and chief investment officer of newfound research due to industry regulations. He will not discuss any of newfound researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions and securities discussed in this podcast for more information is it think

Corey Hoffstein  00:46

In this episode, I chat with Toby Carlisle, a Managing Member at carbon beach asset management, and author of popular value investing books such as deep value and the acquirers multiple. Toby’s approach to value investing evolved from his observations as a corporate lawyer in Australia during the burst of bubble. Watching investors target cash rich, but business companies confused his traditional discounted cash flow mentality. But after watching these activists get their hands dirty, Toby realized that even bad companies can be attractive if they’re trading at a deep discount to liquidation value. In our conversation, we navigate a wide range of topics, including uses and limits of quantitative investing in the realm of special situations, how under the right circumstances, even Apple can be a deep value stock, and why using the opposite of your investment signal to build a short book might be a bad idea. Without further ado, please enjoy my conversation with Toby Carlisle. Toby, thank you for joining me today.

Tobias Carlisle  01:58

Thanks for having me, Cory.

Corey Hoffstein  02:00

So let’s start at the beginning for you, man, clearly not born and raised in America with that Australian accent, why don’t you give us a story of how you came to live stateside.

Tobias Carlisle  02:09

I’m born and raised in Australia, I grew up in a little country town way in the outback, one of my subjects at school was how to shear sheep. This is a real thing that took ring banging the Bush Mob, that means cutting the sum of the hair on the tail. So you can distinguish the cows in this instance, that cattle that have been treated, knocking the horns off branding them, I went to university and I did business and then law school went to work in a law firm in Australia doing mergers and acquisitions. My first day of work was April 2000, had peaked or was like literally just about to peak, I thought I had been brought in to do IPOs of tech companies, because that was sort of what everybody was doing at that stage. And I thought that was really interesting. And they just disappeared, there was no means of raising money anymore. There are lots of mergers and acquisitions that because that was the term of the market, companies are still buying other companies. And it was the just a happy coincidence that it was at this time there were these new investors who were doing interesting things. And one of the things they were doing was targeting these companies that were dot coms that raised a whole lot of money, but had this sort of cash burn, though, literally selling $10 widgets for $20. And you know, losing $10, and every sale and trying to make it up on volume. And I hadn’t read in college Buffett’s letters. And I sort of forced myself to sit down and read the 1934 additional security analysis, which is really, really dry. It’s mostly about railway bonds, which I don’t think there are any publicly traded railways in Australia at the time. And I’d be hard pressed to find very many in the States, too. And so these guys were targeting these busted companies that were terrible businesses. And I was trying to apply my Buffett return on invested capital, that Buffett prefers these wonderful businesses at fair prices that trying to apply that to these businesses, you just can’t do a DCF on something that’s losing money, you end up with this negative value. And these guys were buying these things, couldn’t quite figure out what they were doing. Eventually, I realized this is one of those examples of like a little bit of understanding about something actually makes it really hard to understand what’s actually going on, the Buffett stuff did not help. Basically, these guys wanted the cash on the balance sheet that raised a whole lot of money. They’re trading at a big discount to that cash. If you got in like that. There’s no reason why these things are all down towards money forever and ever. If you get in and stop that silly business, then you’ve got valuable asset and you’ve bought it at a big discount. And then you can keep on doing that. So we didn’t know what they were called at the time as sort of subsequently become activists. But there was no name for them at the time. So I collected a lot of information sort of became very interested in it became a little part of the practice. Mostly it was defense because we were working for bigger clients. These guys were mostly young guys who had little hedge funds, who are being obnoxious to try and draw attention to the fact that These things was so cheap. I went back to the security analysis, later chapters and there’s two of these chapters back to back one talks about buying at a discount or liquidation value. And the other one talks about shareholder rights. That was kind of what started me down the path towards deep value investment.

Corey Hoffstein  05:15

So you get introduced to this style of investing through the law firm, when did you first get your hands dirty actually doing the investing yourself?

Tobias Carlisle  05:23

It took a long time, you have some difficulty investing when you’re a lawyer for big companies that are publicly listed, because there’s any at any moment, one of them could catch a bid. And it’s not a good look, if the junior lawyer has a long position and that he bought a few weeks ago, so we were prevented from investing in just about anything, the first time I really got an opportunity was when I got transferred to the US office. And I thought now it’s safe to invest back in Australia. And it’s pretty much it was safe in the States as well, just because the nature of the work that I was doing was if a multinational head, multi, multi billion dollar acquisition, but they had lots of subs through Southeast Asia or Australia or the Asia Pacific, we had lots of offices, so we could sort of implement that part of the transaction for them. But it was very unlikely that I was ever going to get caught. So it was into the 2000s 2005, something like that, that I had a little bit of investment capital. And the first thing I ever bought was Budweiser, because Warren Buffett bought Budweiser, that was the extent of my analysis, and it went up, and it got taken over eventually. So it worked out okay, but I didn’t do anything other than followed Buffett into the stock. I remembered vividly what had happened in the early 2000s, that this really busted little businesses had got very, very cheap. And I thought if that ever happens, again, if we ever get another stock market crash, basically the same thought process that I have. Now, if we ever see another stock market crash, as impossible as that appears to be in everybody’s minds right now, if that happened again, and things got cheap enough that I would go and dig up all of these Net Cash net net sub liquidation value companies, with the additional requirement that they would have an activist who had already filed a 13 D in the States. And I would buy them and rely on the fact that the activists would work with the market would sort of figure it out. So when 2007 came around, that’s I geared up to do that. And I bought a whole lot of stocks. And I started writing a blog called greenback, which basically just did exactly that. Look for net nets, where there was an activist involved,

Corey Hoffstein  07:16

I want to rewind really quickly, just to give myself a little context, because often here in the US, we have such a myopic view of our markets, right? So we experienced the whole tech boom and bust from our own perspective, market got very tech heavy. My understanding of the Australian equity market is it’s much more like Canada, where you are very dominated by one or two sectors. So I’d love from your experience to get an understanding of how the tech days really did unfold in Australia.

Tobias Carlisle  07:45

That’s exactly right. The Australian market for those who don’t know, it’s half financials. And it’s about another third or a sixth based materials, which is mining, which is what you’d expect. Canada’s very similar. I think info tech is like half a percent. And if you look at MSCI Infotech, something like 12 or 13%, I think the states might even be more than that. So it’s underweight those kinds of things in, boom that people were, if you could come up with a domain, and you had some vague idea about taking over some industry, you could just about launch something out there. Australia is a market that it’s a little bit like Canada, probably it’s easy to there’s an appetite for mining, speculative mining, junior mining, like they don’t have any asset other than an intention to drill something somewhere, and they don’t know if they’re gonna find anything. The equivalent is like maybe a biotech. There’s a little bit of it around in the States. But basically, these things like they have no business model. Their idea is if we find something there, then we’re going to make a lot of money. Most of the time they’re done coming

Corey Hoffstein  08:45

into 2008, you had written greenbacks right before 2008. I started in December 2009. In December 2008 was the catalyst for writing greenback sort of the experience of 2008.

Tobias Carlisle  08:56

Just that all of a sudden, there were these net nets and sub liquidation plays that hadn’t really been available in number were all of a sudden available, it had gone from being something like fewer than 100 to maybe 350, something like that. So there are enough that being selective, I could pick out the ones that had an activist that would net cash, really deep discount to net net, and I thought there’s a good chance that these things are undervalued. And if the world comes to an end, then I’m holding something that’s got liquidation value.

Corey Hoffstein  09:23

Now we’re going to end up ultimately talking about your whole series of books because greenback was your first you ultimately wrote quantitative value with our friend Wes Gray, you wrote deep value. Most recently you wrote acquirers multiple and I know there has been an evolution of your investment process. In writing the greenback blog. Was this an approach that you were trying to systematize or was this sort of a special situations type opportunity? It was more

Tobias Carlisle  09:51

special situations and I was going through, you can do net net style investing quantitatively That’s entirely possible to do it that way. And I had gone through and sort of cherry picked up the ones that had an activist, I felt good about the assets that they had, there was more cash than sort of inventory, which might be hard to sell, maybe the inventory should be written down by this amount, because it’s not worth anything anymore. I got to the end of 2009, after the market and recovered, and I looked at the returns of the ones that I had picked out, and they did really well, that was like 250%, over that year in the course of these ones that I had identified, and cherry picked up. And I thought, I’m really good at this stuff. And then I thought just to torture myself, I’ll go and look at what the entire cohort of whatever it was 250 or 350 stocks that I bought 30 say out of that group. So pretty selective, less than a DESA. What did the whole cohort do? The cohort did 750%. So how did I miss that off so badly? That was the thought that I had, basically, you get a handful of stocks that go up 2050 times. And if you don’t catch those ones that perform like that you underperform. And that’s basically quant investing, you need a bigger portfolio, because you’re gonna get this right tail of returns, and you need to capture those returns,

Corey Hoffstein  11:09

in looking at these net nets that you had invested in. The question that that invites for me was, had you seen the entire cohort and sort of qualitatively screened some out? Or was it that certain ones didn’t even show up on your radar that there were qualified investments out there that you weren’t even aware of? It’s

Tobias Carlisle  11:30

a little bit of both 300 It was, it was a very short period of time. And it was the market was in turmoil from that fourth quarter of 2008 was sickening, first quarter of 2009 was sickening, I think the market last 12 15% in both of those quarters. And I think that probably what I was doing broke even through both of those quarters, which I didn’t think anything, either I didn’t really know if it was going to work or not. And then the market took off. After that it was a combination of I had looked at most of them, even very briefly because the screens, pull them all up. And I’m looking at the ones that are at the deepest discount, trying to decide which ones of those are going to work thinking that the world is going to come to an end here and every listed stock is going to be liquidated. And when they’re liquidated, only the ones that have a liquidation value have returned anything to the people who have invested in. So that’s why I was looking in those stocks, and I was looking at some thinking they’re gonna burn all of their cash, they’re losing too much money. I subsequently found out that this is a common occurrence through lots of different deep value research that it is, in fact the most scary, the ones that are losing the most money, the ones that don’t pay a dividend. So given a choice between one that makes money and doesn’t lose money, the one that makes money does worse than the one that doesn’t make money. Given a choice in the profitable ones between the dividend payers and the non dividend. The dividend payers do worse than the non dividend payers. So it’s sort of this upside down world where your intuition about these things is wrong. And anytime you exercise any discretion, you’re almost inevitably doing the wrong thing. There’s a lot of that in quant that your your instincts are wrong. The reason these things get so cheap is because nobody else wants to touch them. And so if you can overcome that, the gag factor or the ick factor, and grab them, that’s where all the returns come from and skipping over those ones that are the very ugliest means you miss out on those 2050 baggers.

Corey Hoffstein  13:17

So after you torture yourself and discover that your 250 could have been 750 or some unbelievable multiple, what was the next step in your investment journey? It sounds like you were at least enlightened to perhaps you are getting in your own way to a certain degree. I do know ultimately you have adopted a fully systematic approach. Was that sort of the catalyst?

Tobias Carlisle  13:42

Yeah, that was the beginning of the journey. I read James mon tear, great value investor and value kind of philosopher, had written this great piece called an ode to quant and I read that and I saw in there that he said that there was this phenomenon in social studies, which is pretty pronounced. Basically, the idea is that simple statistical models, simple algorithms, outperform the intuition of the best experts, which sounds nuts, but it’s common, you find this over and over again in the literature. And I think in sort of 1975 Paul mele, who is regarded as sort of the godfather of this area of study said something like when you see these studies over and over again reporting the same result. At some stage, you have to sort of acknowledge that this is a phenomenon, that our behavior in these things is sort of deleterious to our expertise. And it’s not just in investing. It’s in selecting wine, vintages, determining which criminals are going to be recidivist college admissions, it’s over and over again, all of these different areas where we just we fool ourselves. So the classic example is story where a professor Goldberg who was a I think it was a psychologist, and he was looking at when people present in a hospital if you’re schizophrenic raining and very deep depression can manifest the same way. There’s a little bit of psychosis in, in the deep depression. And it can be very difficult to determine whether somebody who’s having some sort of ideation that is a little not not connected to reality, and someone who’s schizophrenic is not connected to reality. So he, he came up with this six question framework. And he asked people this question, and then subsequently, when it traded down the track two weeks or a month later, they were able to make a diagnosis, a proper diagnosis, and then they could go back and look at the way that they presented initially and determine was our initial diagnosis correct or not? And I had students ask these six questions and make a diagnosis based on the six questions, then they gave it to treating clinicians and they had them do the same thing. But they didn’t have to follow the recommendation. So they found that basically, the clinicians who applied this rule got better results than people who didn’t apply this sort of questionnaire. But they found that the questionnaire by itself, which was applied by the students without fear of favor, outperformed the best clinicians, even with the benefit of the questionnaire. So somebody with years and years of experience, presumably doing this stuff all the time with the benefit of the questionnaire, which is guiding them in the right direction, still doesn’t do as well as this dumb six question questionnaire. And that’s something that you see over and over again, as a quant. The reason why this happens is this idea that broken leg theory. So the broken leg theory is best explained in the story, the way it’s described in literature, you have this quote model that determines whether an individual goes to theater on a Friday night, and you might include in that quote, model things like, is it raining outside that might stop them from going? Is it an action movie which this person prefers? Or is it a romance movie, which they don’t want to see? So you have your six factors in your quant model? And then you learn on one Friday that the person hasn’t broken leg? And do you therefore override that model to allow for the fact that a broken leg might mean you’re less likely to go to the theater? Or do then follow the model which doesn’t have that information in it? And the answer is that you have to keep on following the model. And the reason is that we exercise our discretion far too frequently, we find lots of reasons to override the model, too many reasons to override the model. And that’s particularly true when you do what I do, which is buy deep value stocks, every single one of these stocks has a broken leg.

Corey Hoffstein  17:25

So let’s bring this into deep value stocks. And the way that you define deep value stocks today, which is highlighted in your book The acquirers multiple.

Tobias Carlisle  17:35

When I was doing my business degree, I used to go and sit in the finance library and read through this is before any of the so I was late 1990s When I was studying, this was before anything was sort of available on the internet, you had to go and get these hardcopy. And I got these things now covered in dust. And that was 30 years old. That’s the age maybe not as old, but maybe it felt like 30 years. But so from the 80s, which felt really old to me in the 90s now doesn’t feel so ultimately felt very old at the time. And I found one that described the metric that private equity firms use to find good LBO candidates as being enterprise value on EBIT da. And the guy who wrote this article said, The way to think about this multiple is as the acquirers multiple, if I could find the person who coined it I’ll give them credit for but I can’t find that periodical. And I wouldn’t be able to find that document anymore. Maybe someone will write in and tell us. I keep on telling that story. I’m happy to hear from whoever coined it. The reason that I describe it the way that I do and the way the way that I found it, Buffett talks about operating income, he regularly talks about operating EBIT, operating income as the way that Buffett describes it. So it’s an apples to apples comparison of correcting for the capital structure, looking at interest and taxes and adding those things back in. So you’re looking at basically the accounting definition of cash flow that’s coming into the business. And then on the other hand, you’re looking at enterprise value, which is market capitalization lets you know what the equity is worth. enterprise value includes other things that an acquirer of the business really has to pay. And that’s they have to find a way to service the debt or pay out the debt. If there are any preference shares in there, they have to find a way to service them or pay them off minority interests, other things like that. So there’s real costs and acquire the business has to pay. So those two metrics together give you a good idea of what the residue of the business that you’re actually paying for is, and then what you’re getting in return in terms of operating income. Buffett has been a long term value investor whose value investment has sort of evolved over time from he was probably a deep value investor in the middle of Graham. And by virtue of meeting Charlie Munger and reading Phil Fisher, he became a more sort of growth quality franchise, high return on invested capital type investors. So Joel Greenblatt wrote a wonderful book that came out in 2006, called The Little Book that beats the market and in there he advocates for this metric that he calls the magic formula one It uses the acquirers, multiple EBIT, operating income on enterprise value. And on the other hand, it uses return on invested capital. And the idea of return on invested capital, as you’re looking for, how much profit does this company generate, for how much money is invested in it, and the more profitable it is, per dollar invested in the better the businesses, which makes perfect sense, because that kind of business can compound at a very high rate, it can become very, very profitable with sort of marginal investment in it. And when you combine that with a value factor, you’re getting these very high quality, high compounding kind of businesses at a cheap price. So green blood tested in the book, over 12 years or something like that. And it worked well, we tested it again. So quantitative value, which came out 2012 was great. And I tested that, and found that that does, in fact, beat the market, even doing stuff like it’s not a small company effect, limit yourself to the biggest companies in the market. If you then market capitalization weighed those companies, you still outperform the market capitalization weighted index. So it’s a very, very good metric. In the course of doing that, I thought, how is it that return on invested capital metric stands up so well, because my own personal experience of buying these companies is that you’re buying companies at the very pinnacle of the business cycle. And you see mean reversion in the profitability. So you buy something that looks really cheap, the acquirers multiple metric, and it looks really good. But the mean reversion in the return on invested capital in the profitability, they become less cheap and less good in the period after you own them. And so I thought, what if we just tested this without looking at the profitability metric? What does that do like just randomize that error, rather than focus on that error? And it turns out, you do better in a raw performance sense. And in a risk adjusted sense, which is the most surprising thing. So the reasons are, mostly it’s that return on invested capital identifies these companies right at the pinnacle of their business cycle. So you’re encouraging competitors from adjacent industries to come in and compete away for those dollars, which just makes sense. There aren’t very many free lunches in the market. And on the other hand, the very worst companies, you can think about many industries that are beaten up, people in the industry believe because it’s so hard to make money they are or they do it forcibly, because they’re just bankrupted. And it creates this period where there’s not very much capital in the industry, there’s not very many businesses there. So when the oil price, say comes back, if you want to access that oil price, you have to go through these oilfield services companies that have left the ones that were able to survive, and they have a period of like supernormal profitability. And I think that’s the reason why not looking at the return. But so just randomizing that era tends to do better than focusing on ROI IC,

Corey Hoffstein  22:38

O, it’s interesting to me, at least when I think about something like return on invested capital, it has this nice intuition to it, right? Where if you can buy a cheap company that can compound their growth at a faster rate. It’s putting not only the valuation tailwinds in your sales, but All right, great. Let’s say if it doesn’t revalue, I’m still getting a bass compound or, but it doesn’t invite the question, at least to me, Well, why is this fast compound are suddenly trading at a massive discount? Right? What is the market know that? I don’t? And it does bring up your point that is this peak profitability for this company, or does it have a sustained moat? And I think Warren Buffett’s approach would be well, let’s try to identify the companies that are high ROIC that do have this sustained moat, your viewpoint not to put words in your mouth. But having read the acquirers multiple is quite simply trying to identify those moats in a quantitative or even a qualitative manner is, in your experience near impossible.

Tobias Carlisle  23:38

After I had done that research, I went back through and I read all of the letters, I’ve done that multiple times, read all of his letters. And every time I read them, I find something new that if I hadn’t, I learned something. And I go back and read it. And I discover that, you know, Buffett KNEW IT 50 years ago, and he’s been trying to explain it. And I just didn’t understand that the first time I read it, when you read his letters, what he’s really saying is, these are the economics of Moats. We’re not hunting for just return on invested capital, that’s almost sort of a symptom of what we’re hunting for, what we’re hunting for, is companies that haven’t mowed. He says that over and over again, and I’m a very slow learner. So I didn’t really understand that. But he gives all of the letters he’s talking about, these are the indicia of modes, so he has a way of identifying them. If you try to approach the, let’s say, don’t possess Buffett’s genius, you need to find some sort of scientific or quantitative way of doing it. And I’ve been hunting for a smart way of doing that, because that’s a way to beat the market as well. If you look for the good ways of doing I think Michael Madison has the best sort of analysis of it. He’s been running this experiment on an ongoing basis, basically looks at a cohort of companies and then he tracks their return on invested capital for over 10 years. And so he divides them into take every company in the universe that top 1000 businesses, divide them into five groups. The first group has the very The highest return on invested capital, the fifth group has the very lowest return on invested capital. And inevitably, they follow the same performance, the highest return on invested capital trends down towards the average, the lowest return on invested capital trends up towards the average. When you look at that, as a group, what he’s what he’s saying there’s basically return on invested capital is highly mean reverting. So how do you find the ones that resist that about 4% of companies are able to sort of resist this and they have this every year, they turn out a pretty good return on invested capital that is better than the average and are able to sustain that compound that year after year after year. And that companies that aren’t particularly glamorous, they’re often companies that have, you know, so for a long time p&g, they have these branded consumer goods that sit on supermarket shelves, Band Aid, lots of things like that Johnson and Johnson has lots of these little products that it doesn’t cost very much to make, they’re able to sell them at a high margin, everybody goes in, you’re not going to buy a knockoff version of band aid, you want the band aid brand band aids, and so they’re able to earn a pretty good return. And on the other side, it’s also true in the in the cohort, that is the worst that trends back to average, there is a group in there that are just set up to fail, you never want to buy the very worst return on invested capital. So they’re the dot coms that don’t have a business model. They’re the the miners of the junior miners that don’t have a deposit, they’re sort of, they’re using shareholder money to hunt for that deposit. If they strike it rich, they do well, but as a cohort, they don’t do well. So they lose money on average. So return on invested capital on average is not a good metric. But the very worst are stocks that you want to avoid. Now listen has sort of looked at the ones that that 4% that are able to avoid the mean reversion he’s looked at that he’s devolved their returns using DuPont analysis, is it a high margin with a low turnover, or is it a thin margin with a high turnover, it tends to be a higher margin will lower turnover tends to be a bit of business. But he’s not able to prospectively identify with each new cohort, which will be the ones that will resist mean reversion in the next 10 years.

Corey Hoffstein  27:06

So I want to take a step back for a moment out of the some of this minutiae detail, because you very rarely meet a value investor who doesn’t ultimately consider themselves to be a disciple of Graham and Dodd and Buffett and who hasn’t read the Buffett letters. But every value investor has a very unique approach, or at least they’re certainly distinct camps of value investing. And so you’ve settled at this point on the acquirers multiple as being your ultimate guiding metric in what you do, I would love to get an understanding of your perspective of the value landscape, how different value investors choose to look at the problem. And ultimately, why you think the acquirers multiple is at least correct for the problem you’re trying to solve.

Tobias Carlisle  27:52

I think there are three broad camps of value investors, they’re the guys who are doing special situations who are looking for genuine arbitrage is so whether it’s a risk arbitrage, or they’re, they’re looking for a hard Cal undervalued security, hard catalyst, I think that’s a very valid way of investing and generates returns that are sort of uncorrelated to the market. And they’re always going to be very idiosyncratic, their returns that can be good in one year, bad. And another year, doesn’t really matter what the market does, then distinct from that as another group, and that they exist on a spectrum. And one end of that spectrum is the Buffett franchise, guys. So we’ll want to do a DCF, there assuming a very high return on invested capital, rapid growth over an extended period of time. So they have some sort of sustainable mode there. And I think that when they do an analysis, they do a DCF style analysis, I think they’ll often find that the implied PE is quite high for those stocks, so that they might buy something at 40 times earnings, thinking that it’s worth 60 times earnings. And I know lots of guys who look like that, in that kind of camp. And I say that the IQ, the gag factor, I’m buying stuff, it’s very ugly when I’m buying it. And I have to kind of ignore the recent track record or, or my own personal feelings about the business in order to buy them, what they have to ignore is the valuation. So they’ll look at 40 times earnings sounds like an insane, that could be very depressed earnings in my world, but in their will that’s compounding, that’s a way to value that company like 40 times earnings is expensive, but they think that it’s going to compound and that’s going to eventually be proven to be a cheap multiple, and the examples that they give her often something like Walmart, you can go back to when Walmart IPO in 1975, something like that in the 70s. And you can look at what multiple would have given you just the market returns since it IPO. And it’s something like you could have paid up to 1000 times earnings, something like that, like off the Richter scale of what you would consider to be value and it will deliver just a market return which is still a pretty good return over that period of time. So that’s one end of the spectrum. The other end of the spectrum is where I am, which is the deep value stocks There’s a company’s that the business is questionable, there’s not much business there, I think it’s better than the market is giving it credit for. But I acknowledge that there are problems with the business, you’re looking at a little bit of balance sheet value, definitely not going to look at compounding, all of these things need to do for my strategy to work is for them to survive the next period of time. And then to find that period, where there will get a little bit better because the competitors have left, the capital has kind of dried up, they’re the last man or few companies left in that space and with a little bit of a better environment for them, they’ll start performing. And so when they do that, you get the improvement in intrinsic value of the business. And then you get a narrowing of the discount from price to intrinsic value. And those two things together, deliver the returns in that group. So I want to

Corey Hoffstein  30:46

with that idea of deep value, bring up almost a counterpoint of your own making, which is Apple, which I don’t think anyone who’s been a student of the markets of the last call it decade prior Oh, after their launch of the iPod and the iPhone, whatever, consider them a deep value stock, right? And people consider these deep value stocks to be ultimately complete dumpster fires. And yet, in 2013, you tweeted about Apple being a massive discount in 2016, you tweeted about them being a massive discount screening incredibly well on that acquirers multiple? How can Apple such a well known name, a fang stock, as we know it now, what most would consider to be a massive momentum play have appeared to be deep value?

Tobias Carlisle  31:34

Well, Apple is a great example because it generates so much cash and that cash is largely built up on its balance sheet in 2013. In a large cap world, it was one of the cheapest 10% of stocks around just by virtue of the fact that and that’s when using the acquirers multiple to value it. So that was backing up the cash that had sitting on its balance sheet, it wasn’t carrying any meaningful debt, or there wasn’t seasonal, or part of the business. And it was throwing off enormous amounts of operating cash flow. And so when you look at those two things together, it was a very cheap business. It seems to happen so quickly for apple that it’s between iPhone launches, or something like that people wonder whether that, is it really a franchise? Is it more of a tech company? Will superior tech, knock it out? If you don’t have an iPhone and laptop and an Apple TV? Will you supplant it with something else when you use a Google Google connection to your TV or an Amazon connection to your TV where you use Alexa instead of the Google Home version of that? And so did Apple’s success need that ecosystem? Because I’m a lawyer, and I don’t come from a consulting background, or from a sort of business facing background, I assume that I don’t know the answers to those questions. And I assume that I can’t figure them out. I can speculate over a beer with anybody else about whether those things are true or not. But do I want to invest on that basis? No, I want to invest where I think that I have a little bit of an edge. And I think that one of the places that I do is that I’m prepared to ignore that stuff, just like randomize that error again, which is basically what I’m trying to do like not commit those four stairs to sort of assume that there’s going to be a variety of errors in there. And I think that Apple was one of those examples. 2016 was a different scenario, that very similar idea, but a much better opportunity in 2016. From my perspective, because einhorn had this idea about, once again, it had built up all this cash on its balance sheet had got cheap relative to that, that little sliver of the business that you’re paying for after backing up the cash earnings was still ridiculously strong. On had this proposal called I preface where he was going to spin off some sort of preference shares and spend the money I can came through and just sort of cut through the clutter and said, just buy back a gigantic amount of your stock, which they did. They fought icon for a little while and said no, let’s do that bought back, the stock was the biggest buyback announced I think at the time, and then they actually bought back more stock than had ever been bought back by a single company. That was in 2016. And then I think Buffett showed up as an investor in the next period of time. And they’ve just again, announced another buyback. So it is one of those companies that has an enormous amount of genuine free cash flow can use the buyback stock when it gets cheap. And the result is that it performs very well. So I

Corey Hoffstein  34:15

want to take this conversation a bit from the philosophical down to the actual practical and what you do at carbon beach asset management. And I know you run multiple strategies, some more on the purely quantitative side, but I want to actually start on the qualitative side, talk about special situations, right. And I think your legal background probably makes you very well suited for that space. But very often when I think of special situations, the first thing my mind always goes to is can something be systematized and if not, ultimately, how can you build an effective portfolio making sure that you are aware of all the special situations that are out there and that you are not just subject to the luck of what you come across? So I’d love to get a sense from you really two things a how you think about building a special situations portfolio and setting expectations for investors? And then be what parts of the process can be systematized today. And do you think can be further systematized in the future?

Tobias Carlisle  35:17

Well, I do think that you are subject to the opportunity set that is available in special situations, it’s entirely possible that in a given period of time, there’s nothing to do. You know, the good example is at the beginning of 2016, we hadn’t done any merger ARB, any risk ARB. And then the Obama Department of Treasury started to crack down on the reverse mergers that were being done for the purposes of moving headquarters overseas to avoid US tax jurisdictions. And so they said, you’re no longer allowed to do that. And when that happened, that blew up a number of deals that were being conducted for that reason. But there are also another group of deals that weren’t being conducted. For that reason, they also blew out the spreads between the where the bid was and where the stock was trading in the market got very, very wide, sort of to the tune of 30%, the deals are going to close inside the year. So it was in less than nine months, which annualize out to a rate sort of 40% plus just a very high rate of return. So we went through found the ones that weren’t going to be blocked by Treasury ultimately decided on Aetna taking over Humana Humana had been very cheap. It had been in the acquirers multiple for an extended period of time, six years, it had been one of the cheapest stocks in the multiple in the screens. And now it had a bid and whether the bid goes through or not, it’s still a very cheap stock likely to compound at a high rate. If the bid goes through great, you get a front end loaded returns. So we put that position on pretty quickly, that shock that had hit the risk apps quite went away. And all of those apps closed off. And so we took those positions down a fair bit, then the Obama DOJ, so not the Department of Treasury came in and said, well, now this is a competition issue, the combination would have been the second or third biggest company. So you’re not it was the biggest, there was another merger that was going through that would be second biggest if that one got blocked, Humana goes through that becomes a second biggest if it doesn’t get blocked, it goes through and becomes the third biggest. So we thought, not knowing whether this deal gets blocked or not. Now, the terms are the same. That period where it’s going to occur is shorter, still a very, very high rate of return requires a pretty big position to be put on, which we did. It traded down as the market got sort of increasingly nervous about its prospects, we increased the size of that position. On the day that the DOJ announced that they were in fact blocking the deal. The stock jumped 15%. It’s one of those funny things about investing that the very worst outcome that everybody was most nervous about actually comes to fruition, it comes to pass. And then everybody says, well, now the uncertainty is gone. So the stocks up 15%. So we knew that nothing was going to happen until December. So we look at other ways of playing the stock, can we sell calls in this stock that will expire before the date, there should be almost no value in those positions, because you know, the upper limit the bid. So we sold those calls, all expired, worthless, before the bid. And then the bid was ultimately blocked. They fought through the courts, and they lost. And then the day that that was announced, the stock was up again, because of that period of time united and the other companies in the sector had traded so far ahead of Aetna, and Humana, which was sort of weighed down by the deal, they then have a lot of catching up to do, and they’ve performed really well in the space afterwards. So I think that’s a good example of a number of things. One of them is that if you’re doing special situations, you want an undervalued security first, that’s how you sort of protect your downside. And also, there’s some return in that, you also have to be aware of other ways of playing the transaction. So not just in the equity options, put some calls and different ways of investing in it. And in terms of sizing the position, there’s some science around it using the Kelley theory, which I know that we’re going to get to at some stage, but then there are lots of reasons why you probably want to undersize Kelly, but you still need to get enough of a position on because they just they don’t come around good opportunities don’t come around so often, that you can afford to not sort of put enough money in a special situations portfolio is always going to be pretty small, half a dozen 10 positions would be a pretty full portfolio, and they’re traded much more regularly than systematic

Corey Hoffstein  39:26

special situations always make the Kuantan me scream. My co pm Justin cybers spent some time on a merger arbitrage desk before he joined New Found and he is through and through a quant and he would tell you merger arbitrage is one of those places where you cannot fully systematize but that isn’t to say there aren’t fully systematic approaches to merger arbitrage. But the true edge is being able to play the special situations recognize why certain merger situation is worth betting on or as you point out a year unique approach to playing that situation, all of which introduce an unbelievable number of degrees of freedom that make it very difficult to actually systematize this, which again, makes my skin crawl because that is opposite of everything I know. And interestingly enough, I mean, again, does sound somewhat opposite to the lessons you learned with your net net experience, right? Which is ultimately, hey, capture everything. Your subset is ultimately going to underperform the cohort. And yet, this is an area where you still believe that qualitative analysis has an edge on the quantitative because of the number of degrees of freedom.

Tobias Carlisle  40:41

I think that’s right. Yeah, you have to be prepared to move from, it’s difficult for the guys who are only merger of zero only ever going to be able to do merge Abernathy, Buffett has said something like merger, ARB delivers about 20% return on investment, I think he might have even been looking at that. Just on the long side, if you’re long short, it might be two different profile anyway, the nice thing about being a special situations, investors, it’s a Swiss Army Knife approach. You don’t have to do merger ARB you can do. So one of the things that we did was an off the run top security that everybody sort of had forgotten about. They just get way too cheap. This was a Bank of America top warrant which off the run, I think it ran out to sort of 2021 2022 the equity and Bank of America got very cheap about two years ago, that warrant was cheap relative to the equity. And both of those things together, you get a little performance and the equity give a lot more performance in Warren and we Delta hedge that which meant that we were short the equity, we were long warrant with the idea that we were sort of trading it as it moved. Ultimately, we lost the equity was up about 50%. So we lost money on a hedge in that instance. And the warrant was up 350% In a very short period of time. So we made money on the warrant that’s that trade worked out. But if it had gone the other way, you’ve got some protection in the equity short.

Corey Hoffstein  41:58

So when you’re a quant investor, and you have call it your screen of the acquirers multiple or something like that, you have your very definitive rules. Ultimately, the question of where do you source ideas from is not a question, right? The rules and the defined universe ultimately define your opportunity set. But special situations again, strikes me as an area where if you gave me a large portfolio of cash today and started saying, Hey, this is a special situations portfolio, have at the idea of where to even begin sourcing ideas, figuring out how to build a portfolio, thinking about the concepts of diversification, hedging risks, taking multiple simultaneous bets, is an incredibly open ended question. And so I would love to get a sense from you. When you think about a special situations book, how do you think about sourcing ideas? How do you think about running multiple trades at once? How do you think about the process of diversification in a portfolio?

Tobias Carlisle  43:01

There’s two very broad approaches. One is just to approach it from the value side first, I find if you find deeply undervalued stocks, there’s some pressure on the management team to do something the board has to sort of take some action, do you buy back stock? Do you sell the business is an activist going to approach you and force you to do those things anyway, there is some pressure on them to do something. So often, the catalyst is about to emerge in that space. So that’s one way of doing it the other way is to start with the transaction. So if you look at the filings, you can set up natural language searches through the filings that return of capital buyback, special dividend, anytime those words, merger, anytime those words that are appearing, the filing is there, you know, then you need to go and see is the stock cheap? Because a lot of those things occur in overvalued stocks. But you don’t want to be in those ones just in case they come apart. Because that’s, that’s how you lose a lot of money. So those are the two very broad approaches in terms of diversification and sizing. That’s a harder question. It’s not, you’re never going to get the quant approach where you can get equal weighted sector bets. That’s not going to happen and all that possibility. I think that one good way of doing it, though, is to do that Kelly bedding approach where you look at what’s the expected return here? What’s our downside? Where’s the market pricing this can punch those into a Kelly formula and get a bit size. And then basically you want to scale that down because Kelly’s always too aggressive, fortunately very successful. So I’m more inclined to take the practical advice than the pure theory. The philosophy behind it is that we’re trying to think like private equity investors or activists who would they’re looking for something that’s undervalued, but it’s a special category of undervaluation that, I know that I’ve been reading a lot recently about Dan Rasmussen, he’s got a private equity approach, but he’s literally trying to do private equity on the market. So he’s looking for things that have got a lot of debt on the balance sheet that can pay it down. I’m at the other end of that spectrum, I’m looking at things that they might have what you call an A lazy balance sheet. They’ve got too much Cash. So that’s something that an activist might like that the activist can cause them to pay the money out of buybacks stock, or just resolve that sort of lazy balance sheet. So that’s the idea you’re looking for deep undervaluation that a private equity firm or an activist might be attracted to, which creates, hopefully a catalyst in the stock. My experience is that the actual emergence of a takeover or an activist is still pretty rare, because we’re only holding about 30 positions in a long book. So we’re looking for things that are deeply undervalued on that metric, we’re looking for things that are generating cash flow. So we’re matching the cash flows to the accounting earnings, we want to make sure that that’s happening on a regular basis. So you look at accruals make sure that the over time the cash flows are keeping the accounting earnings, we also look for things like if you look at the financing cash flow, so that’s how funds itself? Do they raise cash by selling debt? Do they raise cash by selling shares? Do they have a negative financing cash flow from paying a dividend or from buying back stock or from paying down that if you find those companies that have the more negative the cash flows, the better those companies tend to do? And I think there’s a few reasons why one of them is that it demonstrates they do have this genuine free cash flow, they’re able to use for purposes outside of the business demonstrates that when they’re buying back stock, particularly, there’s a potential for them to be undervalued management’s doing the right thing. They’re aware of the undervaluation capitalizing on it, and I’m looking at these things already as being undervalued. So when something’s undervalued on an accounting basis, that cash flows roughly match that accounting undervaluation management seemed to be doing something about it, buying back stock or paying down debt, paying dividends. I think when you get all those things together, you get pretty good performance. So that financially strong, that’s a good, solid long book that you noticed that there’s nowhere in there, there’s a discussion of return on investment capital, or we don’t do that kind of thing, because for those reasons I discussed earlier, I think you find things that have a potential for mean reversion. And I’m looking for things that have potential for positive mean reversion, you can look at the other side of that to create a short book two, the problem with shorting is that an undervalued stock can remain undervalued for a really long period of time, even though the underlying business is doing better and better. Management’s doing the right things, you’re still relying on that irrationality that’s created the undervaluation to correct itself at some stage, and there’s no guarantee that that’s going to happen. On the short side, you’re also relying on that. So you want something that’s very overvalued, fundamentally weak, burning cash, the accounting earnings don’t match the cash flow, earnings. All of those things exist in lots and lots of companies, and they go up every year by a lot, because they’re helmed by someone who’s very, very charismatic, and they’ve got that Deus Ex Machina, they’ve got this way where they keep on the hero keeps on saving the day by selling stock, because people want to be invested in it. Tesla might be example, an example of that the fundamentals of the business, the balance sheet, the earnings, the cash flow doesn’t look great. But the idea is very powerful. And Musk is an incredible entrepreneur who has been able to raise money, lots of different ways. So the risk in a business like that is that charismatic guy raises a whole lot of money and buys you the position. One of the ways as a short you can protect yourself is by looking at the price action company, which is not something that value investors typically like to do. But as a short, you have to be prepared to do something a little bit different. So if you’re going to do it in a quantitative sense, you have to find things where the momentum has already fallen apart, you don’t want to be a hero, sort of standing in front of the moving train and trying to stop it with just by standing that you want to find the thing that’s going up the mountain and it’s slowed and started to roll backwards. That’s when you start shorting it.

Corey Hoffstein  48:44

One of the things I’ve heard from a number of value investors who have tried to run short books is that it is prohibitively expensive to run a short book to actually borrow some of these securities that might be in high demand. And that even if you’re right, you can go bankrupt paying that carrying cost over time, I wanted to get your thoughts on the idea of running an effective short book,

Tobias Carlisle  49:07

what’s one of the very first things that we check is the short interest ratio, how heavily shorted are these stocks. At the time that we’re recording this, there’s a lot of talk about Tesla being a short and being a very crowded short, but when you look at and musk himself has recently come out and said that it’s the most shorted stock on the stock market. It’s not, I don’t think it’s in the top 50 Most shorted stocks in the stock market. And that might be because people are worried about Musk yanking shares or some of the big shareholders yanking their shares. I don’t think the borrow is too bad on something like Tesla, but that is something that you need to be very, very careful of. There are two ways that we protect ourselves. One of them is we don’t short the very most heavily shorted stocks. And by the same token, we don’t buy long, the very most heavily shorted stocks because they do eventually fall apart. It’s just that the cost of carry might eat you alive while you’re waiting for them to fall apart. The other way that we do it is that the short book is much smaller than the long Books are long might be about 4% of the portfolio. And a short would be no more than 1% of the portfolio. So a lot can go wrong with a short before it really hurts the portfolio and then construct a portfolio of shorts and on balance that portfolio or needs to do is not go up as much as the market when the market goes up, and to fall a little bit more than the market when the market goes down. And that’s a very, very effective addition to a long portfolio.

Corey Hoffstein  50:29

So I want to talk to you a little bit about that building a portfolio notion because again, I think this is one of those areas where most research and due diligence and academic effort is spent in the realm of what’s the measure, what’s the secret sauce, talk to me about this acquirers multiple. And there’s this whole other side of the portfolio construction process, which is, alright, I’ve ranked my securities based on the acquirers multiple, how do I actually think about selecting a number of securities? How frequently I want to rebalance? How long do I want to hold these securities?

Tobias Carlisle  51:03

I think that as of the last 10 years that I’ve sort of been trying to actively trade quantitative value strategies. I’m not, I wouldn’t call myself a quant. Nobody else would call me a quant either, so I don’t have to worry about that. I’m a value guy who sort of tries to protect himself from his own behavioral errors by applying that value theory in a systematic way. So I think I’ve become less theoretically pure as I’ve gone along and become sort of more just trying to be more practical, long, short strategies make money when the spread widens, and they lose money when the spread tightens up. And the spreads aren’t really gonna follow them. Sometimes when the markets up the spread is narrowing, sometimes it’s widening. And the markets down, it’s a little bit idiosyncratic, the smart way of building that portfolio, theoretically, might be to do the opposite ends of that spread. But I think that you need a little bit more, the short requires a little bit more, tending the long requires a little different type of tending to work, and they need to be thought of independently, they need to stand up independently. limiting exposure to sectors is something I go back and forth on, it’s not something that I want to do. And the reason is that sectors tend to get cheap or expensive, at the same, the companies in the sector are all pulled along by each other. When they get really cheap, I think you want to hold more of them. And you get there naturally by just applying the screen to the whole market. And they get expensive and do the opposite. And I think you sort of get there naturally, it’s probably, again, not a very academic way, not a very theoretically pure way of applying it, I’m definitely going to be exposed more to that acquirers multiple factor, which is going to have good performance, and it’s going to have periods of bad performance. I like it because I like the philosophy behind it. I understand it when I was wasn’t an investor when I was a lawyer, I understood that there’ll be guys and the activists approaching these companies on that basis. I think that it’s one of those things that had an individual company level, I understand why each company is in the portfolio, and I can look at it. And in five minutes, I understand why it’s cheap, and why it should be in there. And sometimes I feel like if I use other factors, I lose that reason why it’s in the portfolio. So I think there are going to be lots of different ways of applying value factors, lots of different factors that can be applied. And you still one way or the other, making a little bit of a bit. I’m going to make my bet on the acquirers multiple

Corey Hoffstein  53:29

in your book, quantitative value, you run this whole horse race of different measures, and you specifically address this concept of using multiple valuation measures together. You reference the work of Jim o Shaughnessy at O’Shaughnessy asset management who found it very effective to actually combine multiple measures together. I know that’s a very popular approach among quants. And yet in that book, you ultimately found that I believe it was EBIT to total enterprise value that reigned supreme on all measures including Sharpe, above and beyond using a compound measure approach and you yourself focus specifically on the acquirers multiple rather than using a compound measure approach. Can you talk to us a little about why you forego the potential diversification benefits of multiple measures for perhaps the Enhanced Insight that you get from the acquirers multiple?

Tobias Carlisle  54:28

So the argument for using the compound measure Jim O. Shaughnessy, when he first brought out what works on Wall Street, I think it was 1995 He found the best value metric was price to sales. And I think the argument at the time was that sales is sort of undiluted by everything else that occurs down the financial statements, the pure, very top line, you can’t live at the top line even though now we know there are lots of different ways about lying. There are lots of ways that you can lie about the top line, or I’ve discovered them over the last decade. But in subsequent editions of the book, he said there are different factors had performed better I think sometime in the last 10 or 20 years he, he advocated for a compound measure because he said, each of these factors has periods where they outperform in periods where they underperform. But if you use the compound measure, then you’re never going to be the best factor. But you’re never going to be the worst factor either you’re in business the whole way through that your portfolio is going to do pretty well. We tested that in quantitative value and found that the compound measure that we tested, didn’t do as well as any individual measure. But I’m still very nervous that I assurances research is pretty good. And I think that that’s very, very likely that you see that again in the future. And the way that I get around it, is that I say, Well, I like the intuition. I like the philosophy of the acquirers multiple. But I do acknowledge that there are ways that it can be fooled, unusual accounting treatments, unusual businesses will fill this metric. So the way that I get around as I screen out everything on the fringes of other metrics, it looks cheap on an acquirers, multiple bases, but it’s very expensive, on a price to book basis, it won’t be in the portfolio, if it’s too expensive on a cash flow basis, it’s going to be screened out. It’s too expensive on these other metrics, just because I’m nervous that there’s something in that particular business that has filled the multiple. So that’s how I deal with it. It has been pretty effective. I think that the multiple has kept on working over the recent period of time, it’s entirely possible that it falls apart at some stage too.

Corey Hoffstein  56:18

So last question for you. And the question is, if you were an investment strategy, so Toby Carlisle urine investment strategy can be a quantitative strategy. It can be a discretionary strategy, you can be merger arbitrage. You could be market beta, what strategy would you be and why? So let’s have a question of What strategy do you like, but this is more your personality as a person what what investment strategy are you

Tobias Carlisle  56:45

on the momentum got? Equity, momentum, calm confidence guy, this is one of the things like, the more honest I think you are with yourself, the better you are able to protect yourself from the things that you do badly. The reason I’m a deep value, guys, when these companies are really busted up, I look at them and I say, You know what? He’s going to make it he’s going to survive, he’s going to come out the other side. So I’m an eternal optimist, which makes me a momentum guy, Toby, this

Corey Hoffstein  57:09

has been a lot of fun. Thank you for joining me. So listen, Cody. Thanks for having me. Thanks for listening to my conversation with Toby Carlisle. You can find more of Toby at acquirers and on Twitter under the handle greenback. Show notes are available at flirting with If you enjoyed the show, we hope you’ll share it with a friend and leave us a review on iTunes.