The Search for Mispriced Stocks w/ Clay Finck (TIP782)
Summary
Active Value Setup: The rise of passive investing is creating price inefficiencies, setting a favorable backdrop for disciplined value investors to outperform with lower risk.
Markel Group (MKL): A Berkshire-like three-engine model (insurance, investments, ventures) with strong underwriting discipline and float deployment presents a long-term compounding opportunity.
Couche-Tard (ATD): Acquisition-driven consolidation of global convenience stores, efficient deleveraging, and opportunistic buybacks support continued high-ROIC growth.
NVR (NVR): Asset-light, option-based land strategy drives exceptional ROIC and massive buybacks, enabling resilience through cycles and a valuation discount to the market.
Banks Opportunity: Valuing banks via ROE and P/B highlights JP Morgan (JPM) for superior ROTE and OSB Group (OSB) as a high-ROE, low-multiple niche lender.
Japan: Governance reforms, rising buybacks/dividends, and lower valuations vs. the U.S. offer attractive equity exposure, though currency risk needs management.
Capital Allocation: Preference for share buybacks over dividends when below intrinsic value, and caution on large, off-core acquisitions to avoid value destruction.
Risk Framework: Focus on circle of competence, strong balance sheets, and margin of safety to minimize permanent capital loss while targeting obvious mispricings.
Transcript
Bogle himself even said near the end of his life that if all investors utilize index investing then chaos and catastrophe could be expected and markets themselves would fail. Glattis writes here, "An intelligent investor will not only get off this passive investing train, but will use the whole situation to their advantage. Provided that active investors come to grips with the new state of the markets, understand how and in what ways market behavior has changed, and adjust their own investing, they stand a good chance of having their portfolios provide returns higher than those of broad markets while bearing much less risk than that of broad markets. Before we dive into the video, if you've been enjoying the show, be sure to click the subscribe button below so you never miss an episode. It's a free and easy way to support us, and we'd really appreciate it. Thank you so much. Over the past decade, the investment world has fundamentally changed by the rising trend of passive investing. And as more and more capital pours into passive strategies, potentially a smaller and smaller subset of the market is actively engaged in valuing individual businesses in allocating capital based on fundamentals. This trend of course has benefited many investors, but it can be argued that it's created a growing number of distortions underneath the surface. In today's episode, I'll be covering a book that digs into this subject. It's called Hidden Investment Treasures: How to Find Great Stock Investments as the Investment World Goes Passive by Daniel Glattis. Glattis is the founder and director of the Vatalva Fund, a long-term fundamentally driven investment firm based in Europe. He's been an active stock investor since the early9s and started the fund in 2004. The book makes the case that today's market environment dominated by indexing, ETFs, and momentumdriven capital flows may actually be one of the most favorable backdrops for disciplined and patient value investors. Glattis argues that as fewer investors focus on the underlying fundamentals, the gap between price and value has widened in many overlooked corners of the market. Throughout the book, he shares a series of case studies of investments he has personally made in the fund, ranging from companies that our audience is well familiar with, like Berkshire Hathway and Markeel to less obvious opportunities in Japan and banking. In this episode, I'll walk through the core ideas of the book, discuss several of the most interesting case studies, and share the takeaways I found to be most impactful in reading it. So with that, I hope you enjoy today's episode on hidden investment treasures by Daniel Glattis. Since 2014, and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, PlayFink. As I mentioned at the top, on today's episode, I'll be reviewing the book Hidden Investment Treasures by Daniel Glattis, founder of the Vatalva Fund. Vatalva benchmarks themselves against a world stock market benchmark. And over the 16 years leading up to year-end 2024, the fund delivered returns of 511% versus 333% for their global benchmark. We'll be getting into this here shortly, but Glattis actually makes a case for why the S&P 500 is no longer a helpful benchmark due to the increased use of passive investing, which has bit up the prices of stocks in the S&P 500 relative to their underlying fundamentals. So, I found this book to be really interesting and thoughtprovoking as it really made me question what I fundamentally believed about the markets. So in chapter one of the book, he paints a picture of the market environment we're in today and sort of how we got here. And in the remaining chapters, he covers several different investments for the reader to consider, including Berkshire Hathaway, Markeel, Elementacion, Cushard, Stellantis, a basket of Japanese stocks, and several others. From Daniel's perspective, he gets a lot of value in listening to investment ideas from others because he's in the business of making investments himself and having a strong thesis for why he's making the bets he is. He mentions that he's read countless investment books. I can certainly resonate with that. But none of these really focus on sharing investment ideas which you know it makes sense because investments can come and go and what might be a good investment today might not be interesting to someone who's reading 5 years from now. So he not only shares several investment ideas in the book, but he also goes into detail on why he selected these stocks to include in the book, which is of course valuable because you can sort of get an understanding of his thinking process that we can then apply and use some of those mental models to other investment situations. He writes here, "By examining those cases, I demonstrate that today one can find in the markets a whole range of companies whose stock prices are significantly lower than their intrinsic values, whose quality of business is very high and whose associated risk is often much lower than the risk of the market as a whole." End quote. The majority of the stocks outlined were purchased in his fund and were still held at the time the book was published, which was later in 2024. Glattis argues that today's market environment is better for value investors than it's ever been over his investing lifetime, which is over 30 years. Many would say that with the rise of the internet and new technologies to share all this information, it would become more and more difficult to find mispricings because the market can react so quickly to new information. But Glattis believes that there are fewer and fewer investors actually trying to identify the mispricings and act on them. Let's call these types of investors value investors. Well, many people would categorize value investors as investors who buy stocks that have low PE ratios, low price to book ratios, which you know tend to be companies that are not growing much and they tend to be more established and stable businesses. And a growth investor would be in contrast to this looking for younger companies with above average growth potential. Value investing as defined in the book is not related to what earnings multiples an investor is willing to pay or whether they prefer more established and stable companies versus companies with rapid growth. A value investor simply looks to buy shares at prices that are lower than their value. And the expected growth of a company always plays an important role in estimating that value. No stock can be accepted or rejected simply on the basis of whether it trades at a low or high multiple of earnings or cash flows or based upon whether the company's growing fast or slow. The Vulva fund primarily holds what would be described as growth companies that are increasing their intrinsic value by at least 10% per year, a rate above that of the stock market as a whole. Now, buying something far less than it's worth seems quite a logical way to invest. So, why are so few people actually trying to do this? In recent years, of course, we've seen the rise of passive investing. Passive investors aren't really interested in how much a stock is worth or how much they have to pay for it because they put their money into investment instruments that by their composition replicate some index. Ironically, passive investors who are not interested in individual stocks and are indifferent to the prices they're paying for the underlying shares rely on the actions of active investors who by seeking out individual attractive investments maintain a process known as price discovery. In theory, if most market participants were active investors, then you'd expect the price discovery process to be relatively fast and efficient. But research from 2019 suggests that more than 50% of the total amount of money managed in the US market is invested passively. These investments are in a variety of index funds and ETFs as well as in other retail pension and institutional index linked products. And there are also funds that outwardly appear to be active but behave more like these passive funds otherwise known as closet indexers. And then when you account for even more passive flows since 2019 and the fact that there are major shareholders in the publicly traded companies, you know, such as the founder or the CEO, Glattis estimates that around 20% of capital in the market can be regarded as actively managed money. And that doesn't necessarily mean that that 20% of capital actually looks for disparities between price and value. For example, it could be momentum strategies, algorithmic trading, or technical analysis. For the past 15 years or so, passive investing has been a tailwind for the S&P 500, helping lift the valuation multiples higher over time. But if the reverse situation happens where these net inflows turn into net outflows, then we could see a considerable decline in the broader market because there just wouldn't be enough capital to absorb that big selling pressure. Now, much has been said about the increased levels of concentration of the top companies in the S&P 500. As of the time of recording, the top 10 companies account for around 40% of the S&P 500's value. When there are passive inflows, the companies with the highest waiting will have the most money allocated to them. And those shares, they have to be sold by somebody if they're being purchased. So, you know, of course, with every buyer, there's a seller. Oftentimes, these sellers end up being active investors. But when that trend reverses and there are passive outflows, it's the largest stocks that are being sold the most and experience the largest declines because there just aren't enough active buyers to keep up with that large selling pressure coming from the passive investors who again make up most of the market's capital. If we look back at 2022 for example, the Magnificent 7 which includes Alphabet, Amazon, Meta, Microsoft, Nvidia, and Tesla, they collectively declined by 40% but their earnings per share only declined by around 8%. Their PE ratios contracted by 1/3 from 38 times earnings to 25 times earnings. So meanwhile, the S&P 500 during that year, it only declined by 19%. And of course, we saw in 2023 and 24 markets rebounded and the valuation levels of these companies soared back to new highs. Now, this isn't meant to necessarily criticize passive investing as it is a sound long-term investment strategy for most people, but Glattis outlines that everything, no matter how good the idea, has its negative consequences, and the impact can often run counter to the original intent. The more extreme an original idea and its application, the more pronounced the side effects can be. Glattis believes that the prominence of passive investing is at unprecedented levels and there has never been anything like it before and it's critical that investors understand its impact. The situation with so much passive capital in the markets creates a situation where most market participants are invested in the market, but they aren't necessarily concerned with what exactly they're buying and at what price. If you're a value investor and you seek to buy businesses at a discount to their underlying value, then it's a pretty good situation to be in if the person selling the shares to you doesn't necessarily understand what they own and the underlying value of what it is they're selling to you. So the point that Glattus is getting at is that Jack Bogle, he popularized indexing and the idea was based on the premise that markets were efficient and passive investors would simply take whatever price the market would give them. But since passive has overtaken the market, passive investors have gone from price takers to price makers, creating a more inefficient market. Bogle himself even said near the end of his life that if all investors utilize index investing then chaos and catastrophe could be expected and markets themselves would fail. Glattis writes here, "An intelligent investor will not only get off this passive investing train, but will use the whole situation to their advantage. Provided that active investors come to grips with the new state of the markets, understand how and in what ways market behavior has changed and adjust their own investing, they stand a good chance of having their portfolios provide returns higher than those of broad markets while bearing much less risk than that of broad markets. So with that as a backdrop, Glattis shares 15 case studies in the book, a few of which I'll be getting into here. In his view, each case study represents a stock that is priced significantly below their intrinsic value as of September 2024 when the book was published and it represents a highquality business and often has associated risk that is much lower than that of the overall market. The first chapter is on Bergkshire Hathaway, which I know our audience is well familiar with. And my co-host Stig Broers already does a deep dive on for the Bergkshire episode each year where he brings on Chris Bloomstrand as a guest just prior to the Bergkshire meeting in May. I won't get into the specifics of Berkshire here for this episode, but Glattis has Bergkshire as a core holding in his fund and he expects around a 10% annual growth in the intrinsic value over the long term. So I wanted to turn to the chapter on a company often referred to as Baby Bergkshire Markell Group. While having a similar business model, Markell is just 140th the size of Bergkshire Hathaway. Remarkably, Bergkshire has still managed to generate very similar returns to Markel over the past few decades, but I suspect that Berkshire's investable universe is quickly shrinking with their ever growing cash pile. So, I think that's going to make it pretty difficult for them to compound at such high rates going forward, which makes Markeel Group potentially more interesting for us as investors. Over the years, several companies have tried to present themselves as the next Bergkshire Hathway, but few have succeeded. Markell Group may be one of the few that have been successful at emulating Bergkshire success over long periods of time. Glattis writes, "Although it is far from being of Berkshire quality, this is a business that is so interesting and promising that it makes sense to give it proper attention." End quote. Markell's obvious advantage over Berkshire is obviously its size, giving it less constraints in terms of its future growth prospects. Markeel was started in 1930 by Samuel Markell in the state of Virginia and they first entered the insurance business. Today, Samuel's grandson, Steven Markel, is the chairman of the board. The company went public in 1986 with a market cap of just $15 million. Tom Gainner, the CEO of the company today. He joined Markeel in 1990 as the company's equity portfolio manager. The stock traded for $20 when Gainner joined the company, and today shares trade for around $2,100, representing more than a 100x increase. Gainer describes Markeel as a company that is powered by three engines. The first engine is insurance and reinsurance. Today, Markell is the world's leading specialist insurance company and the third largest US provider of excess and surplus insurance. Markell's insurance business has grown steadily over the years and has been consistently profitable. In a very Berkshire-like fashion, Markell is conservative when it comes to underwriting policies, setting aside reserves for future claims and not chasing future growth just for the sake of growth. Insurance companies can get themselves into trouble when they try to chase unprofitable business and are unrealistic in underwriting expected future claims. When it comes to insurance, discipline is of utmost importance, which Markell has consistently showcased. Markeel's second engine is its investment portfolio. Bergkshire is well known for using its float as an interestfree source of capital to invest in stocks. Markeel takes a very similar approach and today has over $32 billion in float. Now, not all of this is invested in the stock market. They need to ensure that they're able to conservatively pay future claims. So, a good portion of the float is invested in bonds that are duration matched with expected future claims while also generating interest income and about 1/3 is invested in equities. Tom Gayner is a great investor and his investment returns over the past 20 years have exceeded the S&P 500 by 1% peranom. The remarkable part about this is just how diversified he is. When I pull up his most recent 13F, his top 10 positions make up just 43% of the portfolio and he owns more than 100 stocks. It also includes several well-known US blue chips and the top positions as of today include Berkshire Hathaway, Alphabet, Brookfield Corp., Amazon, and Dearco. Glattis estimates that the average overall return on their float will be around 5%. Markell's third engine is the newest, Markel Ventures, which management started building in 2005. Markell Ventures is their arm that invests in private non-insurance businesses to add more diversification to the conglomerate. It primarily consists of older economy companies and tends to avoid technology and information sectors. Like Berkshire, Markeel purchases these companies with the intention of holding them indefinitely. As of the time of writing, this segment produced annual revenues of 5 billion per year. When Glattis totaled up the estimated annual profits from these three segments, he came to a total estimate of $1.5 billion per year. And as of the time of writing, Markeel traded at a market cap of 20 billion, which he believed was undervalued for a company with the track record and management team that they had. Over the 20 years leading up to the book being published, Markell compounded operating income at 11% per year, gross premiums compounded at 9% per year, and the investment portfolio also compounded at 9%. Investors like to judge the valuation of companies like Berkshire and Markeel based on the price to book ratio. But judging the valuation based on this metric can be a bit tricky for Markel. Because as Markeel Ventures continues to grow and continue to play an increasingly important role in the conglomerate, book value becomes less and less relevant since acquisitions are accounted for at cost. So it's probably better to judge the valuation based on maybe the sum of the parts methodology. Glattis views Markeel as a prime candidate to be a hidden investment treasure. Because of its medium size, it doesn't have a large waiting in the indices. And since it belongs in the financial sector and the property casualty insurance subsector, passive capital doesn't substantially flow to this area of the market. Additionally, since it's a rather boring investment that, you know, won't make investors rich overnight, it can continue to quietly compound without receiving much attention from retail investors. I should also mention that each year during the Bergkshire weekend in Omaha, I attend the Markel brunch where Tom Gainner and other managers host a free event for investors to socialize and ask some questions. It's a really fun event and if you happen to be in Omaha during the Birkshire weekend, I would highly encourage you to attend the Markell branch as well. I also like that Markell has a very broad and loyal shareholder base. At the Markel branch, there are hundreds of people eagerly listening to management's responses to questions, and the questions asked are rather sophisticated. So, I think that management does a really good job of communicating with shareholders in building out a strong base of well-informed, quality shareholders. I'd also like to mention that I put together a video that explains how you can attend the Berkshire Hathway shareholders meeting and how you can join us at the events that TIP is hosting. I'll be sure to get that video linked in the show notes for those who are interested. The second case study I'd like to highlight is Elementacion Cousard. Prior to getting into the business, Glattis educates the reader extensively on capital allocation, share repurchases, and dividends. He strongly favors companies that are good capital allocators and tends to favor companies that are share cannibals as well. Share cannibals are companies that have repurchased a significant number of their shares and have done so at attractive valuations. The reason he tends to favor wise share repurchases over dividends is that share repurchases can add value to existing shareholders when they're done well below the intrinsic value of the company. In this case, value is transferred from the seller to existing shareholders because of the advantageous price the shares are purchased at. Whereas with dividends, no value is created because the company is simply sending a check to the shareholders. Share buybacks are essentially an investment by the company into itself with a return on capital that is usually higher than that what is offered by available investment opportunities and without the risk associated with such investments. If management can maintain the discipline to buy back shares only at favorable prices and if this is not at the cost of excessively growing debt levels, then share buybacks can have a highly positive impact on both share value and share price over the long term. He then shares a word of caution with regard to acquisitions. Acquisitions for managers can be tempting as having your company in the headlines for buying your largest competitor seems a lot more fun than a headline that states that you bought back 1/5if of your shares and acquisitions come with big risks for shareholders. Glattis writes, "Our study of market events and our own investment experience lead us to conclude that the greatest potential risk for value destruction is through acquisitions. This is because overall it is a form of capital allocation to which the largest volumes of money are directed. End quote. Are you looking to connect with highquality people in the value investing world? Beyond hosting this podcast, I also help run our tip mastermind community, a private group designed for serious investors. Inside, you'll meet vetted members who are entrepreneurs, private investors, and asset managers. People who understand your journey and can help you grow. Each week we host live calls where members share insights, strategies, and experiences. Our members are often surprised to learn that our community is not just about finding the next stockp, but also sharing lessons on how to live a good life. We certainly do not have all the answers, but many members have likely face similar challenges to yours. And our community does not just live online. Each year we gather in Omaha and New York City, giving you the chance to build deeper, more meaningful relationships in person. One member told me that being a part of this group has helped him not just as an investor, but as a person looking for a thoughtful approach to balancing wealth and happiness. We're capping the group at 150 members, and we're looking to fill just five spots this month. So, if this sounds interesting to you, you can learn more and sign up for the weight list at thevesspodcast.com/mastermind. That's the investorspodcast.com/mastermind or feel free to email me directly at clay@theinvestorpodcast.com. If you enjoy excellent breakdowns on individual stocks, then you need to check out the intrinsic value podcast hosted by Shaun Ali and Daniel Mona. Each week, Shawn and Daniel do in-depth analysis on a company's business model and competitive advantages. And in real time, they build out the intrinsic value portfolio for you to follow along as they search for value in the market. So far, they've done analysis on great businesses like John Deere, Ulta Beauty, AutoZone, and Airbnb. And I recommend starting with the episode on Nintendo, the global powerhouse in gaming. It's rare to find a show that consistently publishes highquality, comprehensive deep dives that cover all the aspects of a business from an investment perspective. Go follow the Intrinsic Value Podcast on your favorite podcasting app and discover the next stock to add to your portfolio or watch list. Acquisitions can be troublesome if management's ego gets involved and they get too far ahead of themselves not keeping shareholders in mind. In management's appetite for acquisitions is typically at its highest at the peak of a bull market. The worst acquisitions tend to be those that are very large, are paid for with stock rather than cash, and are outside the buyer's existing core business area. Furthermore, it's often the case too that the announcement of these acquisitions is unexpected and the market is caught off guard, causing an immediate negative reaction for the stock price. Now, when you're partnered with a good management team with, you know, a good track record of looking out for shareholders, this potential risk for investors is largely eliminated. With all that said, there are some companies that have a long track record of growing through acquisition and have done very well. These companies don't overpay. They're able to integrate these businesses well, and they're patient in waiting for the right opportunities. They ensure that when acquisitions are made, they are likely to be value accreative to shareholders. Almentacion Kushtard is an example of such a company which I'll refer to here as ATD which is the ticker symbol. ATD is one of Canada's most interesting and successful business stories. The company was founded by Alan Bousard in 1980 at the age of 31 and today Bousard is the company's chairman. In 1980, he decided to open his first convenience store near Montreal. And his groundbreaking idea at the time was to keep the store open 24 hours a day. Fast forward to today, the company owns 17,000 stores in Canada, the US, Northern Europe, and Asia. Remarkably, of the stores they own today, 75% of them came through acquisitions. Stores acquired by ATD tend to perform better in their hands than previously to the acquisition, showcasing their operational excellence. Debt is often used in making acquisitions and then it's typically paid down rather quickly to give the company flexibility to make further acquisitions in the future or buy back shares at favorable prices. Over the past 20 years, ATD has made around 75 acquisitions and its stores span across 25 different countries. And since the convenience store industry remains highly fragmented, there is still a significant opportunity to continue to grow through acquisitions. In the US alone, there are 150,000 convenience stores and gas stations of the type that ATD operates, 7,000 of which are ATDs. That's less than 5% of the total market. As in many other industries, the expense structure favors the larger players over the smaller ones, especially when it comes to things like purchasing fuel. Since large players are able to have a lower cost structure, it makes sense for the industry to continue to consolidate. ATD is one of those companies that has steadily grinded out high returns over the years. Since their IPO in 1999, the stock has compounded at an average rate of 21% peranom. This has been driven by disciplined capital allocation and high returns on invested capital. And as long as the company continues with this sound strategy, one should expect it to continue to perform well from here. Jumping to the third hidden investment treasure I wanted to discuss today, we have NVR. I've long considered chatting about homebuilders here on the show, but I haven't come around to pulling the trigger on it. Several value investors and some members of our mastermind community have been interested in homebuilders like Dr. Horton and Toll Brothers. So to tee up the discussion here on NVR, Glattis ruminates on the best type of business one could own. The best businesses are those that generate high returns on capital and are able to reinvest the capital earned over the long term with similarly high returns. The magic of these is that the value of the business compounds to extraordinary levels when given enough time. But these types of companies are quite rare. So maybe the next best case might be a business that generates high returns on capital, can reinvest only a relatively small portion of that capital at high rates, and then return the excess capital to shareholders in the form of buybacks. Now, one wouldn't expect a home builder to be the prime case study for a business with high returns on capital. So, I I think about where I live. I live towards the edge of town here in Lincoln, Nebraska. And I can't help but notice how many of these new neighborhoods on the edge of town put up houses that are more or less they look the same. It seems like an industry that would be very capital inensive and very commoditized. Furthermore, housing is a cyclical industry which can make it difficult to consistently turn a profit if there are years where demand for housing is weak and homebuilders are left holding several unsold homes. If we look back at the history of NVR back in the 1980s, they were a quintessential home builder and land developer. That is to say that they would buy land that wasn't yet ready for home building as it needed to go through phases of zone permitting, planning, utilities, and infrastructure engineering into construction. Only after all of this could a home be built. As one would expect, this process was costly, tying up a lot of capital, and it took several years for the time and effort to bear fruit. The process also carried risk. In the early 1990s, there was an economic and construction recession, and NVR ended up declaring for bankruptcy. But when it emerged from bankruptcy in 1992, it had a business model that was completely different from its previous one. Glattis explains that the model is still in place today and uniquely positions NVR among its competitors. This business model led the stock to be one of the best performing stocks over the past 30 years. NVR's business model is based on three fundamental pillars. The first pillar is low capital requirements. The second is an efficient home building process and the third is highly efficient allocation of capital. Any company that builds houses needs to have an inventory of land upon which to build in the future. And home builders tend to have several years of developments so that they're always able to fill demand for new houses. But if you're a homebuilder, holding the land for several years is very capital inensive, expensive, and inefficient, and it tends to be financed with debt, meaning that you have these annual interest costs. Additionally, you risk that the land will decrease in value while you hold it. To avoid these risks, NVR almost completely avoids buying land that is not ready for development. Instead, they focus on buying ready land and not with cash, but through purchase options. The option premium can typically be as high as 10% of the land price. And this alone comprises the capital and risk involved for NVR. Should they decide to withdraw from the intended purchase, in the worst case, it will only lose the option premium. Not only is this approach less risky and less capital intensive, it also gives NVR much more flexibility and optionality relative to just straight up buying the land that they think they need. To put some numbers around this, in 2023, NVR built 20,000 homes and at the end of the year they control just over 141,000 lots, which would be enough for 7 years of construction. It spent $584 million on them, which is only about $4,000 per lot on average, making for a very low cost and efficient way of acquiring inventory. The second pillar is the high efficiency of their development process. NVR is focused on a few key markets and on building market leadership in those markets. Geographically, it has four major segments in the US, which mostly look to be in the eastern part of the country in states like Pennsylvania, New York, Ohio, and Florida. In some of these markets, NVR has a market share in excess of 20%. Second, NVR produces pre-fabricated building components near its key markets, which significantly reduces its cost. Third, they use independent subcontractors to build its houses, working on fixedpric contracts. This makes their margins more stable. When the construction industry was in a crisis in the US between 2006 and 2011, the number of new homes built dropped significantly. And NVR was the only publicly traded home builder that remained profitable and even performed well. Fourth, NVR overwhelmingly builds homes only when they are pre-sold and when the down payment has been made. So they do not engage in speculative construction and there is very low risk in them being stuck holding many unsold homes. And fifth, NVR offers mortgage financing to its home buyers and sells the loans to banks providing them with a high margin segment with low capital requirements. The third pillar of NVR success is highly efficient capital allocation. Given NVR's unique business model in the industry, it is not capital inensive. And given the construction method itself, NVR considers itself more of an assembler putting the house together than a builder as it does not require much capital for machinery and equipment. NVR doesn't pursue acquisitions and seeks to grow organically and gradually strengthen its position in existing markets and grow into surrounding markets. Their low capital needs and high margins relative to its industry results in high returns on invested capital and just as important high returns on incremental invested capital. NVR has a strong balance sheet with net cash and the vast majority of the cash the business generates is deployed into share buybacks. here. As of the time of recording, when I look at the financials for the trailing 12 months, I see $1.3 billion in free cash flow and nearly $1.9 billion deployed into share buybacks. Just as remarkably, their capex line is just 26 million. That's just 2% of free cash flow. Due to their approach to capital allocation over the past 30 years, the vast majority of NVR shares have been retired. At the end of 1995, the company had just over 15 million shares outstanding. And that number today is 2.8 million. So over the past 30 years, the shares outstanding have declined by over 80% which is about a 5.4% decline in the share count per year. Set another way, if you bought shares in NVR at the end of 1995, your proportional ownership stake in the business increased by over five times since then without you actually needing to purchase additional shares. What's also just as important is that NVR stock-based compensation looks to be rather modest. So they aren't like many other companies that buy back shares simply to offset the dilution that is happening through stockbased comp. To get a sense of how high the returns on capital are, Glattis walked through the financial statements from 2023, which was a pretty average year or perhaps let's say a normal year for the industry. He calculates return on invested capital as simply the net profit divided by the invested capital. With a net profit of 1.59 billion and invested capital of roughly 2 billion, ROIC is therefore almost 80%. When you have a company that generates so much cash, has low capital intensity, and repurchases shares at a modest valuation, it's no wonder that we've seen shares of NVR compound at high rates for three decades now. If we zoom out and look at the industry more broadly, there is no doubt that they operate in a cyclical industry. The primary factors that drive demand for new home construction in the short to medium-term are employment, real income levels, availability, the cost of financing, and home prices. Looking at new home builds over time throughout the 1990s, we saw this figure rise as the economy was booming. There was a temporary decline in the early 2000s and then at the peak of the GFC, new home builds rose to 2.2 2 million and crashed all the way down to just 600,000 around 2012. Now today, this figure has steadily increased back to 1.8 million new builds as the industry recovered over the years. Looking back at the historical financials for NVR, the cyclicality of the industry has certainly impacted this business. Revenues declined by more than half during the GFC and they also saw a revenue decline in 2023. However, they did remain profitable the entire time while other homebuilders did not fare as well. But even with the cyclicality, the long-term trend is a net positive for home builders here in the US, primarily due to population growth. The Joint Cent's study estimate that around 1.5 new homes would need to be built annually to meet demand, which is more than what has actually been built in many recent years. To close out the chapter, Glattis covers the sources of competitive advantages for NBR and potentially why the business model has not been replicated by others in the industry. For any business that has increased by 100x over the past few decades, you should expect others to want to join the party. Glattis's firm has been following the residential construction industry for more than 20 years and as of the time of writing they believe that there are no successful imitators among their competitors. The theory for why that is is that it's simply not easy to apply the model. So it may not be as straightforward in practice as it might appear on the surface. Now, it's sort of an easy copout to just say what they do is just so difficult to do, but it certainly could be the case. Well, if any business is so good, why wouldn't the market just realize that and price the shares accordingly? As value investors, we must come to our own conclusion as to what we believe the business to be worth. In the past, the market has clearly gotten the pricing wrong for NVR. And that suggests that the efficient market hypothesis just does not hold in this case. With a track record like NVR, you'd think that the market would come around to putting a premium on this business. But in Glattis's view, the market views NVR as just another homebuilder that operates in a highly cyclical industry. As of the time of recording, NVR's PE ratio is just 16, while the S&P 500 minus the MAG 7 trades at around 22 times earnings. That's nearly a 30% discount to the broader market. And over the past decade, the PE ratio for NVR has been around in the mid- teens, so it's priced at a similar level to its recent history. and the stock seems to really fly a bit under the radar given that management makes no effort to promote its own shares. They don't hold quarterly conference calls and its quarterly reports are brief. So, Glattis expects the positive trends of the past to continue and for the company to perform well over the long term. For the fourth case study we'll be discussing today, we won't be talking about an individual company, but the broader market of Japan. Glattis titles this chapter Japan seeking treasure in a country most investors ignore. What I liked about this chapter is that it provides this broader perspective and some lessons from history as well. Many of the best investments tend to be in areas of the market where other investors just aren't looking. If we take a step back in time, the NIK225 index became one of the largest bubbles in financial history, peaking out in 1989. For those not familiar, the NIK 225 is a Japanese stock index that tracks the performance of 225 large publicly traded companies listed on the Tokyo Stock Exchange. Glattis launched his fund in 2004, and at that point, the index was still down 30% from its peak 15 years earlier. As far as investors were concerned, Japan was a market that was falling and just not worthy of anyone's attention. Meanwhile, China's economy was rapidly growing and getting much more investor interest. In Glattis's words here, Japan was seen in many eyes as a country with slow GDP growth, an old and declining population, large debt, and often struggling with deflation. It's no wonder that investors saw much more potential in a market like China. To look at the positive side, Japan did have perhaps the longest life expectancy, a healthy population, an absence of poverty and obesity, low levels of corruption and crime, the best infrastructure of any major country in the world, and a sophisticated, homogeneous, and educated population. Japan is also an advanced country technologically and Japanese companies have invented and or successfully commercialized a number of products that have since become almost indispensable to consumers. A few examples include the microwave, a whole range of computer chips, the digital watch, the transistor radio, 3G mobile telephones among several others. If you look at many products that we use every day, Japan is a part of several of them. A quarter to onethird of the content in an iPhone is from Japan, the most of any country. As of the time of recording, the Japanese stock market is the third largest in the world after the US and China. And to help put things into perspective, there are around 4,700 publicly traded companies here in the US and nearly 4,000 in Japan. I think many investors would be surprised to discover how broad and diverse the Japanese stock market really is. Now, just because there is innovation happening in a country doesn't necessarily mean that it's necessarily investable. Our investment principles should apply regardless of the market we're investing in. While investors deemed Japan uninteresting and filled with companies that had low returns on capital, too much cash sitting on the balance sheet, and a lack of shareholder value creation, some things started to happen underneath the surface to get the market picking back up. In light of the great financial crisis, the Nikk 225 plunged by more than 50% and it hardly recovered from 2009 to 2012. In 2012, the Liberal Democratic Party pursued monetary easing, budgetary stimulus, and structural reforms that helped spark investor interest and helped kick the market back into gear. And in 2014, further pressure was put on the efficiency of companies and for an increased focus on shareholder value creation and even further pressure was added in 2020 and 2023. If management did not prioritize shareholders in their decision-making and did not present a clear plan to improve ROIs or inefficient capital allocation, then they risked being delisted. One index required that companies maintain ROIs in excess of their cost of capital and that their shares must trade above book value. Glattis mentioned that he hadn't seen oversight like this anywhere else in the world. And as a result, many companies have increased their dividends, increased the use of share buybacks, and made other strategic decisions to add value to shareholders. Now, the impact of these reforms aren't going to drastically impact the companies overnight. But for investors in the Japanese market, it is necessary that management is shareholder friendly and understands the impact of their capital allocation decisions in order for value to be recognized and appreciated by investors. From the end of 2012 to the time of recording, the NIK has compounded at just shy of 13% per year. However, the Japanese yen has weakened substantially over that time period. At the start of the time frame, the yen to USD ratio was around 86 and today it's 157. So, holders of yen get substantially less dollars when making that conversion, which has implications for investors like myself who are based in the US who invest in Japan. When adjusting for the currency, the annual returns were closer to 8% per year. Since Glattis' firm didn't have the capacity to cover the Japanese market extensively given their involvement in other markets, they decided to take more of a passive approach to investing in Japan. In his view, passive investing can be a good form of investing if it's based on analysis and it makes sense both in relation to price and composition of the underlying asset. The NIK 225 index met both of those requirements for them. However, they did have concerns about the currency risk and hedging such risks doesn't come too cheap. So, they settled on purchasing the Nikk 225 index by means of futures contracts to largely eliminate the currency risk. He explains how it works in the book. So, I won't bore you with all the details here. As of the time of writing, the PE ratio of Japanese stocks was 17, while the PE ratio here in the US was 28. And the Japanese have generated higher earnings growth over the past decade, have lower indebtedness, and changes are still being made by companies to try and unlock more shareholder value. It also can't be ignored that Buffett invested in the five leading Japanese trading companies in 2020. Buffett, of course, saw these companies as cheap, and I think investors underestimate just how big of a home run this has been for Bergkshire. Since the end of 2020, all five of these stocks are up by more than 4x, which would equate to a 30% plus compounded annual growth rate. I've personally looked a bit into investing in Japan myself, and I do own one SAS business in Japan that is rather small. I'm in agreement with him that the currency risk just cannot be ignored. I tried to overcome that in my investment by buying cheap and ensuring that the future growth is strong. When you buy cheap and the thesis ends up even moderately playing out, it's very hard to lose unless the currency significantly goes against you. For those interested in checking out businesses in Japan, there's a Substack called Made in Japan that I follow that publishes differentiated ideas. The writer is an analyst who lives in Japan and I think they put out great work. So, I'll get that blog linked in the show notes for those that are interested. Their page also lists a bunch of other substacks that discuss Japan in depth as well. Now, I'll be the very first to say that listeners should not take this as a recommendation to invest in Japan. There's that saying that investors that send their money internationally trade known risks for unknown risks due to things like cultural differences, potentially less disclosures or transparency, or a language barrier that simply prevents you from understanding the businesses as well. Glattis closes out the chapter by stating, "I have seen several situations in my lifetime where a country's entire stock market can be considered a hidden investment treasure. It is almost certain that such opportunities will continue to occur in the future." End quote. The fifth case study that I'd like to touch on today is on banks including JP Morgan Chase and OSB Group. This chapter reminded me of the two interviews I've had with Derek Pleki, who's an investor in the financial sector. He's compounded at 22% per year since 2008. One of the best track records I've ever seen. One of the reasons that Pleki has just done so well investing in this sector is that a lot of investors just don't look at financials. They don't look at bank stocks. And of course, that creates these big mispricings. I learned from my conversations with Derek that the banking industry just has a lot of depth to it and it offers good opportunities to earn good returns with relatively low risk. But that doesn't come for free as you need to have a framework for analyzing and coming to understand banks. And it's easy to see why most investors would shy away from banks. Glattis recommends studying and analyzing 50 banks of different sizes, markets, and types in order to get an overview of the market globally and how things differ between different banks. The first tip he shares with regards to analyzing banks is that free cash flow should not be used to value banks because it's a metric that's difficult to estimate. Part of the reason is that it can be difficult to parse out the growth versus maintenance capex. The main variables he looks at for valuation purposes are based on the balance sheet, the amount of equity, and the return on that equity. From a simplistic point of view, one can model out the starting and ending price to book ratio, what the return on equity will be over time, and correspondingly how that will impact the book value over time. Since Glattis tends to use a discount rate of 10% when valuing stocks, the intrinsic value of a bank that earns returns on equity of 10% is expected to be around 1 times book value. So the price would be interesting in this case if it were trading below book value. And if returns on equity are greater than 10%, then the intrinsic value would be somewhere north of one times book value. It's important to look for businesses that earn at least 10% returns on capital because then time is on your side as an investor. As of the time of publication, Glattis' fund was long two banks, JP Morgan Chase and OSB Group. They view JP Morgan as the strongest and most resilient global bank, which is the stock they added to the fund during the market plunge in March of 2020. Today, JP Morgan has the number one position for banks in terms of customer deposits with 11% market share. It's the number one corporate and investment bank, the largest credit card issuer by spending and balances, the largest mortgage issuer, the largest auto lender, and the largest payment processor. The company has been led by Jaime Diamond for more than 20 years now. Since Diamond was CEO of Bank 1 in March of 2000, which would eventually merge with JP Morgan 4 years later, he's delivered returns of 12.1% through a year- end 2023, while the S&P 500 returned just 6.9%. For a bank to perform well over the long term, it must consistently earn high returns on equity and ensure that there aren't significant losses during the temporary crisis such as the Great Financial Crisis. JP Morgan satisfies both of those conditions. During the GFC, many banks of course did not survive and JP Morgan was the only major US bank that did not need government assistance and was profitable and actually mitigated the impact of the crisis on the entire financial sector by taking over the failing Bear Sterns in March 2008. JP Morgan's management prioritizes return on tangible equity, which has been around 15% since the merger with Bank 1. This is the rate at which the bank's capital is accumulating before dividend payments and share buybacks. Jaime Diamond says that he expects JP Morgan to be able to achieve an average return on tangible equity of around 17% and over the 5 years leading up to the book here, that figure was 19%. Glattis writes here, "When one considers that these five years have included a global pandemic, dramatic inflation, rapidly rising interest rates, falling bond prices, and a US banking crisis. This is a respectable result. Other big banks can only dream of such returns." End quote. And just briefly here on OSB Group, this is a smaller, more specialized bank based in the UK. They provide mortgages to professional landlords. While JP Morgan is trading at a hefty premium to book value, this company currently trades at around 1.1 times book value and earns returns on equity of around 15%. Glattis's fund purchased shares of OSB in the summer of 2024 when the stock traded for around 4 and a half times earnings, paid a dividend yield of 8 1.5% and had a price to book ratio of just.7. In his view, the stock was significantly undervalued. Some might question why a good business would be valued so cheaply by the market. And one potential reason, as we got into at the beginning here, is simply that this segment of the market is largely ignored by most investors. With OSB being a smaller bank, passive flows largely avoid this company, and many investors mostly shun the banking sector, too. Lastly, the UK market has overtaken Japan as one of the least favored developed markets. Despite how much investors ignore certain pockets of the banking sector, banks are important to the functioning of an economy and of companies and they constitute an important part of capital markets. So perhaps in the future, this sector will prove to be fertile ground in searching for investment opportunities. I really enjoyed reading through the final chapter of the book to wrap things up. Years ago, Glattis and his wife bought a piece of land where they planted flowers, shrubs, and trees, and they named the land Bergkshire Park. Watching the trees grow does not happen in a matter of days or weeks. It happens in a matter of many years. From day to day, a person does not really notice really any change. But if you look back after years, the differences can be astounding. This is a close analogy to investing in stocks. Picking individual investments for your portfolio is like planting trees. Most people like to watch the day-to-day and week-toeek price movements of stocks, and I must admit, me included. But what really matters is understanding the underlying business and the seeds they are planting that will bear fruit for the years to come. Just like trees, when you look back over a period of years, the changes in value of businesses can be enormous. Now, not all stocks will grow and blossom as expected, but Glattis laid out many of the things he likes to look for in the stocks he invests in. As he illustrated at the beginning of the book, he believes that today's conditions are quite ideal for selecting individual stocks because of how much less efficient the market has become with the rise of passive investing. Glattis pulled in a quote from Mark Leonard, founder and former president of Constellation Software. Leonard wrote in his 2018 letter to shareholders, "Index investors buy our stock because we are part of whatever index they are emulating. Their actions are formulaic. Despite the fact that they may be long-term holders, it is difficult to find someone to speak with at these indexing institutions, and even if we do, they rarely know much about our company." End quote. Then Glattis writes, "This sentence captures well what disturbs me about index investing. Index investing makes the market even more inefficient by suppressing its price discovery function and ultimately constraining the performance of the economy as a whole. End quote. And then you also add in the impact of the internet and the easiness of making trades on our phone with zero commission platforms. It points to Buffett's line about how the market has become more and more casinolike. But with the potential fragility of the market here in the US, that isn't a good reason alone to shun stocks. When an investor looks for hidden treasures, they can surely find stocks with higher expected returns and lower corresponding risk. When people talk about investing in stocks, they love to talk about the returns, but they rarely discuss the risk. One reason is that returns are easy to measure in hindsight, but there's no objective measurement or definition of risk. is largely a subjective category. What might seem risky to one person might seem just fine to another and vice versa. It's often argued that in order to earn higher returns, one must take more risk. But the great value investors do not believe this. While academia shares that risk is equal to volatility, Buffett and others share that risk is in fact the potential for losing money. Glattis then breaks down further how we can minimize risk. He has three points here. First is to have an awareness of our own abilities and skill set. If he had to name one thing that causes investors to lose the most money, it's when they get into things they do not understand. This is true for all types of investments and investors, regardless of experience. We need to have a good understanding of the boundaries of what we probably understand and what we almost certainly understand and then concentrate our investments only in areas that lie within this imaginary circle of competence. The second pillar of risk management is to avoid the risk of permanent loss of capital or said differently minimize the probability of losing money. A permanent loss of capital is a situation in which an investor loses part or even all of invested capital on a particular investment without being able to recover it. Now, this doesn't mean that we avoid volatility. Share price fluctuations are normal. But if you buy a business that is overinded and files for bankruptcy when a major crisis hits, then that is a permanent loss of capital that cannot be recovered. The most common causes of permanent loss of capital tend to be poor business quality, high levels of debt, and poor management actions. If we simply invert this, we should focus on highquality companies we understand with high returns on capital and strong free cash flow, have minimal debt, and have management that allocates capital effectively. The final pillar of risk management is, of course, putting an emphasis on paying a fair price. A stock presents different levels of risk depending on the price you pay. A stock that's priced at $100 might be a low-risk investment, but if it's priced at $500, it might be a very high-risisk investment. Of course, Buffett shared to only buy shares well below our estimate of intrinsic value. But we must also have a relatively high confidence around that estimate of value. Otherwise, we're speculating. Furthermore, Glattis wants to use intrinsic value estimates that are conservative and realistic, and the gap between price and value is wide to make room for a margin of safety. And it's important not to over complicate things. We don't want to build out an elaborate model to show that a stock is undervalued by 5 or 10%. Based on his experience, the more sophisticated a valuation model, the poorer the investment outcome. It's much better to wait for situations where a stock's cheapness is so blatant that no further complex calculations are needed. Although it can't be measured, the end result is that hopefully a portfolio of stocks that put these practices of risk management to good use will have lower overall risk than an investor who buys a broad market portfolio of hundreds or even thousands of stocks of which they know next to nothing about. and the companies in your portfolio will be of higher quality, have less debt than the market average, making them more resilient. Based on these observations, I believe it's possible to construct a portfolio with lower risk and higher perspective returns. So, that wraps up today's episode. I want to extend a special thank you to Daniel Glattis for this book. It's very well written, and I would encourage the listeners to pick it up. And it looks like in his annual letters, he also provides updates around changes to his portfolio and the top positions in his fund. So, I think we'll close out the episode on that note. Thanks a lot for tuning in to today's episode and I hope to see you again next week. >> Thanks for listening to TIP. Follow We Study Billionaires on your favorite podcast app and visit the investorspodcast.com for show notes and educational resources. This podcast is forformational and entertainment purposes only and does not provide financial investment, tax or legal advice. The content is impersonal and does not consider your objectives, financial situation or needs. Investing involves risk including possible loss of principle and past performance is not a guarantee of future results. Listeners should do their own research and consult a qualified professional before making any financial decisions. Nothing on this show is a recommendation or solicitation to buy or sell any security or other financial product. hosts, guests, and the investors podcast network may hold positions in securities discussed and may change those positions at any time without notice. References to any third party products, services, or advertisers do not constitute endorsements, and the investors podcast network is not responsible for any claims made by them. Copyright by the Investors Podcast Network. All rights reserved. So I feel that only a true master of their craft can make money shorting a stock and then turn around not too long after and go long before it becomes a multibagger. So that's exactly what you did with Robin Hood. There were two, you know, environmental reasons why they missed the quarter and I just thought they were temporary and it it traded down to the $8 where I bought it and they still had that $8 a share in cash. Also like technically it had built a big base like it you know had covered in March of 22 and from March of 22 to November of 23 the stock kind of was flattish and it had built that long base. So it, you know, I got fortunate that it took off soon after I bought it.
The Search for Mispriced Stocks w/ Clay Finck (TIP782)
Summary
Transcript
Bogle himself even said near the end of his life that if all investors utilize index investing then chaos and catastrophe could be expected and markets themselves would fail. Glattis writes here, "An intelligent investor will not only get off this passive investing train, but will use the whole situation to their advantage. Provided that active investors come to grips with the new state of the markets, understand how and in what ways market behavior has changed, and adjust their own investing, they stand a good chance of having their portfolios provide returns higher than those of broad markets while bearing much less risk than that of broad markets. Before we dive into the video, if you've been enjoying the show, be sure to click the subscribe button below so you never miss an episode. It's a free and easy way to support us, and we'd really appreciate it. Thank you so much. Over the past decade, the investment world has fundamentally changed by the rising trend of passive investing. And as more and more capital pours into passive strategies, potentially a smaller and smaller subset of the market is actively engaged in valuing individual businesses in allocating capital based on fundamentals. This trend of course has benefited many investors, but it can be argued that it's created a growing number of distortions underneath the surface. In today's episode, I'll be covering a book that digs into this subject. It's called Hidden Investment Treasures: How to Find Great Stock Investments as the Investment World Goes Passive by Daniel Glattis. Glattis is the founder and director of the Vatalva Fund, a long-term fundamentally driven investment firm based in Europe. He's been an active stock investor since the early9s and started the fund in 2004. The book makes the case that today's market environment dominated by indexing, ETFs, and momentumdriven capital flows may actually be one of the most favorable backdrops for disciplined and patient value investors. Glattis argues that as fewer investors focus on the underlying fundamentals, the gap between price and value has widened in many overlooked corners of the market. Throughout the book, he shares a series of case studies of investments he has personally made in the fund, ranging from companies that our audience is well familiar with, like Berkshire Hathway and Markeel to less obvious opportunities in Japan and banking. In this episode, I'll walk through the core ideas of the book, discuss several of the most interesting case studies, and share the takeaways I found to be most impactful in reading it. So with that, I hope you enjoy today's episode on hidden investment treasures by Daniel Glattis. Since 2014, and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, PlayFink. As I mentioned at the top, on today's episode, I'll be reviewing the book Hidden Investment Treasures by Daniel Glattis, founder of the Vatalva Fund. Vatalva benchmarks themselves against a world stock market benchmark. And over the 16 years leading up to year-end 2024, the fund delivered returns of 511% versus 333% for their global benchmark. We'll be getting into this here shortly, but Glattis actually makes a case for why the S&P 500 is no longer a helpful benchmark due to the increased use of passive investing, which has bit up the prices of stocks in the S&P 500 relative to their underlying fundamentals. So, I found this book to be really interesting and thoughtprovoking as it really made me question what I fundamentally believed about the markets. So in chapter one of the book, he paints a picture of the market environment we're in today and sort of how we got here. And in the remaining chapters, he covers several different investments for the reader to consider, including Berkshire Hathaway, Markeel, Elementacion, Cushard, Stellantis, a basket of Japanese stocks, and several others. From Daniel's perspective, he gets a lot of value in listening to investment ideas from others because he's in the business of making investments himself and having a strong thesis for why he's making the bets he is. He mentions that he's read countless investment books. I can certainly resonate with that. But none of these really focus on sharing investment ideas which you know it makes sense because investments can come and go and what might be a good investment today might not be interesting to someone who's reading 5 years from now. So he not only shares several investment ideas in the book, but he also goes into detail on why he selected these stocks to include in the book, which is of course valuable because you can sort of get an understanding of his thinking process that we can then apply and use some of those mental models to other investment situations. He writes here, "By examining those cases, I demonstrate that today one can find in the markets a whole range of companies whose stock prices are significantly lower than their intrinsic values, whose quality of business is very high and whose associated risk is often much lower than the risk of the market as a whole." End quote. The majority of the stocks outlined were purchased in his fund and were still held at the time the book was published, which was later in 2024. Glattis argues that today's market environment is better for value investors than it's ever been over his investing lifetime, which is over 30 years. Many would say that with the rise of the internet and new technologies to share all this information, it would become more and more difficult to find mispricings because the market can react so quickly to new information. But Glattis believes that there are fewer and fewer investors actually trying to identify the mispricings and act on them. Let's call these types of investors value investors. Well, many people would categorize value investors as investors who buy stocks that have low PE ratios, low price to book ratios, which you know tend to be companies that are not growing much and they tend to be more established and stable businesses. And a growth investor would be in contrast to this looking for younger companies with above average growth potential. Value investing as defined in the book is not related to what earnings multiples an investor is willing to pay or whether they prefer more established and stable companies versus companies with rapid growth. A value investor simply looks to buy shares at prices that are lower than their value. And the expected growth of a company always plays an important role in estimating that value. No stock can be accepted or rejected simply on the basis of whether it trades at a low or high multiple of earnings or cash flows or based upon whether the company's growing fast or slow. The Vulva fund primarily holds what would be described as growth companies that are increasing their intrinsic value by at least 10% per year, a rate above that of the stock market as a whole. Now, buying something far less than it's worth seems quite a logical way to invest. So, why are so few people actually trying to do this? In recent years, of course, we've seen the rise of passive investing. Passive investors aren't really interested in how much a stock is worth or how much they have to pay for it because they put their money into investment instruments that by their composition replicate some index. Ironically, passive investors who are not interested in individual stocks and are indifferent to the prices they're paying for the underlying shares rely on the actions of active investors who by seeking out individual attractive investments maintain a process known as price discovery. In theory, if most market participants were active investors, then you'd expect the price discovery process to be relatively fast and efficient. But research from 2019 suggests that more than 50% of the total amount of money managed in the US market is invested passively. These investments are in a variety of index funds and ETFs as well as in other retail pension and institutional index linked products. And there are also funds that outwardly appear to be active but behave more like these passive funds otherwise known as closet indexers. And then when you account for even more passive flows since 2019 and the fact that there are major shareholders in the publicly traded companies, you know, such as the founder or the CEO, Glattis estimates that around 20% of capital in the market can be regarded as actively managed money. And that doesn't necessarily mean that that 20% of capital actually looks for disparities between price and value. For example, it could be momentum strategies, algorithmic trading, or technical analysis. For the past 15 years or so, passive investing has been a tailwind for the S&P 500, helping lift the valuation multiples higher over time. But if the reverse situation happens where these net inflows turn into net outflows, then we could see a considerable decline in the broader market because there just wouldn't be enough capital to absorb that big selling pressure. Now, much has been said about the increased levels of concentration of the top companies in the S&P 500. As of the time of recording, the top 10 companies account for around 40% of the S&P 500's value. When there are passive inflows, the companies with the highest waiting will have the most money allocated to them. And those shares, they have to be sold by somebody if they're being purchased. So, you know, of course, with every buyer, there's a seller. Oftentimes, these sellers end up being active investors. But when that trend reverses and there are passive outflows, it's the largest stocks that are being sold the most and experience the largest declines because there just aren't enough active buyers to keep up with that large selling pressure coming from the passive investors who again make up most of the market's capital. If we look back at 2022 for example, the Magnificent 7 which includes Alphabet, Amazon, Meta, Microsoft, Nvidia, and Tesla, they collectively declined by 40% but their earnings per share only declined by around 8%. Their PE ratios contracted by 1/3 from 38 times earnings to 25 times earnings. So meanwhile, the S&P 500 during that year, it only declined by 19%. And of course, we saw in 2023 and 24 markets rebounded and the valuation levels of these companies soared back to new highs. Now, this isn't meant to necessarily criticize passive investing as it is a sound long-term investment strategy for most people, but Glattis outlines that everything, no matter how good the idea, has its negative consequences, and the impact can often run counter to the original intent. The more extreme an original idea and its application, the more pronounced the side effects can be. Glattis believes that the prominence of passive investing is at unprecedented levels and there has never been anything like it before and it's critical that investors understand its impact. The situation with so much passive capital in the markets creates a situation where most market participants are invested in the market, but they aren't necessarily concerned with what exactly they're buying and at what price. If you're a value investor and you seek to buy businesses at a discount to their underlying value, then it's a pretty good situation to be in if the person selling the shares to you doesn't necessarily understand what they own and the underlying value of what it is they're selling to you. So the point that Glattus is getting at is that Jack Bogle, he popularized indexing and the idea was based on the premise that markets were efficient and passive investors would simply take whatever price the market would give them. But since passive has overtaken the market, passive investors have gone from price takers to price makers, creating a more inefficient market. Bogle himself even said near the end of his life that if all investors utilize index investing then chaos and catastrophe could be expected and markets themselves would fail. Glattis writes here, "An intelligent investor will not only get off this passive investing train, but will use the whole situation to their advantage. Provided that active investors come to grips with the new state of the markets, understand how and in what ways market behavior has changed and adjust their own investing, they stand a good chance of having their portfolios provide returns higher than those of broad markets while bearing much less risk than that of broad markets. So with that as a backdrop, Glattis shares 15 case studies in the book, a few of which I'll be getting into here. In his view, each case study represents a stock that is priced significantly below their intrinsic value as of September 2024 when the book was published and it represents a highquality business and often has associated risk that is much lower than that of the overall market. The first chapter is on Bergkshire Hathaway, which I know our audience is well familiar with. And my co-host Stig Broers already does a deep dive on for the Bergkshire episode each year where he brings on Chris Bloomstrand as a guest just prior to the Bergkshire meeting in May. I won't get into the specifics of Berkshire here for this episode, but Glattis has Bergkshire as a core holding in his fund and he expects around a 10% annual growth in the intrinsic value over the long term. So I wanted to turn to the chapter on a company often referred to as Baby Bergkshire Markell Group. While having a similar business model, Markell is just 140th the size of Bergkshire Hathaway. Remarkably, Bergkshire has still managed to generate very similar returns to Markel over the past few decades, but I suspect that Berkshire's investable universe is quickly shrinking with their ever growing cash pile. So, I think that's going to make it pretty difficult for them to compound at such high rates going forward, which makes Markeel Group potentially more interesting for us as investors. Over the years, several companies have tried to present themselves as the next Bergkshire Hathway, but few have succeeded. Markell Group may be one of the few that have been successful at emulating Bergkshire success over long periods of time. Glattis writes, "Although it is far from being of Berkshire quality, this is a business that is so interesting and promising that it makes sense to give it proper attention." End quote. Markell's obvious advantage over Berkshire is obviously its size, giving it less constraints in terms of its future growth prospects. Markeel was started in 1930 by Samuel Markell in the state of Virginia and they first entered the insurance business. Today, Samuel's grandson, Steven Markel, is the chairman of the board. The company went public in 1986 with a market cap of just $15 million. Tom Gainner, the CEO of the company today. He joined Markeel in 1990 as the company's equity portfolio manager. The stock traded for $20 when Gainner joined the company, and today shares trade for around $2,100, representing more than a 100x increase. Gainer describes Markeel as a company that is powered by three engines. The first engine is insurance and reinsurance. Today, Markell is the world's leading specialist insurance company and the third largest US provider of excess and surplus insurance. Markell's insurance business has grown steadily over the years and has been consistently profitable. In a very Berkshire-like fashion, Markell is conservative when it comes to underwriting policies, setting aside reserves for future claims and not chasing future growth just for the sake of growth. Insurance companies can get themselves into trouble when they try to chase unprofitable business and are unrealistic in underwriting expected future claims. When it comes to insurance, discipline is of utmost importance, which Markell has consistently showcased. Markeel's second engine is its investment portfolio. Bergkshire is well known for using its float as an interestfree source of capital to invest in stocks. Markeel takes a very similar approach and today has over $32 billion in float. Now, not all of this is invested in the stock market. They need to ensure that they're able to conservatively pay future claims. So, a good portion of the float is invested in bonds that are duration matched with expected future claims while also generating interest income and about 1/3 is invested in equities. Tom Gayner is a great investor and his investment returns over the past 20 years have exceeded the S&P 500 by 1% peranom. The remarkable part about this is just how diversified he is. When I pull up his most recent 13F, his top 10 positions make up just 43% of the portfolio and he owns more than 100 stocks. It also includes several well-known US blue chips and the top positions as of today include Berkshire Hathaway, Alphabet, Brookfield Corp., Amazon, and Dearco. Glattis estimates that the average overall return on their float will be around 5%. Markell's third engine is the newest, Markel Ventures, which management started building in 2005. Markell Ventures is their arm that invests in private non-insurance businesses to add more diversification to the conglomerate. It primarily consists of older economy companies and tends to avoid technology and information sectors. Like Berkshire, Markeel purchases these companies with the intention of holding them indefinitely. As of the time of writing, this segment produced annual revenues of 5 billion per year. When Glattis totaled up the estimated annual profits from these three segments, he came to a total estimate of $1.5 billion per year. And as of the time of writing, Markeel traded at a market cap of 20 billion, which he believed was undervalued for a company with the track record and management team that they had. Over the 20 years leading up to the book being published, Markell compounded operating income at 11% per year, gross premiums compounded at 9% per year, and the investment portfolio also compounded at 9%. Investors like to judge the valuation of companies like Berkshire and Markeel based on the price to book ratio. But judging the valuation based on this metric can be a bit tricky for Markel. Because as Markeel Ventures continues to grow and continue to play an increasingly important role in the conglomerate, book value becomes less and less relevant since acquisitions are accounted for at cost. So it's probably better to judge the valuation based on maybe the sum of the parts methodology. Glattis views Markeel as a prime candidate to be a hidden investment treasure. Because of its medium size, it doesn't have a large waiting in the indices. And since it belongs in the financial sector and the property casualty insurance subsector, passive capital doesn't substantially flow to this area of the market. Additionally, since it's a rather boring investment that, you know, won't make investors rich overnight, it can continue to quietly compound without receiving much attention from retail investors. I should also mention that each year during the Bergkshire weekend in Omaha, I attend the Markel brunch where Tom Gainner and other managers host a free event for investors to socialize and ask some questions. It's a really fun event and if you happen to be in Omaha during the Birkshire weekend, I would highly encourage you to attend the Markell branch as well. I also like that Markell has a very broad and loyal shareholder base. At the Markel branch, there are hundreds of people eagerly listening to management's responses to questions, and the questions asked are rather sophisticated. So, I think that management does a really good job of communicating with shareholders in building out a strong base of well-informed, quality shareholders. I'd also like to mention that I put together a video that explains how you can attend the Berkshire Hathway shareholders meeting and how you can join us at the events that TIP is hosting. I'll be sure to get that video linked in the show notes for those who are interested. The second case study I'd like to highlight is Elementacion Cousard. Prior to getting into the business, Glattis educates the reader extensively on capital allocation, share repurchases, and dividends. He strongly favors companies that are good capital allocators and tends to favor companies that are share cannibals as well. Share cannibals are companies that have repurchased a significant number of their shares and have done so at attractive valuations. The reason he tends to favor wise share repurchases over dividends is that share repurchases can add value to existing shareholders when they're done well below the intrinsic value of the company. In this case, value is transferred from the seller to existing shareholders because of the advantageous price the shares are purchased at. Whereas with dividends, no value is created because the company is simply sending a check to the shareholders. Share buybacks are essentially an investment by the company into itself with a return on capital that is usually higher than that what is offered by available investment opportunities and without the risk associated with such investments. If management can maintain the discipline to buy back shares only at favorable prices and if this is not at the cost of excessively growing debt levels, then share buybacks can have a highly positive impact on both share value and share price over the long term. He then shares a word of caution with regard to acquisitions. Acquisitions for managers can be tempting as having your company in the headlines for buying your largest competitor seems a lot more fun than a headline that states that you bought back 1/5if of your shares and acquisitions come with big risks for shareholders. Glattis writes, "Our study of market events and our own investment experience lead us to conclude that the greatest potential risk for value destruction is through acquisitions. This is because overall it is a form of capital allocation to which the largest volumes of money are directed. End quote. Are you looking to connect with highquality people in the value investing world? Beyond hosting this podcast, I also help run our tip mastermind community, a private group designed for serious investors. Inside, you'll meet vetted members who are entrepreneurs, private investors, and asset managers. People who understand your journey and can help you grow. Each week we host live calls where members share insights, strategies, and experiences. Our members are often surprised to learn that our community is not just about finding the next stockp, but also sharing lessons on how to live a good life. We certainly do not have all the answers, but many members have likely face similar challenges to yours. And our community does not just live online. Each year we gather in Omaha and New York City, giving you the chance to build deeper, more meaningful relationships in person. One member told me that being a part of this group has helped him not just as an investor, but as a person looking for a thoughtful approach to balancing wealth and happiness. We're capping the group at 150 members, and we're looking to fill just five spots this month. So, if this sounds interesting to you, you can learn more and sign up for the weight list at thevesspodcast.com/mastermind. That's the investorspodcast.com/mastermind or feel free to email me directly at clay@theinvestorpodcast.com. If you enjoy excellent breakdowns on individual stocks, then you need to check out the intrinsic value podcast hosted by Shaun Ali and Daniel Mona. Each week, Shawn and Daniel do in-depth analysis on a company's business model and competitive advantages. And in real time, they build out the intrinsic value portfolio for you to follow along as they search for value in the market. So far, they've done analysis on great businesses like John Deere, Ulta Beauty, AutoZone, and Airbnb. And I recommend starting with the episode on Nintendo, the global powerhouse in gaming. It's rare to find a show that consistently publishes highquality, comprehensive deep dives that cover all the aspects of a business from an investment perspective. Go follow the Intrinsic Value Podcast on your favorite podcasting app and discover the next stock to add to your portfolio or watch list. Acquisitions can be troublesome if management's ego gets involved and they get too far ahead of themselves not keeping shareholders in mind. In management's appetite for acquisitions is typically at its highest at the peak of a bull market. The worst acquisitions tend to be those that are very large, are paid for with stock rather than cash, and are outside the buyer's existing core business area. Furthermore, it's often the case too that the announcement of these acquisitions is unexpected and the market is caught off guard, causing an immediate negative reaction for the stock price. Now, when you're partnered with a good management team with, you know, a good track record of looking out for shareholders, this potential risk for investors is largely eliminated. With all that said, there are some companies that have a long track record of growing through acquisition and have done very well. These companies don't overpay. They're able to integrate these businesses well, and they're patient in waiting for the right opportunities. They ensure that when acquisitions are made, they are likely to be value accreative to shareholders. Almentacion Kushtard is an example of such a company which I'll refer to here as ATD which is the ticker symbol. ATD is one of Canada's most interesting and successful business stories. The company was founded by Alan Bousard in 1980 at the age of 31 and today Bousard is the company's chairman. In 1980, he decided to open his first convenience store near Montreal. And his groundbreaking idea at the time was to keep the store open 24 hours a day. Fast forward to today, the company owns 17,000 stores in Canada, the US, Northern Europe, and Asia. Remarkably, of the stores they own today, 75% of them came through acquisitions. Stores acquired by ATD tend to perform better in their hands than previously to the acquisition, showcasing their operational excellence. Debt is often used in making acquisitions and then it's typically paid down rather quickly to give the company flexibility to make further acquisitions in the future or buy back shares at favorable prices. Over the past 20 years, ATD has made around 75 acquisitions and its stores span across 25 different countries. And since the convenience store industry remains highly fragmented, there is still a significant opportunity to continue to grow through acquisitions. In the US alone, there are 150,000 convenience stores and gas stations of the type that ATD operates, 7,000 of which are ATDs. That's less than 5% of the total market. As in many other industries, the expense structure favors the larger players over the smaller ones, especially when it comes to things like purchasing fuel. Since large players are able to have a lower cost structure, it makes sense for the industry to continue to consolidate. ATD is one of those companies that has steadily grinded out high returns over the years. Since their IPO in 1999, the stock has compounded at an average rate of 21% peranom. This has been driven by disciplined capital allocation and high returns on invested capital. And as long as the company continues with this sound strategy, one should expect it to continue to perform well from here. Jumping to the third hidden investment treasure I wanted to discuss today, we have NVR. I've long considered chatting about homebuilders here on the show, but I haven't come around to pulling the trigger on it. Several value investors and some members of our mastermind community have been interested in homebuilders like Dr. Horton and Toll Brothers. So to tee up the discussion here on NVR, Glattis ruminates on the best type of business one could own. The best businesses are those that generate high returns on capital and are able to reinvest the capital earned over the long term with similarly high returns. The magic of these is that the value of the business compounds to extraordinary levels when given enough time. But these types of companies are quite rare. So maybe the next best case might be a business that generates high returns on capital, can reinvest only a relatively small portion of that capital at high rates, and then return the excess capital to shareholders in the form of buybacks. Now, one wouldn't expect a home builder to be the prime case study for a business with high returns on capital. So, I I think about where I live. I live towards the edge of town here in Lincoln, Nebraska. And I can't help but notice how many of these new neighborhoods on the edge of town put up houses that are more or less they look the same. It seems like an industry that would be very capital inensive and very commoditized. Furthermore, housing is a cyclical industry which can make it difficult to consistently turn a profit if there are years where demand for housing is weak and homebuilders are left holding several unsold homes. If we look back at the history of NVR back in the 1980s, they were a quintessential home builder and land developer. That is to say that they would buy land that wasn't yet ready for home building as it needed to go through phases of zone permitting, planning, utilities, and infrastructure engineering into construction. Only after all of this could a home be built. As one would expect, this process was costly, tying up a lot of capital, and it took several years for the time and effort to bear fruit. The process also carried risk. In the early 1990s, there was an economic and construction recession, and NVR ended up declaring for bankruptcy. But when it emerged from bankruptcy in 1992, it had a business model that was completely different from its previous one. Glattis explains that the model is still in place today and uniquely positions NVR among its competitors. This business model led the stock to be one of the best performing stocks over the past 30 years. NVR's business model is based on three fundamental pillars. The first pillar is low capital requirements. The second is an efficient home building process and the third is highly efficient allocation of capital. Any company that builds houses needs to have an inventory of land upon which to build in the future. And home builders tend to have several years of developments so that they're always able to fill demand for new houses. But if you're a homebuilder, holding the land for several years is very capital inensive, expensive, and inefficient, and it tends to be financed with debt, meaning that you have these annual interest costs. Additionally, you risk that the land will decrease in value while you hold it. To avoid these risks, NVR almost completely avoids buying land that is not ready for development. Instead, they focus on buying ready land and not with cash, but through purchase options. The option premium can typically be as high as 10% of the land price. And this alone comprises the capital and risk involved for NVR. Should they decide to withdraw from the intended purchase, in the worst case, it will only lose the option premium. Not only is this approach less risky and less capital intensive, it also gives NVR much more flexibility and optionality relative to just straight up buying the land that they think they need. To put some numbers around this, in 2023, NVR built 20,000 homes and at the end of the year they control just over 141,000 lots, which would be enough for 7 years of construction. It spent $584 million on them, which is only about $4,000 per lot on average, making for a very low cost and efficient way of acquiring inventory. The second pillar is the high efficiency of their development process. NVR is focused on a few key markets and on building market leadership in those markets. Geographically, it has four major segments in the US, which mostly look to be in the eastern part of the country in states like Pennsylvania, New York, Ohio, and Florida. In some of these markets, NVR has a market share in excess of 20%. Second, NVR produces pre-fabricated building components near its key markets, which significantly reduces its cost. Third, they use independent subcontractors to build its houses, working on fixedpric contracts. This makes their margins more stable. When the construction industry was in a crisis in the US between 2006 and 2011, the number of new homes built dropped significantly. And NVR was the only publicly traded home builder that remained profitable and even performed well. Fourth, NVR overwhelmingly builds homes only when they are pre-sold and when the down payment has been made. So they do not engage in speculative construction and there is very low risk in them being stuck holding many unsold homes. And fifth, NVR offers mortgage financing to its home buyers and sells the loans to banks providing them with a high margin segment with low capital requirements. The third pillar of NVR success is highly efficient capital allocation. Given NVR's unique business model in the industry, it is not capital inensive. And given the construction method itself, NVR considers itself more of an assembler putting the house together than a builder as it does not require much capital for machinery and equipment. NVR doesn't pursue acquisitions and seeks to grow organically and gradually strengthen its position in existing markets and grow into surrounding markets. Their low capital needs and high margins relative to its industry results in high returns on invested capital and just as important high returns on incremental invested capital. NVR has a strong balance sheet with net cash and the vast majority of the cash the business generates is deployed into share buybacks. here. As of the time of recording, when I look at the financials for the trailing 12 months, I see $1.3 billion in free cash flow and nearly $1.9 billion deployed into share buybacks. Just as remarkably, their capex line is just 26 million. That's just 2% of free cash flow. Due to their approach to capital allocation over the past 30 years, the vast majority of NVR shares have been retired. At the end of 1995, the company had just over 15 million shares outstanding. And that number today is 2.8 million. So over the past 30 years, the shares outstanding have declined by over 80% which is about a 5.4% decline in the share count per year. Set another way, if you bought shares in NVR at the end of 1995, your proportional ownership stake in the business increased by over five times since then without you actually needing to purchase additional shares. What's also just as important is that NVR stock-based compensation looks to be rather modest. So they aren't like many other companies that buy back shares simply to offset the dilution that is happening through stockbased comp. To get a sense of how high the returns on capital are, Glattis walked through the financial statements from 2023, which was a pretty average year or perhaps let's say a normal year for the industry. He calculates return on invested capital as simply the net profit divided by the invested capital. With a net profit of 1.59 billion and invested capital of roughly 2 billion, ROIC is therefore almost 80%. When you have a company that generates so much cash, has low capital intensity, and repurchases shares at a modest valuation, it's no wonder that we've seen shares of NVR compound at high rates for three decades now. If we zoom out and look at the industry more broadly, there is no doubt that they operate in a cyclical industry. The primary factors that drive demand for new home construction in the short to medium-term are employment, real income levels, availability, the cost of financing, and home prices. Looking at new home builds over time throughout the 1990s, we saw this figure rise as the economy was booming. There was a temporary decline in the early 2000s and then at the peak of the GFC, new home builds rose to 2.2 2 million and crashed all the way down to just 600,000 around 2012. Now today, this figure has steadily increased back to 1.8 million new builds as the industry recovered over the years. Looking back at the historical financials for NVR, the cyclicality of the industry has certainly impacted this business. Revenues declined by more than half during the GFC and they also saw a revenue decline in 2023. However, they did remain profitable the entire time while other homebuilders did not fare as well. But even with the cyclicality, the long-term trend is a net positive for home builders here in the US, primarily due to population growth. The Joint Cent's study estimate that around 1.5 new homes would need to be built annually to meet demand, which is more than what has actually been built in many recent years. To close out the chapter, Glattis covers the sources of competitive advantages for NBR and potentially why the business model has not been replicated by others in the industry. For any business that has increased by 100x over the past few decades, you should expect others to want to join the party. Glattis's firm has been following the residential construction industry for more than 20 years and as of the time of writing they believe that there are no successful imitators among their competitors. The theory for why that is is that it's simply not easy to apply the model. So it may not be as straightforward in practice as it might appear on the surface. Now, it's sort of an easy copout to just say what they do is just so difficult to do, but it certainly could be the case. Well, if any business is so good, why wouldn't the market just realize that and price the shares accordingly? As value investors, we must come to our own conclusion as to what we believe the business to be worth. In the past, the market has clearly gotten the pricing wrong for NVR. And that suggests that the efficient market hypothesis just does not hold in this case. With a track record like NVR, you'd think that the market would come around to putting a premium on this business. But in Glattis's view, the market views NVR as just another homebuilder that operates in a highly cyclical industry. As of the time of recording, NVR's PE ratio is just 16, while the S&P 500 minus the MAG 7 trades at around 22 times earnings. That's nearly a 30% discount to the broader market. And over the past decade, the PE ratio for NVR has been around in the mid- teens, so it's priced at a similar level to its recent history. and the stock seems to really fly a bit under the radar given that management makes no effort to promote its own shares. They don't hold quarterly conference calls and its quarterly reports are brief. So, Glattis expects the positive trends of the past to continue and for the company to perform well over the long term. For the fourth case study we'll be discussing today, we won't be talking about an individual company, but the broader market of Japan. Glattis titles this chapter Japan seeking treasure in a country most investors ignore. What I liked about this chapter is that it provides this broader perspective and some lessons from history as well. Many of the best investments tend to be in areas of the market where other investors just aren't looking. If we take a step back in time, the NIK225 index became one of the largest bubbles in financial history, peaking out in 1989. For those not familiar, the NIK 225 is a Japanese stock index that tracks the performance of 225 large publicly traded companies listed on the Tokyo Stock Exchange. Glattis launched his fund in 2004, and at that point, the index was still down 30% from its peak 15 years earlier. As far as investors were concerned, Japan was a market that was falling and just not worthy of anyone's attention. Meanwhile, China's economy was rapidly growing and getting much more investor interest. In Glattis's words here, Japan was seen in many eyes as a country with slow GDP growth, an old and declining population, large debt, and often struggling with deflation. It's no wonder that investors saw much more potential in a market like China. To look at the positive side, Japan did have perhaps the longest life expectancy, a healthy population, an absence of poverty and obesity, low levels of corruption and crime, the best infrastructure of any major country in the world, and a sophisticated, homogeneous, and educated population. Japan is also an advanced country technologically and Japanese companies have invented and or successfully commercialized a number of products that have since become almost indispensable to consumers. A few examples include the microwave, a whole range of computer chips, the digital watch, the transistor radio, 3G mobile telephones among several others. If you look at many products that we use every day, Japan is a part of several of them. A quarter to onethird of the content in an iPhone is from Japan, the most of any country. As of the time of recording, the Japanese stock market is the third largest in the world after the US and China. And to help put things into perspective, there are around 4,700 publicly traded companies here in the US and nearly 4,000 in Japan. I think many investors would be surprised to discover how broad and diverse the Japanese stock market really is. Now, just because there is innovation happening in a country doesn't necessarily mean that it's necessarily investable. Our investment principles should apply regardless of the market we're investing in. While investors deemed Japan uninteresting and filled with companies that had low returns on capital, too much cash sitting on the balance sheet, and a lack of shareholder value creation, some things started to happen underneath the surface to get the market picking back up. In light of the great financial crisis, the Nikk 225 plunged by more than 50% and it hardly recovered from 2009 to 2012. In 2012, the Liberal Democratic Party pursued monetary easing, budgetary stimulus, and structural reforms that helped spark investor interest and helped kick the market back into gear. And in 2014, further pressure was put on the efficiency of companies and for an increased focus on shareholder value creation and even further pressure was added in 2020 and 2023. If management did not prioritize shareholders in their decision-making and did not present a clear plan to improve ROIs or inefficient capital allocation, then they risked being delisted. One index required that companies maintain ROIs in excess of their cost of capital and that their shares must trade above book value. Glattis mentioned that he hadn't seen oversight like this anywhere else in the world. And as a result, many companies have increased their dividends, increased the use of share buybacks, and made other strategic decisions to add value to shareholders. Now, the impact of these reforms aren't going to drastically impact the companies overnight. But for investors in the Japanese market, it is necessary that management is shareholder friendly and understands the impact of their capital allocation decisions in order for value to be recognized and appreciated by investors. From the end of 2012 to the time of recording, the NIK has compounded at just shy of 13% per year. However, the Japanese yen has weakened substantially over that time period. At the start of the time frame, the yen to USD ratio was around 86 and today it's 157. So, holders of yen get substantially less dollars when making that conversion, which has implications for investors like myself who are based in the US who invest in Japan. When adjusting for the currency, the annual returns were closer to 8% per year. Since Glattis' firm didn't have the capacity to cover the Japanese market extensively given their involvement in other markets, they decided to take more of a passive approach to investing in Japan. In his view, passive investing can be a good form of investing if it's based on analysis and it makes sense both in relation to price and composition of the underlying asset. The NIK 225 index met both of those requirements for them. However, they did have concerns about the currency risk and hedging such risks doesn't come too cheap. So, they settled on purchasing the Nikk 225 index by means of futures contracts to largely eliminate the currency risk. He explains how it works in the book. So, I won't bore you with all the details here. As of the time of writing, the PE ratio of Japanese stocks was 17, while the PE ratio here in the US was 28. And the Japanese have generated higher earnings growth over the past decade, have lower indebtedness, and changes are still being made by companies to try and unlock more shareholder value. It also can't be ignored that Buffett invested in the five leading Japanese trading companies in 2020. Buffett, of course, saw these companies as cheap, and I think investors underestimate just how big of a home run this has been for Bergkshire. Since the end of 2020, all five of these stocks are up by more than 4x, which would equate to a 30% plus compounded annual growth rate. I've personally looked a bit into investing in Japan myself, and I do own one SAS business in Japan that is rather small. I'm in agreement with him that the currency risk just cannot be ignored. I tried to overcome that in my investment by buying cheap and ensuring that the future growth is strong. When you buy cheap and the thesis ends up even moderately playing out, it's very hard to lose unless the currency significantly goes against you. For those interested in checking out businesses in Japan, there's a Substack called Made in Japan that I follow that publishes differentiated ideas. The writer is an analyst who lives in Japan and I think they put out great work. So, I'll get that blog linked in the show notes for those that are interested. Their page also lists a bunch of other substacks that discuss Japan in depth as well. Now, I'll be the very first to say that listeners should not take this as a recommendation to invest in Japan. There's that saying that investors that send their money internationally trade known risks for unknown risks due to things like cultural differences, potentially less disclosures or transparency, or a language barrier that simply prevents you from understanding the businesses as well. Glattis closes out the chapter by stating, "I have seen several situations in my lifetime where a country's entire stock market can be considered a hidden investment treasure. It is almost certain that such opportunities will continue to occur in the future." End quote. The fifth case study that I'd like to touch on today is on banks including JP Morgan Chase and OSB Group. This chapter reminded me of the two interviews I've had with Derek Pleki, who's an investor in the financial sector. He's compounded at 22% per year since 2008. One of the best track records I've ever seen. One of the reasons that Pleki has just done so well investing in this sector is that a lot of investors just don't look at financials. They don't look at bank stocks. And of course, that creates these big mispricings. I learned from my conversations with Derek that the banking industry just has a lot of depth to it and it offers good opportunities to earn good returns with relatively low risk. But that doesn't come for free as you need to have a framework for analyzing and coming to understand banks. And it's easy to see why most investors would shy away from banks. Glattis recommends studying and analyzing 50 banks of different sizes, markets, and types in order to get an overview of the market globally and how things differ between different banks. The first tip he shares with regards to analyzing banks is that free cash flow should not be used to value banks because it's a metric that's difficult to estimate. Part of the reason is that it can be difficult to parse out the growth versus maintenance capex. The main variables he looks at for valuation purposes are based on the balance sheet, the amount of equity, and the return on that equity. From a simplistic point of view, one can model out the starting and ending price to book ratio, what the return on equity will be over time, and correspondingly how that will impact the book value over time. Since Glattis tends to use a discount rate of 10% when valuing stocks, the intrinsic value of a bank that earns returns on equity of 10% is expected to be around 1 times book value. So the price would be interesting in this case if it were trading below book value. And if returns on equity are greater than 10%, then the intrinsic value would be somewhere north of one times book value. It's important to look for businesses that earn at least 10% returns on capital because then time is on your side as an investor. As of the time of publication, Glattis' fund was long two banks, JP Morgan Chase and OSB Group. They view JP Morgan as the strongest and most resilient global bank, which is the stock they added to the fund during the market plunge in March of 2020. Today, JP Morgan has the number one position for banks in terms of customer deposits with 11% market share. It's the number one corporate and investment bank, the largest credit card issuer by spending and balances, the largest mortgage issuer, the largest auto lender, and the largest payment processor. The company has been led by Jaime Diamond for more than 20 years now. Since Diamond was CEO of Bank 1 in March of 2000, which would eventually merge with JP Morgan 4 years later, he's delivered returns of 12.1% through a year- end 2023, while the S&P 500 returned just 6.9%. For a bank to perform well over the long term, it must consistently earn high returns on equity and ensure that there aren't significant losses during the temporary crisis such as the Great Financial Crisis. JP Morgan satisfies both of those conditions. During the GFC, many banks of course did not survive and JP Morgan was the only major US bank that did not need government assistance and was profitable and actually mitigated the impact of the crisis on the entire financial sector by taking over the failing Bear Sterns in March 2008. JP Morgan's management prioritizes return on tangible equity, which has been around 15% since the merger with Bank 1. This is the rate at which the bank's capital is accumulating before dividend payments and share buybacks. Jaime Diamond says that he expects JP Morgan to be able to achieve an average return on tangible equity of around 17% and over the 5 years leading up to the book here, that figure was 19%. Glattis writes here, "When one considers that these five years have included a global pandemic, dramatic inflation, rapidly rising interest rates, falling bond prices, and a US banking crisis. This is a respectable result. Other big banks can only dream of such returns." End quote. And just briefly here on OSB Group, this is a smaller, more specialized bank based in the UK. They provide mortgages to professional landlords. While JP Morgan is trading at a hefty premium to book value, this company currently trades at around 1.1 times book value and earns returns on equity of around 15%. Glattis's fund purchased shares of OSB in the summer of 2024 when the stock traded for around 4 and a half times earnings, paid a dividend yield of 8 1.5% and had a price to book ratio of just.7. In his view, the stock was significantly undervalued. Some might question why a good business would be valued so cheaply by the market. And one potential reason, as we got into at the beginning here, is simply that this segment of the market is largely ignored by most investors. With OSB being a smaller bank, passive flows largely avoid this company, and many investors mostly shun the banking sector, too. Lastly, the UK market has overtaken Japan as one of the least favored developed markets. Despite how much investors ignore certain pockets of the banking sector, banks are important to the functioning of an economy and of companies and they constitute an important part of capital markets. So perhaps in the future, this sector will prove to be fertile ground in searching for investment opportunities. I really enjoyed reading through the final chapter of the book to wrap things up. Years ago, Glattis and his wife bought a piece of land where they planted flowers, shrubs, and trees, and they named the land Bergkshire Park. Watching the trees grow does not happen in a matter of days or weeks. It happens in a matter of many years. From day to day, a person does not really notice really any change. But if you look back after years, the differences can be astounding. This is a close analogy to investing in stocks. Picking individual investments for your portfolio is like planting trees. Most people like to watch the day-to-day and week-toeek price movements of stocks, and I must admit, me included. But what really matters is understanding the underlying business and the seeds they are planting that will bear fruit for the years to come. Just like trees, when you look back over a period of years, the changes in value of businesses can be enormous. Now, not all stocks will grow and blossom as expected, but Glattis laid out many of the things he likes to look for in the stocks he invests in. As he illustrated at the beginning of the book, he believes that today's conditions are quite ideal for selecting individual stocks because of how much less efficient the market has become with the rise of passive investing. Glattis pulled in a quote from Mark Leonard, founder and former president of Constellation Software. Leonard wrote in his 2018 letter to shareholders, "Index investors buy our stock because we are part of whatever index they are emulating. Their actions are formulaic. Despite the fact that they may be long-term holders, it is difficult to find someone to speak with at these indexing institutions, and even if we do, they rarely know much about our company." End quote. Then Glattis writes, "This sentence captures well what disturbs me about index investing. Index investing makes the market even more inefficient by suppressing its price discovery function and ultimately constraining the performance of the economy as a whole. End quote. And then you also add in the impact of the internet and the easiness of making trades on our phone with zero commission platforms. It points to Buffett's line about how the market has become more and more casinolike. But with the potential fragility of the market here in the US, that isn't a good reason alone to shun stocks. When an investor looks for hidden treasures, they can surely find stocks with higher expected returns and lower corresponding risk. When people talk about investing in stocks, they love to talk about the returns, but they rarely discuss the risk. One reason is that returns are easy to measure in hindsight, but there's no objective measurement or definition of risk. is largely a subjective category. What might seem risky to one person might seem just fine to another and vice versa. It's often argued that in order to earn higher returns, one must take more risk. But the great value investors do not believe this. While academia shares that risk is equal to volatility, Buffett and others share that risk is in fact the potential for losing money. Glattis then breaks down further how we can minimize risk. He has three points here. First is to have an awareness of our own abilities and skill set. If he had to name one thing that causes investors to lose the most money, it's when they get into things they do not understand. This is true for all types of investments and investors, regardless of experience. We need to have a good understanding of the boundaries of what we probably understand and what we almost certainly understand and then concentrate our investments only in areas that lie within this imaginary circle of competence. The second pillar of risk management is to avoid the risk of permanent loss of capital or said differently minimize the probability of losing money. A permanent loss of capital is a situation in which an investor loses part or even all of invested capital on a particular investment without being able to recover it. Now, this doesn't mean that we avoid volatility. Share price fluctuations are normal. But if you buy a business that is overinded and files for bankruptcy when a major crisis hits, then that is a permanent loss of capital that cannot be recovered. The most common causes of permanent loss of capital tend to be poor business quality, high levels of debt, and poor management actions. If we simply invert this, we should focus on highquality companies we understand with high returns on capital and strong free cash flow, have minimal debt, and have management that allocates capital effectively. The final pillar of risk management is, of course, putting an emphasis on paying a fair price. A stock presents different levels of risk depending on the price you pay. A stock that's priced at $100 might be a low-risk investment, but if it's priced at $500, it might be a very high-risisk investment. Of course, Buffett shared to only buy shares well below our estimate of intrinsic value. But we must also have a relatively high confidence around that estimate of value. Otherwise, we're speculating. Furthermore, Glattis wants to use intrinsic value estimates that are conservative and realistic, and the gap between price and value is wide to make room for a margin of safety. And it's important not to over complicate things. We don't want to build out an elaborate model to show that a stock is undervalued by 5 or 10%. Based on his experience, the more sophisticated a valuation model, the poorer the investment outcome. It's much better to wait for situations where a stock's cheapness is so blatant that no further complex calculations are needed. Although it can't be measured, the end result is that hopefully a portfolio of stocks that put these practices of risk management to good use will have lower overall risk than an investor who buys a broad market portfolio of hundreds or even thousands of stocks of which they know next to nothing about. and the companies in your portfolio will be of higher quality, have less debt than the market average, making them more resilient. Based on these observations, I believe it's possible to construct a portfolio with lower risk and higher perspective returns. So, that wraps up today's episode. I want to extend a special thank you to Daniel Glattis for this book. It's very well written, and I would encourage the listeners to pick it up. And it looks like in his annual letters, he also provides updates around changes to his portfolio and the top positions in his fund. So, I think we'll close out the episode on that note. Thanks a lot for tuning in to today's episode and I hope to see you again next week. >> Thanks for listening to TIP. Follow We Study Billionaires on your favorite podcast app and visit the investorspodcast.com for show notes and educational resources. This podcast is forformational and entertainment purposes only and does not provide financial investment, tax or legal advice. The content is impersonal and does not consider your objectives, financial situation or needs. Investing involves risk including possible loss of principle and past performance is not a guarantee of future results. Listeners should do their own research and consult a qualified professional before making any financial decisions. Nothing on this show is a recommendation or solicitation to buy or sell any security or other financial product. hosts, guests, and the investors podcast network may hold positions in securities discussed and may change those positions at any time without notice. References to any third party products, services, or advertisers do not constitute endorsements, and the investors podcast network is not responsible for any claims made by them. Copyright by the Investors Podcast Network. All rights reserved. So I feel that only a true master of their craft can make money shorting a stock and then turn around not too long after and go long before it becomes a multibagger. So that's exactly what you did with Robin Hood. There were two, you know, environmental reasons why they missed the quarter and I just thought they were temporary and it it traded down to the $8 where I bought it and they still had that $8 a share in cash. Also like technically it had built a big base like it you know had covered in March of 22 and from March of 22 to November of 23 the stock kind of was flattish and it had built that long base. So it, you know, I got fortunate that it took off soon after I bought it.