Podcast Summary
Myths of Private Equity's Success: Private equity's past success driven by size, value, and leverage may not guarantee future results due to increased competition and higher valuations. Myths of operational improvements and lower risk in private equity are misconceptions.
Private equity's outsized returns from 1980 to 2010 were largely driven by size, value, and leverage. However, these factors may not guarantee similar results moving forward due to increased competition and higher valuations. The first myth of private equity is that it creates value through operational improvements, but in reality, a significant portion of returns come from financial engineering. The second myth is that private equity is less risky and less volatile than public markets, but private equity firms' quarterly mark-to-market valuations can be misleading. Private equity's underperformance since 2010 can be attributed to the influx of capital and the resulting competition for deals, leading to inflated valuations and diminishing returns.
Private equity investments: More volatile than perceived: Despite lower day-to-day price fluctuations, private equity deals carry greater risks due to significant debt and operational improvements may not offset increased debt levels.
The perceived stability and lower volatility of private equity investments compared to public markets can be misleading. While private equity deals may not exhibit the same level of day-to-day price fluctuations as public markets, the underlying risks can be greater due to the use of significant debt and the focus on operational improvements. However, data from private equity deals that issued public debt reveals that revenue and EBITDA growth often slow post-acquisition, and while there may be some cost-cutting and efficiency improvements, the increase in debt levels outweighs any potential gains. These findings challenge the common belief that private equity investments are less volatile and that operational improvements are the primary driver of returns.
Understanding Private Equity's Focus on Valuation: Private equity's success hinges on accurate valuation to manage high debt levels and maximize returns. Valuation's importance is often overlooked, but it significantly impacts success.
Private equity firms' primary goal is to buy whole companies to restructure their capital, with the aim of increasing leverage and enhancing equity returns. While operational improvements are often discussed, they are secondary to the initial goal of buying growing companies and leveraging them up. Private equity valuations are crucial, as they are more important than public equity valuations due to the high debt financing in private equity deals. An increase in purchase price leads to increased debt levels, interest payments, and a negative effect on free cash flow yield. The importance of valuation in private equity is often misunderstood, but it plays a significant role in the success or failure of these investments. While some private equity firms, like 3G, have gained fame for their operational improvement strategies, it's essential to look at their track record and the actual financial results to determine their effectiveness. Empirical evidence is key when evaluating the potential of private equity firms to deliver excess returns over public markets.
Private equity's success with cost cutting: Invest in firms with a proven track record of creating value, not just relying on high-profile deals or anecdotes.
Cost cutting is a successful strategy for private equity firms, as shown by companies like 3 gs, which have consistently doubled EBITDA margins post-acquisition. However, not all firms are equally skilled at operational improvements, and investors should be cautious about allocating capital to firms with high buyout multiples, as the asset class becomes increasingly competitive and expensive. Additionally, historical data suggests that private equity may not outperform the public equity market when deals are made at high valuations, despite common beliefs to the contrary. It's crucial for investors to allocate capital to firms that can demonstrate a track record of creating value across their portfolio and not just rely on anecdotes or high-profile deals. Furthermore, many successful investors throughout history may have achieved their success due to the specific industries or reference classes they chose to invest in.
Choosing the right reference class and identifying undervalued areas: Successful investing involves identifying overlooked opportunities in undervalued areas and using data to make informed decisions, rather than relying solely on expert judgment or intuition.
Successful investing often comes down to choosing the right reference class and hunting in undervalued areas where consensus is lacking. This was evident in the careers of investors like Mitt Romney and private equity giants, who found success not because they were the best stock pickers, but because they identified overlooked opportunities in small cap private businesses and insurance float, respectively. However, making accurate forecasts is crucial in investing, and expertise alone does not guarantee improved forecast accuracy. Instead, using base rates and statistically significant predictors can provide a more reliable basis for evaluating potential investments. For instance, analyzing the performance of comparable private equity deals based on size, value, and leverage can offer valuable insights into the likely success of a buyout. Ultimately, the key to successful investing lies in understanding historical probabilities and making informed decisions based on data rather than relying solely on expert judgment or intuition.
The importance of identifying persistent factors in investment decisions: Investors should focus on identifying persistent factors, such as human tendency to crave narratives and skilled individuals, for accurate forecasts. A systematic approach, like Ray Dalio's, can help in identifying and implementing such factors in live trading.
Relying on individual expertise or track records alone for investment decisions may not lead to accurate forecasts. Instead, it's essential to focus on identifying persistent factors that are less likely to change. One such factor is the human tendency to crave narratives and the existence of skilled individuals who can identify opportunities. To put this philosophy into practice, investors can follow a systematic approach, such as that of Ray Dalio, which involves coming up with a logical principle, testing it across various markets and geographies, and then implementing it in live trading. The speaker's logic is based on the historical success of private equity firms, which bought small, cheap, and highly leveraged companies, resulting in high free cash flow yields. This strategy has been empirically proven to work across various markets and geographies. However, investors must also consider potential risks, such as bankruptcy, when implementing this strategy. To mitigate these risks, they can use quantitative rules, such as eliminating firms with low credit ratings or high short interest. Ultimately, a successful investment strategy involves striking a balance between the blue team, which focuses on buying cheap, highly leveraged stocks, and the red team, which focuses on risk management.
Leverage and Deleveraging in Small, Cheap Firms: Investing in small, cheap, and levered firms can yield higher returns, but it's crucial to focus on the direction of leverage, specifically the deleveraging process, for potential equity gains.
Investing in small, cheap, and levered firms can offer higher returns compared to unlevered small cheap firms, despite the increased risk. Leverage increases free cash flow yield, making it possible to access a broader range of high-yield opportunities. However, it's crucial to focus on the direction of leverage, specifically the deleveraging process, as firms that pay down debt become more attractive to a wider pool of investors. Deleveraging is also a predictable phenomenon, making it an important factor to consider when investing in levered firms. By looking at a company's history of debt paydown, investors can increase their chances of predicting future deleveraging and potential equity gains.
Improving equity investment accuracy with Bayesian boosted trees and fundamental analysis: Bayesian boosted trees can enhance equity investment accuracy by considering additional factors beyond traditional ones, while fundamental analysis helps ensure investments are made on good signals.
A simple Bayesian boosted tree algorithm can improve on a 60% accuracy rate in identifying profitable investments in equities by considering additional factors beyond historically significant ones like asset turnover, net debt to enterprise value, market cap, and price momentum. The process involves first identifying a small subset of global equities that exhibit desirable characteristics, then further winnowing down the portfolio through a combination of fundamental analysis and timing. The team at the firm goes beyond the quantitative screen by reading financial statements, checking earnings call transcripts, and waiting for price drops before investing to ensure they're not buying on a bad signal. By doing so, they aim to add value to their portfolio about 70% of the time, as shown in their three-year track record. Despite the challenges in adding value relative to a simple algorithm, the team's approach of sanity checking the quantitative work through fundamental analysis has proven effective.
Investing based on pessimistic outlooks often inaccurate, expand investment universe: Focus on objective reasons for potential failure, expand investment universe beyond domestic markets
Subjective guesses based on historical 10-K analysis for identifying better-performing companies has often been inaccurate, as the value factor is predicated on pessimistic outlooks being wrong. The speaker suggests that even seemingly disastrous investments, like Canadian mining stocks, can deliver impressive results. The speaker also shares their experience of force ranking their portfolio and finding little distinction between top and bottom performers, except for the worst performers slightly underperforming. The key takeaway is that investors should focus on identifying objective reasons for a company's potential failure, rather than relying on pessimistic outlooks. Additionally, the speaker encourages expanding the investment universe to a global opportunity set, as limiting oneself to domestic investments may result in missing out on potential opportunities. The speaker's global fund is an example of this approach, with approximately 40% in the US, 35% in Japan, and the remainder in emerging markets and Europe. The speaker also notes that some geographies, such as Japan, may offer predictable outcomes due to unique financial systems that prevent public companies from going bankrupt.
Unique investment opportunity in Japan with low valuations and distinct business culture: Investing in Japan offers low valuations and a unique business culture. Focus on avoiding worst quality companies and consider removing irresponsibly levered ones for better performance.
Japan offers a unique investment opportunity with a large number of publicly listed companies, low valuations, and a distinct business culture. Originally drawn to Japan by the abundance of cheap stocks, Dan found that the market's low volatility was due to the explicit support for small businesses from banks and the government. This backstop for small companies contrasts with large exporters, which are heavily dependent on external business cycles and face greater volatility. Additionally, the investment strategy of focusing on avoiding the worst quality companies rather than solely seeking high quality ones has proven effective. However, it was discovered that removing irresponsibly levered companies from the investment universe would have led to better performance during recent cycles.
Impact of High Yield Rates on Companies and Equities: Companies face increased borrowing costs and refinancing risk with high yield rate volatility, but strategies like small value and levered small value can still succeed with patience and discipline. Long-term perspective is crucial for managing risk and improving investment outcomes.
While interest rates have historically shown no correlation with equity returns, the borrowing costs and refinancing risk of companies are significantly impacted by changes in high yield rates. Companies in the US and Europe need to be prepared for the volatility that comes with these markets, as high yield spreads can spike and cause panic in levered equities. To manage this risk, firms can only accept locked-up capital to ensure alignment and a long-term perspective. The Hippocratic Oath of investing is to not lose people money, and extending the time frame for investments can greatly improve outcomes. Despite the risks, strategies like small value and levered small value can still be successful if investors remain patient and disciplined. It's important to note that the industry as a whole needs to focus on helping investors understand the importance of a long-term perspective and the detrimental effects of short-term thinking and timing decisions.
Long-term alignment of investor incentives in private equity: Private equity's 10-year lockups and subjective valuations foster long-term focus and help investors avoid behavioral pitfalls, but lack of transparency can lead to risks.
The alignment of investors' incentives through long-term commitments, like in private equity, could be a game-changer for the investment industry. Private equity's 10-year lockups with subjective valuations create a long-term focus and help investors avoid the behavioral pitfalls of frequent buying and selling. However, this lack of transparency and constant feedback can lead to risks if the investments turn sour. Regarding competitive advantage, Michael Porter's Five Forces framework has been widely accepted for understanding industries and businesses. Originating from the industrial organization theory, this framework emphasizes the importance of industry structure and market power in determining a firm's profitability. Porter's work built upon the structured conduct performance theory, which formed the basis for antitrust legislation. The Five Forces framework has been criticized for lacking empirical evidence, and alternative approaches, like resource-based view and capabilities-based view, have emerged to provide more nuanced insights into competitive advantage.
Empirical challenges to Porter's Five Forces: Empirical evidence disproved the correlation between industry structure and company profitability, making relying on market share or industry structure as indicators of success potentially misleading for investors.
The theory of Porter's Five Forces, which suggests that industry structure and market power dictate a company's profitability and market share, has been empirically disproven since the 1970s. Chicago School economists challenged this theory through studies on industry concentration and profit margins, revealing no correlation between industry structure and company performance. As a result, antitrust courts and the field of industrial organization stopped relying on this theory. For investors, this means that relying on market share or industry structure as indicators of a company's success can be misleading and potentially dangerous. Instead, focusing on the impact on customers and other factors may provide a more accurate understanding of a company's competitive advantage. While the 5 Forces framework may still be useful for managers as a way to think about competitive dynamics, it's essential to recognize its limitations and consider alternative approaches to strategy development.
Focus on what you love and make customers happy: Success comes from enjoying the process, making customers happy, reading widely, and committing to continuous learning, rather than relying on strategic plans or forecasts.
The most satisfying and effective approach to building strategies and running businesses is to focus on what you love doing and doing it well for your customers, rather than relying on elaborate strategic plans or forecasts. Michael Batnick, the speaker in this discussion, emphasizes the importance of enjoying the process and making customers happy, rather than getting lost in strategic plans and PowerPoint presentations. He suggests that reading widely and deeply is a key part of this process, as it allows you to learn from the best minds in your field and stay up-to-date with the latest research. Ultimately, Batnick argues that the most successful businesses and investments come from a deep understanding of the fundamentals and a commitment to continuous learning, rather than relying on complex plans or forecasts.
Combining Quantitative Focus and Activity for Productivity: Effective work can be achieved through quantitative focus and combining activities like reading and walking. Identifying potential fraudulent companies in public equity markets presents challenges, but capacity constraints and focusing on small cap opportunities can lead to profitable investments.
Being quantitatively-focused and combining activities like reading and walking can lead to effective and productive work, despite appearing less labor-intensive. The speaker emphasizes the importance of distinguishing activity from effectiveness. In the financial markets, the speaker finds interest in identifying potential fraudulent companies in the public equity markets, despite the challenges of making profitable short bets. The speaker also emphasizes the importance of capacity constraints in their investment strategies, and their focus on small cap opportunities, rather than expanding into larger markets.
Research on forecasting for more accurate predictions: Philip Tetlock's research on forecasting reveals individual adjustments can improve accuracy, underutilized in investing
Investing involves making predictions about the future, and Philip Tetlock's work on forecasting is an invaluable resource for investors. Tetlock, a student of Daniel Kahneman, has conducted extensive research on how to make more accurate forecasts and has found that individual adjustments can be made after base rate assessments. This literature is surprisingly underutilized in the investment industry, making it a contrarian yet impactful area of study. On a different note, the speaker also shared their experience writing a book about a slave revolt in New Orleans during the 19th century American South for their senior thesis. They found the study of this historical event intriguing because it highlighted the moral compromises and tensions between economic progress and slavery. Despite the lack of primary sources from the enslaved people themselves, the speaker constructed a narrative using available records, such as wills and court cases. This experience showcased the importance of critical thinking and constructing narratives from limited information, skills that are transferable to investing.
Mapping out the past of enslaved people through data analysis: Thorough analysis of data, context, and emotions uncovers truths about history and investing
History, like investing, requires a thorough analysis of data, empirical tools, and an understanding of the context to uncover the truth. The speaker described his process of mapping out the past of enslaved people by combining data from various sources, such as legal records, property records, and old land maps, to create a visual representation of their origins. He then used this information to piece together a narrative, considering the emotions and experiences of those involved. The speaker also shared his interest in writing a book debunking bad ideas in finance and investing, emphasizing the importance of evidence, logic, and the scientific method. The kindest thing anyone has ever done for him was his mother's dedication to reading to him as a child, which instilled a lifelong love of learning.
