Disclaimer:
Just a quick reminder, this podcast may contain general advice, but it doesn’t take into account your personal circumstances, needs, or objectives. The scenarios and stocks mentioned in this podcast are for illustrative purposes only, and do not constitute a recommendation to buy, hold, or sell any financial products. Read the relevant PDS, assess whether that information is appropriate for you, and consider speaking to a financial advisor before making investment decisions. Past performance is no indicator of future performance.
Steve Johnson:
Hello and welcome to episode eight of Stocks Neat. I’m Steve Johnson, Chief Investment Officer at Forager Funds and I’m joined by the portfolio manager of our International Shares Fund, Gareth Brown. Hi Gareth, how are you?
Gareth Brown:
Hi Steve. Hi everyone.
Steve Johnson:
Thanks for tuning in. We’re going to cover a few topics today. We’re going to kick things off with the madness of the momentum driven markets that we’ve been operating in for the past few years, move on to some basic investing principles that have been forgotten along the way, and have a chat about one of our favorite topics at the moment Gareth, Twitter and it’s battle with Elon Musk. We’ve taken on board the feedback and we’ve got an Irish whiskey here today called Bushmills. Claims to be the oldest continuing whiskey distillery in the world.
Gareth Brown:
I put the word out on Twitter a few weeks ago, looking for recommendations. No one suggested Bushmills but none of the other ones that we got recommended were available in the bottle shop downstairs. So we’re stuck with this one today.
Steve Johnson:
I tried to order one yesterday but was not going to get here in time. So maybe another Irish whiskey somewhere down the track. There’s some really interesting different ones out there that we want to give a crack to, but this is fairly widely available. So other people can access it as well.
Gareth Brown:
Follow along at home, huh?
Steve Johnson:
Come to that later. Gareth, my CIO letter to our June quarterly report, which this year we combined with the performance report, I said that these are the most momentum driven markets that I’ve ever experienced. I’ve never experienced anything like it. Do you think that’s true?
Gareth Brown:
Yes. And I think that’s true going back a couple of years on both the upside and the downside. I think there’s been times of extreme correlation that have lasted months, not years, that maybe match in magnitude, but not this two, three year… Well, three year period now really, it’s quite unique.
Steve Johnson:
Yeah, it hasn’t really made… There are themes that are driving people’s behavior. Obviously commodity stocks have had a really good year as inflation has taken off. Small caps and tech stocks have had a really bad year as interest rates have gone up for reasons that we’ve talked about on previous podcasts. But the actual individual stock performance has almost been irrelevant. If you’re in that sector, you’re going with the tide and if you put out a great result. We’ve seen stocks get one and two day bounces and then just resume the same trend again.
Gareth Brown:
Yeah, there’s some pockets of the market like resources that have gone up. Most of the market has been falling and you can go from growth to value or you can go from small to large and you can change the magnitudes a little bit, but you’re experiencing pain.
Steve Johnson:
I posited some theories in that report. One being that there is just more uncertainty than usual about the near term future. I think there’s always a lot of uncertainty about what the world might look like in five years time. But we’ve been through this pandemic, we’ve had enormous amounts of government stimulus, we’ve seen lots of, I think, surprising features. They all seem obvious in hindsight in terms of who the beneficiaries were and who the losers were. But for me, there have been a lot of surprises along the way. And now we are in a position that we haven’t experienced in a generation around rising interest rates and inflation really messing up what the next few years might look like for profitability. So I think that is a factor in terms of what’s going on. But the magnitude of the moves for me feels like it’s more about something else. I posited the theory that there’s more retail money, there’s more momentum driven money, there’s less people caring about the values of the businesses. Is there anything else you’re thinking about? Do you think that is true and fair?
Gareth Brown:
I think a working thesis I’ve had for quite some time now is that the markets are, most of the time, getting more efficient. And we’ve talked about this in terms of moves to ETF’s or index funds and most of the time getting more efficient, but sometimes just these violent seismic shifts that seem to be much bigger now than they were 50 years ago. Whereas you could find inefficiencies to harvest more regularly, 50, 60, 70 years ago. You need to be able to respond to dysfunctional markets now to build an edge, I think.
Steve Johnson:
Yeah. So I guess the question now is I feel like this is probably here to stay. I think that the accessibility of markets, the ways that you can gamble on different things, I think the casino nature of it has always been there. But now if you want to, you can go and buy a crypto ETF because you want to own crypto stocks and you can do that very easily at the touch of a button on your phone. You can be buying US small cap stocks if you feel like it in the middle of the night here in Australia. So the trend in the waves of money, and maybe even the money monetary influence on markets, it’s not-
Gareth Brown:
I think that’s a huge one that stands out there. You’ve had interest rates set specifically to encourage people out the risk curve. And it just got crazy and the new technologies make that easier and more accessible. I don’t want to get into a Austrian school type argument here, but we’ve had central bankers that are happy to use market prices to bring forward demand to deuce an economy. There’s always the flip side of that and the more they use that tool, the more we’re going to suffer on the other side from time to time.
Steve Johnson:
So as an investor, how do you navigate it?
Gareth Brown:
Our performance this year shows that it’s not easy. Margin of safety always gets down to price and the ability to pivot that portfolio into safer investments and or cash, at times I think is really important. And I’m saying that from a position of weakness because I don’t think we’ve done that well at all the last 12 months, but that’s the ideal here. If we are going to have stock markets deuced in effect, we need to be able to respond that way.
Steve Johnson:
Yeah. I think you need to try and make that volatility your friend. So it’s not about completely ignoring it, because I think it can create enormous opportunities at both end of the spectrum. But to the extent that you let it start dictating your behavior, it can become very, very detrimental, to the extent that you see it as an opportunity to be taken advantage of. I think we both agree we could have done a better job of that over the past 12 to 18 months. I don’t want to talk too much about that here today. People can come along to our roadshow if they want-
Gareth Brown:
Yeah, and performance reports about-
Steve Johnson:
And hear a little more about that or read the performance report. I think just recognizing this as a factor that is probably permanent and being far, far more conservative in the heady times and being very aggressive, which we are doing in the dysfunctional times. I think it has the potential to add even significantly more value for active fund managers that can navigate that environment well.
Steve Johnson:
One thing we’ve talked a lot about over the years that I think gets forgotten in times like this, is just this concept that there is actually a difference between the share price and the value of the business. And particularly in small cap stocks, I often just sit there and a share price can be down 10% and it might be $500 million company, a company like Enero that we’re invested in in the Australian fund, I think that’s maybe a $300 million market cap, but it is a very, very illiquid stock. And you can have a day where $10,000 worth of shares trade and the share price is down 10% because there’s nobody there to buy them on the other side and someone wants to sell.
Steve Johnson:
And I always sit there and I think, you just got to remember that share price is just a transaction. Someone has bought some shares, someone has sold some shares. Oftentimes that might be a really good guide to the value of the business because there’s lots of smart people trying to work out what the value of the business is and exchanging. But ultimately it is only a transaction and that’s all it is and it doesn’t determine the value of what you own. And it’s something I’ve been trying to spend a lot of time on. And I thought we could dig into it a little bit today, is really just focusing on the difference between those two things.
Gareth Brown:
Look, it’s hard after the year that we’ve just had, to get on any soapbox and talk about the theory of investing because we haven’t nailed it. But it’s very, very important here to focus on evaluations, conservatively put them together and to not get too caught up in the markets swings either way. And I think one subset of that is this idea of a cheap stock. We need to be very, very skeptical of a stock that we consider cheap when you have this crazy bull market and everything’s going up and you think you’ve found this diamond in the rough that’s on its own. Very often they turn out to be mistakes. Whereas we have a more dysfunctional market, which we’re seeing at the moment, and you’re finding lots of things. And you can have a lot more faith in your judgment, I think because you can see why things might be cheap versus this dysfunctional market.
Steve Johnson:
Yeah, I think that environment is really, really important. Actually just sit there and even write down what sort of environment that you think you’re in. And in fact, if we talk about a couple of little specifics, we actually sold some stocks that we’d done really well out of and then we went and bought some things that we thought were relatively really cheap at lower earnings multiples and thought well, these are in the value spectrum, they’re going to protect us. And they’ve performed-
Gareth Brown:
As poorly-
Steve Johnson:
… stock price wise, just as poorly. So I think A, start with the environment and say well, is this an environment for me to be finding cheap stocks. If not, then have a strong bias towards, it’s probably not going to be cheap, right? There’s probably a lot of people that have had a look at it and said they don’t want to own it for a certain reason. And I think vice versa, you can talk yourself out of things when things are dysfunctional by thinking well, there must be something here that I’m not noticing. Whereas I think if you, again, sit down and say well, is this an environment where people on a fairly wide scale might be getting things wrong. Or not even getting it wrong in terms of thinking about the value of the business, they’re just doing it for a completely different reason. You actually need to shift your skepticism metre or a bit and say well, okay, this is actually the right sort of environment for me finding these sorts of things.
Gareth Brown:
Yeah, I agree with that. And I guess just to reiterate that point, you sell a fast growing stock in a market like we had in 2021. The right place, in hindsight at least, is probably not in smaller value stocks. It’s probably in things that are really going to be resilient. And the Alphabets of the world, for example, it’s come off a bit more recently, but has performed relatively well and served a purpose in the portfolio that a smaller value stock hasn’t because we’ve hit this dysfunctional market.
Steve Johnson:
Yeah. And I think that context is really important, even for all those little rules that people have. I think when you find a good business or a great business and it’s run by good people, own it forever. That’s a really nice rule in most market environments. I think when you’ve had a 10 year bull market and everyone’s talking about that as a concept and it’s all quality, quality, quality, then I think the radar just needs to be up saying, well okay, if I’m ever going to ignore this rule, it’s in an environment like this, that doesn’t mean the rule’s wrong, it doesn’t mean it’s not useful, it just means that there are probably times when you need to be ignoring even that. Just to wrap up this section, where do you sit on the whole efficient market hypothesis after what’s happened over the past couple of years? Well, maybe explain it first for people that…
Gareth Brown:
Efficient market comes in various forms, but the hard form efficient market is that all stock prices reflect all publicly available information at all times, basically. So there is no point being an active investor. And then there’s some softer, formal semi forms, I’m not even sure what they’re called, but where it mostly reflects most of the information most of the time. And I think that caveated version is probably fairly true most of the time. The markets have gotten a lot more efficient over the last 70 or 80 years, a lot more efficient. There’s a lot of computer power, there’s a lot of brain power.
Gareth Brown:
All the rocket scientists that are working at somewhere like Renaissance, have moved to make markets more efficient most of the time. And then we’ve layered that with things like index funds that recognize that fact and most of the time do well for their investors because they keep the cost down and they give you market exposure. But again, I think that probably introduces some Achilles heels that occasionally, you can take really big advantage of. So I think the market is mostly, really quite efficient most of the time and getting more so. I think the big disruptions for that are probably getting bigger and more fruitful to take advantage of if you have the right psychology and fire power to do it.
Steve Johnson:
Yeah. And I think once again, it’s not about whether it’s right or wrong, it’s about trying to recognize an environment in which it is going to be more likely to be right than wrong. And yeah, over the past few years, there have been plenty of times when, if not getting it right, even being dramatically overly optimistic just because there was so much money coming into the market. And we’ve probably spent less time over the past two years than at any point that I can remember, where I’ve thought this is just a sensible battle between the pros and cons of what’s going on. It has been so wave momentum driven on either side that there are always, the majority of the time, normally is… Well, this is a fairly decent weighing up of the risks and the pros and cons of what’s going on out there. Pour a whiskey?
Gareth Brown:
Yeah. I think that’s a good idea. I should have pre-opened this, shouldn’t I? Why don’t we move on to the next topic while I’m trying to open this?
Steve Johnson:
Well, speaking of market efficiencies, we’re going to move on to a stock with tens of billions of dollars of market capitalization, where very significant amounts of shares trade every day called Twitter.
Gareth Brown:
Heard of it.
Steve Johnson:
It’s a stock Gareth, that you do have some fairly strong views on, despite there being lots of shares traded every day. And I do want to caveat this conversation with, we have a lot of conversations internally about what do we know and what don’t we know and where is our edge. And I think this is a very, very public situation at the moment where lots of smart people are trying to work out what’s going on in the world. But a fascinating situation, I think either way.
Gareth Brown:
Yeah. So I think just to maybe set the scene here, we bought Twitter, most of our position, in 2020. We thought the market was underestimating its growth, potential, the stock basically doubled and then it’s halved and it’s come back right to where we’ve been buying. I think it’s been a battle between the growth and potential of this business and the execution, which has been broadly terrible over most of its life. Big stock based comp payouts, not generating tons of cash flow. So just not living up to that potential, and in hindsight, would’ve been better for us to probably never own it. Ideally we would’ve sold it last year, at twice the price we paid for it but I think realistically, this is probably a stock where we’ve stepped a bit out of our circle of competence and given up some edge there. Anyhow, earlier this year, Elon Musk came along to save the day, lobbying a bid for $54.20 a share when the stock had been trading low to mid thirties. We sold some of our position there at a discount to his bid price.
Steve Johnson:
So the board initially told him to go away. Well, without disclosing what he was supposed to disclose at the market.
Gareth Brown:
Yeah, again, he didn’t follow the disclosure regulations in the US. So the SEC, again, sniffing around what he did. So he missed the dates that he was supposed to disclose. He kept adding to his position. So ultimately a bunch of shareholders that might have been very interested to know that Elon Musk was involved, were denied that information. So who knows? There may be court cases. I’m not even sure if there is court cases yet, but there may be around that.
Steve Johnson:
So that allowed him to buy more without people knowing what they should have known. He ended up with a 9% stake, started making a bunch of cryptic tweets about…
Gareth Brown:
So basically came on to the scene and said, either I’m going to join the board here, I’m going to buy the company or I’m going to start a competitor. That was the three options. The board initially looked at a poison pill situation. So something that would stop him from being able to take advantage.
Steve Johnson:
Well, they did actually-
Gareth Brown:
Yeah, I think they did.
Steve Johnson:
… put that in place, yes.
Gareth Brown:
But anyhow, then they invited him onto the board, he knocked them back, then he decided to bid for the whole company. Came up with what we call a very seller friendly contract. So agreed to exclude a whole bunch of standard things from a contract, signed it with, I think, zero due diligence. He basically gave up the right to go and look at the inner workings and get all that non-public information just to fact check whether he still wanted to own it at that price. And came up with a deal and signed the dotted line. And then it was just a few weeks later, started rambling on about spam bots and issues with the information he’d been given.
Steve Johnson:
Well, I think really importantly, in between these things happening, there’s been a meltdown in similar advertising based businesses, the wider tech market, worries about recession and he’s been public in some of his concerns about recession. So the whole market-
Gareth Brown:
And his own Tesla stock that he’s probably selling to fund most of this, also is down dramatically.
Steve Johnson:
And then he started-
Gareth Brown:
Buyers remorse.
Steve Johnson:
… tweeting all of these concerns about things that were fairly publicly known. In fact, he himself had acknowledged.
Gareth Brown:
One of the big problems with Twitter that we need to fix is the bot problem. Now he’s saying, oh we’ve got a bad bot problem and I’ve been sold a lemon.
Steve Johnson:
Cutting to that, just recently, this is only a week or so ago now.
Gareth Brown:
So he formally walked out on the deal a week and a half ago. Something like that, or maybe a bit longer. Twitter came back very quickly with, I think it’s a 60 page document. They are pursuing him in the Court of Chancery in Delaware. Now 60% of SNP 500 companies are domiciled in Delaware. It’s like legal arbitrages seems to be their main business, it’s a very small state. And Twitter is now suing, Twitter, who’s domiciled in Delaware, is going to sue Musk in that Court of Chancery in Delaware to try and enforce this contract. So it’s a well worn legal path going to this court because so much of America is domiciled there.
Steve Johnson:
Now the bid was $54 a share. It had been trading down-
Gareth Brown:
Yeah, sharply.
Steve Johnson:
… before this all happened and then he announced that it happened and it traded down even further. At one, point low thirties. $31, $32 was the market price of the shares and he’s bid $54 and he’s got a binding contract to say he was going to pay $54 and they’re taking him to court. It has since rallied somewhat, since this Twitter document came out and we’ll get to that in a second because it’s very, very interesting. But the whole saga is just, I think, a fascinating even exploration of the whole US legal system.
Gareth Brown:
Yes. So I don’t have any extra insights around that if you wanted, but do you want to move on to this document? Because I haven’t gone and copied out a bunch of stuff, but I did read it and it’s a fascinating document. It is dropping in all sorts of stuff that he’s done. There’s the legalities of the situation, but then also how he’s acted in bad faith. That’s really an important part of the legal framework here that, the contract says I will act in good faith to execute on all these things and very, quickly he’s questioning the business. There’s a poop emoji in the legal document. Everyone knows that Musk is a very loose unit. And a lot of that has been very… Lawyers must have had an immense amount of fun putting this together…
Steve Johnson:
You can Google it, it’s publicly available. I’d really recommend people go and read it because it’s a very cleverly put together, readable document that’s the basis for a book, you would think, and really well done. But the interesting piece here is, he’s got a legally binding contract to buy something. He said he’s not going to do it. They’re suing him saying, you have to.
Gareth Brown:
Sorry, just to clarify, he said he’s not going to do it because he’s making up some rubbish that Twitter hasn’t delivered on X, Y and Z, right? He’s made a legal argument. It’s a shallow one.
Steve Johnson:
Yeah. So most legal experts seem to be saying he doesn’t really have a leg to stand on here. There’s lots of precedent around this issue and Delaware in particular, rule fairly quickly on these things, mostly in favor of you signed a contract, you’ve got to deliver. But the stock price is still trading at a massive discount. And lots of people are saying well, that might be true, but he’s not going to do it anyway. Which is the really bizarre part of this conversation. I think you’ve got an audio clip…
Gareth Brown:
I do. I just want to address two things here. So Twitter is suing for what he’s… Listen for this term in the clip I’m about to play. They’re suing for specific performance. So that means I have an agreement to sell to you at $54.20 a share, we’re going to do that, right? They want the courts to say Elon Musk has to buy Twitter for $54.20 per share. The other potential route that… Let’s say the judge favorably views Twitter’s argument but they might go down a monetary compensation route. So Musk, you have to pay a billion dollars, Musk you have to pay $10 billion, who knows what the number is. But that’s the route that I think Elon’s arguing for.
Gareth Brown:
I don’t think he expects to get out of this paying nothing, but I think he expects to pay something. Twitters shareholders are going to be rorted out of 20 billion plus here, if this deal doesn’t go through. And I think it’s unlikely. If the compensation is monetary compensations, it’s going to be that kind of an amount. So you’re sitting here, are we going to get specific performance? Are we going to get monetary compensation and if so, how much? I want to play a short snippet here, because I think Twitter has… I’m a layman but it looks to me like Twitter has a pretty strong case that they win here. But this is a snippet with Carolyn Burger, I think it is, or Berger. She’s a former vice chancellor of this very court in Delaware and she thinks the argument’s interesting, but then she gets onto the topic of what the remedy’s going to be.
Steve Johnson:
Listen closely to this.
Gareth Brown:
It’s one of the most astounding things I’ve ever heard.
Court Snippet:
Justice Berger, good to have you with us.
Thank you.
First, I know you had a chance to read the complaint, which came out last night at around five o’clock. Just give me your thoughts on the case that Twitter is making that Mr. Musk is in breach and therefore needs to complete this deal and specific performance.
I think the complaint is pretty straightforward and if the complaint is what prevails in terms of what the facts are, I think Twitter’s in a very strong position to be on the winning side. Now, that’s not to say that they necessarily will get specific performance.
Why not? Why won’t they get specific performance if that’s what they’re going for and if in fact it’s a case that they would prove where he just says buyer’s remorse, which is not a reason to walk away.
Right. The problem with specific performance, especially with Elon Musk, is that it’s unclear whether the order of the court would be obeyed. And the courts in Delaware, courts all over, are very concerned about issuing a decision or issuing an order that then is ignored, flouted. And it reflects poorly on the court in terms of being able to give relief to the parties that are asking for it. So I think it’s much more likely in this case that the court would say if Twitter prevails, Twitter will get money damages as opposed to specific performance and have the deal go through.
Gareth Brown:
That’s about enough. You’ve known that some people are above the law, but you’ve never heard a judge basically say as much, that there are people who are either too rich, too powerful or too crazy to face the full consequences of the law. And I’m blown away by this. There are people that are too big to jail. Elon Musk seems to be one of them.
Steve Johnson:
Well, we will see because it hasn’t gone to court yet. And for me, from a distance, this is just a fascinating exploration of the US legal system because the whole country is really built on the strength of its court system and its legal system and the ease of doing business there-
Gareth Brown:
And contractual law in particular, let’s say. They really believe in the sanctity of the contract. Whereas other countries will pierce that, look at different meanings. What’s written in a contract in the US is supposed to be sacrosanct.
Steve Johnson:
I remember a couple of years back when TikTok was really taking off and president Trump came out and said, we’re closing it down, it’s over, because it’s owned by the Chinese government, which politically, was very, very popular. And TikTok took the president to court and said you can’t do that, it’s against the law. And the courts ruled very, very quickly that TikTok, Chinese owned company, was a hundred percent right and that the president of the US could not shut that business down. And a lot of people were really critical of that as, this is America? Why can’t America do what it wants? And for me, it is the fundamental reason about why the place is so successful, is that you can actually do that. That you have power to enforce something, granted you need money to go through the court system itself, but at least Twitter has plenty of that. So for me, it’s going to be really, really interesting to see how this unfolds. I’ll be surprised personally, if who he is makes one scaric of difference when it comes to the court law.
Gareth Brown:
And I actually think Carolyn Berger, she may have a point but I actually think they’ve got to think of the second order implications of all this stuff. If Musk gets off and the society perceives it’s because he’s too big to be held accountable and given the consequences that everyone else would get, the first defense of anyone else that goes to that court is going to be, whatever you say judge, I’m not going to follow it. Point two, I think I’m right, you know what I mean? It brings the whole thing into… She may be right and it may go that way and it may be hush, hush, but everyone knows why it will go that way. If they resoundingly win the legal argument but get crappy compensation for it, it really calls the whole thing into question.
Steve Johnson:
Well, as we’re recording this here today, it’s Tuesday afternoon Sydney time. And I think Tuesday US time, there’s going to be a decision about whether they’re going to accelerate the court case or not. Well, I think I saw a headline saying the judge has COVID so maybe that won’t happen as quickly, but it’s going to be an interesting few months ahead as we watch that saga unfold. So Gareth, I touched on this earlier, we’re drinking an Irish whiskey called Bushmills. This one’s a 10 year old. They do have some older, more expensive versions as well. What are your thoughts? What are you tasting?
Gareth Brown:
It’s very workman like. I like it. It’s easy to drink. I would call this an airplane whiskey. This is the kind of thing I would like to get when I’m flying on a trip to Europe or something. Just nothing too complicated, easy going.
Steve Johnson:
They’re calling it the world’s oldest licensed whiskey distillery. 1608 so it’s more than 400 years old. I always worry when I see something like that, that you’re paying for that label rather than paying for the whiskey itself. I think you’re right, it’s very drinkable. Is there anything you’d you’d line it up against?
Gareth Brown:
No. It’s probably the Johnny Walker of Irish whiskeys. I occasionally have a Jameson with my parents, that’s in that range. I don’t know, I get a coconutty something off of Jameson that I don’t get here. It’s a little bit simpler. Very nice.
Steve Johnson:
They’re claiming honey, vanilla and chocolate notes.
Gareth Brown:
Yeah. Get none of that.
Steve Johnson:
It’s all right. We’ll try and get our hands on that bottle that Liam Short recommended for us. Thank you Liam. If you’re tuning in here, we’ll get one of those for a later version of the podcast. Thank you for tuning in once again to Stocks Neat and please let us know anything you’d like to hear us discuss, any whiskeys you’d like to listen to us taste and yeah, the usual admin address. Gareth’s on Twitter, along with Elon Musk, @forager_gareth or myself, or the wider Forager team. Thanks again for tuning in.
