Episode 380: Value Investing Is Still Possible in Today's Bloated Market
On this week's Stansberry Investor Hour, Dan and Corey welcome Chris Pavese back to the show. Chris is the president and chief investment officer of Broyhill Asset Management. A value-oriented investment firm, Broyhill prioritizes safe, long-term success.
Chris kicks off the show by sharing a few book recommendations and explaining all about Broyhill. He covers how he got his start at the company, what differentiates it from other asset managers, and its core value-investing philosophy. As Chris notes, we've seen one of the longest stretches of value underperformance in history. However, Broyhill has kept pace with the S&P 500 Index over the past decade, despite not holding the "Magnificent Seven" tech stocks and half of the portfolio being in foreign markets. Chris says...
We're just looking for mispriced securities. So we're not focused on any particular sector. A lot of times, we're looking for situations that aren't dependent upon the market going up or value outperforming growth. We're looking for specific catalysts... We've kept up with arguably the strongest headwinds to value investors in history. I'm looking forward to seeing what we can do when and if those headwinds actually ever turn into tailwinds again.
Next, Chris explains what closed-end funds are and why they see such major swings in sentiment. He also gives his macro outlook in regard to the Federal Reserve's rate cuts and what it means for the economy. Chris highlights the fact that today's market is one of the most concentrated in history. But as he points out, there are pockets of value in many areas, especially internationally. And despite all the geopolitical turmoil, he advises against abandoning equities completely.
I don't think the right answer today is to avoid stocks. I think the right answer is to avoid the Vanguard 500 mutual funds or managers that basically just hide behind the S&P 500. [The right answer is] to avoid passive indices. Because there is value out there.
Finally, Chris discusses the importance of having a margin of safety and practicing common-sense risk management. He also mentions that the Biden administration is going hard with antitrust regulation and blocking a lot of deals, which is causing wide spreads in stock price when mergers and acquisitions are announced. Broyhill uses this merger-arbitrage strategy a fair amount to get easy money. Plus, Chris shares Broyhill's underwriting methods to gauge a business's intrinsic value...
We're looking at probability-weighted returns for every position in the portfolio... We're saying, "OK, so... if it plays out like this, we think the business will be worth this much. If we're off base and actually it unfolds more like this, we think the business is worth this much." And we'll have an upside case and a downside case, at a minimum, for every name in the book.
Click here or on the image below to watch the video interview with Chris right now. For the full audio episode, click here.
(Additional past episodes are located here.)
Dan Ferris: Hello, and welcome to the Stansberry Investor Hour. I'm Dan Ferris. I'm the editor of Extreme Value and The Ferris Report, both published by Stansberry Research.
Corey McLaughlin: And I'm Corey McLaughlin, editor of the Stansberry Daily Digest. Today we talk with Chris Pavese, president and chief investment officer at Roy Hill Asset Management.
Dan Ferris: And I've known Chris for many, many years. We see each other about once a year at the Valuex Vail Investment Conference. He's smart, he knows a lot about investing, and he is just a great guy to talk to. So let's do that. Let's do it right now. Let's talk to Chris Pavese right now.
Chris, welcome back to the show. It's been a while.
Chris Pavese: Yeah, good to see you, Dan.
Dan Ferris: Just so our listeners know, Chris and I see each other once a year at Valuex Vail. So, he's a die-hard value investor, and I strongly encourage you to go to his website, broyhillasset.com. There's lots of great stuff there and we'll talk about some of it today. But first, the question I'd like to ask you in particular. You're a voracious reader, and I want to know what you've been reading lately that you might like to tell us about.
Chris Pavese: Yeah, so, good start, we always like to talk about books. I'd say the most recent thing that jumps out, something that I shared with the rest of the team, was a book titled Unreasonable Hospitality. And so, it was written by the manager of Eleven Madison Park, which at some point in the last several years was ranked the No. 1 restaurant in the world. We don't have any investments in the restaurant industry, but like most investors, we are in the client service industry.
And so it's just super interesting to watch and learn about how they approached hospitality and what made them different and stand out. And I think what took me there initially was I saw the book being held in an episode of The Bear. I don't know if you guys are a fan of that on Hulu. It's, I think, one of the top shows on television, but it's about a Michelin-star chef that winds up back in Chicago at an Italian beef shop and transforms that into another Michelin-star restaurant in Chicago.
And in the kitchen, they were holding a copy of this book. So, yeah, definitely worth the read for anybody that is in any type of client service industry. And then, I guess I should maybe share one more that's slightly more investment- or at least analytical-oriented. A friend of mine referred me to Fermat's Enigma, which I've read earlier this year. It's just this fascinating story of – and this was actually made into a documentary, as well. It's this fascinating story of a modern mathematician that solved a 350-year puzzle that had stumped experts for centuries.
So it's just this wonderful novel that reads almost like science fiction, combining math, perseverance, and just intellectual curiosity and adventure. And so I've gone on to read just about everything that the author had written. And the other one I'll call out which was a lot of fun, he wrote a book called The Simpsons and Their Mathematical Secrets. So I had never realized, obviously the Simpsons are highly intelligent and ahead of their time, but there are seven writers on The Simpsons with advanced degrees in either mathematics, physics, or science, or some sort of scientific field.
And it's just amazing how much they've kind of weaved into different episodes over the years where, unless you're a mathematical genius, you probably totally miss the joke. But it's just, yeah.
Dan Ferris: All right, well, as you were talking, I'm adding all these to my Amazon cart.
Chris Pavese: Good. You got any for me, Dan?
Dan Ferris: Actually, the latest thing that I really dove into and read cover-to-cover was NATO: What You Need to Know. It's a short book about NATO's eastward expansion in Europe. And it also suggests maybe NATO shouldn't even exist anymore, because it was there to sort of guard Europe against the Soviet Union, so it's, why is it still around? And it paints a grim picture of NATO as a kind of warmongering organization, so. But it's a short read. I think it's [crosstalk] 200 pages, yeah.
So, reading a little bit about war here and there and just came across that. But otherwise, the one that I recently started, we interviewed a guy named Brody Mullins, and he wrote a book called The Wolves of K Street, which – and he's born and raised in Washington, D.C., and doesn't think or talk like a swamp rat. So, I didn't know before we interviewed him, and Value during the interview, I was, like, "Wow, I like this guy." [Laughter] So, we invited him to do an onstage sort of fireside chat with me at our Vegas conference in Las Vegas, in about a month or so here. And I'm going to get through this book, I'm going to read every word of it in preparation for that.
Chris Pavese: Yeah, Dan, I'm still on that one on Audible. I'm listening to that one, so, as well, yeah.
Dan Ferris: Oh, cool. Great. So that's what I got recently here.
Chris Pavese: Add them to the list, thanks.
Dan Ferris: So, I did mention that you have a really good website. Nobody could go to your website and spend a decent amount of time and come away not knowing what kind of investor you are. But rather than tell people to turn the podcast off and go to the website, maybe we'll just get you to kind of fill in some of those blanks. And if you and I just met and I said, "What kind of investor are you?" what kind of investor is Broyhill Asset Management?
Chris Pavese: Yeah, well, first of all, appreciate the feedback that probably came through on the site. It probably doesn't look like most investment manager websites. I think we've got – most of the investment team at the firm has a unique blend of backgrounds across the arts and sciences, including my own, which is why we kind of tried to make that shine through, really, on the site. So I could start with –
Dan Ferris: Wait, are you the architect in the group [crosstalk]?
Chris Pavese: I am, or at least I wanted to be at one point in time. I initially went into school as an architecture major and came out with a finance degree, but that's driving a lot of the design you see on the site. Why don't I start – so, I'll start with the family office itself, which predates my involvement. So, Broyhill family office was founded in 1980 after the sale of Broyhill furniture industries. So, the office has been around for about a half a century, at this point.
I joined in '05, which I guess makes it nearly 20 years that I've worked for one family. Which is kind of hard to believe, initially, as a PM on one of the family's internal equity strategies, then as the family's chief investment officer, and now as the president and chief investment officer of Broyhill Asset Management, or "BAM." So BAM spun out of the family office in just the past couple of years, independent entity today, we still manage money for the family, in addition to other families, foundations, institutional investors, high net worth investors.
I think of ourselves – and we've always thought of ourselves – as a value-driven investment critique, so per your opening comments. I think what differentiates Broyhill is our almost obsession and focus on capital preservation. The way I put it, I'm basically paid to worry so that our investors don't have to. The core of what we do has been the same for as long as I've been here. We've run a concentrated portfolio of global equities, and we do that with, or we try to do that, most of the time, with a rational objective and long-term perspective.
And I would just say, in a nutshell, at the end of the day, we're just looking for mispriced securities. And we go wherever we see them or wherever we think we're going to find them.
Dan Ferris: How concentrated are we talking?
Chris Pavese: We generally run with 10 to 20 names. I think, over the years, I've figured that out, using a scientific process called the "sleep-at-night factor." If I get close to 10 names, I start losing sleep, because I feel like we're a little bit overconcentrated and one wrong move can cost a lot. Once we start pushing up against 20 names, I start losing sleep again, because I feel like we're not as close to each of our investments as I should be. And so, we're typically – we're probably around 16 today, so we're kind of right in the sweet spot.
Dan Ferris: How many people are at Broyhill now?
Chris Pavese: So, the investment team is myself, and we've got three other analysts on the investment team, and then we've got our chief of staff, we've got one gentleman that runs operations, and then we are currently in the process or at least considering adding one more analyst to the team. And I think that's probably about it, Dan. You know me. I think I'm a better manager of money than I am of people. And so, we want to keep this small, we want to keep having fun. I think culture is tremendously important to us, and so, just making sure we're working with the right people, both in terms of colleagues at the firm and investors, that's first and foremost.
Dan Ferris: How about firm size, is that something you discuss in public or no?
Chris Pavese: Yeah, we're somewhere, let's say, between 250 million to 300 million today.
Dan Ferris: That's a nice business. That's nice. And at this point, are you still mostly working for the family, or is the balance of the assets more with other clients?
Chris Pavese: Yeah, I was fortunate. We began managing some external capital even while I was still inside of the family office. And so, when we spun out the investment arm, it's not like we started day one with one large investor. When we spun out, the asset base was probably 50-50 in terms of Broyhill family capital and external capital. Today, we're probably closer to two-thirds, one-third, so, again, there's that sleep-at-night factor in terms of having a little bit more diversification in the client base as well, which I think is a good thing.
Dan Ferris: So, one of the things that fascinates me with money management firms, especially value investors who have been value investors for a long time, I guess the basic question is how do you keep your clients? And I'll tell you, specifically, I'm asking this question because I came across an old interview that Jason Zweig did with Peter Bernstein, and he emphasized –
Chris Pavese: Wow, that was old.
Dan Ferris: Yeah, it was '04 or something, I think. And Bernstein died in '09, at the age of 90. And anyway, it reminded me of you, and I came across this in the past, I don't know, three, four days. Well, to be honest, I came across it in the past three or four months, and the tab has been open on my computer all the time. [Laughter]
Chris Pavese: [Crosstalk]
Dan Ferris: Yeah. So, I finally read it two days ago or whatever, and I was, like, "Oh, this reminds me of you guys," because I knew we were going be talking to you. Because the emphasis, he said, maximizing returns is OK if you know that the drawdowns aren't going to kill you. And I don't know, I just thought that sort of reminded me of you. But it also reminded me, as I thought of you, that it gets hard, sometimes for some people, to keep clients when the returns aren't roaring along with the Mag Seven or in early 2021 when the Ark fund was peaking and all that, people kind of said, "Hey, why aren't we participating in this?" So, I think it's kind of a good question to say how do you hang on to clients?
Chris Pavese: Yeah, it's a fair question, a lot to unpack there. Let me first say, before I forget, thank you. I think Peter probably wrote one of the best books on risk management in the industry. I think that was back in the early 2000s. And Jason, I think, is one of the best writers, and probably one of the most independent thinkers in the financial journalism industry. So, yeah, fortunate to have gotten to know him over the years as well.
I would say the short answer is what I just mentioned previously, and it goes back to making sure we are really working with the right investors. We've turned away investors that we didn't think were a good fit or saw a mismatch philosophically that were really large accounts. And so, we'd rather work with a smaller investor, knowing that they're sleeping well at night because they trust us and have known us over the years. But it has been probably one of the longest stretches of value underperformance in history we're coming up on.
There's been a little bit back and forth in recent years, but more or less since the financial crisis, if you've done anything outside of U.S. tech, you've diminished returns. So whether you invested abroad or whether you invested in value or basically any other sector of the market. I was reading something by Morningstar, recently, and I'll have to go back, Dan, I don't remember the stats off the head. But they had stats around the amount of assets and the number of funds and the value and growth categories, over the last decades.
And you saw the same thing in the late '90s, right? Like, there's that famous letter from Julian Robertson literally almost to the day of the peak in '99 to 2000, when Tiger folded, just basically saying, like, you just had record numbers of value managers just throwing in the towel, closing up shop, either because they were completely frustrated or because their clients were completely frustrated. So I would say two things. One, we've been extremely fortunate to have just a wonderful investor base.
We've never really had a business development effort here, and so most of the investors that we work with have come to us. Because they've been, in most cases – have seen our work, following our work, reading our work, for years and years and years. And then at some point, something changes in their environment or their world or their situation where they're ready to call and learn more. And we pick up the phone and it's like we've known them already for five years, or they feel like they've known us already for five, 10 years.
So it's a really easy – you can see when that's a good fit. And those clients, typically, I use the example, in March '20, I think the only time my phone rang was, there were two or three of our larger investors that I knew had a good bit of cash on the sidelines, and they were calling to ask if it was time to send in more money. So, it's few and far between where we get calls from investors worried about what we're doing, worried about what's happening in the markets. It does happen, right, but I think the client base is one of the most underappreciated competitive advantages an investor can have in the industry.
And then, two, we've been fortunate – I wouldn't say – so, well, let me say this, we don't benchmark against the S&P, because we run a global portfolio. That being said, we've generally kept pace with the S&P, over the last decade or so, even with a value tilt, even with not owning the Mag Seven, even with having half the portfolio outside of the U.S. where anything outside of the U.S. has underperformed. So we're well ahead of global equity benchmarks and any value benchmark.
Because I think there's a big difference between types of value investors, right? You've got value investors that are just buying crappy commodity companies that you're depending upon catching the cycle, right? Because over time, almost every company in the commodity sector has destroyed capital. You've got value investors that are just buying low [price-to-earnings (P/E)] stocks like banks or other cyclical businesses. And like I said at the outset, we're just looking for mispriced securities, so we're not focused on any particular sector.
A lot of times, we're looking for situations that aren't dependent upon the market going up or value outperforming growth, we're looking for specific catalysts. So we have been fortunate to hold up, I think, better than most value managers, over the last decade or so. What I like to say is we've kept up with, arguably, the strongest headwinds to value investors in history, for the last decade. I'm looking forward to seeing what we can do when and if those headwinds actually ever turn into tailwinds again.
Dan Ferris: All right, so I want to focus on the words "mispriced securities," because that's not just mispriced stocks, right? What other –[crosstalk]
Chris Pavese: Our focus is predominantly equities. Historically, we've managed money. The only other example I would throw out there, historically, we've managed money for family offices, right, high-net-worth families, for the most part, taxable investors in high tax brackets. So there have been times, over the last, well, in the 20 years that I've been at Broyhill, where we've seen really interesting opportunities in the closed-end fund markets. Where closed-end funds, so, I don't know if we want to get into the definition there for your readers, Dan, but they trade like stocks.
So when you buy an open-ended mutual fund like a Vanguard fund, let's say you put $1,000 into that fund, that transaction happens at the end of the day after the market close. So Vanguard knows the value of the fund, and they issue shares based on the exact value of the fund at market close and the price of all of those underlying securities. And in theory, funds can take in money, and they can lose money over time. You mentioned Ark, earlier. Ark surged in 2021.
I think in 2020 and '21, in one of those years alone, they took in over $10 billion. So, mutual funds can grow and raise assets, and they can shrink and lose assets, open-ended funds. Closed-end funds launch with a defined pool of capital, and they trade like a stock, but it's actually, you could have an S&P 500 closed-end fund. And the difference being it's not issuing shares like an open-end fund does when investors want to buy the fund. Investors can just say, "OK, I see this closed-end fund trading for $10 today. I want to buy some."
And if you've got a lot of investors that are trying to buy it at the same time, that may push up the price of the fund from 10 to 11, even though the value of the securities in the fund may not have changed. And so you can get this discrepancy between the price of the fund and the value of the securities that the fund actually holds. And because that market is geared toward retail investors, you see major swings in sentiment. And so, there have been times, over the last, and COVID was the most recent – during COVID, in March 2020, we were buying closed-end municipal bond funds that were literally trading at 20% to 25% discounts to their net asset value.
And so, the underlying bonds that the funds held were worth 25% more than what we were buying them for at that price of the fund. And then when things settle down, that discount just closes and you're able to earn not only the income that the bonds are throwing off, but that spread as it closes. But for the most part today, we are almost exclusively focused on public equity markets.
Dan Ferris: OK. I have to let the reader in behind the curtain here, because I can't resist. The moment is too perfect [crosstalk].
Chris Pavese: [Laughs] Uh-oh.
Dan Ferris: Well, you and I are talking maybe a couple hours before the Fed is going to tell us how much they're going to cut interest rates, which they will have done by the time our listener is hearing the sound of our voices. What I want to know is do you care at all? Before we talk more about equities, I want to talk more about that, and maybe some specific names if you got them, lately, but I want to get this macro thing out of the way.
Corey McLaughlin: Yeah, do you care [crosstalk], which I will be writing about momentarily, here, for our daily newsletter, yeah.
Dan Ferris: Yeah, there you go.
Chris Pavese: Much as I would like to tell you guys that we've got a crystal ball pointing to 25 or 50 basis points today, it seems like a coin toss to us. And I would even say, I think Buffett made this quote a while ago, and this is exactly how I feel today. Even if I knew the answer to that, I don't know that I'd be – I think the market's reaction is a coin toss. I was just back-and-forth with the team this morning, and I think the consensus is if they go 25, the market's going to be worried that's not enough and they're too far behind the curve and you get a big sell-off.
If they go 50, markets are going to cheer that, thinking it's coast is clear, we're back to go, go Fed, printing money, and markets rip. What's interesting, though, is, if you look back at the last several decades of cutting cycles, historically, when the Fed starts with 50, it has not been a good sign. The Fed started with 50 in '99 to 2000, and they started with 50 in '07 to '08 and they started with 50 in 2020. And I think the message there is what do they know that we don't?
Are things a lot worse than we're currently seeing on the surface in terms of the economy? So, who knows. And the other thing, the point is, historically, the beginning of a rate-cut cycle is totally intuitive. But if a rate cut is followed by a recession, markets are lower following the rate cut. If the rate cut is not followed by a recession, markets are higher. So, I guess bottom line, recessions are bad for markets, if that's breaking news for your audience here today. [Laughter]
But we don't necessarily pay a whole lot of attention of what the Fed is going to do. I think the bigger piece, at least in the short-term, is kind of what it means for sentiment. We gave a presentation recently that talked to that in terms of the record crowding in the markets, the record hurting, record concentration at the top of the market. So, I would say yes about macro, my favorite line is we worry top-down, but we invest bottom-up, right?
So, we're looking at individual securities and we're looking for mispriced assets, as we talked about, but you can't ignore what's going on in the rest of the world. That being said, I don't think you can let that wag the tail of the dog, either.
Dan Ferris: So, the presentation you just referred to, is that the one called Equal Opportunities on your website?
Chris Pavese: That is. Have you seen that already? I didn't realize it went out, yet. Yeah.
Dan Ferris: [Crosstalk] Yeah, yeah, I liked it.
Corey McLaughlin: Now, you mentioned mispriced securities. You also mentioned capital preservation, early on. What does that mean to you and what would kind of keep you up at night, at this point? Macro things, maybe not, or maybe, I don't know. What's on your mind, there?
Dan Ferris: I want to pile onto that question, too. I'm going to pile onto that question and say, Chris, [inaudible] how the hell are equities good for capital preservation? [Laughs]
Chris Pavese: Fair enough. So, I think the first answer – let me take that in reverse order. And this goes back to the presentation you just mentioned, Dan, so you've seen these numbers. But the way we think about it, we looked at the last 65 years where the S&P 500 has outperformed to this extent that we saw. And so, the first time we gave this presentation was back in June/July, and June was, I think, the blow-off top for momentum stocks.
And so, we went back and looked at markets, then, over the last 65 years, and basically saw that, well, one, there's been a few times in history where markets have been this concentrated. 1929, 1999, today, and then you had brief spikes in mid-'60s and mid-'70s where markets were extremely concentrated. Every one of those corresponded with important inflection points. The other thing was, in every one of those instances, you saw massive bifurcation in the markets, where the top of the market looked really expensive, but everything else was generally reasonably priced or even cheap.
And there were absolutely pockets of value. So go back to – we've been using this analogy for a while now, but if you go back to '99, 2000, when the market topped, S&P went on to lose roughly half of its value. Nasdaq lost a whole lot, a lot more than that. But the average stock in the market, or the median stock, was actually up 25%, over the following two years, from the market peak. Because as we're seeing today, the average stock nobody was interested in, right?
Back then, it was a different set of securities, in the '70s, it was a different set of securities. Today, it's – actually, a handful of the same securities from the '90s. But everybody's obsessed with what's going on with the FAANGs or the Mag Seven or whatever acronym we've made up as the composition of that basket changes. And people are just completely ignoring the other 493 stocks in the S&P 500, which I think are very attractively priced. Or at least, I wouldn't say overall, but where I would say we are finding things attractively priced.
And then even more so, looking at things outside of the S&P 500, right? The U.S. has outperformed the rest of the world because it's a very tech-heavy index and U.S. tech has been driving the U.S. markets higher. International markets, a lot of international markets are very cheap. And we're finding a lot of securities where comparable businesses in the U.S. trade at 2 times the valuation of very similar businesses selling the same products in the same markets that are just based outside of the U.S.
I forgot the first part of that question, Corey. I think it was basically what we worry about?
Corey McLaughlin: Yeah, like capital preservation, what that means to you. And if something were to keep you up at night in that area, what are those things?
Chris Pavese: Yeah, I mean, generally, what keeps me up at night are individual names in the portfolio. Because by definition, as value investors, we're buying things, we're often buying things with a lot of hair on them. Which means we're often buying on the way down, which means we're often wrong before we're right. And so, we're scaling into positions as stocks, assuming stocks get cheaper after our initial purchase. Which means you look wrong for a while.
And so, we're constantly doubling back on "Are we wrong and did something really change, or is this consistent with what we were thinking?" So, I would say more often than not, it's an individual name in the book that's keeping me up. Today, I think just the geopolitical environment. I think just what you're seeing, whether it's Russia, Ukraine, whether what we're seeing in the Middle East today, whether it's China-Iran, China-Taiwan, and I'll resist the urge to get into the U.S. election cycle and we'll just leave that alone, hopefully, today.
But that's the scariest thing to me. I don't remember another time in my career where the world seemed like it was in such a precarious position where – and people forget, right? Sometimes it's just, you don't know what little stone that gets tossed in the pond, what ripple from that stone is going to cause the dominoes to start falling. It's often something minor or a mistake or an oversight or a policy blunder or just, that escalates quickly and then makes it hard for leadership to walk away or talk down.
And things just, things can spiral out of control really quickly. And I'm not sure we've got the leadership in a lot of the largest economies today, let alone this country, where they've got the discipline or even care to think about this stuff. As opposed to just worrying about ESG-related issues in our individual economies.
Corey McLaughlin: Yeah, I'm with you there, the leadership seems lacking everywhere or – [crosstalk]
Dan Ferris: Well, I'll go further. It's almost like some leaders in some economies, and we don't need to name names or, I agree, get into the election cycle or anything, but it's almost like some political leaders sit down and say, "We got a good thing going here. How can we really screw it up the worst? What can we do? What do people want to hear that would be the absolute worst idea that has never worked in history and proven time and time –" You know what I'm saying?
It's just, I feel like, at this point – and, OK, I'm going to break the rule I just made. For example, when Kamala Harris talks about wanting to fight price gouging, so that's price controls. And speaking of books I read recently, I forget the full title, but I think it's Forty Centuries of Wage and Price Controls: How Not to Fight Inflation was a book I read recently. And 40 centuries? That's a pretty good sample. And it never worked once.
So, the fact that bad ideas can just live on and on and on, it's like professors who have tenure and the bad ideas don't get them fired. And they just come back. I have to laugh at it because, I don't want to cry, but I agree with all of this. And yet, Chris, and yet, people like me complain about this stuff endlessly and wring our hands about the market endlessly. But I was born in 1961, and I started working, actually, when I was, like, 10 years old.
But if I had just put everything I could into the stock market, as soon as I started earning money, we might not be talking, because I'd be on a yacht somewhere. You know what I'm saying? So –
Chris Pavese: Yeah. I think, it's funny, Dan. I tell people I started the conversation by saying people pay us to worry for them. And unfortunately, that's just how I've been programmed naturally. I think a lot of it is just upbringing and the time of your upbringing and what people have gone through, and so, I am a natural worrier. That being said, we were talking to a prospective investor, at some point in the last year, and he asked me the question, "Given everything you're talking about, should I just wait?"
To your point, if you're worried about capital preservation, why don't I just wait for markets to come back and then invest at much cheaper levels. And I would say a couple of things. One, I don't think that's the right answer. I don't think the right answer today is to avoid stocks. I think the right answer is to avoid Vanguard 500 mutual funds. or managers that basically just hide behind the S&P 500. It's to avoid passive indices, because there is value out there.
And then the other thing I said to him was, listen, per earlier conversation on being paid to worry, there's probably been – I can probably count on one, maybe two, hands how many times since I've been at Broyhill where, in speaking to a prospective investor, if I were asked that question, I would've said, "You need to give it all to us right now. I've never been more bullish. I think markets are priced to compound at 20% annually for the next five years."
I can probably count on one hand how many times I've said, "Give it all to us. We're going to put it all to work." And to your point, over those 20 years, you've done all right investing in S&P 500. So bottom line, listen, I'm paid to worry. I think I'm a better stock picker, we're better stock pickers than we are market timers. And so, even though we're worried, and Dan, I know you followed us and read our work and there's definitely, you can see that worry come through in our writing, quarter after quarter after quarter, year after year.
But that doesn't mean we're not taking risk and trying to earn solid risk-adjusted returns. It just means we're being very careful and making sure that we're being compensated for the risks we're taking. So I don't think it's – and that goes back to the earlier question on how does investing in stocks and capital preservation, how do those two comments jive? And I think that's really it.
Dan Ferris: Yeah. Some of what you said reminded me when you said the answer is not to sort of wait and stay in cash, reminded me of a book by Peter Cundill, famous value guy, called – I think the title was There's Always Something to Do, right? Something somewhere in the world is cheap and your job is to find it. Cheap and decent, not just a cheap piece of garbage, right? Because they're everywhere.
Chris Pavese: Yeah. No, I love that. We talk about all the macro worries a lot. But then you remember, or you try to remind people, like, "Yes, but what else are you going to do? [Laughs] What's the other game in town?" I don't know, I haven't found a better one.
Dan Ferris: Right. I want to emphasize, though, this point. I want to make this point about capital preservation, for our listener, really as explicit as possible. It sounded to me like the answer was basically margin of safety, right? Because the securities you're looking for are mispriced and there is a margin of safety there, you can look at equities and say, "Yeah, this is suitable for long-term, admittedly, long-term capital preservation, because our business is to know the value of things and to buy it when we can get it below that value." And a really great illustration being the closed-end funds you mentioned.
Chris Pavese: Yeah, so, that's absolutely one component of it. And I would say that's really the first pillar of our investment philosophy is make sure we're buying with a margin of safety, because valuation is an imprecise science. And so, like any valuation we put out there, we're probably going to be wrong. So we want to make sure we're buying so far below that number that we've got room to be wrong.
The other thing that I think is just, the industry does a great job of completely bastardizing – is trying to quantify risk. I think risk management, to us, is just common sense.
Dan Ferris: Yeah, couldn't agree more.
Chris Pavese: So today, and it was the same thing in 2021, we were really worried about what we were seeing in the markets, signs of excess speculation ever, signs of excess leverage in the system. And especially today when I go back to the earlier comments of the bifurcation between the haves and have-nots in the market, we started, about 12 months ago, we had a good bit of turnover in the portfolio. And we wound up, after making a handful of trades, and this was bottom-up, but we took defensive sectors of the market up to almost two thirds of the portfolio.
That's relative to global equity benchmarks or the S&P 500. That's probably, I don't know, it's probably 3, 4 times the weighting of the indexes. And what's interesting there is, typically, that's what you want to own when you're worried about risk to the economy, you want to own stuff that is less cyclical. In theory, you should be paying up for that stuff right now, but because nobody cares about it and everybody's just more fascinated by chasing Nvidia and the Mag Seven, defensive sectors of the market were about as oversold as they had ever been historically.
And about as undervalued as they had ever been historically. They've rallied a bit this year. What's interesting is consumer, I think, utilities are actually outperforming tech this year, believe it or not. And so, it's common sense, it's buying with a margin of safety, and it's also thinking about – it's being creative with regards to portfolio construction. So, one of the other ways we differentiate ourselves from, I think, other value investors in the market is we look for more special situation, event-driven type of situations.
Today, for example, there's a number of, well, really, for the last few years, with this administration's kind of antitrust policy, a lot of ARBs aren't comfortable stepping in front of that political risk, Which means the spreads for announced merger acquisitions, some of them are about as wide as we've ever seen. Generally, like, merger ARB you think of as almost like a cash/fixed-income-type expected return, with a good bit more volatility if you get some wrong. We're seeing spreads that are just, I mean, that are basically discounting like 20% to 40% odds of deals getting done, when historically, 90% of announced deals have closed.
And those are nice, especially in times like this, where if the market did fall, if you've got a portion of the book that's invested in situations where the only thing that matters is the ruling, it doesn't matter if the markets are up or down, we think that makes a whole lot of sense in terms of thinking about how to preserve capital in the market.
Dan Ferris: Yeah, I used to think more about merger ARB than I do, but we recommended, in our newsletter, Kellanova, and we said it was worth whatever, almost exactly what they're paying for it, basically, like, $83.50, I think it is. It was, like, $80.
Chris Pavese: Good call.
Dan Ferris: Yeah, it's, like, $80.
Corey McLaughlin: Yeah, Dan, when I saw that, by the way, I said, "Were they reading Extreme Value when they made this deal?" [Laughter]
Dan Ferris: Yeah, that's right. The buyers were reading Extreme Value. They were, like, "Dan's right."
Corey McLaughlin: Yeah, you were spot on there.
Dan Ferris: Of course, that was really, that's a Mike Barrett pick, and he runs our valuation model. And he's that guy, he's forgotten more about valuation than I will ever know. Finding him more than 10 years ago now, it was gold. It was amazing. But, yeah, so I noticed that, too, just in that one example. So you have some of those in the portfolio.
Chris Pavese: We do. Not as much as I would like. In '21, '22, that was probably the biggest component of the portfolio. We had over 20% of the portfolio invested in one situation where we felt extremely confident. And for what it's worth, we only go that big – so the way we come at merger ARB is, we first try to underwrite the security via our typical process. And we're typically looking to buy three- to five-year doubles, right?
So round numbers, if you pencil that out, we're looking for 15% to 25% IRRs. If we can underwrite a business where we still think it's a three- to five-year double if the deal falls through, and if the deal goes through, we make 20%-plus in six to 12 months, we should be, right, those types of situations don't come along often. I think I can think of two or three in my career. And when we see that, we will go really heavy, because it's hard to see.
Like, if the deal closes, we make money in the short term. If it breaks, it's a business we think is worth 2 times anyway in three to five years, so we're comfortable holding through a break. And that's different than most merger ARB investors where, as soon as the deal is off, right, investors are going to puke up the stock, and that's where you see selling pressure.
Dan Ferris: Do you have an example of one of those two or three that you mentioned that you could – [crosstalk]
Chris Pavese: Yeah, so, the most recent was Microsoft's acquisition of Activision, which Microsoft was buying Activision for $95 per share in cash. There was roughly a $3 in breakup fee. So it was almost that we would've gotten – and there was a point in time, within the last six, 12 months, that that deal was on the table where you could've bought the shares for 75 bucks. The market was basically, you had the FTC trying to block it, and then you had the U.K. CMA trying to block it.
We had been looking at the industry for probably the last three to five years, had not gotten involved until that point. Microsoft bid for Activision, because the company had some corporate governance issues, and the stock was probably halved or more when Microsoft stepped in. So we were sniffing around at that time, and then we just stepped in and said, "If the deal closes, we'll take 95 bucks. If it doesn't, we think it's $150 stock in three, five years." And then, coincidentally, the only other time we had been that big was an almost identical situation.
So, the issue with Microsoft-Activision was you had distribution buying content, so it was vertical integration. Historically, at least in the U.S., I don't think we've ever successfully blocked a vertical merger. The larger issues are horizontal, where you've got competitors buying another competitor where you're eliminating competition. Vertical, right, Microsoft owned Xbox and they were buying Activision which makes some of the games for Xbox.
A very similar situation about 10 years, maybe not 10 years prior, was AT&T's purchase of Time Warner, which I think, and this is from memory, maybe the deal price was $105 or something along those lines. It was the same thing, AT&T is a distributor of cable channels, they were buying content, and this was – actually, it was right around a decade ago, because this was right at the beginning of Trump's first administration in '16. And he was blasting CNN, which Time Warner owns, and he was very vocal about wanting to block the deal.
And in both cases, the law just didn't support it. And we were able to underwrite the businesses where we thought we had a lot more value even if the deal closed. So, I wish we can find one of those today. We've got a handful of much smaller situations where we don't have quite the conviction, but I still think the risk-reward's tilted in our favor.
Dan Ferris: That was my next question, just wanted to make sure you didn't have one of those today. So you mentioned, and I was going to get to this, we have to get to some version of it, you mentioned just doing your normal process in underwriting a security. And I thought maybe the first thing our listener needs to know is, "Why is this guy using an insurance word to talk about analyzing a stock? Underwriting. What's he talking about? Who is this guy? Who is this Pavese? What is this?"
Chris Pavese: [Laughs] Underwriting a name is just the research we do to understand the business, understand the competitive dynamics of the industry, understand the macro backdrop, understand the peers that they're competing with. And then ultimately, try to pencil in what we think the business is worth. So, our process, we typically pick something up, because we're a small team, and the first look is geared to trying to reject it as quickly as possible. And so it's either pass or do we want to spend more time on this, is it worth spending more time on?
And if it's worth spending more time on, what are the three biggest items that we need to focus on. And so, if we decide to continue, we may spend a week, a couple weeks, a couple months, or longer, researching the industry, researching the company. And ultimately where we want to get to is, when I say we're underwriting to a three- to five-year double, we're looking at probability weighted returns for every position in the portfolio. So we're not just saying, best-case scenario, what do we think this thing is worth.
We're saying, OK, if this happened, if it plays out like this, we think the business will be worth this much. If we're off base and actually it unfolds more like this, we think the business is worth this much. And we'll have an upside case and a downside case, at a minimum, for every name in the book. Sometimes we've got a lot more scenarios than that. And then we probability-weight every one of them. So that's absolutely more art than science, but we're saying – and we've got data that shows, historically, we've been right about 60% of the time.
And so, our base rate, our starting point for underwriting businesses is 60%, to the upside, 40% to the downside, and then we just constantly tweak those numbers. So with every new piece of information we get, we're looking at did that change what we think in terms of what the business is ultimately worth? Or did that change what we think about the likelihood that this is going to happen or that's going to happen.
And so, we're constantly tweaking those numbers throughout the day, throughout the quarter, as new information comes in. And we're ranking names on probability-weighted expected return and sizing them accordingly.
Dan Ferris: I have a question about getting the new information and changing an intrinsic-value estimate. I'm not even sure how to ask the question, but I've thought for some, as a value investor, you learn that the market price changes a lot more a lot faster than the value. And it makes me wonder, as I hear you talk about this, I wonder, if I were sitting over your shoulder for years and years, how many times did a quarterly report really change things for you so much? What's the likelihood of any given quarterly having a real big change?
Chris Pavese: Yeah, so, good question. We're rarely forecasting quarter to quarter. We're generally, as I said, looking out three to five years. And so, what we're doing is thinking about, OK, in a normalized operating environment, what do we think this business should earn. And what do we think that those earnings are worth? So, it's interesting, I'll give you another piece of data. So, the folks, the software we use for this process, they've got 15 years of data across dozens of managers and probably millions of trades.
And they looked at the data they had on file, historically, to see if they can find any particular variables that were predictive of which managers would perform best. So what variables, if any, were predictive of outperformance or alpha generation. The only thing they found, the single factor, was the frequency of manager updates. And when you think about that, it doesn't make sense intuitively, but if you go back, I'm guessing you've probably read, if you dust it off, Dan, Tetlock's Superforecasting?
Dan Ferris: Oh, yeah.
Chris Pavese: So, that was entirely consistent with what they found, in that the best forecasters tweaked their assumptions at the margin with incremental data pieces. So, we're not talking about, we thought this thing was going to grow 10% annually, and the most recent quarter comes in at 2%, so we take our numbers down to 2%. But if we were expecting 10% and it came in at 2%, right, we're going to say, "Hmm, did something change there or is it just quarter-to-quarter noise?"
Or even, something as similar, I'll give an example. Philip Morris has been our largest position for some time, the stock's done very well this year on the heels and the excitement for Zyn nicotine pouches in the U.S. At the beginning of this year, they started talking about shortages. That makes it pretty obvious that we could start nudging our upside scenarios, and the likelihood that they're going to sell more Zyn than we had thought, like, they're basically selling everything they can make. And guidance comes up every single quarter.
And so, anytime we see a data point like that, we're either tweaking our assumptions for volume growth over time, we're thinking about how market share might shift. But also, if our upside scenario priced in faster growth in the U.S. markets, we may start putting a little bit more weight on that. And then, as those probabilities shift, your expected values shift for every name as well.
Dan Ferris: Oh, that's a good answer. Thank you for that. So it's actually, we've been talking, like, the time has flown by, I have to say, which is great. [Crosstalk] talk with you.
Corey McLaughlin: Yeah, I feel more educated right now.
Dan Ferris: We've come to the moment when I asked the final question, which is the same for every guest no matter what the topic, even if it's a nonfinancial topic. And if you've already said the answer, by all means, please feel free to repeat it. The final question is, if you could just leave our listeners with a single thought today, what would you like that to be?
Chris Pavese: Yeah, that's easy. And only because we just did our investor call, and we finished that call encouraging investors to just remember one thing. And I think it's just along the lines of what we discussed earlier in terms of, if you're worried about markets today, I don't think the answer is to avoid stocks altogether. I think the answer is to avoid passive indices. And really, the best way to manage risk and the crowded momentum-driven benchmarks, and let me clarify, momentum-driven U.S. benchmarks, is to simply rebalance away from what's working towards what's not.
So, rebalance towards what's expensive and towards what's cheaper. Because what's cheaper, like I said, the bottom of the market is about as cheap as it's been historically. And that's typically been a very good signal for active value managers on a one-, three-, and five-year basis looking forward.
Dan Ferris: Hey, listen, Chris, it's always a pleasure to talk with you, and it was a great pleasure this time, as well. Let's do it again sooner than every few years. [Laughter]
Chris Pavese: Happy to, Dan. Thanks for having us.
Dan Ferris: You bet.
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Of course, I enjoy talking with Chris, because I've known him for years and he's a value investor. So, I guess the fact that I enjoyed it is no big surprise. But I would guess you probably did, too.
Corey McLaughlin: I enjoyed it, too, yeah.
Dan Ferris: Yeah, there you go.
Corey McLaughlin: For sure. You get a sense of – first of all, it sounds like he's got like a great firm set up there and situation and is very comfortable with what they're doing. And if you have clients that in March of 2020 are calling you and asking you, the only question they're asking is if they should put in more money, I think you got a good setup. So, yeah, I'm jealous of that. And, yeah, it was fun hearing all of his thoughts on just how they go about investing for the long-term. And I can see why probably have been doing better than most value investors, the last decade or so.
Dan Ferris: Yeah. Good guy, really smart, good investor. Obviously, you don't get a few hundred million bucks under management doing a value strategy without being pretty good at it [laughs] and hang on to it. Maybe we should invite him back and just do a whole show on their process. He's really good at kind of breaking things down and kind of telling us exactly why they do what they do. And I find it a good mix of the overall ideas, we worry top-down and invest bottom-up, that kind of thing.
And then, the very specifics of things like merger ARB, I thought he did a great little discussion of that for us. He's a perfect podcast guest, I guess, if you want to talk about value investing, right?
Corey McLaughlin: Oh, yeah, [crosstalk] very good perspective on the whole thing, on top-down, bottom-up, just like you said. So, yeah, it was fun.
Dan Ferris: Yeah, great fun. All right, well, that's another interview and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as we really did. We do provide a transcript for every episode. Just go to www.investorhour.com, click on the episode you want, scroll all the way down, click on the word "Transcript" and enjoy. If you liked this episode and know anybody else who might like it, tell them to check it out on their podcast app or at investorhour.com, please. And also, do me a favor, subscribe to the show on iTunes, Google Play, or wherever you listen to podcasts. And while you're there, help us grow with a rate and a review.
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For my co-host, Corey McLaughlin, till next week, I'm Dan Ferris. Thanks for listening.
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