A little-known family investment office made big news this week…
Archegos Capital Management’s risky leveraged bets on ViacomCBS Inc. and Discovery Inc. set off a wave of forced liquidations at a number of Wall Street Banks.
Estimates show Bill Hwang, the man behind Archegos, levered his positions as much as 5X and so far has triggered the liquidations of positions approaching $30 billion in value.
Dan takes a deep look at this story of greed and hubris before leaving listeners with one crystal clear takeaway.
Then Dan invites Tucker Walsh onto the show for a conversation about one of the hottest sectors of the market over the past year – small cap growth stocks.
Tucker is head of the Small Company Growth Team and lead Portfolio Manager at Polen Capital’s U.S. Small Company Growth strategy. Prior to joining Polen Capital Tucker spent 10 years as CEO at Copper Rock Capital Partners and 9 years as Managing Director and Head of Small Cap Growth Team at State Street Research.
Tucker and his team look to invest in fast-growing, disruptive businesses that use technology to compete in the digital age.
But he stresses that profitability is important, and discipline is critical when you’re investing in this space. Thoroughly researching and investigating each company and objectively looking at both best and worst case scenarios without getting attached is key.
During their conversation, Tucker shares the name of a few stocks he thinks could have massive potential in the coming years and are great buys right now.
Then on the mailbag, listener Peter W. writes in explaining why he was not happy with Dan’s interview last week… He argues Dan and Per left out some pretty important details during the conversation about regulations.
Dan listens to Peter’s side and gives his rebuttal to this question and many more on this week’s episode.
Head of the Small Company Growth Team and lead portfolio manager at Polen Capital
Mr. Walsh joined Polen Capital in 2017. He is Head of the Small Company Growth Team and lead portfolio manager of the firm's U.S. Small Company Growth strategy. Prior to joining Polen Capital, Mr. Walsh spent ten years as CEO and Head of Portfolio Management at Copper Rock Capital Partners and nine years as Managing Director and Head of Small Cap Growth Team at State Street Research. He also spent seven years working in research for Cowen & Co., Merrill Lynch & Co., Cowen Asset Management and Chilton Investment Company. Mr. Walsh received a B.A. in Economics from Washington and Lee University.
2:30 – Archegos Capital Management gives us yet another example of greed and stupidity during this stage of the bull market… “They were levered up, some estimates as high as 5 times…”
6:27 – “What is it with rich people using leverage?!? I mean, if you’ve got $10 billion, what the hell do you need to lever up 5X for?”
9:40 – “This is a typical sign of the top, we’re getting near the end of the cycle, people are starting to blow up…”
14:53 – This week, Dan invites Tucker Walsh onto the show to talk about small cap growth stocks. Tucker joined Polen Capital in 2017 and is head of the Small Company Growth Team and lead Portfolio Manager of the firm’s small company growth strategy. Prior to joining Polen Capital Tucker spent 10 years as CEO at Copper Rock Capital Partners and 9 years as Managing Director and Head of Small Cap Growth Team at State Street Research.
19:12 – Dan gets Tucker’s take on a hot topic that comes up with small caps, “How important is profitability to you?”
23:25 – Dan asks Tucker about which small caps he likes, and Tucker shares the name of one of his favorites… a small company with fierce brand loyalty that was only made stronger during the pandemic.
30:06 – “…that actually creates that brand value, but it doesn’t have to be for everyone to be a great investment.”
33:08 – How small is too small for Tucker? “We only own about roughly 30 holdings, so we’re very picky, it’s very high hurdle to get in… and companies with market capitalizations with $4-$500 million generally do not have those characteristics.”
40:57 – Tucker shares how a team-based approach helps him when investigating companies. He assigns two people specifically to make a counter-case against any given company they’re looking at.
46:01 – “…One great example of that is Etsy, which we really didn’t have an opportunity to buy in our small cap product, until the sell-off in the pandemic.”
51:50 – Dan asks, “Is there anything you that find really attractive right now, that you recently initiated, that you think is still really quite buyable today?”
54:28 – As their time winds down, Tucker leaves the listeners with one final thought, “Time is your friend… So time in the market is key, not timing the market.”
57:01 – On the mailbag this week, one listener writes in with a follow-up question about the benefits of DRIP investing. And another listener asks Dan’s his thoughts on if the U.S. government would ever actually attempt to confiscate gold and what that could look like… Then finally, Peter W. explains why he was not happy with Dan’s interview last week… Dan listens to his side and gives his rebuttal to this question and many more on this week’s episode.
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Here's your host, Dan Ferris.
Dan Ferris: Hello, and welcome to the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value published by Stansberry Research.
Today we'll talk with Tucker Walsh. He's a portfolio manager at Polen Capital and we'll talk about his specialty, small-cap growth stocks, something everybody loves to talk about lately.
This week in the mailbag listener Peter W. was not happy with our interview last week. Plus, questions about gold and DRIPs. In my opening rant, I'll talk about the same thing many people are talking about this week the fiasco at Archegos Capital Management. That and more, right now, on the Stansberry Investor Hour.
So here's the story, this guy, Bill Hwang, is a former employee of Julian Robertson, the famous hedge fund guy who had a company called Tiger, like Tiger Investment Management I think it was called. And he was one of the famous, you know all-time famous hedge fund guys. And I know at one point their strategy was long the best 200 companies and short the worst 200.
And Tiger has sent lots of people out into the world. They call them "Tiger Cubs" – when somebody leaves Tiger and then goes out on their own. And usually, Robertson is behind them and he stakes them with some money. And one of these Tiger Cubs is this guy named Bill Hwang. And Bill Hwang left in 2012 because he pleaded guilty to insider trading, basically. They had the Tiger Asia fund that he was in charge of, and he pleaded guilty and he agreed to just get out of the securities industry for the rest of his life.
But he was back in business really quickly with this firm called Archegos Capital Management because it was just family money. And apparently, his family is very wealthy because as of recently, it was thought they were managing like $10 or $12 billion. However, Archegos wasn't just managing $10 or $10 billion... They were levered up – some estimates as high as five times so like maybe $40 or $50 billion... something like that. Wow, that's a lot.
And what happened recently was you saw two of their big positions, ViacomCBS and Discover – like the Discovery Network, you know, all those nice science shows on TV. Those two stocks they had gone up like rocket ships and then, last week... last Friday, they were just tanking really hard.
Well, Thursday night, Archegos had finally gotten itself in trouble. It was running out of money and it was on the verge of getting margin calls. So they got all their bankers together on a conference call and according to the press reports, they all agreed to an orderly wind down of this fund.
Of course, then Friday there's like some estimates, the estimates are different but let's just say $20 or $30 billion of selling. You know the banks were selling them out. And so, these two stocks, Discovery and ViacomCBS, just tanked really hard. And these banks that were lending him money – UBS, Morgan Stanley, Goldman Sachs was in it – there was a bunch of them, you'd recognize all the names. Nomura was another big one. I think Credit Suisse was another one, too.
And Credit Suisse and Nomura, I think, were the hardest hit. They had lent this guy money and he was using – it's a weird, it's a weird thing because first of all, like they welcomed this guy back into the fold even though he was barred in the security industry. You know they welcomed him back into the fold as a client because he had tons of money and he wanted to borrow tons of money and that's fees for them, right?
And he was apparently using total return swaps to take big positions in these stocks. He was taking big, concentrated positions. And the way that works, the total return swap is, let's say I'm Bill Hwang and you're Morgan Stanley or whoever, so I pay you a little regular payment based on something like the live ____ interest rate or something like that.
So I make this regular payment to you and then, from you to me, you pay me a payment based on the total return of the asset – in this case, stocks, right? And that goes both ways, so when the position is screaming straight up and it's doing really well and it's doubled or tripled or whatever it is, you're paying me a ton of money. And I'm still making you this little, usually a fixed – it can be a variable payment but it's an interest-rate-like payment so it's pretty small these days, right?
And then, you know, when I'm making a ton of money in these stocks, you're making these huge payments to me. Then they're falling and so, it goes the other way. And if you're my bank, you're like, "OK, enough of this, you've got to put up more money." You get a margin call, and the bank says you've got to put more cash in your account or we're going to sell you out. And you know, they're selling him out.
And one of the articles I read said that they thought they would have him all set out in 20 trading sessions or so. You know, like four weeks or something. And I don’t know, this episode is rich with possibility for us, right? First of all, leverage... I mean. what is it with rich people using leverage? If you've got $10 billion what the hell do you need to lever up five times for?
I understand maybe he got there by leverage but once you get to $10 billion, you're like, "Oh, OK, I'm cool, I don't need any more leverage." Or you ought to be. And frankly, who wouldn't be there if you had $100 million or a billion or two billion or something? You know, why do you ever need to use leverage like that it's just ridiculous.
And he was known as a very aggressive, a smart, aggressive guy. So they knew all about him. They knew that he was thrown out of the securities industry, you know, pled guilty to insider trading, and they were only too happy to welcome him back.
So you know, what does that tell you about investment banks, you know, about all these Wall Street banks, right? They're in it for the money. You know, this is a business and they're in it for the money and if somebody can generate fees for a few years, yeah, we'll take the risk.
But it's a weird thing because these total return swaps... like, nobody knew about this. Some of the articles – there's an article in Bloomberg about how this guy very quietly and secretly had this $10 billion fortune that people didn’t know about because of the total return swaps. Like the asset is on the bank's balance sheet. They own the asset, I just have, you know, I just have this swap agreement where I'm getting the return off of it in return for making these payments.
And apparently, as Warren Buffett taught us in his 2002 letter is there's a whole big thing about derivatives in there that you ought to read. You know the leverage on these things is crazy... it's inherently crazy. You have to put up very little capital to do these total return swaps so they're inherently highly, highly levered. And it's, I don’t know, it sounds like somebody putting all their money in naked call options or something. It could just blow up at any minute.
I thought we were down all this. We'll never be done with all this, we will? And some people are writing about the possibility of a contagion. Justice Little over at tradestops.com had a piece about – he said this is like the first popcorn kernel popping. And so, maybe more of this is going on and we'll find out about it when they all start blowing up.
I don’t know if that's true. I don’t know if there's necessarily a contagion that’s starting. I feel like Bear Stearns really lit the match in the 2008 financial crisis when their hedge funds failed. And they were all levered up and had mortgage securities... and it was, you know, it was just a sign of the times. It looked like lighting a match to a big pile of dynamite.
I don’t know if Archegos Capital Management and Bill Hwang are that match for this episode or not, but I know it's typical. It's exactly the kind of stuff – this is like typical sight of the top. We're getting near the end of the cycle... People are starting to blow up. You remember Bernie Madoff, he only turned himself in because the markets were crashing and he couldn't keep up the façade anymore.
So scandals and blowups and things happen a whole lot more at the end of the cycle than they do, you know, in the middle of it. So I think that's probably the big lesson here. Another is leverage, you know, "what the hell are you thinking, don't use leverage?" And margin on the stock exchange is at a high, relative to GDP, so lots of people are using leverage to buy stocks these days and I think you're crazy to do it. Don't do it. Most of the time, I say I won't give you individual advice... I'm giving you individual advice: don't use leverage, it's insane.
So this is a story, just type "Archegos Capital" or "Bill Hwang." Archegos is spelled just like it sounds, and there's a million articles about it – it's everywhere. And you should read about it because it's, you know, it's a tale of the time. It's a sign of the time and it will teach you – like you put this episode in your head and you say OK. And the next time you start to smell something like the next time you see a stock like ViacomCBS go ballistic, the charts on that and Discovery and a couple other names the guy was into to, Vudu was one of them, Tencent Music Entertainment was another one. When the charts on these big-cap stocks go ballistic like that start scratching your head and wondering if there's not another Bill Hwang Archegos behind it.
And you know I've said it again, I've said it before... ballistic charts do not correct by going sideways – they correct by crashing straight back down. So, you know, be careful out there I guess is ultimately it.
And also, I'm going to do my quote of the week now because it also speaks to hubris, right, this guy was filled with hubris. He thought he was going to lever up and make tens of billions more, I guess. And I heard this quote by Christine Lagarde, who's in charge of the European Central Bank now, and she was being asked about investors testing central banks. And she said, she was smiling but I think she was serious, she kind of had a straight face. She said, "They can test us as much as they want." That's the quote of the week because oh my God, this woman is actually saying, she's like daring you, she's daring investors, go ahead, we got – she's basically saying we've got your back.
And in that same interview, she did say we'll do everything we can, you know, everything that is required I think was the phrase she used. Meaning everything that's required to prop markets up and keep them from crashing. Plain and simple, they're supporting asset prices that's what they're doing when they go to work and they know it. And she just about admitted it.
And her predecessor, you know, Mario Draghi back in 2012, quite a while ago, he said a very similar thing – "We'll do whatever it takes." Because in the wake of the financial crisis, the growth was just too slow and he said, "We'll do whatever it takes." And what did that get you? Negative interest rates. So they can test us as much as they want, Christine Lagarde, president of the European Central Bank says. Ay, insanity.
All right, let's talk to a sane guy who knows what he's doing. Today's guest is Tucker Walsh from Polen Capital, let's talk with him right now. Let's do it.
Since I've been talking about regulation and policy within this show, I should bring up cryptocurrencies because that's the polar opposite of organized economics and regulated activity. And the best person to explain what to expect in 2021 in cryptos is Stansberry Research's in-house cryptocurrency expert, Eric Wade.
Eric is stepping forward with what could be the biggest moneymaking prediction this year. Eric was on the show last month teaching us all a lesson in bitcoin. If you already own bitcoin and you want to know what to do next then this crypto event needs to be required viewing.
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Today's guest is Tucker Walsh. Tucker Walsh joined Polen Capital in 2017. He is the head of the small-company growth team and lead portfolio manager of the firm's U.S. small-company growth strategy. Prior to joining Polen Capital, Tucker spent 10 years as CEO and head of portfolio management at Copper Rock Capital Partners and nine years as managing director and head of small-cap growth team at State Street Research. He's our small-cap growth guy.
Tucker, welcome to the program.
Tucker Walsh: Thanks for having me, Dan.
Dan Ferris: So the topic today these small-cap growth companies is one that is, I'm sure, near and dear to our listener's heart. Anybody can sit here and say "Apple's a great business and Google's a great business," but to find XYZ small-cap company that has a good chance of growing five or 10-times or something like that is a lot different of a proposition.
And it seems that that is what you do. I was reading on your website and you guys are looking for these companies that you think have a great competitive advantage and can just grow and grow and grow. And it seems like growth is the big enchilada for you, is that right?
Tucker Walsh: Yeah, that's correct. We want the combination of growth and a really solid business model. And so, quality plus growth... we think gets the best opportunities for compounding the highest percentage chance for compounding.
And one thing that is a bit daunting for people that are looking at small-cap as an area to invest in is the several thousand companies that are publicly traded, which ones do you home in on? And for us, we really go for the best companies in our category. So we concentrate in, roughly, 30 holding stands so that what we're doing is really trying to zero in on the companies that are competitive advantages, as you mentioned, have a repeatable growth process.
So it doesn’t even have to be fast growth, but it has to be repeatable growth, really solid margin structure and cash generation, a top-notch management team, and the ability to take the cash flow that they generate and reinvest into the business.
And we think that the creates a flywheel effect – we call it our flywheel for compounding. And all of those elements together create the right environment for compounding we believe.
Dan Ferris: So Tucker, I have to say, a few years back, flywheel was like this really kind of buzzy word in the business and investment communities. Why do you use it? What does it really mean to you?
Tucker Walsh: Well, for us, we like the imagery and sort of the thought process behind the kinetic energy that goes with a flywheel. And the fact that all of the elements I mentioned have to work together. And when they work together and they're working together at a really solid pace, it does create that kind of energy.
And the faster that flywheel spins without interruption, meaning that if the company is able to grow at a reasonably rapid rate, let's say 15% or 20% annually for several years and have a really strong margin structure and cash generation and the management team does a great job by building great culture and reinvesting in the business, all of those things working together create breakout opportunities. The ability for that company to be a much better performer than the average company.
Dan Ferris: Right. So you hit on when you were sort of going down your list there with margin structure and cash generation and reinvestment, you hit a lot of things that, I mean I have a list of almost those exact same things that we put in every issue of the newsletter that I write. And even when we're recommending a company like Costco or something and it makes me wonder about profitability.
How important is profitability to you? Because there are a lot of small companies around that are growing really fast and they may even have a business model that is considered attractive but they're just not making any money. How important is profitability?
Tucker Walsh: Yeah, to us it's very important but the level of profits is less important than just having cash generation and the ability to reinvest. So just going up a little bit further on the P&L, one of the things that's really important to us is that when a company has a competitive advantage – and namely, a very strong customer connection – by having that, if the management team is very skilled, they can price the product really effectively for the actual value add of the product.
And that's important because you're getting a solid gross margin that enables the company to then spend on the operating expenses... to then try to generate more business in the future. Whether that's investing in R&D so that there's more product development in the future or sales and marketing to attract new customers.
And so, when you have that dynamic and the company is disciplined, and that's one thing that's really important to us, we, as investors, are very disciplined in the way that we look at things. We want cash generation because that is what makes a business durable over time and also allows for the kind of growth over time without interruption that we look for.
But we also look to invest with management teams that are disciplined. And we do listen for that. When we talk to management teams or listen on their quarterly conference calls, we want to make sure that they're stressing the fact that they're building for the future, they're long-term in nature, they're trying to grow, but that the P&L is run in a very disciplined fashion.
Dan Ferris: OK, I'm stuck back on something you said, which really sounds intriguing. This idea of, basically, it sounded like matching the gross margin with the value add of the product or service offered. It sounds like you have, it sounds like you would have to have a method of measuring the value add independent of the gross margin and then being able to say well, this gross margin is too much, too little, just right. Do I have that – am I thinking about this the right way?
Tucker Walsh: Well, the thing that we try to focus in on is trying to understand the company's gross margin relative to similar peers to see if there is something that's particularly special there.
So take, for instance, with brands, brands are able to price their product at a premium because there is a trust factor with a customer. Whether it's a B-to-B brand or a B-to-C brand, direct to consumer. And so, when that is in place, you're generally going to have a business model that allows for a little bit more capital to be able to reinvest back into growth.
It isn't, actually, very precise for every business, it really depends on each business, but the important part is that the robust margin structure is there. Because as you mentioned before there are a lot of companies out there right now that are losing money but they're losing money because they can't really get a premium for their product.
And at the same time, they're really spending a lot at a very rapid pace to keep up fast growth. And eventually, if they don't produce enough margin, they're going to keep relying on outside capital. And that's just a very difficult way to try to create long-term value creation.
Dan Ferris: So Tucker, can you share a name or two with us that's like a quintessential, you know Polen Capital small-cap growth company that really is a good example of all these elements that you're putting together here?
Tucker Walsh: Sure. Well, I like to – for example, like these use somewhat household names. Given the fact that we're in small-cap, they're not always household names but in this particular case, Dan, you may have heard of Yeti who makes the coolers and drinkware. And now they're into other outdoor lifestyle products including luggage and bags, etcetera.
And Yeti is a great example of meeting all of the elements of the flywheel. And actually, plays to the issue we were talking about before about pricing. So Yeti started as a brand that was mostly for the fishing community. They made a very rugged and what they considered at the time to be the best cooler out there.
And they created a following that then they were able to create that can create more of a lifestyle and outdoors brand that migrated to drinkware. So many people are aware and use their tumblers, which are much better than all of the other knockoffs that are there so people do want to pay a premium for those and be photographed with them on Instagram, etcetera.
And they've built a tremendous brand that is that competitive advantage that's the customer connection. They have a repeatable sales process because they expand their product line very intentionally. They use data from the sales that they make. They understand their customers very well. And so, they're able to get repeat purchases and also attract new customers without doing a lot of advertising the brand itself actually brings customers to them.
They have a strong margin structure because with the coolers and the drinkware, so when you go on the site, you'll see that their products are priced at a premium but they also get outstanding reviews. So if you look at their site on Amazon, you'll see that they get very, very high reviews. And people are very enthusiastic about what they're getting for the price.
That creates a really solid margin structure, they generate a nice amount of cash, and then they're able to reinvest that back. And one of the things that we've seen in the pandemic, so a lot of companies have been forced to modify their businesses or pivot in different directions due to some demand destruction.
And in Yeti's case, they started the pandemic at about a quarter of their business or so being direct-to-consumer and the rest going through channels like sporting goods manufacturers or a newer relationship with Lowe's to now close to 60% being direct-to-consumer. Which includes the Amazon site, but most of their direct to consumer now is coming from the yeti.com site.
And just the investments that they have made in the years prior to that, so that's why we really focus on quality in the management team, agility of the organization, the culture that's involved, but also that reinvestment piece. Where are they spending? What are they trying to do? And so, in Yeti's case, they've spent money on trying to make sure that they were able to pivot in a situation like what happened with COVID, not knowing that COVID would happen.
And so, they had no interruption to their business, and in fact, we think that the company is even stronger now, and it positions them well to expand internationally, be more of a global brand and beyond.
And so, that's where we think that flywheel works – when working in unison, it really creates this strength of the company that can really add a lot of intrinsic value over a number of years.
Dan Ferris: You know, Tucker, as you've been talking, I went on to Yeti website, I have to say if I were in your shoes and I was in the meeting and I was getting pitches from analysts and somebody came at me with this, I would just look at all these products, you know tumblers and bottles and mugs and jugs and barware and coolers and I would think I can get this stuff anywhere. That would be like, that would be my first knee-jerk reaction. What would you tell me?
Tucker Walsh: Well, I think we struggled with that a little bit at the beginning too, Dan. We wanted to understand better what was behind some of the numbers. So Yeti showed up on a quantitative screen that we have that looks for the things that I was mentioning before. So we wanted to see, we like to see consistency in the growth but we also like to see a strong margin structure, returns on capital, or strong incremental returns on capital.
Sometimes that will come in the form of cash flow return on invested capital so that there may be parts of the P&L where it may not show the strength of the business due to the accounting but if you are able to understand what's happening with the cash flow that will tell you a lot. And in this particular case, Yeti scored very highly on both growth and cash flow return on invested capital.
And so, we figured there had to be something there. We needed to understand it better. As a team, we've spent a lot of time over the last several years trying to get a better handle on the proliferation of smaller brands in the digital age and the ability for companies that didn't have what would be considered to be sort of an '80s or '90s mote in the form of brands. Which used to be you had a brand, you had shelf space in the front of the store, and then you'd have excess cash to reinvest in advertising so you'd really just be blitzing the customer with that.
Well now, in the digital age, it's much more dispersed where smaller brands can get broader reach, they can have a direct line to the customer. And we believe that this has opened up a lot of opportunities for companies like Yeti whereas you said, yes, there are others that make knockoffs, but there's a significant set of customers that want high quality, are willing to pay up.
There's also a status issued with better brands too. So just like people want to be photographed with a Starbucks cup, they also want to be photographed sitting on top of a Yeti cooler with their dog. And so, that actually creates that brand value but it doesn't have to be for everyone in order for it to be a great investment.
And that's what we felt like we learned when we spent some time really trying to understand what is the brand about, who are they trying to connect with, and do we believe there's a long runway for not only the products we see today but other products they can introduce in the product line in the future?
Dan Ferris: Yeah, that would be another question like how far can we go with this? What could they do that they're not doing now? That would definitely be a question, you know, in my mind.
But one thing I noticed, I'm looking at just like a Yahoo quote here and it says the market cap is about 6.3 billion. Which makes me wonder how small is small? What's our universe for your small-cap growth strategy?
Tucker Walsh: Yeah, so we want to make investments generally below three or four billion. Three or four billion type of range and below at initial investment. We believe that gives the best opportunity for the small-cap category. You get two things, we believe, down in the smaller end of the spectrum.
One is potentially a longer runway for faster growth. So the companies that we're generally looking at aren't going to run into the law of large numbers for quite a few years. That's number one. Number two is that you get a little more inefficiency down in that area.
So that's where we like to make investments, but when we make investments, we have a long-term horizon. And we think that's a significant strategic advantage for us and a competitive advantage for us that’s been part and parcel of the Polen philosophy going back 30 years for the large-cap strategy.
And in doing so, what we're doing is finding a company, a business, a management team that we want to put money to work with, think like owners, have a long-term horizon, and let them do all the hard work. So then, when we make an investment down there the goal is to have it compound such that it gets to be a market cap that's of a size that will be lifting our weighted average market cap. So we'll manage that statistic, the weighted average market cap to provide that small-cap exposure.
And when a company gets up into the eight to 12 billion range, we'll start to make some trends, and eventually move it out of the portfolio and reinvest it back into something under three or four billion.
Dan Ferris: I see. And I'm sorry, is it possible for a stock to be too small for you?
Tucker Walsh: Generally, we don't make any initial purchases under 500 million, Dan. A lot of that has to do with the fact that the companies at that market cap are generally not going to have enough of the elements or all the elements of our flywheel.
So we are disciplined. As I mentioned before, we only own roughly, 30 holdings so we're very picky. There's a very high hurdle to get in. And companies with market capitalizations of four or 500 million generally don't have that kind of characteristic. We wouldn’t say that it will never happen but it generally does not happen. So our range at initial purchase that we tell everyone is about 500 million to that three or four billion.
Dan Ferris: OK. It's interesting, isn't it, it's a small-cap strategy but a business just has to be big enough to perform a certain way, doesn't it?
Tucker Walsh: We believe so, absolutely. And there's a lot of talk right now about disruptive innovation disruption and in the small-cap category, we think by definition you're always investing in disruption.
So I've been doing analysis in portfolio management in the small-cap category for 30 years now and that's all I've really known in looking at small-cap companies. They're trying to disrupt the status quo. They're trying to find a new way to deliver more or better value, more convenience to customers.
But one of the things that's also important that there is discipline involved. And in those 30 years, I've seen different capital cycles and the companies that have the combination both of really strong product and a strong management team and a strong organization, plus financial discipline are the ones that end up being the ones you look aback and say, oh, that was $2 billion market cap, now it's 25 and you say OK.
So the folks that we're talking about this strategy, they pulled it off, they were able to do that. And not everyone can do it, obviously. So that's really important is having a, as you said, get to that size where then that next stage of the company's growth can deliver the kind of compounding, we're looking for.
Dan Ferris: OK, so you're looking for – I'm just reading off your website here – it says we believe superior earnings – stability is the word you used – and financial strength serve as a margin of safety that typically results in less volatility during declining markets. There's three or four questions in there for me but the first one is, less volatility in declining markets for small caps, that's a tall order, isn't it?
Tucker Walsh: Well, I guess we would give the caveat that it would be less volatility within the small-cap category. And we do feel strongly that that is true. And so, one of the purposes of having an allocation to small-cap, we believe, is that you're investing in the future. You're investing in the next set of large-cap companies... they do come from the small-cap area.
But not all of them make it there. So we do think that having the kind of the strength in the business model that I was discussing before, is really the number one element to being able to be strong for many years. And so that we can sleep at night thinking like owners and owning a position in the company.
And so, what typically happens in a very challenging economic environment or in a challenging market environment is that companies that are a little bit further out on the risk spectrum, meaning they are growing very rapidly but need outside capital, those are stocks and companies that are a lot of great risk when things go, when things don't go in a straight line.
And that's why it's important to us to have that cash generation. What we've seen in the pandemic – so the first thing that a lot of companies did, all the well-run companies that we own, the first thing that they did was make sure that everything was really solid with their balance sheet. And make sure that if they felt like they were going to be really strongly impacted that they were able to withstand that demand shock.
And not all companies can do that. And in past downturns, the companies that were a little bit further out on that risk spectrum, and the ones that were really dependent on capital from the outside were the ones that had the most trouble and the stocks were the worst performers.
Dan Ferris: Yeah, so much of what you say and of this stuff written on your website, it just reminds me of Warren Buffett. It says though instead of having hundreds of billions at his disposal he had hundreds of millions to manage. And I feel like he'd do and say everything you're doing and say.
Tucker Walsh: Yeah, we really, we, obviously, admire Warren Buffett and believe that the quality of the companies is very important to having great investment returns. We also like to see companies that are trying to move forward and trying to grow that do it in a way that is very disciplined. And also, brings forward a lot of the things that are necessary to building long-term intrinsic value, right?
So a component is doing this today, this is what you see, and so, let's go back to Yeti, for example. They did coolers and then they did tumblers, and now they're doing other areas like bags and luggage, etcetera. But pretty much any sort of rugged, outdoor type product is available for them to introduce with the strength of their brand over time.
But they do such an exceptional job of executing on what we see today, but in five years, in 10 years it won't be what we see today. They will have evolved and built on top of what they have today. And we think that's really key to creating great long-term value both in the company and in the stock price performance.
Dan Ferris: OK, I'm going to zero back in on that one paragraph I read, the idea of earnings stability and financial strength serving as a margin – I get financial strength serving as a margin of safety. But earning stability is tougher because from the point of view of a capital allocator, you know, it's stable up until right now, let's just say.
But then you're committing capital and it better darn well be stable next year and next decade if you wind up holding the thing a good long time. How do you get that kind of conviction? Does it come right away when you make the initial allocation or do you build it over time and build a position over time? And get higher conviction and then, OK, we really do have a margin of safety and earning stability here.
Tucker Walsh: Well, for us, since we only own, roughly, 30 companies, we take our time. We are very deliberate in our investigation of the company. So we build conviction through our team-based approach. And so, we have a team of seven individuals and we work together in teams of two when we do an extensive deep dive into a company that we're very interested in. And two people on our team make the affirmative case, the investment case, and two people will make the counter case or look for places that the flywheel can get interrupted.
And we do that because we A, we want to work well as a team and eliminate as many biases that we can. And we also think that it's very hard for the human brain to have both the positive and the negative case held at the same time and be completely objective about either one.
So when we work together as a team, we reduce blind spots and then, we also really try to just develop an understanding of what the company is trying to do, where they're trying to go, how it will get there. And we'll even do at the tail end of our process do what is called a premortem. And so, in the health care profession after a patient dies, they'll do what's called a postmortem figuring out what happened. And so, what we do is we do an exercise where we say OK, this investment was a bad investment for us. Why was that? And when there was a demand shock what happened to the business model?
And Dan, that's how we build conviction in the possible outcomes that can happen in the future. Because we can't predict the future, even the companies can't predict the future but if we can say with some certainty that if something went wrong, this company has a margin of safety built in, in the way the business is managed, In the way that they can get access to capital if need, and also, that they can weather that sort of downturn. Those are the things that can give us the longer-term conviction.
Dan Ferris: OK, I like the topic of conviction because I think it's really important to our listeners. Because professionals can have conviction but the individual investors who make up the bulk of our audience, I'm certain that they're challenged by conviction, especially during times like we experience, roughly, one year ago.
Which leads to my next thing that I'm really curious about here, what did you guys do in the first quarter, you know, especially in March of last year? How did you behave? Were you working seven days a week, 15 hours a day all of a sudden? And what were you doing at that time?
Tucker Walsh: Well, after a brief, I guess I would call it acclimation period to everyone being working remotely, so at the same time that the markets were very volatile we were all getting used to being working from home full-time and being isolated at home. And so, actually, you know that was a pretty significant adjustment in and of itself. And we actually did – I'll give my team a tremendous amount of credit for how well everyone adjusted and really stayed very positive in the face of what was a very uncertain period.
But from a business perspective, in looking at the companies, our holdings, and trying to figure out what's going to happen here is we really went back to the basic principles that I just mentioned. Is to just look at the business model and say if we did a demand destruction analysis and we said if this happened, what would happen with the company and its ability to have enough capital to continue to grow?
I mean we don't worry about our surviving because we've already invested in companies with a margin of safety with a great business model. But there are some companies that due to what happened in the pandemic where their demand destruction was severe enough that you had to worry about whether or not they could compound value. Would people return to being in a physical location is one example.
And we did make some adjustments in the portfolio because we were concerned that there was enough of a dislocation that it would last a while. But at the same time, we were finding opportunities where there were companies that were higher market cap than our cutoff but let's say they were at six or eight billion and they had come down to that three or four billion range.
One great example of that is Etsy, which we really didn't have an opportunity to buy in our small-cap product until the selloff in the pandemic. So we took the opportunity with sales we made where we felt like some of the businesses would be impaired for some time and bought a company, a position in a company like Etsy where we thought that the outlook was very strong and a lot of upside. And it turned out that was a good move for the portfolio.
One other thing I'll mention is that we actually launched our small to mid-cap product in the throes of the selloff of the pandemic, April 1. And so, we were thinking offensively, especially for the companies that had been sold off rather hard. So, anyway, that's the combination of what we were looking in at that time.
Dan Ferris: Wow, you bought Etsy during the pandemic bear market. Nice move. I mean at the bottom it was like below 40 and now it's like 200. So I'm guessing your strategy has done extraordinarily well over the past year because I know that's the only name that has performed like that.
Tucker Walsh: Well, they did a lot of the hard work. They did a fantastic job of pivoting the business. This is actually, you know Etsy is a really great example of how a well-run organization, a well-run company with a great culture, and actually, passionate customers. And in this case, it's a two-way market, so they have passionate sellers on the platform too.
They actually made a plea to their sellers... for those that could manufacturer masks to please do so and sell them on the Etsy website so that it would take some of the strain off of the demand for medical masks to keep that to have enough of a supply for the health care workers. And it was a really, just a great thing that they did in general, but the sellers really arose to the occasion.
And so, a lot of new customers flocked to the Etsy site and it created, obviously, a swell in demand for masks. But the follow-on effect, one year later now, is that the non-mask traffic for Etsy is up 99.0%. So it really, so that kind of a, you know, it was a terrific, just a great cultural move for the company to do that. But also, it's going to have a lot of great residual benefits for them in the future and that really is a testament to how great the management team is.
Dan Ferris: Yeah, that's a very cool story. I have to ask, I'm a value guy and all the listeners know it, but valuation is its' a different animal when you get down to these smaller, faster-growing companies, isn't it? Do you think about it much and if so, what's the key insight that you might have for us about the way you think about valuation?
Tucker Walsh: Sure. So we look at valuation last in our process. We do evaluate valuation. One of the reasons that we do that for our style is that we want to make sure that we are doing a really thorough job of understanding the company. Understanding how and if it can compound over a number of years.
If it can do that, the precision on valuation becomes much less important for the outcome of the stock compounding. We believe this because if you get a business that is really well-connected with a customer, that has a robust business model, strong management team, that can reinvest and do things with that model, and get into adjacencies and areas that you can't see today... That is generally what provides the serious outsized return.
We do it in a way that we think is very disciplined so we like to refer to how we do it as investing in disruption with a lot of discipline. So when we find those, what we want to do, if it fits all of the elements of the flywheel, we just want to make sure that the valuation isn't completely way off the grid.
The level of precision, as I mentioned, is not as important. Meaning that if the company several years out can be two to five times the size, and the valuation is in line with the peer group, and also has a free cash flow yield several years out in the future that we think is reasonable from that standpoint, then really, time and patience is your friend. Because the companies generally can do a lot better with those elements that I just mentioned.
Dan Ferris: OK, so as we pointed out, the markets have just screamed for a year here and you've given us a couple of good examples with Yeti and Etsy and stuff. And it makes me wonder as we get close to finishing up here, is there anything that you find really attractive right now that you've recently initiated that you think is still really quite viable today?
Tucker Walsh: Well, yes, we actually think that everything that we own today is viable.
Dan Ferris: Really?
Tucker Walsh: Yes, we actually think that all of the companies that we own are undervalued as you look out over the next few years. We're not surprised by price volatility. In fact, it's one of the things that is something that we're used to in the small-cap category. But because we take a long-term horizon, the compounding happens over that period but it's not in a straight line.
The companies, themselves, are less volatile than the stock prices. And so, when you do get a strong run-up like we had last year, there can be some volatility in the next three to 12 months. That volatility doesn't necessarily have to be down. But what we're looking at if the company has, if the stock has appreciated, well, what's happening with the business? And if the business has gotten a lot better, oftentimes it really justifies the stock price.
Etsy and Yeti are two great examples of that where the companies really executed well in the pandemic. They were already terrific companies before the pandemic and they were well-positioned to be able to weather a demand shock. And what they did is they pivoted and created a stronger company that will be a strong growth company, we believe, for several years to come.
And so, the price appreciation we think is well-justified and they're well-set-up, we think, to be great investments as we move forward. And that's why we rung a concentrated portfolio – we only want to be involved in the companies that we have that kind of conviction in.
Dan Ferris: It sounds good to me, man. All right, we've actually been talking for a while now, I do have one more question for you. It's my final question that I ask all my guests, exact same question. If you could leave our listener with a single thought today what would it be?
Tucker Walsh: I like to use the phrase that has been used by many long-term investors, which is, you know, time is your friend. So time in the market is key, not timing the market.
Dan Ferris: Oh, I like that. I like that a lot. Yeah, straight to the point too. And it's true, you know, you're not going to pick the bottoms or the tops, right, it's you're just not going to do it, so it's far better to just stay in. And we told the story recently on the program of the coffee can portfolio. I imagine that one's near and dear to your heart.
Tucker Walsh: Yes.
Dan Ferris: All right, wow, this has been I feel like the time has raced by here.
Tucker Walsh: Yes.
Dan Ferris: So we're definitely going to invite you back I think is the answer to that.
Tucker Walsh: OK, great. Thank you, Dan, really appreciate it. Thanks for having me on, it was a great conversation, really appreciate all the questions, and for having me do the podcast. Definitely would look forward to doing it again.
Dan Ferris: OK, bye-bye.
Well, I like this small-cap growth thing that we're on. You know, we've had a couple folks recently, Tucker's one of them, where we're talking about just a bunch of different stocks that are not, you know, it's not Facebook and Google and Apple, for God's sake, or Tesla, you know, or something that everybody talks about all the time.
And I'll tell you something, when I asked him what we could buy now, you know, basically, what's undervalued now? And he said everything, I was sitting here going really, wow. And he said it with a straight face and lots of conviction it sounded like to me. So that speaks to a real long-term, serious, high conviction kind of a strategy.
And you know, you can go knock around, I was knocking around on their website polencapital.com. And there's lots of good stuff on there so maybe check it out.
All right, that was cool. Let's do the mailbag. Let's do it right now.
In the mailbag each week you and I have an honest conversation about investing or whatever is on your mind. Just send your questions, comments, and politely worded criticism to [email protected]. I read as many e-mails as time allows and I respond to as many as possible. You can also give us a call at our listener feedback line that's 800-381-2357. 800-381-2357. Tell us what's on your mind.
Got some good stuff this week. The first one is from Johnny L. And he says, "Hello, Dan, thank you for the podcast. The diverse ideas and guests you bring each week stimulate thoughts and perspectives that I may not otherwise have considered. As I listened to Per," that's Per Bylund last week's guest. "As I listened to Pare discuss regulations in Episode 117, I couldn't," well, he said 117, it was actually 199. "I couldn't help think about how similar regulations are to a surgeon's scalpel. They could be either good or bad depending on the hand that holds it.
In the hand of a skilled and disciplined surgeon, the scalpel might only be used in those rare times needed to remove a cancerous tumor, one that would otherwise kill us. The problem is that instead of electing skilled surgeons we, the people, tend to elect the plastic surgeons who tell us that everything that makes us who we are is ugly and should be removed. Before we know it, they have used the scalpel to make millions of incisions removing every wart, mole, and beauty mark. The result is a slow death bleeding out from those millions of cuts." Johnny L.
Thanks for the e-mail, Johnny L. I see the point you're making but I believe that what you're pointing out here is the reason why most regulations just aren't going to work. I feel like what you're saying is human nature just doesn’t do this regulator thing very well at all. Right, human nature in the case of Bernie Madoff was, you know they took the evidence to the SEC 10 times or whatever it was. It was like eight or 10 times over roughly a decade that Harry and Markopolos took the evidence to the SEC and said there's fraud here, there's fraud here, there's fraud here, you know, eight or 10 times.
And you know, human nature was oh, gee, Madoff, God, he's such a bigwig Oh boy, we don't, you know, oh, we're going to look the other way. We can't get him in trouble. This can't be right. You know, that's the problem. The problem is once you initiate the regulation, it's guaranteed to be, you know to have bad surgeons, you know using your little analogy, your story here. You know you're guaranteed everybody who tries to use the thing is going to be a bad surgeon. And if it requires all that skill, you know, it's sort of you want to think of this the way Peter Lynch talked about investing, you know. You want to invest in a business that a market could run because sooner or later one will, you know.
But I see where you're headed and I think you're making, actually, a very good point. Thank you for that.
Next is Alex W. and he says, "Dan, I just finished the Annie Duke episode." That's Episode 181, November 19, 2020. He continues, "And ordered two of her books on Amazon.com. Thank you for interviewing her. At the end of that episode, there was a letter that asked about DRIPs, dividend reinvestment plans. I think you misunderstood the question. I'm going to rephrase the question so you have a fair shot at answering it in a meaningful way."
And then he says, "If the main benefit to DRIPs in the past was that I was getting fractional ownership of shares without paying commission and now I can buy fractional shares without commission any old time I want with, for example, Robinhood. Is there still a benefit to being in the DRIP program for my long-term stocks? To which you might say, yes, one possible benefit is dollar cost averaging and another would be not spending the dividend on something else, as well as the benefit of not allowing to lay fallow in your account. Keep up the good work. Alex W."
Thanks, Alex. You're right, yeah, if that is the question as you framed it, then I would say that just being on automatic pilot in a good business where you're reinvesting the dividends is absolutely the best way to compound. Right, you want to reinvest in a good business. You want to keep your capital in there so when they take it out and they issue this dividend, you know, you put it right back in so they can continue doing good things with your money and compounding at high rates over a long period of time.
I just like the automatic pilot feature too just because, you know, if the cash piles up in your account, you know what cash does, it burns a hole in your pocket and you're liable to do something foolish with it. And if you just always reinvest the dividends in your best stocks, then it kind of keeps you out of trouble and it keeps you heading in the right direction.
But thank you for the clarification, I appreciate it.
Next is John A. And John is worried about being too paranoid. He says, "Hi, Dan, there has been a lot of talk about the government confiscating physical gold if the stuff hits the fan, so to speak. I don't really want to think that they would do it, but since they have already done it before, I want to be wise in considering it.
The ____ physical gold trust seems like a reasonable alternative way to own physical gold but what would happen if the U.S. government started physical gold? Sprott says the gold is stored in the Royal Canadian Mint. Is that owned by the Canadian government? Will there be a cooperation by the U.S. and Canadian governments to hand it over?
Would the U.S. government halt the trading of the PHYS?" The ticker symbol is PHYS, P-H-Y-S. "You know, the Sprott Gold Trust like they did Xiaomi?" It was a Chinese stock that got halted, apparently, in his account. And then, he finally says, "Or am I just being drawn into the conspiracy world? Ever forward, John A."
I don't think you're just being drawn into the conspiracy world and hey, you know, powerful people in politics and business and everywhere else conspire to do things, don't they? I don't think you're being crazy in considering this. And to consider yes, you know, would the U.S. get the cooperation of the Royal Canadian Mint? They might. They might do just that. I think the key to having gold out of the reach of governments is having it in more than one place. I don't want to offer any advice but I'll just leave it there for you. And it's an excellent question and you're not just being paranoid, you're being smart.
Finally, this week we have Peter W. who was not really happy with our interview with Per Bylund last week. Per is an economist and we talked about regulation and all the damage that regulation does to an economy and Peter W. has a problem with that.
He says, "Dear Dan, I don’t know how a discussion on regulation could not include a discussion of ___but your guest seems to have managed it. He provided counterfactual arguments for the case of overregulation but failed to consider the counterfactual of under regulation.
As an example, regulation is necessary where the market does not properly price the cost of ___. Examples from the past include the industries that dumped waste into the Cuyahoga River to the point of it catching on fire or the ethyl corporation that promoted the use of lead additives in motor fuel to the detriment of residents living close to motorways. Both of these are examples of market failure and any discussion on the useful of regulation must include a discussion of extraneities in market failure."
And then he said I brought up the issue but failed to pursue it. Then he moved onto another topic of minimum wage and he said a lot of things. He said, "Your guest also seems to have missed the value of the minimum wage. The limiting case of no minimum wage is when labor is free. Arguably, free labor in the form of slavery was a major reason why the Confederate states did not industrialize at the same rate as the north. So consider had agricultural labor, "
But I don't want to read all this, it goes through all the stuff about slave labor. "Without a market for labor-saving innovation where would our civilizations be now? So absent of minimum wage economic output per unit of labor will be reduced."
This is all nonsense. So Peter, on the subject of minimum wage, slavery is kidnapping, it's illegal. It's done in the world, it has always been done, it probably always will be but in the United States, at least, and in most civilized, in civilized countries, it's illegal, right? The world is up in arms at the, I believe it's announced ___ slaves being used in China, as well they ought to be.
And frankly, I think we're tolerating it too much. We should be all over China about this. It's kidnapping. You're saying that you own human beings.
So the whole thing about minimum wage and slavery is silly. I'm sorry, it's just wrong. Kidnapping and minimum wage don't have anything to do with one another.
And to say, then you say the argument that a low minimum wage will increase employment is akin to the – increase unemployment I think you met – is akin to the broken window fallacy that your guest cited. Both cases and resulting activity results in only a marginal economic gain compared to that.
I'm not sure the point you were trying to make here. You lost me. You said, "A large proportion of the population will be employed in occupations that provide only marginal added value without a minimum wage. If a large proportion of the population only had marginal economic value, on average, we will all be poorer."
This is just dumb. Wages are an expense, Peter. They're an expense. If you pay too much for it, you will demand less of it. Period. You're overthinking this. You sound like an academic. I hope you're not because we don't need more academics with this nonsense. But you're just dead flat wrong about minimum wage.
As far as the other things, a lot of those failures aren't market failures at all. You know, they're failures of – to establish private property. You know we pollute the hell out of things that are commons, right, it's the tragedies of the commons because we say oh, everybody owns it. You know, the government won't let someone own it, so everybody owns it so it gets polluted. When it comes to dumping waste in places that a much bigger problem than anything else is that there's no private property there, right?
So if focus much more on letting people own things and giving them an incentive to keep them up, then we would not have some of these problems that you're saying are a failure of the market and a failure of too little regulation. Most of the time, the failure is of too much and it's a failure of the government not allowing the market to work.
And I'm not saying it's 100 percent of the time. I'm not saying you don’t have somewhat of a point. Let's face it, like air pollution, I mean that's a tough one, right? What am I going to do, own the air? I'm allowed to pollute the air over my factory but no other air? You know that just doesn't work. It's not feasible. And you have to say look, you're polluting air, you're going to kill somebody, cut it out. You just have to, there's no other way around that. There's no demand for more polluted air.
And polluted air is a bad thing, you know, we've all been to the, well, I don’t know if we've all been to them but we've at least heard of these cities where they're just doing something like you know, they're burning a lot of coal or something else. And it's just fouling up the air horribly and you can hardly breathe and it's really bad for you. And that's no good, I agree that's, you know, human beings shouldn't choose to live in places like that but sometimes they feel they have no choice, I guess.
And that's the other thing, look, if everybody chooses to be there and they don't want to go somewhere else where the air's cleaner, you know, none of this stuff is a slam dunk. No regulation is slam dunk but a lot of regulation is really, really bad and creates, it mostly makes life harder for newer participants, for newer competition. It's mostly used to tamp down competition. And people who say otherwise are just fantasizing.
Anyway, I shot this e-mail, I shot your question back to Per Bylund, so if he gets back to me with a response, maybe we'll read it next week. But thank you, Peter, it's a valid – these are valid questions I just feel passionately that you're wrong.
OK, that's another mailbag and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as I did. Listen, if you liked this episode and you really enjoyed it and you want to tell the world about it, please do. Send somebody a link to the podcast so that we can continue to grow.
Anybody you know who might also enjoy this show... just tell them to check it out either on their podcast app or at Investorhour.com and I thank you for doing it. 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. You can follow us on Facebook and Instagram and our handle is @investorhour. You can follow us on Twitter and our handle there is @investor_hour. If you have a guest you want me to interview drop me a note at [email protected]. Or give us a call at our new listener feedback line, 800-381-2357. 800-381-2357 and tell us what's on your mind.
Till next week, I’m Dan Ferris, thanks for listening.
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