The Exchanges

Q When you went off to college, you were coming from a completely different upbringing, I imagine, than anybody else there. What was that like when you jump into college in the U.S.?

A I can't claim to have been a well-adjusted student. I was certainly probably socially very maladjusted. My neighborhood in Madrid had about a quarter of a million people. Spaniards would have dinner very late at night, and then you go for your paseo around midnight. And arriving at Chapel Hill, where the business is closed at five p.m., while I'm still waking up for my siesta, it took me quite a while to get used to. But then also, I realized that I had a very different life and childhood and a lot of cultural references than young people, and being young and foolish, you expect the world to adapt to you rather than adapting to it, and so I think it took me some time to find my feet there, but I ended up becoming very good friends with a lot of professors. I was very nerdy and bookish, but really ended up developing a great community, many of whom I'm still in touch with.

AI assessment note: “I can't claim to have been a well-adjusted student. I was certainly probably socially very maladjusted.”

Q You talked last time we had on the show about a natural monopoly. How did you decide which ones you wanted efficient?

A If you read an economics textbook, they talk about natural monopolies, which would be things like power utilities, water utilities, and it makes no sense to lay down two sets of pipes or two sets of copper wires. You tend to have one company and then to make sure that the consumer doesn't get gouged, you have a regulated rate of return and the regulator sets that. Those are natural monopolies. I think of natural monopoly a little broader, which is to say, does the delivery of the product dictate that there be a few players? Going back to the financial exchanges, you don't want to be transacting on dozens of exchanges. You want the highest amount of liquidity, and that's why you end up with one exchange that does one contract. That has a natural reason for existing, and that's what I call natural monopoly, which is much broader than the economics textbook. The unnatural monopolies, I think, are pernicious and bad for consumers, and those are essentially ones where absent Excessive regulation or mergers to monopoly. You would have competition. My entire book was written against these where the regulators and antitrust have allowed all sorts of mergers that should never happened. And then there's excessive regulation and talked about the McCurran Ferguson act with insurance where you can't sell insurance contracts across state lines. And so the U S spends more on healthcare and me…

AI assessment note: “does the delivery of the product dictate that there be a few players?”

Q It's been five years since you were last on the show. You dove in a little bit with your early childhood background, and I thought it'd be fun to flesh that out a little bit, and then we'll jump into what you've been doing. So take me back to how did your family end up in Spain?

A My parents were Presbyterian missionaries, and my parents actually wanted to work with university students, so be university chaplain. But they were also penniless missionaries, which means that they ended up settling in one of the cheapest neighborhoods in Madrid for rent. That was San Blas, which I don't think they knew at the time, but it had the highest rate of crime and juvenile violence and heroin use in all of Europe. The university students weren't particularly interested in what my father and mother had to say, and they were seeing all this need in the streets around them. And so they ended up helping heroin addicts get to rehab centers, and there wasn't almost anything in Madrid at the time, so they were generally sending them north or south to Santander, Victoria. They knew that they wanted to start a center after about two years because there was just so much need, but they didn't even know how to start it. That wasn't even their background. One addict came in and started sharing an apartment with, Lindsey McKinsey was an Australian missionary, and then he brought his friends in, eight recovering addicts in an apartment. The neighbors weren't thrilled, so then they had to go find a farm, and then it filled up with 30 men overnight. The center just grew almost exponentially after that, given the need. But my brothers and I would go hand out flyers in the neighborhood…

AI assessment note: “My parents were Presbyterian missionaries, and my parents actually wanted to work with university students”

Q When the AIDS epidemic ran through the neighborhood, what was that like at the time?

A It hit Madrid a little later than it did San Francisco or New York. People started getting a lot of the diagnoses in the mid-eighties, and then the average incubation period is generally about five years. It can go up to 14 years. So it was really in the late eighties, early nineties that the deaths started happening around us. And the peak of deaths in Spain was 95, and at first, some people were so ashamed to have it that people were HIV positive, but you didn't know that, and so it was only later, as numbers started growing, that my parents were encouraging everyone in the drug rehab center to get tested, and then found out that most of the addicts were HIV positive, and then they had a conference and brought doctors in, and then my childhood in high school really revolved around an enormous amount of studying, but going with my mother and father to Ramon y Cajal, which is one of the largest hospitals in Madrid, where they had the Main infectious diseases ward for AIDS.

AI assessment note: “it was really in the late eighties, early nineties that the deaths started happening around us”

Q Well, why don't we start at the beginning? I know your upbringing has some fascinating aspects to it.

A Yes, I suspect that my upbringing is one of the first things people notice, because it is pretty weird. And when you're growing up, often things seem normal until you encounter other people who don't share the same background. So I think it was really sort of only late in high school and in college that I started realizing just how odd my childhood was. But my parents, my mother and father were Presbyterian missionaries. And they moved to Spain in the 19 eighties, and they started working with heroin addicts, because Spain had one of the highest rates of heroin use in Europe. I mean, it still has a pretty high rate. And by coincidence, they settled in San Blas, which was a neighborhood of Madrid that had about 10,000 gypsies living there and a huge drug problem. And then they just started helping the addicts on the street, realized that, you know, they were sending them off to drug centers, particularly in the north of Spain. And they thought that there was so much need in Madrid that they decided to start a drug center. And so they started with one addict in 1985, and then today there's drug centers in about 25 countries with over two and a half thousand addicts, and it's all run by the addicts themselves. So the drug rehab basically operates a series of businesses, you know, like sort of charity stores, whether it's secondhand furniture, secondhand clothing. I used to work in…

AI assessment note: “my mother and father were Presbyterian missionaries. And they moved to Spain”

Q laundry list of some of the sectors that you discuss in the book, and maybe we'll pick one or two and talk about them. So this isn't just tech giants. It's insurance, paper, agriculture, hospitals, cable, airlines, beer, milk, funerals, Payments, dialysis, glasses, tax preparation, credit bureaus, banks, meat and poultry, PBMs, medical care, and title insurance as a subset. So is there a commonality in those sectors and subsectors?

A Yes. You could broadly put those different industries into two separate categories. One would be what you could call natural monopolies. Economists tend to refer to natural monopolies as industries like electrical utilities. It doesn't make sense to lay down copper wires to every home in Manhattan. You get one and then you just regulate it to make sure that they're not gouging people and they get a return on assets and so on. But I use the term a little more broadly where, you know, the delivery of the product dictates there not be many, many players. And earlier I referenced network effects and things like that. You then have another broad set of companies that, what I call unnatural monopolies. Absent regulation or legislation, There would be multiple competitors, and you would not have two companies dominating the U.S. beer industry. For example, the idea that Burger King or McDonald's might achieve a duopoly in the restaurant industry is insane. Basically, you and I could go get a kitchen and a cook and start competing. The question why this doesn't happen when it comes to alcohol is because even though there has been an explosion of craft breweries, most craft breweries don't really ship their beer beyond county lines. This is essentially a legislative and regulatory problem where Going back to the ending of prohibition, what happened was it was all devolved down to the st…

AI assessment note: “Yes. You could broadly put those different industries into two separate categories.”

Q In addition to buying more on the dip, how do you think about ads and trims along the way?

A Our median size has been about six percent per, per position. Some positions have been larger. Partly they've had slightly higher IRRs and we wanted to allocate more capital to them, but also they performed tremendously well. And so they've ended up reaching at 14, 15% of the portfolio. And it's not even, it's not like every stock's going up that much. Obviously they wouldn't get that big relative to the other positions, but I do think Returns tend to have a Pareto distribution, and I think as a manager, if you immediately start trimming a winner, you're going to have worse returns, just mathematically. We do have tolerance for having a few larger positions as they perform, but the one thing that we're trying to do is to not overtrade, we trade very little, is to optimize the portfolio, which is rather than if money comes in the beginning of the month, add pro rata across the board, we have an internal IRR For each stock that we calculate. Now, I'm sure that we're getting that wrong, but at least it's a useful exercise to go through, and we try to allocate the most capital to the ones with the highest expected IRR.

AI assessment note: “if you immediately start trimming a winner, you're going to have worse returns”

Q Once you've mapped out this landscape, how do you do your homework on the companies that you potentially want to invest in?

A We have four analysts plus myself. So five at the firm, arguably we might be overstaffed relative to our assets, which are approaching four hundred fifty million, but we don't have to hire more as we get bigger. I thought it was important to have the full team before we had whatever assets might justify Having this great team of analysts, but we will spend months on industries and companies. We'll map out the value chains and profit pools in great depth. We'll go away and read half a dozen books on any industry. I'll go away and read hundreds of news articles, obviously read all the financial filings, whether they're SEC or other regulatory agencies that companies often have to file with. We will do our write-ups on the industry, write-ups in the company, and then we'll start talking to management once we feel that we have A good grasp of exactly what's going on, and management is critical. It's interesting, my parents did social work, and once I met a great investor who's essentially unknown, but with a terrific track record, and he told me, he said, well, I'm in the business of social work, and I thought this was a little shocking. He's clearly an enormous moneymaker, and he said, ultimately, investment funds and companies are groups of people, and they're motivated by a vision, they're motivated by a leader, and that's why I think it's critical to understand who is managing …

AI assessment note: “We'll go away and read half a dozen books... read all the financial filings”

Q So you have a range of clients, a fair number of hedge fund managers, you mentioned endowments. How do they use your research?

A I would say that everyone uses it slightly differently in terms of different funds have their own internal processes, and then some of them have different mandates, but there's a couple use cases. So for example, a lot of our clients are equity long short funds, and their real fear is essentially being blown up and caught off guard like in We're exposed to cyclical sectors or banks. And so what they really want to use us is as an insurance policy of sorts, where they want to know that things are turning down so that they use us for that purpose. And we also have, by the way, like a lot of market health indicators and buy and sell signals that we've generated to try to capture these divergences in terms of sentiment positioning and so on. I think for some of the allocators who might have a longer timeframe, they're not so worried about what's happening month to month, But they would like some slightly longer term themes in terms of what should they be avoiding, what should they be allocating to. So when we started out, the first big report that we wrote, I wrote that one, and it was called Spain, a hole in Europe's balance sheet, and it was essentially laying out the path ahead for Spain and part of the periphery. And so being able to avoid that at the time was very, very useful. Likewise, the Brazil long or other positive, we've recently put out a piece early this year on Argen…

AI assessment note: “there's a couple use cases. So for example, a lot of our clients are equity long short”

Q What have you learned recently that's most struck you?

A So I thought of writing a book on the history of financial markets, and I may do that at one stage. And the thing that really struck me doing all this research was that we think that we live in new and interesting times. A lot of these problems have been looked at over time, and whether it's Romans creating essentially an early form of insurance called bottomry, and I found this amazing book written in 1688 by a Sephardic Jew, and the book's called Confusion of Confusions, and it's sort of a diary of a trader in the Amsterdam Stock Exchange. And so we sit around, you know, you and I chatting on this podcast as if we're rediscovering the world and the investing world. Like, these things have been around for a very long time, and often they're created independently, whether it's in China or ancient Greece. And so in a way, these simultaneous discoveries are that, like, the modern world needs the financial markets to function, whether it's insurance or stock markets. And a lot of the problems that we face today from a behavioral standpoint, like, have been faced by people before us. And so that's one reason why I think education, sorry, history and learning is very important, because it helps answer some of our problems today. But just seeing that in practice was extraordinary.

AI assessment note: “the thing that really struck me doing all this research was that we think”

Q would describe your investment management tech, request a demo at ridgeline.ai. And now, back to the show. All right, so as you laid it out in the book, we could start with the obvious one, which is the tech giants, which everyone thinks about. So you wrote something about that. What's your take on that perspective of where monopolies are a problem or become a problem with the tech giants?

A What's interesting is almost any interview that I do about the book always starts with the tech giants is the first question. So it's a great thing, meaning that people might not be talking about monopolies right now if the tech giants hadn't raised this issue. And there's certainly a lot of other hidden monopolies. So to the extent that monopoly is now becoming a common word in our vocabulary again, I think it's a wonderful thing. So Google and Facebook essentially are an ad duopoly in terms of the ad market. Google is a monopoly when it comes to search with roughly about 90% market share globally. Facebook on the social side is a little over 80%. On the social side you also have Twitter, Snapchat, and so on. But basically they have monopolies in their respective fields, and then they have a duopoly when it comes to online ads. And the big problem here essentially is that while there are very strong feedback loops, Google is essentially like a two-sided market between searchers and advertisers, and then Facebook essentially has very strong network effects. You want to be on the social network where all your friends are. One of the big problems here is that they're able to use their platform to their own benefit. So Google is not just serving you every single search result according to their page rank. They actually can favor Google related businesses. They're able to make sure…

AI assessment note: “One of the big problems here is that they're able to use their platform”

Q Where are some other areas of, let's call it, opportunity cost or things that you could have or close to buying and chose not to?

A There've been quite a few of those. One of our analysts and I spent months and months on the semiconductor industry. The industry has become much more concentrated, primarily due to technological complexity, and in some cases, capital intensity. And we spent an enormous amount of time working on it. We did not by late to twenty-twenty-two. Obviously, that's had a terrific run since. And part of that was that we'd written a sort of thirty-page paper looking at previous semicycles and looking at What you end up seeing in terms of book to bill ratios, supply coming online. And so we thought this is not the right moment to buy. We'll go lower and we'll have the opportunity here and we've done the work. Now, of course, they just took off like a rocket. Many of these have doubled and more than doubled. I think there's an element of hype in some of them. And the valuations today are certainly not at all attractive relative to the fundamentals in many cases. So that's an area where other people have made money. We've not, but I think that it's an absolute sin to lose money for investors. I'd far prefer to have a lower return, not losing money than I would to flail about and punish myself for having missed an opportunity that produced great returns. I think if we can take care of the losers, the winners will take care of themselves.

AI assessment note: “One of our analysts and I spent months and months on the semiconductor industry.”

Q You've mapped out these companies. You have a database. And then you start talking about investment implications. I just formed a money manager to invest in them. What was that original thought process of how you take that information that these businesses exist and turn it into an investment strategy?

A There are two approaches one could take, which is a long, short approach where you buy the good companies and short the bad ones. The other one is essentially having a much more long-only approach, which is a sort of long-term investing, thoughtful approach. The short side, I've learned an enormous amount from my friend, John Hempton, who I deeply admire. I've spent weeks with him. Talking from early in the morning to late at night. There's no way I can compete with what John does on the short side. And I think that there's a variety of problems with shorting, not that it doesn't work, but rather that you can get short squeezed and there's a lot of hype. And often now with high borrow costs and all hedge funds shorting the same names, you end up paying a lot more than you would have previously. So you're running a negative carry game where time's against you. So I started thinking the thing that would one compound money to high rate to avoid permanent loss of capital and significant drawdowns. And then three, most importantly, is let me and the investors sleep at night. So if you can't do that, and you can't stick through a strategy, then it's going to blow up at some stage. And I thought this, to my mind, owning very high quality companies, so a quality plus value approach, where you're getting paid to own, because these companies generate cash that they can dividend back, or …

AI assessment note: “There are two approaches one could take, which is a long, short approach”

Q What have you learned about being a portfolio manager now a couple of years in that you didn't realize you needed to know when you started?

A One of the main things is obviously if you're an analyst, you tend to fall in love with individual positions. You don't tend to think holistically about how do all these positions fit in together. And just because something is a terrific bargain today, it doesn't mean that it's the best thing that you could possibly buy because can you keep on adding capital to it over time? Particularly a fund like ours that's growing, and so you have to be able to buy positions that you think you can consistently add capital to, not just that you had that great one-off mispricing on that one day, and then there's not either the liquidity to do it, or that mispricing closes so quickly that you can't add more capital to it, because we try to be pretty disciplined about having less than 20 positions. That's one, and Stuart Roden of Lansdowne said that good analysts don't tend to make good portfolio managers because of Not seeing how the portfolio gets put together and how to manage adding and taking off positions relative to falling in love with your idea.

AI assessment note: “You don't tend to think holistically about how do all these positions fit in together.”

Q So how do you go from spending your days creating models of liquidity indicators and leading indicators on the economy to writing a book about monopolies?

A So the answer to that is that one of the charts that really bugged me was we have a leading indicator for US wages, and the indicator itself, when you invert it or you turn it upside down, Leads corporate profits very well. And so, you know, wages are one of the biggest parts of the corporate spending, and employees are a huge part. So if employees are not getting most of the economic pie, then corporations are, and therefore corporate profits are going to be very high. And that's exactly what we've seen over the last couple years. Our indicator was telling us that wages should be going up. And so I was going to visit clients, many here in Midtown. I remember like one meeting specifically where And I was looking at it at Central Park, and the hedge fund manager was telling me, he's like, well, your indicator's broken. It's just not working. And I said, well, no, our indicators work very well. They do. I said, just give it time. And of course, went back to his office again a year later, and he's like, your indicator still doesn't work. And I thought, oh dear, this is pretty bad. I need to go look into this one. And so I started looking into why is it that wages just really weren't going up very much, and why our indicator might be broken. And sometimes the world does change. So some of our fixed income models after QE really stopped working if you knew what Growth rate was, and …

AI assessment note: “looking into the question of why corporate profit margins were so high, that was the first thing”

Q I know you've compared that to sort of the Valiant story. The concept of Transline was always that these are very low priced parts compared to a plane or something like that. So how do you think about that price dynamic where how much does a seatbelt cost? Oh yeah, you could raise the price of a seatbelt.

A That's an argument that some smart hedge fund investors have, and they, and there's like a class of companies that are low price in terms of the relation to the whole, and therefore give you some pricing power. And this, you often find this with drugs, where the pharma industry says, well, drugs are only about 10% of U.S. spending. They're the largest part of the spending that employers pay, and the consumers pay out of pocket. And if you look at some of these drugs, while it might be a total part of the whole, gouging a customer and getting There was Wilson's disease was the classic with Valiant, where absent regulation, they would not be able to charge 300 grand a year for a life threatening drug that really should cost pennies, right? And so to me, that's just price gouging with no aggregate benefit. Like there's no benefit that you're deriving or the society is deriving from these companies providing it. There's basically just a lack of competition from legal and regulatory reasons, and then people are gouged. It's that simple.

AI assessment note: “to me, that's just price gouging with no aggregate benefit.”

Q What are some of the other things that you've seen that caused you to change your mind?

A One of my favorite books is the curse of the mogul. It's just a terrific read on media. It was written by a former Goldman banker who is teaching finance, and he was pointing out that media itself tends to lead towards Uneconomic decision making, which is to say that whether it's the arts or music can't be judged on financial metrics. And so therefore a lot of capital gets destroyed in pursuit of acquisitions and growth. And we did buy a media company where the CEO, as it turned out in the conference calls was much more interested in expanding that empire. And then I was like kicking myself thinking I tell all the analysts to go read the curse of the mobile and then I'm ignoring it briefly.

AI assessment note: “One of my favorite books is the curse of the mogul.”

Q How does that work alongside the rest of the people on the team?

A What I try to do is to insulate the analysts from any involvement with the operational side of the business, which is I want them looking at stocks and looking at industries. I also want them to have the freedom to spend two, three months on an industry and company. With the team, we have multiple meetings a week that are brief. We'll update each other on our work. They don't have to produce a report or an email or anything on a weekly basis. And then when they do produce it, it's very high quality. And one thing that we try to do is to share the write-ups and the industry work and even Thought pieces on themes, whether it's the role of a middleman or other ones we've worked on with investors. We know that our allocators who've invested in us as family offices and endowments are not trying to front run us or to double down on positions. And I think a competitive advantage of a fund is to have great LPs. And if you have LPs who have a long timeframe in mind, then you can do long-term investing in the fund. If you have LPs who have a short Time frame in mind. There's no way that you're going to succeed as a manager doing long-term investing.

AI assessment note: “With the team, we have multiple meetings a week that are brief.”

Q So you mentioned the notion of price, which is, I know when I was studying bad antitrust, it was, are the consumers hurt because prices are artificially high? What are the alternatives to That metric as a means of trying to determine whether a merger should or shouldn't be able to go through?

A Firstly, like, if they did focus on price, I would be thrilled. I think the problem is that they say that they care about price, but then they allow tons of mergers to go through where prices actually go up. So I would say it's just a complete absence of enforcement of their own standard. It reminds me of what Gandhi said. They once asked Gandhi what he thought of Western civilization. He said he thought it would be a good idea. The sort of consumer welfare standard about price, I think, would be a good idea if it was actually practiced. There's extensive evidence that mergers, particularly under six players, lead to higher prices. But even moving beyond price, so in the case of the digital giants, Facebook's free, Google's free, so like, who's complaining? There's no harm. The arguments there are, one, the anti-competitive effects, which is, i.e., that they are discriminating against other people, and there are cases in the Stated that you had to provide sort of open and non-discriminatory access to your competitors, right? You can't, just because you have it doesn't mean that you can't allow your competitors to use it. And I would argue that if these businesses are in the business of providing search results, then they shouldn't be favoring their own. Or if Amazon's in the business of providing sort of a third party delivery of goods, they can't ultimately be favoring their o…

AI assessment note: “moving beyond price... The arguments there are, one, the anti-competitive effects”

Q How have you found the path of raising capital?

A The best way to look at Endowments and large investors. These are like oil tankers. They just move slowly. They have their own internal strategy. They have their own internal allocations. This is not something that happens overnight. It's natural that they want to see a manager do well. And then they have to get to know you and we have to get to know them. And so I think that most things in life are a marathon, not a sprint. And so I hope that I can have good health and do this for the next 4050 years. And I think that investing is one of the few Lucky professions where you don't have to retire due to physical aches and pains of your job at the age of 40 or 50, or even be forced out in your mid-sixties. Buffett, Munger, and Templeton, you know, were doing it in their nineties. I hope I can do that. I think that looking at investors, if I want to have a long-term approach for my business, certainly they have one for theirs, and so I'm not in a rush and just trying to make sure that they get to know us.

AI assessment note: “These are like oil tankers. They just move slowly.”

Q What are the economics of a business like that look like?

A Their returns on capital have been in the high teens over the last decade. They have one controlling family. The shareholder died and his kids have been there. They were about to do a bad acquisition. Didn't go through. Thank God they've replaced the CEO. But broadly, you're dealing with slightly below 15% operating margins. And high teens returns on capital. And this is a business that is an industrial business. It's not to say that it doesn't have any cyclicality, but I do think that having a slightly lumpier, but higher earnings per share, free cash flow per share is better than having a very stable lower one. And I think there's a preference often to have these very stable ones and to avoid anything that's slightly cyclical.

AI assessment note: “Their returns on capital have been in the high teens over the last decade.”

Q we can replay that in the feed, we talked about a bunch of your early career, and then your macroeconomic research business, Variant Perception. And at the time, you had just written The Myth of Capitalism. We'll have that story in the show. It was unclear what would happen with the book. So why don't we jump to that point in time, the book comes out, and what happened afterwards?

A I had worked on the myth of capitalism. First, I was working on the ideas, essentially the ideas behind it without even knowing that there was a book there. I just thought this was a very interesting question. Why are corporate profit margins so high? Why are some companies much more profitable than others? And so it was through the process of digging into that, that I realized that it's not the only reason, but it's certainly a very important reason was the rise in industrial concentration in the U S. So the rise of monopolies, duopolies and oligopolies. The book myth of capitalism was meant to be a look at the public policy and history of this. There was some economics, but not really looking at the investment aspects of that. I was writing all this text, but I was also, whenever I'd find a company, I'd put it into a database, and then I'd start looking through who are the holders of these companies. And I started noticing something that a lot of the investors I most admired, and who have great track records, were owners of these companies. Some companies, I think, are slightly parasitic, where they merge to end up having a higher market power, and then they raise prices. But others essentially have these Critical functions within industries, and you'd have to invent them if they didn't exist. And so I started thinking these companies consistently generate free cash flow and …

AI assessment note: “First, I was working on the ideas, essentially the ideas behind it without even knowing”