The Exchanges

Q So before we turn to the three things that work on the short side, I'm curious, as you focus in on these horses, It sounds so simple, right? You find these durable compounders and you just hold them for a long time. What are the challenges that come up in managing that portfolio and the inevitable volatility that you see in these names over time?

A The biggest challenge you have on a compounder portfolio is you've got to be extremely patient, both in terms of holding them and waiting for them. And this is one of the things why I think it's very simple, but it's very, very hard. So in 2017, spanning 2017, we had enormous performance, but we bought one stock for 17 months. When you have a big analyst team and you buy one stock in 17 months, it drives them crazy. So our construct is we have three books on each side of our portfolio. Three on our long and three on our short. Book one is live. Book two is fully battle ready inventory. Book three is a curated research universe. Our team focuses exclusively on the second portfolio. My job is the first portfolio. So their job is to make sure the portfolio is primed with potential performance. And if we get price volatility, we are fully battle prepared and it's inexcusable to us not to be prepared. So it's a separation of research process from risk decisions. The challenge with compounders is you have to be patient and that's the scarcest commodity in my view in global equity markets. So when you get violent rotations, like we did in December of 2018 and in March of 2020, we bought three stocks in a week, which for us is the equivalence of hyperactivity. We get the chance to upsize everything and we get the chance to rotate into higher quality and we get the chance to finally buy…

AI assessment note: “The biggest challenge you have on a compounder portfolio is you've got to be extremely patient”

Q I want to dive through that. Before we do that, you mentioned that ZBI was structured as an equity market neutral strategy. What was the thinking behind structuring it that way?

A So the thought process in setting up equity market neutrality was the family believed very fervently that in equity market neutrality, it would reward skill through cycle and remove the vicissitudes of markets. And so it was more reliant on alpha, what we could produce, the skill and repetitive process of what we could produce versus just the time arbitrage of markets. Now, I disagreed with the Structure. Although it was incredibly successful because I actually do believe that time arbitrage is one of the greatest advantages in markets. If you can exploit it, the family chose differently and was again, insanely successful in exploiting it. But when I left ZBI and created Aravart Global, I started off with a more traditional tiger net long structure, but actually after reviewing what had happened to the markets, and we'll get into that at some point in this conversation, I actually shifted to a significantly higher net structure. Because I think the structure of the market had changed, and time arbitrage is one of the most potent forces that we have in our arsenal.

AI assessment note: “the family believed very fervently that in equity market neutrality, it would reward skill”

Q So why don't you walk through a bit of what ZBI structure was and how you learned along the way while you were there?

A So ZBI was the private investment vehicle for the Ziff family. The Ziff family came from Ziff Davis publishing, and it was run by the three brothers. So the patriarch was Bill Ziff, and it was run by his three sons. This was an incredible learning opportunity and a phenomenal culture. So I started there in the summer of 2000, and there was about six of us inside there. And interestingly enough, they love training from the bottom up. So not one of us, including the portfolio manager Ian McKinnon had professional Public market experience at the time. So it was designed as an equity market, neutral structure, one central book. I ran at the end of it, three of the sector portfolios that focused into it. It was wonderful, wonderful culture. The brothers also learned this from Ziff Davis, which was an extraordinary culture in its industry. And this was really all about people processes and training. So first of all, on the people front, incredibly good people, very hardworking, very curious, very performance oriented, but given the room to be accountable, authentic, And actually do their thing. So process over outcome was a really important part of what we do, um, at ZIF and we were very, very drilled. So training was an essential part of this. They have a very high training culture and we were exposed to many of the greatest investors in the world. The ZIFs were very connected and t…

AI assessment note: “it was designed as an equity market, neutral structure, one central book.”

Q And where did you come out in terms of just your gross long exposure given all these different factors?

A So we sit at about one 30 today, and I think this is a really important question for long, short portfolios and even long only portfolios for that matter. I think it's human nature to want to hold dry powder. It's just satisfying being able to add down. It sounds better. It sounds more. Responsible, more adult. The problem is our cost of capital, our realized earnings power is 20% the last four years, including COVID. And we project 30 to 40 over the next two to three years. Very high for our standards, but it's coming out of a cyclical trough. For us to hold dry powder, the base rate of a 20% drawdown in markets is about five percent of time. And so you have to time that perfectly in order for that dry powder to be executed in our portfolio construct. So at the moment we've moved it to a central tenancy of about one 30 in a long short portfolio. One of the core advantages of long short is the levered balance sheet. And so if we don't use leverage, we're kind of fighting with only one arm tied behind our back.

AI assessment note: “So we sit at about one 30 today”

Q So as you look out over the coming years, what do you see as the biggest challenges to success?

A Let me touch on market observations, and then let me touch on business construct, if I may. From the market observations, I think there's three big thematics that we'll have to face. One is, there's obviously certain speculative components in the market today. The second is there's a big inflation debate. And then third, there's some tugs on factors, growth value, as an example, and, and small cap versus large cap. So in terms of the market outlook, speculative markets are challenging markets to deal with. But again, in the next 20 years, we're going to face them all. So what's the specific challenge of this? It means retail, by the way, is fully back. So retail is 20% of traded volume right now. It's double what it was in 2019. It's driving a lot of options. It's driving pockets of extreme movement. We saw this in 2010 and 1999. It's kind of interesting. It's two things mixed together. So you've got secular and you've got dramatic cyclical. So we've got micro caps dramatically outperforming the large caps, by the way, on dollar value of stock, as well as size of company. This is classic what happened in. And actually a cyclical recovery, yet alone one of this size, the worst quality businesses fly the most. In fact, the worst quality businesses that are levered fly the most. If I was a trader, that's what I would be trading right now. That's I know the framework. I just don't …

AI assessment note: “From the market observations, I think there's three big thematics that we'll have to face.”

Q You used the words game selection. I want to take a step back a little bit from your own research process and think about how do you view game selection? Let's just start with in long, short equity, which has been under scrutiny for so long.

A So let me define game selection. First of all, I think it's the most important decision we as leaders and as allocators make. It's literally choose the game. And what I mean by that is there is tons of very hard-working, hyper-intelligent people in this industry. If you don't direct them to an inefficient market with a system to exploit that inefficiency, that effort is wasted. It's by far the most important decision we make. And by the way, from my perspective, the most transformative moment in my investing career was shifting from variant perception to unfair fights. I made it in 2016. My firm is named after Genghis Khan's army. And the whole notion of his strategy was based on unfair fights. And that one decision changed everything in our approach to our long book. We even stopped using the three playbooks because only one mattered once you embrace this one fact. So game selection and, and now let's shift to the long short equity business. Long short equity, when I entered it in 2000, it was experiencing what would be at that point a decade of the golden era, like uncorrelated, extremely high returns, a dream shot for equity investors, and then everything changed in GFC. So part of the reason I came into the long short world was it was an advantaged balance sheet. We could do things that others couldn't, that helped us be uncorrelated, manage risk, and generate alpha through…

AI assessment note: “now let's shift to the long short equity business. Long short equity, when I entered”

Q So let's go through each of those a bit. How do you define compounders?

A Compounders at its finest, in my view, is some elements of either monopolistic or oligopolistic market structures that can compound earnings power at a brisk rate over long periods of time. So compounding, I think, is the most important thing we do in investing, period. That is, in my view, the entire quest of the mission. And compounders, by definition, is the most Mathematically elegant version of it. It's effectively finding companies that can compound and have durable earnings power for long periods of time. And within compounders is hyper growth to lower, but steadier growth and everything in between. So within compounders at large, what we found for us is we only focus on what we call horses, which is a type of gap and it's not hyper growth and it's not slow because our true north is we believe earnings power drives Total return over time. Not in the short term. In the short term, multiple is a very large driver. By the time year three through five, it's almost exclusively earnings power that's driving total return, and by year 10, multiple almost has nothing to do with it. So what we've landed on in Compounders actually is a version of exclusively focusing on monopolies and oligopolies, finding growth rates of earnings power that is in the twenties to thirties, multiples of the underlying market, And then finding them with reasonable prices that lets us navigate volatili…

AI assessment note: “monopolistic or oligopolistic market structures that can compound earnings power at a brisk rate”

Q Fantastic. All right. Yeah. And I want to turn to a couple of closing questions before I let you go. What is your favorite hobby or activity outside of work and family?

A Well, there's very little time outside of work and family. The first one would be, I'm an avid reader. So I try to read between a hundred books a year. I love to read. And fortunately that feeds obviously into our core passion of investing. My biggest hobby, which obviously is also been challenged by COVID is I love to travel. I'm an Aussie to the heart. And, uh, I did, you know, 300 day trips around the world in my twenties, which were the best things I ever did. And I really miss being on the road and just seeing the world and being close with my friends. And the last part of that, my wife and I are big foodies. It's all linked into that. I think it's one of the greatest joys in life. And, uh, I can't wait to go back and explore all the great food around the world.

AI assessment note: “The first one would be, I'm an avid reader... My biggest hobby... I love to travel”

Q And given the shorter time windows on the expected execution on the short side, how does your team's time allocation get spent on longs versus short research?

A I think people would be stunned by this. I actually don't understand it when people spend 60 to 80% of their time on the short side. My focus is where the money is. The short side is very difficult and it's very time intensive. And so one of the parts that we get to amortize our time really effectively is because we're so price disciplined on our short, we get to recycle our shorts for long periods of time. So for example, there are single names that we've shorted three plus times in the last two years successfully every time. And why it's the same thesis. We love it at one price. We hate it at another. We're not day traders. And again, trading is not my skill, not at all what we base our outcomes on, but we're disciplined in that risk skew is great at one price. Risk skew is horrible at another. And that band is wide enough for us to make money. So to answer your question, us as an institution, we would spend less than a third of our time short selling less than a third. And we can sustain five to 800 basis points a short alpha by doing that because we've built up seven years of inventory.

AI assessment note: “we would spend less than a third of our time short selling”

Q And so what is the optimal way of approaching long short equity today?

A First of all, I don't want to say that I ever know what optimal ever means. I think there's so many ways to make money and there's so many gifted investors that just like investing at large, I don't think there is a perfect way. However, there are choices to be made. So let me stop and look back and then explain what my answer to that is. First of all, there was a secular and cyclical changes that have affected this industry over the past 10 years. The secular shift that we worked out in 2010, it creeped up on us. Interest rates drive short rebate. Short rebate is what allowed us to be uncorrelated and very high through cycle return. That changed in GFC. So the front end of the curve drives short rebate. Front end of the curve went to the zero bound. So short rebate went from four to 500 basis points to -40 basis points at present. That is a dramatic shift in the business model, which I believe to be secular. I don't believe the front end of the curve is getting back to those levels in a very long time. The impact henceforth is how much alpha is required to create a through cycle profit neutral or additive on a P and L basis short portfolio. At 500 basis points, you needed about three to 400 basis points of alpha to break even through cycle. That lets you lever for long short spread through cycle. Now it's closer to 800 basis points. That's a very heavy lift to break even. The …

AI assessment note: “there are choices to be made. So let me stop and look back and then explain”

Q You mentioned unfair fights, and most of the time in investing, when people think about those inefficient markets, unfair fights, it's usually some idiosyncratic new thing in a corner somewhere where other people aren't playing, and the core of what you're doing, these horses, are generally well-regarded companies and names, and I'm curious, why do you think that is an unfair fight?

A First of all, we define an unfair fight by the competitive win rate is very high. So you win a lot more than you lose and you retain a lot more than you lose. And the starting premise of that is business quality compounds value every day. So the question you're really asking, and this is the big quest. So the quest to the right tail, the right tail being defined as the hall of fame of investing or extremely high return, whatever you want to define it at. But how do you get there? The game of investing is about how do you systematically exploit inefficiency? That's the real question. And so the questions for us is where does the inefficiency lie and what is your system to go exploit it? Our quest is effectively finding durable brisk compounders and we find them in inefficient volatility. So the thing that we have to separate here is we define inefficient markets as those where edge and skill has a benefit. You can accrue consistent outperformance against that market alpha. The next one is what is an efficient market? An efficient market is means there's no benefit to skill. Either it's been competed away or it's completely unknowable. These concepts are different than competitive markets. You can have competitive markets that are efficient or inefficient. You can have uncompetitive markets that are efficient or inefficient. And now the last layer here is volatility. So volatilit…

AI assessment note: “we can exploit when price meets or goes below our intrinsic value.”

Q What are some of the other disciplines that you've brought in that help you get over the behavioral biases to effectively hold these compounders over time?

A So I'm not a naturally patient person. I come with pretty high energy to everything I do. So I'm a highly visual person and we had to create our own risk systems over the last Five years that lets me see the profit potential of our businesses. So my source of strength comes from the quality of our businesses, the quality of the people that we partner with and the quality of my team. My source of patience comes from earnings power. So when I can see, literally see that every day our portfolio is compounding earnings power at 20 to 30% year on year. What I know is that if I do nothing, I already know in a year's time, the intrinsic value of my portfolio is materially higher. And so I've separated out price signal from performance of our portfolio. We focus on potential energy in our portfolio. Our portfolio is either coiling with profit potential or it's performing. I can't control the ladder. We focus only on the format. We surrender to the ladder. And so what lets us be super patient is I can literally see now it's false precision. Let's be clear about this. On what the future return potential, I don't know the path and how it gets there, but I can see literally on a two, three, or four year basis, what is broadly embedded in my first and second portfolio, and I can broadly see what the factor risks that we're taking to get there, and the default for us is largely do nothing wh…

AI assessment note: “we had to create our own risk systems over the last Five years”

Q is sort of a deeply personal and human business at its core. And I'm curious, as you've thought through all of these structural things about the business and the processes that you wanted to implement, what parts of it do you think resonated most for you in establishing kind of the goals and the processes that particularly from 2016 forward that you wanted to implement with you and your team?

A So Ted, one of the first realizations for me in deeply studying high performance management teams as well as high performing investors is the element of authenticity. So what I found is there's three A's in high performance teams. Authenticity, autonomy, and accountability. Stars need the room to make mistakes, learn, perform, and they need to be held accountable because A players like to play with A players. The authenticity part is the most important part of all though. Why? Because There's thousands of funds in this world, and if you're going to make a contribution, it needs to be the most genuine version of you. That's the only thing that the world needs. It doesn't need another fund. And so for us, the first lesson that came through here is let's go back to the three frameworks. We've done very well with two of them. We've done woefully with a third. I know the strategy works. It's me. That's the variable. So the analog I give you there is I've had tennis lessons almost my entire life. I'm 49 years old. I'm never going to be Roger Federer, right? Roger has the talent. And the ability to execute at a very high level. I know what a perfect forehand looks like. I just can't hit them under stress all the time. And I think this is a really important thing most people have to get in mind is like, just because you know what's the right thing to do doesn't mean you can do it. And …

AI assessment note: “one of the first realizations for me... is the element of authenticity.”

Q Compounders is certainly a word that you hear very desirable. I'm curious, as you looked at compounders, take the other side of that, which is what are the compounders that you may see other people invest in that you think don't work very well?

A So one of the false gods in our industry is actually the highest performing short-term stocks are lower quality businesses that are levied. If you catch them in the right part of the cycle, or you catch them when they're transitioning from lower quality to higher quality, those are explosive one year returns. So the trade-offs that I see in people that are coming into compounding is they making like great businesses really trade cheaply. And those that are much more optically valuation sensitive will tend to lower quality businesses if they don't have the patience to wait For great businesses to become cheap. Henceforth, they're trading off business quality. And the reason why they do it. So Ted, I'm not a golfer. I play once in a while, but it's the equivalent in my view, when you're bringing out your honking driver and you smack it down the middle of the fairway and it goes 300 yards, right? But the problem is it's one out of 15 of those holes where it's actually gone straight. That's what keeps pulling people in. So the hardest part about being an investor in high quality compounding is you require At a systems level to build in patience, to wait for great businesses to become cheap. It's very rare, or you need to have the fortitude to be able to predict two, three, four years out and have the boldness to hold through volatility, to see your thesis out. Those are very, very …

AI assessment note: “highest performing short-term stocks are lower quality businesses that are levied.”

Q Great. All right. Last one. And I'm going to ask you about mistakes for our premium members. What life lesson have you learned that you wish you knew a lot earlier in life?

A The number one is game selection. I think this changes lives entirely. People, if they're even listening to this podcast are invested in improving themselves. But if you don't choose the right game, no effort is going to matter. So if you're choosing efficient volatility, you're just running in circles. You're tap dancing on landmines. You've got to know where to focus your effort, and then unleash all the hounds inside of you to go and attack it, but choose the right game, and so unfair fights changes everything, and I wish I'd known that younger, and with a little bit more attention, I've got a lot of energy, but a lot of it was wasted, and I think, look, it's inevitable part of the game, but having wise counsel to know where to focus that energy, and focus on the right game, changes everything,

AI assessment note: “The number one is game selection.”

Q Okay, let's turn a bit to the short side. And as you mentioned, there were three frameworks that you think work for shorts. What are those three frameworks?

A So we have to define this to be a little careful, um, because I think risk is poorly understood on the short side. Our mission on the short side is to deliver five to 800 basis points of alpha consistently. So it's alpha long short spread that matters in equity long short portfolios. And I actually think the left tail in short selling is extremely dangerous. So the down 50 to down a hundred that your thesis is wrong is also happens to be the up hundred. So if you study Any index in any year in the world, six of the top 10 are really low quality businesses. Why? Because it's low prediction and probably very cheap and something happened and they explode. So we actually don't even look. It's very different. We're studying the far right tail on the longs, which by the way, requires only consistency at the 80th percentile to land in the top five over time. So the one year curve is the 80. The ten-year curve is in the five or in the three, actually. The left side, we're focused on the second quartile consistently because the first quartile is extremely dangerous and very hard to replicate. By the way, very sexy to pitch, very, very hard to risk manage, and very, very difficult to execute. So we focus on the second quartile of consistency with the mission of five to 800, which we've done for the majority of the time we've existed, and more importantly, consistently. So here are the th…

AI assessment note: “So here are the three. The first is We call them structural shorts.”