Sean Stannard Stockton - Managing In a Volatile Environment
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Bill: Ladies and gentlemen, welcome to The Business Brew. I'm your host, Bill Brewster. This episode features Sean Stannard-Stockton, President and CIO of Ensemble Capital Management. Sean is a repeat guest. He was the fifth or so episode of this podcast. He's an investor that I look up to very much and I hope you all enjoy this program.
Sean: We're doing good, Bill. It has been a very trying couple months 2022. We also think that there are very unusual opportunities in the market today and I very much look forward to talking to you about what's going on.
Bill: I just got back from Markel and I did a panel there, and I thought it was nice to get in a room where people were focused on the bottoms up and long-term thinking as opposed to thinking about liquidity drains, and whether or not we're in an inflationary environment. I realize those things are important. Inflation specifically is important for the long term, but it was nice to get back to basics a little bit.
Sean: Yeah, I think at the end of the day, at least the types of investors that we strive to be, your focus needs to remain on the companies that you own, the majority owner and operative Ensemble Capital, because we're in the asset management business, behaviors of financial markets matter a lot to our business, of course. At the end of the day, I need to stay focused on our business. Not what's going to happen in three years in the macro environment, whether there is a war in Ukraine or whether the war in Ukraine escalates much further than they are already at. And yet, at the same time, it's critically important as we've written about in the past that investors are macro aware and understand the context that they cannot and we cannot know what's going to happen to macro environment a year or more from now. But we can understand the context of what's happening today and the range of possibilities. It's critical that investors have all that in mind as they're doing that company-level fundamental analysis.
And then things like liquidity, and issues like that, and whether it's force selling across the market, again, it's important to have context to understand why are stocks moving the way they are. And yet, also it's not necessarily our job to try and trade against those prices other than to the extent that they present opportunities for us to trade on a fundamental basis at dislocate market prices.
Bill: It's been wild, especially, I think the last week and a half. We're recording on May 13th. Lord only knows what happens between now and when the episode comes out. It should be about 10 days, but the way that things are moving around, prices could change a ton. How are you thinking about decision making in a volatile environment and keeping your wits about you, I guess, is probably the way I think about it?
Sean: Yeah, I think that should be one of the most important considerations that all investors think about is not just what decisions do I need to make, but how should I go about making decisions. That's something that we've spent the last 20 years thinking about and figuring out. For instance, we've published extensively on our position sizing framework. In conditions like these, if you don't have a framework for making decisions about position size, you are going to be run over by the volatility and making these gut calls. This is an environment in which your gut is wrong. That's just the case, right? Now, you might make a gut call and be right for a week, right for two weeks, and maybe even get successful and lucky. But the human gut is not designed for market conditions like this. The fight or flight response is something that everybody is exposed to. You might think, “Well, I know about that. So, I can avoid it.” It's just not the case. Your brain is going to dump chemicals into your body that trigger a fight or flight response.
It's a very effective response, because a long time ago, you're walking out in the forest, and you think you hear a bear, you just run away. What's the downside, right? There's no reward from saying, “Well, I stayed here and I was right.” There wasn't a bear. There's no upside. But in financial markets, the price of the opportunity is adjusting alongside the real dangers, and risks, and opportunities that are being presented. And so, your brain is telling you to behave in a way that wouldn't be rational, if there was not the market price adjustments to offset it. You can look around at every company in our portfolio and everyone else's portfolio and recognize that risks have spiked for a number of different reasons that we can talk about over the rest of this interview. That's just true. But prices have adjusted. The question becomes, “Have they adjusted by more than they should based on that risk?” And so, if that's the case, you get rewarded for not running, even though, the danger is real. That's really hard for the human brain to identify and understand. So, I think it's critical that investors have a process for making decisions.
In our case, we have a position sizing framework that's very much based on our conviction in businesses and fair values. We’re very structured way for thinking about fair values, especially the terminal value, which is a place where you can change small assumptions, and create wildly different outputs, and it's easy for analysts to solve for the price target they want or that feels good by just adjusting terminal, it's super dangerous. We've built the structure processes. It doesn't mean we're going to get it all right. It just means that we have these guardrails around ourselves that help us make decisions even under conditions of extreme stress and fight or flight response going off in our brains like they're going off in everybody's brains.
But I think just as importantly is to think about, how do you inoculate yourself to some degree against that fight or flight response? It's just like you think about cognitive biases in general. Your audience fully understands that there's all these cognitive biases that humans have of different types and that they are exposed to those. Many people think that if you read about them, then you are inoculated against them. But it's not the case. A psychologist will tell you, “You can know about them and that will help you mitigate them, but only a little bit. You're still plagued by them.” And so, you need a process for making decisions that takes that into account.
One thing that our firm has been doing a lot of for the last couple months in particular is recognizing that you can't sprint a marathon. You can do sprints, and pauses, and sprints, and pauses, and you can do that for a very, very long time. But you can't wake up every morning well before the market and just go a mile a minute all day long, and do that for months and months at a time. We did this business all through the financial crisis. It's two and a half years top to bottom. You never could have sprinted through that whole process. Just like a performance athlete recognizes that to do your best performance, you need periods of rest as well. You need to get a lot of sleep, you need to eat well, you need to keep doing all of your routines and keeping a good mental health. I think that's critical for investors just this moment in time. And so, both personally, as individuals, but also as a team, we've been doing structured work around that like, “How do we take deep breaths?”
One thing that I've been doing personally, I've never been someone who stretches just to relax. On the advice of our Director of Talent & Culture, we started talking about stretching as it means to release stress. I'm started just doing stressors, five minutes of stretches every morning. I've been personally shocked at the mental release that that causes. That's what's worked for me. But I think every investor needs to be thinking about, “How do I for myself personally find routines that I can sustain over long periods of time?” Because we might be in for a long period of stressful activity, not just in financial markets, but in global activities. We've already been through two years of that.
Bill: That’s what I was just thinking. [laughs]
Sean: A lot of people thought we were at the end and it just might be another year or two.
Bill: Yeah. The 2020s are not off to the greatest start of decades that I've lived. It's interesting. Something that you were thinking of fight or flight, it's funny. In bear markets, I often think the flight response is one of the first ones that gets triggered. But as you were talking, I was wondering, if the fight response also gets a little bit too embedded where it's like, “Well, the market is sold off and I know that I was right before. So, am I right now and digging into previous position?” Being able to be mentally flexible is very important. I think I loved your last piece, where you wrote about the fundamentals of your company’s, because I think that's the best way to remain rational, because if you're looking to the market price as evidence of being right or wrong, it's going to be very, very hard to get through this period, I think.
Sean: I think that's right. If you look at, I can't comment on every company, of course, but across our portfolio as we published recently, Netflix has had a deterioration in their operating metrics. There's no doubt about that. But across the rest of our portfolio, looking just at core drivers like revenue and earnings, and both that Q4, Q1 reports, as well as full year guidance, there hasn't been much change. It is mostly things are on track. Businesses like Mastercard that we own our portfolio, which literally has real time analytics in the global consumer spending, analytics that are probably superior to many government economic statistics. They're saying, “Consumer spending remains very strong. Our financials are robust. Global consumer spending remained strong.” They reiterated their full year outlook. If you X out currency, in which that's just one of those operating environments, US dollars and very strong that's dampening reported results for companies in a way that is not fundamentally changing their intrinsic value. And yet, what the market's saying is that, yes, things are good now, but they're going to get a lot worse later this year.
When you think about inflationary environment in which the Feds tools can absolutely do the job to dampen inflation driven by US only inflationary issues. We have more demand than we have supply, we have far more consumer demand than we have labor. The number of people employed in United States is no different than it was just before COVID, but demand is a lot higher. And so, the Fed has the tools to address that. But the Fed does not have the tools to address a shortage of oil due to war in Ukraine, the Fed does not have tools to deal with supply chain crises in China due to a COVID outbreak. They recognize that and because of that the market is rationally worried that we're going into the stagflationary environment. We started writing about the stagflationary panic in early March and our point in saying, “Panic was not to say that it's all made up and there's not going to be any stagflation, but to say the market is aggressively selling off many businesses due to this worry.” And yet, stagflation has been a very rare event. Globally, it's happened basically once in the United States, very rarely in any other developed economies.
Even when you have strong evidence that something's going to happen, if it's a rare event in general, it doesn't mean it's just going to happen. You need overwhelming evidence that something is certainly going to happen for a very rare event to actually play out. And yet, we recognize it could play out that way and so, we have to manage our portfolio recognizing those risks.
Bill: This stagflationary argument, I missed the whole inflation called period. So, I don't know why I listen to myself. But I do wonder how long that persists and what does that actually mean? Because to your point on terminal values, theoretically, return on invested capital times your reinvestment rate. That’s what drives your multiples in a terminal state. Obviously, inflation being a perpetual problem should reduce your return on invested capital, but if it's a two-year problem and you're dealing with a 30-year asset, it's not to me the number one risk that somebody should be focused on, but I also don't want to minimize it. How do you think through that?
Sean: One of the problems of stagflation is that it really only happened United States in the 1970s. And yet, think about a typical recession. What do investors do during a recession? They look at a company and they say, “Well, how has it performed in past recessions?” You look at, “Well, there's been four recessions, and it's happened this way, and three out of four of them, and you set some probabilities, and you have some framework for thinking about how the business might perform in a recession.” If it's a newer business and it hasn't operated in past recessions, you might say, “Well, yes, but there're other businesses just like this one that had been around during past recessions. And so, we know how that that works.”
But with stagflation, it only happened during one time period. That was very different than today's time period. Extraordinarily different. The stagflationary drivers today are not the stagflationary drivers of the 1970s. Even more importantly, think about the businesses that make up the market today. It's not just that these particular businesses didn't exist in 1970s. The whole premise of these business models didn't exist. We own a lot of Google that we've owned for about a decade. How does search engine ads work in a stagflationary environment? There's no precedent. You can't go back and say, “Well, in the 1970s, it was like this.” You can't look at ad spending the 1970s, because it might offer some insight into total demand for advertising, but it doesn't tell you a lot about search advertising. But humans, mostly reason by analogy. They look at, “Well, this happened before in these ways, this what's happened later.”
Right now, investors are being forced to make exclusively first principal analysis of their companies and understanding what would happen in this particular type of stagflationary environment. The uncertainty around that is very, very high. What do people do when there's uncertainty? They basically sell. I don't know and I'm worried. So, I have to get out of this. Or, they look at the 1970s, they do something simplistic and they say like, “Oh, my gosh, that P/E multiple went to 10 and tech stocks were down 70%.” But tech stocks in the 1970s were entirely different class of businesses with entirely different business models than what we refer to as tech stocks today. So, if you think about something like enterprise software as a service, it's going to behave a lot differently than Intel did in the 1970s in a stagflationary environment.
Bill: Yeah, the margins are much higher, I think, on average, at least gross. Something that I think is a really fascinating thing to think about is, what do the valuation implosions do to some of the incentives below the gross profit line and do we get to see some of these companies flash their true profitability that's been promised for so long? Do we get to test that thesis finally and see which revenue is not created equal, I guess?
Sean: I think we saw a version of that, almost like a mirror image of that over the last two years in Google, where we've long had the contention that the underlying profits of the Google Business excluding other bets was much, much higher and that they were reinvesting very significantly through the income statement. You've seen how margins have expanded dramatically. They may well reinvest back in the business and drive those back down over time. But not because they have to, not because those are actually their core operating costs, but because they can and want to to drive additional opportunity. I think that you might see something very similar as people are dealing with, what are the costs that we can get rid of and what are the costs that we can't get rid of? That's going to be an interesting thing for investors to learn about, for sure.
I really think that this moment demands a deep understanding of the businesses that you own and understanding of that business models. The only way I think that you can do that, only I know how to do that is owning a focused portfolio of businesses that you buy on the premise that you're going to own it for five to 10 years or longer. In our case, right now, most of the businesses that we own our portfolio today are the same businesses we owned on the way into COVID, and the same businesses we owned five years ago. We know these businesses inside and out. We can't know exactly how they're going to react in a stagflationary environment or if we don't get stagflation, we just have continued inflation. But at least we deeply understand the business models. We don't just have to reason by analogy and say, “We own these tech stocks. What tech stocks do in the 70s?” I think that reasoning by analogy is going to crush a lot of investors.
Bill: When you own something for so long and then the opportunity set has changed so much with the volatility from over the past six months, do you have a bias to stick with what you own or are you pretty dispassionate about replacing a company that you own with something that may, I don't know, look better in a model or in theory, but you don't really know it yet.
Sean: We try and be very dispassionate about that, but we still have a very high hurdle to move something that we're new to learning about, to replace stocks that we know inside and out. We go through that process in two ways. One, the research process on a new company often is six, nine months, or longer. Now that it takes one of our analysts that long to do an initial report, but that the initial report explains, “Here's the business model. What's going on?” But if we're making the claim that this is a really superior business is undervalued, it's going to take more than even two dedicated weeks of research on one company and nothing else. It's just two weeks, right?
Bill: Yeah.
Sean: One thing getting back to the psychology of being an investor, once you are aware of a company and interested in it, you start noticing things that are relevant to it all around you. I think that's just a very normal behavior. Our brain, it's called a cocktail effect, we intentionally screen out noise to focus on signal. It's called the cocktail party effect. Because if you're at a cocktail party, there's all this noise around you, but you screen it all out, so you can focus on the person that you're talking to. But as soon as somebody makes some that you become aware of them, a second person, you then tune into that voice too, and you hear things that you were just a moment ago where invisible to you because your brain, without you knowing was screening it out.
Bill: Yeah.
Sean: And that happens to investors, too. Our brain intentionally screens out information that's not relevant to us. So, we can focus on what is relevant. But once you start looking at new company, your brains like, “Oh, well, this stuff's relevant, too.” And so, suddenly, it starts seeing information in the market, in your everyday life lots of things like that. It takes some time to do that. Our research process is time intensive and we are slow to replace existing names on purpose, but we do try and be dispassionate about that process. You're absolutely right. We're working hard on looking for new companies because there are some amazing declines in businesses that appear to be very good businesses. If we're right, if those are good businesses and these declines are much larger than declines in our own stocks, well, we should be making some trades.
Bill: Yeah, it's interesting. After so long of growth outperforming, I would maybe now argue that growth is value, which is a mental shift that people need to potentially make. But I know that that's not how you classify things, but it's just been interesting to see how quickly the multiples have come down and some of the commentary around that I think it caught a lot of people off guard.
Sean: I think that's exactly right. Our firm doesn't think about our strategy as a growth strategy or a value strategy. We're just looking to buy very high-quality businesses that have huge competitive advantages and highly relevant products and services run by super capable management teams, and doing businesses that we can really understand. Some of those businesses are very fast-growing businesses, some of those businesses grow along with the economy. There're all sorts of amazing, wonderful businesses that have different growth rates, and you can buy, and make a lot of money in businesses that grow quickly or grow slowly. I think history proves that. A lot of businesses that have returned, really, really great numbers over long periods of time. Some are slow growing businesses and some are fast growing businesses, right?
I think that if you can reject that completely false classification of growth and value, since it's self-evident that growth rates are a component of the value of a company not its opposite, I think that you then free yourself to understand that a business that might look and feel like a high flyer speculative, stock at 80% cheaper prices is not a high flyer and not speculative. If the value initially before the decline was premised on irrational speculation that business is not a high-quality business, then who cares is down 80%.
Bill: Yeah.
Sean: But if the business itself is a good asset, quality asset, and it's that deeply on sale. Don't think about whether this is a growth stock or a value stock. Its cashflows, you're buying on the cheap and that's really valuable.
Bill: Yeah, I think the other thing that I am encouraging myself to think about is whether or not the stocks going to go lower from here, because trying to time a bottom, I don't think is something that I can do very well, I just personalize it.
Sean: I completely agree and I've had that experience in both directions where I think earlier in my career, we would do all of this work and say, “Hey, this stock is really cheap,” and then we'd get ready to buy, and say, “Well, gosh, it's been pretty strong over the last week or two. Maybe we just wanted to pull back. Do want to buy a stock up 10% in two weeks or something, and we'd pause, and two weeks later is up another 10%, and now, you're thinking, well, do I buy it at 20%, have I missed it?” The question is, no, you haven't missed it. You thought it had enormous upside, not 10% upside, you know?
Bill: Yeah.
Sean: And so long ago, we did away with all of that and we built out this position sizing framework that focus on conviction and discount to the valuation, and we pay zero attention to stock price movements are trying to guess what they're going to be in the near term. During this earnings season, there was a lot of companies that reported quarters that were fully in line with expectations and reaffirm their guidance. And then the stock fell 10%, or 15, or 20%. That's really difficult as an analyst to say. Everyone's worried about this thing, collapsing. I got the analysis right and the stock is still down 10% or 15%. You have to ask yourself, “Well, maybe that's because I'm wrong on the valuation and the stock is not." It had to beat and raise to be worth what it was worth. You have to be open to that possibility.
But the other possibility is that people are just panicking. We own some stocks, looking at it saying, “Oh, my gosh, this is a 6% position, they report next week, look what's happened to these other companies that already reported?” Did a lot of analysis. at the end of the day, we said, “Look, it's not our job. We don't have the skill set to guess how the stock price is going to react.” It is our job to understand the fundamentals. Once we affirmed for ourself that we still have confidence in these fundamentals and then the company reported as we expected. The fact that stock dropped 10% or 15% makes you feel sick to your stomach, but we still did the right thing from our perspective. Someone else might say, “No, you didn't. It went down. So, you were wrong.” But if you try and trade around those quarters and guess what other investors are going to do, you're just playing a crowd psychology game. And unless, that's your business model, we trade crowd psychology. You're going to get yourself all wrapped up, and messed up, and lose sight of the fundamentals themselves. If you're going to own businesses for five, or 10 years, or more, the psychological swings will help you enter and exit businesses, stocks at attractive prices, but what you really need to get right is the long-term fundamentals.
Bill: Yeah. Do you want to just give people a refresher on how you think about position sizing and stack ranking your idea set, because I think it's something that a lot of people could learn from?
Sean: Sure. Like every investor, we want to own stocks that traded at a deep discount to what we think they're actually worth. We also want to understand how confident are we of that. The Kelly criterion is a well-known way to think about position sizing was designed for gambling, but how big of a bet should you make based on the probability that you're going to win and how much you would win if you're right. What that math tells you is that as much as very big wins are very attractive. If you have a bet that says, “Hey, if I'm right, I get paid 10 to one then you might want to bet big on that. That's a big payoff.” Even more important in determining your size of the bet, their position size in your portfolio is how likely it is that you're going to be right. In position sizing our portfolio, we actually focus more heavily on how likely we are to be right in our analysis.
The secondary consideration is how much upside there is. Because if a stock is only modestly undervalued, but you had perfect foresight, you knew exactly what the fundamentals were going to be, you're going to beat the market, because it's undervalued, you're right, over time the price is going to reflect the fundamentals, and you're going to have maybe a low level of outperformance, but any level of outperformance is a job well done. It's hard to beat the market, right?
Bill: Yeah, that’s their job.
Sean: Whereas you have something else-- Yeah, if you have another investment that is very deeply discounted and you think is likely to work out the way that you do and the upside is huge, but you recognize. But there're a number of different situations where I might be wrong. It still might be a great investment, once you adjusted for the upside potential. But it needs to be a lower position size in your portfolio. When we think about how likely we are to be right, the reason you can't use the Kelly criterion for investing is you don't know how likely you are to be right on any given stock. In gambling, you can say, “This is how poker works. These are the odds.” And that doesn't work in investing. You can only estimate it.
What we focus on are, what are the elements that give us conviction in a business. Those were pretty sticky numbers for the most part. Your confidence in business and different elements of management and things like that shouldn't fluctuate a whole lot. But there are also times like now, where a stagflation area environment is a real possibility. I'm hopeful it will not happen. I would even say that. I don't think it's the base case and it's not what we expect. However, it may happen. I just think that's what the facts tell us. Because of that over the course of this year, we've made adjustments to our conviction levels in different companies to recognize the fact that, well there is this probability for this rare event that quite honestly we didn't spend a lot of time talking about stagflation over the last 20 years because this thing, just like very-- We didn't pre-COVID say, “Well, what if there's a global pandemic, how will that impact our companies?”
Bill: Yeah.
Sean: Unfortunately, as an investor, you can't take every low probability event into account. You can recognize that there is uncertainty and position size recognizing that weird things might happen that I'm not even thinking about yet and we did do that. But there are businesses in our portfolio that would thrive much more than others, say a persistent period of stagflation. Therefore, we now have higher conviction on a relative basis to other holdings in those companies. And then all else equal, we want to own more of those and less of the others. But that's not making a call on stagflation and then aligning our portfolio for a particular macro-outlook. You just recognizing the odds and how they shift your conviction.
Bill: Yeah. It's closer to having a portfolio that you're comfortable with and then shifting it around to adapt to the environment that you're in. I'm pretty sure I'm saying exactly what you just said to me, but that's how I hear what you're saying.
Sean: Yeah. I think that the important nuance is that if you as an investor saying, “Oh, my gosh, there might be stagflation. So, I should sell this company.” What you're really doing is you're making a bet on your ability to forecast the macro accurately. You might say, “Well, look what the markets doing. The markets telling us, there's going to be stagflation.” But you look at lots of different parts of the financial market, they're not saying the same thing. Equities seem to suggest that energy prices are going to be a huge inflationary pressure for a persistent period of time. But if you look at oil prices, oil is trading about $100 a barrel, the same price it traded at between 2011 and 2014. And December 2023 contract is about $85. The oil market is not priced for some persistent ongoing oil price spike.
Now, the oil market is not traded more efficiently in the equity markets. It's all humans trading stuff. There is no doubt that there is a situation in which the conflict in Ukraine could evolve in ways that cause oil prices to spike dramatically or even the 2023 contract to move much higher above the current contract. Those are possibilities. But that's not what exists today. I think it's important for people to understand that even the financial markets are telling us, “We don't know what's going to happen. There's not certainty. There's not a one-way trade.”
if you exit stocks saying, “This is going to happen,” the only reason I think you would do that is if there's a position your portfolio that would basically die if stagflation occurs. Then even if there's only a 10% chance, you got to get out of that company. You don't want to own businesses that have a chance of dying, unless, that's part of your strategy and they're very small position sizes.
Bill: The other thing that I've thought about over this time is, it's nicer to think about the risks before they occur and not that you can think of every single risk. But I think that a commonality among some of the more quality investors that I talk to is the resilience of portfolio companies to make it through a number of different scenarios. I think when I read your letter, for example, NVR versus maybe a land heavy strategy, maybe in an inflationary environment NVR would benefit more if they own the land at a really cheap cost basis or whatever but you have more resiliency and adaptability in the model as I perceive it.
Sean: That's right. With a business like NVR, you can look at. Well, what if the housing market crashes? Well, guess what? That happened not all that long ago, and NVR navigated that period, and you can see how they operated, and you can recognize that while the stock is very likely to decline. It is not going to kill the business. If you hold the business through that time period to the other side, it's going to radically outperform the land heavy builders. Yes, that's what happened in the past, not because they got lucky, but because the nature of the business is fundamentally business model is slightly different than their competitors. I think that resiliency is one of the really key things.
Going into COVID, we sold out of a single position in our portfolio. It was a supplier of low cost with mission critical parts to automakers that we had owned for quite some time. But in March of 2020, we said, the thing is a bunch of automakers could collapse. If that's the case, this is just a little vendor to them. They have no bargaining power. In the normal noncollapsing situation, they don't need that bargaining power. It's just the fact they're so low cost and mission critical that they can get the price they need. But if the automakers are all collapsing, they're in big trouble and they don't have the scale to do what they would need to do. So, we exited that position.
But we kept everything else. You might think yourself, “Well, wait a second. The condition of the world changed so much, how could you've stuck with most of your portfolio? Why didn't you change in reaction to this huge change in the environment?” The reason is that while we had not prior to COVID thought about how would a global pandemic impact our portfolio, we've always thought about how resilient are these businesses. I think that as we went into the inflationary as opposed to stagflationary environment, inflation has been strong for quite some time now. We had 6% inflation all through the fourth quarter when equities were at all-time highs. And so, that environment, the inflation itself is not what's driving down stock prices.
In the summer of 2021, we wrote a long piece about the high-pressure economy that we believed we were entering. That's much as a forecast just observing. This is the context in which we're operating in. We've always prioritized pricing power. We want companies who offer products and services that their customers find so unnecessary or so desirable that they're willing to absorb price increases. We have a portfolio that while we hadn't, we bought these companies said, “We think inflation is going to be 6% in the fourth quarter of 2021.” We had priorities buying businesses that have pricing power and that's one of the resilience tools that let you get through various problems, including a stagflationary environment.
Bill: Yeah. How have valuations, like, have you changed any thoughts on whether or not valuations impact the downside and conviction? I don't bring it up as a pain point, but we both watched what happened to Netflix and I know it was a fairly large position for you. How has that situation played out and evolved your thinking on that like, either that scenario or has it had broader implications on how you're thinking about portfolio construction?
Sean: Great question. I'll fully address Netflix and I'll first address the simpler question around valuation. If you as an investor had assumed as of 2021 that interest rates were going to stay very low forever. Well, you were wrong and you would need to adjust your valuations. Because if you had assumed very low interest rates for a very, very long period of time, that would create a valuation that's nonsensical with higher interest rates. All during the last decade more than that, but just because it's a period of low rates and now higher rates, we've always assumed that interest rates are going to revert to save the 10-year yield is going to be similar to long run nominal GDP. There is both very strong academic evidence for why that isn't the case and there is also very strong practical evidence. That's actually what it's done. It doesn't do that for every tick of the tenure or the economy, but it does over time.
We wrote extensively in say, 2018 and 2019 when the Fed was going through a rate hiking cycle that if you have a 4% nominal growth economy like we did for a decade post financial crisis, it makes every sense that you should have a 4% tenure, not a 2% tenure. That doesn't mean it's going to be there every year, but it's going to drive towards that over time. In our case, we never assumed interests interest rates are going to stay low forever. If interest rates move above our long-term expectations, we're unlikely to say they're going to stay there forever. This is why the terminal value in the structure around valuing the terminal value business is so critical. Because if you're in the process right now of saying, “Oh, well, guess what, the debt cost for this company is going to be more 5% in perpetuity, not 3%,” that's going to finally change your valuation and you have to react to the fact that you were wrong before, right? In our case, we haven't had to do that.
Now, Netflix has been the position error portfolio, where the operating metrics have not stayed consistent with our expectations. In the fourth quarter of 2021, they added 8.3 million new subscribers. If you look at the business in 2018 and 2019, so pre-COVID, they added about 28 million new subscribers in each of those years. In 2020, they brought in, I'm doing this from memory. There're about 37 million new subscribers. Why did it jump so much? Well, because we were all forced to shelter in place. In this last two weeks of March and in April, everyone just said, “I'm stuck at home. If you didn't have Netflix, you signed up for Netflix.” What else you're going to do, right?
Bill: Yeah.
Sean: Or, you played video games, right? It made every sense in the world to us that the growth that was experienced as excess of growth in 2020 pulled forward demand because a lot of people who maybe would have subscribed later in the year did it in April, so they don't have to be added later. Over the course of 2021, we saw that offset normalize. And so, that by the end of 2021, the average between the 2020 excess subscriber growth and then the lower number in 2021 average to about 28 million a year the same as the two years prior. The 8 million subscribers added in Q4 was consistent with their average Q4 in the past and suggested that we're they're right back on track. So, that was our expectations going into all of this.
Then Netflix says in January, “For reasons, we don't really understand, subscriber additions slowed down starting in the last two weeks of December and had persisted in the first two weeks of January.” They got a very low number of subscribers much lower than we would have expected. Then more recently, they announced that they had brought in only half a million subscribers in the first quarter and guided to a loss of 2 million subscribers in the second quarter, which is a loss of 0.9% of their subscriber base. What you have taking the Q1 results and the Q2 guidance is that you basically have the business subscriber levels flatlining.
Now, the media narrative around Netflix is that they are hemorrhaging customers. Everyone's canceling it. Its competition. And yet, if that was the case, you would likely see subscribers actually going down right in some material away, not in a statistical noise way of less than 1%. And two, if it was competition, which would be a huge issue for our thesis. You would see other streaming providers, the competition is supposedly winning these customers, reporting numbers that reflected those people that would not sign up for Netflix signing it with somebody else. And yet, you are not seeing that today.
In our view, what's happened is that, in Latin America, you've had high inflation and you've had relatively weak labor relative to say, the US, where US investors are most familiar. And in the US, you had inflation. Basically, everyone who wants a job has one, and there's big wage gains, and people have all this cash on their balance sheet. Still, today the upper 60% of households by income have four times as much cash in their checking and savings as they did prior to COVID. You have this very robust consumer and yes, they're facing inflation. But they aren't behaving all that differently. Look at business like Chipotle in our portfolio. They've radically increased prices, but they aren't really seeing any slowdown. People are just saying, “Well, yeah, I get it. There's inflation. I have the money to pay. So, I'm going to keep going.”
But Latin America does not have those sorts of balance sheets to the consumer and they don't have that employment growth and wage gains. And so, unfortunately, we do not appreciate the degree to which an inflationary pulse in Latin America would dramatically slow subscriber additions. We didn't anticipate that there would be a war, that what makes people worry about World War III on the edge of Europe in which consumers in Europe, especially facing big price spikes, and heating prices, and diesel prices with thing themselves maybe I'm not thinking let's sign up for Netflix, maybe I'm watching CNN to see what's going on in my neighbor.
But in the United States, Netflix lost 600,000 subscribers. If you look at the past years, when they have raised prices by 10% like they did in January, they have typically lost a few 100,000 subscribers. In the first quarter in the United States, it appears to us that Netflix is customer behavior, despite all the inflation and despite a 10% price hike of Netflix own service have continued to pay behave very normally. We've seen in Asia continues subscriber growth in Asia. Asia's economies are much further behind in the recovery to pre-COVID levels than in the United States. But Latin America is a real problem. There's no doubt about it. And yet, the stock now trades at 14 times estimated earnings for this year.
The whole time we owned Netflix since we first invested in 2016, the issue has been, does the valuation justify this very high optical P/E ratio. Our contention has always been it has, because they can raise prices so much and that drives the bottom line so much. In the United States in the four years prior to COVID, you had a 49% subscriber growth and 42% price increase. There's quite literally no business, other major consumer facing business that can raise prices by a 40% rate over four years while also growing their customer base that much. That's enormous pricing power and that's what we're looking for. They raise prices 10% in the United States and those subscribers stuck in place in normal behavior patterns. But it appears that the pricing power or at least the pricing power in the context of this inflationary, stagflationary environment in Latin America, and the war in Europe has not been as robust as we expect. And so, that has deeply called the long-term thesis into question. And yet, at these prices, we've held our position, because the price at this level implies that what's really happening is really a high probability that Netflix is done. It was a fad, it's over, we go into perpetual decline, and that seems extraordinarily unlikely to us.
Bill: It brings up an interest sell question. I struggle because I feel when I have held the stock and I've said, “Well, the prices declined more than my thesis,” I just don't think I've done very well on that. The unfortunate thing is when I think about how young my career is doing this, I don't have enough-- My N is insufficient to draw a statistical conclusion. There're not enough iterations of testing that. But how do you think about saying, “Okay, well, the thesis has changed a little bit.” When I'm listening to you speak, though, a lot of what is going on, at least my perception of what you're saying is going on is macro driven and not necessarily execution driven. Well, my confidence in Netflix' strategy comes from my perception of their ability to execute. So, I'm curious to just hear you talk about how price weighs into sell decision versus the qualitative and that tension between how those things interact if that makes sense?
Sean: Yeah, you're referring to the very important concept of value traps. Stocks that are very cheap in any logical way of looking at them and yet, it turns out that they're not cheap, because what the price was really saying was that those fundamentals are going to deteriorate really dramatically. In my own career, having done this for a long time, I've had both experiences. I've owned a stock that got very cheap, and thought it was going to do well, and maybe bought more, and ended up being wrong. I've had other experiences in which things worked out very well. Our firm had an investment in Apple from 2009 through 2018. In the summer of 2012, they launched a version of the iPhone that wasn't such a hit. The stock fell, I believe, 48% while the market rose over that time period. At the time, a lot of people said, “Well, the iPhones just like every other cell phone. It is just like the Blackberry, it’s just like Motorola Razor.” It's a hit for a while and then it goes to zero. That was the thing about the iPhone is that prior to the iPhone, every single hit phone, market leading phone went to zero subsequently. It's not that it lost market share. They all went to zero.
Bill: Yeah, that’s wild. That's totally true.
Sean: Yep. And so, because of that, Apple was extraordinarily cheap for a long period of time because people rationally were reasoning by analogy and saying, “Well, we've seen hit cell phones before they go to zero.” In fact, the iPhone was a transformative device. Not because it was just so cool, but because the whole ecosystem and business model of smartphones was fundamentally distinct. Rather than having this cool phone, you had this pocket computer that connected you to this global internet in ways that have become indispensable to most everybody. There're enormous number, billions and billions of people around the globe own smartphones and depend on them. Apple got a new version that did well, and they were back on track, and the stock did extraordinarily well after that very large drop.
Now, that one lesson is no reason to hold Netflix. Netflix is not Apple. The conditions are fundamentally different. But I think it's our job as analysts to understand when is it right, probabilistically correct to hold or add to a stock that is down a whole lot, and when is it time to pull the trigger and exit the position. I think the way I think about it is that our conviction in Netflix has declined. Behavior that we did not expect occurred and therefore that gives us information that in this case tells us that Netflix' service does not appear to be as necessary as desired within an economically constrained household, within Latin America, and potentially within Europe. While at the same time, we've gotten evidence that even in a high inflationary environment, it is just as relevant to US consumers as it always has been in the past. We have to incorporate that into our thinking. Both our conviction in the business as well as our forward forecasts have been adjusted because of this new information.
One thing you never want to do and this is where I think value traps come in is you say like, “I know, there's all these problems, but look how cheap the stock is. I should just hold on.” No, that's wrong. That's when you exit. You need to maintain at least a base level of confidence in your forecasts and a base level of conviction, the different elements of the business, because if you don't have those, you shouldn't own it at any price.
Bill: Yeah, it becomes too hard to put a valuation on.
Sean: That's right. Markets are really quite efficient. Our job is to outperform the market, which means, we believe markets are not perfectly efficient, but they are highly efficient. That's why it's so hard to outperform by all that much.
Bill: Yeah.
Sean: Even these very brilliant teams of people utilizing the most incredible resources really struggled to outperform by all that much. We can all hope to do a little bit better. Now, a little better over a couple decades, compounds into a whole lot better and that's why we're all in this game. But at the end of the day, if you don't have a very high level of conviction, in each element of the business and a high conviction in your forecast, you got to assume the market price is the efficient price. It's not our job to own efficiently priced stocks. So, that's when your thesis breaks, that's when you get at it at any price.
Bill: Yeah, I have a friend who-- I guess, the best way to say it is, default is always that the market price is correct. If he thinks he's right, he's always trying to disprove his own thesis. What you just said, really rings true or at least, triggered that thought for me, because I don't know. When I was a little more green I just assumed, “Oh, I see one thing and the market sees another, and that's how I'm going to outperform.” I have with a little more experience realized that maybe the aggregate of humanity knows a little bit more than I do. People ask me, “How the podcast has changed me?” I say, “The more smart people I talk to, the more I realize I don't know anything.”
Sean: That's the analogy around wisdom is that initially, as a young person, you think you don't know anything. You recognize that very quickly, you think everything. Then later you learn again that very little.
Bill: [laughs]
Sean: But you do start to understand, what it is that you do know and what are the many things that you don't know. That was a conversation we had internally during the early days of the attack in Ukraine is that I know with certainty that our team does not have the ability to analyze incoming military data and make forecasts about the evolution of this conflict. I also know that experts also don't know. Geopolitical experts have a horrible record of forecasting, really, really bad. That is different than say going into COVID. Going into COVID, my team understood that we were not epidemiologists. We were not going to be able to make these forecasts. But there were people who do understand epidemiology, who could not tell us, “Here's what's going to happen.” But could tell us, “Here's how pandemics work, here's the range of possibilities, here is what you'd need to look for to understand the progression of this event.” And so, we could ramp up very quickly by figuring out who knows what they're talking about and learn from them, which is what investors do on all sorts of different topics, right?
Bill: Yeah.
Sean: But you need to understand, what are the topics in which there are experts who because they're experts actually have real insight and what are topics in which nobody has real insight? Unfortunately, geopolitics is one of those. There're very smart people who have spent their careers working in this area and they can understand context. But much like economists, they can understand context really well, but they can't tell you what's going to happen in the future. Humans do not have the ability to make forecasts about complex dynamic systems like economics and geopolitics.
Bill: How are you thinking about underwriting a business? This is just a question I've been asking myself and I'll give away my answer. So, maybe you know where my bias is, but I've come to the conclusion that if I can't do it on the business, then I just shouldn't be looking at the business right now, but it's interesting. We had the COVID bump, and I think the market over extrapolated growth, and then now, I think we have the travel bump, and I wonder if the market is over extrapolating a little bit of travel demand. But I do think that's more secular or at least was pre-COVID, and now, we have this inflation bump. How are you interpreting data in a world that seems to be very chunky right now for lack of a better term and stuff is stopping, and then going, and trends are starting, and then stopping, how are you thinking through that?
Sean: No matter how much investment analysts like ourselves tell us that our forecasts are based on these analytics of the business and the competition in the industry, honestly, a lot of its trend following and trend analysis. A lot of forecasts are basically looking at past growth rates, and behaviors, and then making assumptions about future conditions, and applying those trends. That's actually not a bad way to do forecasting. The problem is that in a normal recession say, as I referred to earlier in the interview, you can look at other recessions. You can understand what are the early cycle industries, what are the mid cycle industry, what are the late cycle industries? If a recession starts about now, which industries are going to enter their own recession at which time periods, which ones are going to exit at other time periods? COVID was not any of that. And so, you have these wildly divergent trends.
In a normal economic cycle, businesses might be early, mid, or late cycle businesses, but they are all following the same core set of macro-economic activity. Whereas, since COVID began and continuing today, you have wildly divergent trends. I'll give you an example. Within a single business, so we have a large investment in Home Depot. Home Depot is today about 50% of the revenue comes from, “Do-It-Yourself homeowners.” People like you and I, who went to Home Depot to get a light we want to put in the garbage alley, right? And then another 50% is from pro-contractors, who are doing jobs and midway through the job, they're like, “Oh, man, we need these parts, and everything, and we can't order it for delivery in two days.” They said, “We're going to take a run or we’re going to go out to Home Depot and pick up all this stuff.” So, it's almost this convenience store in a way for pro-contractors.
In the summer of 2020, you and I, and basically, every homeowner in the United States was like, “Well, all I can do is socialize outside with my friends. So, I better fix up the deck, put it in a barbecue. Put up a pergola, or gazebo, or something. Maybe I'll put in a hot tub.” There was this massive splurge of do-it-yourself spending at home improvement stores that greatly benefited Home Depot's results. But at the same time, those same people were saying, “But the last thing I want is some contractor, who I don't know coming into my house when none of us are vaccinated.”
Bill: Yeah.
Sean: The contractors who maybe were ready to go work say like, “With the county office, they're not even issuing permits. We can't do any real work.” The pro contractors basically were unable to operate. Here we arrived at the fourth quarter of 2021. And Do-It-Yourself spending, we believe, Home Depot does not break this apart and tell analysts what it all is. Lowe's offers more commentary. You can do some extrapolation and you can just look at what's going on in the economy. But we believe that Do-It-Yourself spending has been declining even as Home Depot's revenue has been growing. It is starting to get back down towards more normalized level. It was greatly elevated in a COVID bump way and has been in the process of normalizing.
But pro-contractor spending in the fourth quarter of 2021 was likely over 20% growth rates. The pros are all saying the same thing. “We're booking jobs for 2023. We are booked for all of 2022.” If you have demand destruction, you're dropping people out of the end of your backlog, right? But everyone who drops out, the next person in line is pulling forward. It's important for investors to understand you can just look at their same store sales and say demand is growing or falling. Under the cover, there are these wildly divergent trends. They're averaging into some number, but that average is probably giving you no signal. It's just noise. You need the signal is that the two trends that are operating in different ways and understanding how those are going to operate going forward will tell you what the full number is going to be. But the full number itself on a blended basis doesn't have much informational content. That's happening all around the economy and travel's a great example.
Bill: Yeah, the other thing that I've been thinking about is, to your point on what the market is signaling, I believe the market is saying, “Okay, well, it's true.” Especially with some of these cyclicals, they're saying, “Okay, people are buying homes today, but rates are going up to the point that they're not going to be buying homes.” The home builders right now are saying, “Well, some people are getting disqualified, but other people are backfilling that backlog” like you said. And then I get to the point where, “Okay, well, if we are in a scenario, where policy breaks the back of inflation, why can we not be in a scenario where policy can fix a problem that it created,” if that makes any sense?
On a long enough time horizon, I know I don't know, but I think it's very easy going back to the fight or flight thing. I think it's very easy to worry for me at least to worry about like, “Boy, if I buy the stock and it goes down 20%, aren't I going to feel like an idiot?” The next year and a half may look really bad, but I'm trying to remind myself that we're all dealing with long duration assets. At least when things were a little more euphoric, I claimed that time arbitrage was a good strategy. So, I should continue to claim that when things are less euphoric.
Sean: That's right. One thing we saw during earnings season is companies that had either significant currency exposure. US dollar is up 10% year to date.
Bill: Yeah, it's the best asset. [laughs]
Sean: That dramatically reduces the value of foreign revenue to a US domiciled company. In a typical quarter, FX currency might impact results by a percent or two and for higher growth business that might just be noise within everything else, so you don't bother to model it. But when you have a 10% move in the dollar in four months, you have a very quick and large impact on your reported revenues from overseas. One of the dynamics that we've seen play out this earning season is that companies achieve their first quarter expectations. They reiterated their full year outlook and they guided the second quarter down due to currency.
Well, that currency impact does not mean that you're going to have declining growth rates or lower growth rates forever. It means that there has been a reset of the value of foreign revenue. If you think it is going to continue, you're just making a currency call that the dollar is going to keep appreciating. And maybe that's your outlook as an investor. But we don't believe we have the ability to forecast currency exchange rates and the evidence shows that very few people are any good at that at all.
And then there's situations like China, where we know that there has been shutdowns and then rapid re-openings in the past. We also know that China has to do that to maintain their economy. And yet, we also know that the COVID situation in China could just get a whole lot worse and they might wish to reopen. If you have a business say and again this was the earnings season, where they're saying something along the lines of our Q2 guidance, because of our exposure in China has been reduced. But we expect to make it up in the back half of the year. You should recognize it. That's actually completely rational. However, you are also needing to assume that COVID spike does not continue in in China. But that is a very different analysis than saying, “Oh, my gosh, my growth company missed, my growth rates are slowing down.” It's like, no there's a very known event that's occurring that is outside the control. The company has anything to do with demand for the products and services at a core level. But macro event that may continue, so you can't just throw it out.
Bill: Yeah, I say that I'm trying to remind myself to get the basics. But one thing that I continue to wonder about, I don't know if you're familiar with Michael Green's theory of just that the amount of money that's entered passive has made the active manager. There are fewer of us out there and I wonder if there's a scenario, where passive-- If we see sustained passive outflows, which I think we saw last week. If there's just like a pocket of really generational opportunity and I don't think it'll stay for very long, because I think it would be a V scenario. But I just wonder if there's an air pocket in some of these stocks. The difference of how growth guys look at things and how value people look at things, and I shouldn't say guys, there's growth women, too. But there's just such a big dichotomy that I think some of these stocks get put in a penalty box and it takes a big drop but that's temporary. So, I think bottoms up is the way to go.
Sean: Yeah. If you have some sort of cascading redemptions that forced stock prices lower, what you're dealing with is an environment in which the sellers of the equities are distressed or forced to sell, no matter the price. You mentioned that in relation to index funds, but that is almost certainly happening with some very well-known, very well-regarded hedge funds, who have enormous assets and who have owned a lot of the, I would term very speculative meme type stocks that peaked all the way back in February of 2021. And yet, those same funds also own some very high-quality businesses. It suggests that there is almost certainly some degree of forced selling in the market. When you have a distressed seller, they are forced to agree to a price that is far below any rational intrinsic value.
Now, that does not mean that every stock that's down is down for that reason. But it is clear that there is that pressure in the market in some stocks to some degree today. I can't think of any better reason to be buying an asset, a quality asset that you have conviction in. Where an opportunity presents itself where somebody is coming to you and saying, “I have to sell this. I have to sell it right now. What will you buy it for?”
Bill: Yeah.
Sean: I mean, what a blessing? What a terrible event for them to go through and what opportunity for the other side? You're not taking advantage of them. They need to sell the asset, they need to find a buyer. You are providing them the liquidity that they must have that you do have. This is the opportunity available to people who cannot look at the stock price as an indicator of the business value, but to understand the business value, and understand the price, and recognize when they're presented with an amazing opportunity.
Bill: Yeah, I like that. It's a good reminder to people out there. I know your analysts, I hung out with Todd at Berkshire, I'm not sure if they need your coaching right now, but how are you keeping your analyst's heads on straight, when they have a recommendation or something to you and their stocks are going against them. Is their internal coaching that's going on? I suspect they probably don't need much, but I figured I'd ask.
Sean: It is just as much the case that they're coaching me, too. If you have a well-developed team, you should recognize that seniority does not make you immune to fight or flight. It does not make you immune to worries about what's going on in the world. It doesn't make you immune to watching a big holding drop 60% or 70% and cause enormous psychological pain and difficulty. All of us are working together to hold each other up. I think the key thing that we've done in our shop is that we have a lead analyst on each company, who's charged with managing that particular position and pitching it to the team and everything. But each of us rank every position on this conviction scale because we force rank all of our holdings, including the businesses that we are not the leading analyst on and into quartiles. We have our top quartile in terms of competitive advantages, middle quartiles, lower middle bottom, management quality, value created for employees, our level of understanding of the business. We do each of those things.
Then the fair value, the model is managed by a single analyst. If we're trading on it, we've all agreed to it. If any of us have any concern about a model of somebody else, it's incumbent upon us to discuss that and to get to a point, where we can all live with. In addition, every member of the team has veto power over every company in the portfolio. If one member in our team says, “Listen, I no longer have confidence in this business, something has changed in a way that I've lost conviction.” We have a very high threshold for a business to be in our portfolio. We only own 20, 25 stocks, and there're lots of stocks to look at. We better have something that we all won't agree on. We have huge ongoing debates about every position in our portfolio, but every analyst has said that every company crosses a threshold level of conviction on each of our conviction analysis points. Every analyst has the ability to veto a company.
If any analyst says, “Guys, I just realized I don't understand this business as much as I did given these new events that have happened.” Or, “Hey, team, the management, I think they're making some big mistakes and I've lost a lot of confidence on management.” They can veto the position. Now, first, the others, if they don't agree have the opportunity to make a counter. We can have long debates about this. Weeks, or months of debating this. But in the end, if the person who's called veto is not convinced, they have the power just to pull us out of the position. What that allows is that every one of us is responsible for every company in the portfolio. If it's in the portfolio, we haven't vetoed it.
When a stock goes very hard against us and other teams might look at the lead analyst and say, “That person really screwed up.” Every one of us could have pushed the veto button and gotten out of it. By not doing that it is on us just as much as anybody else what the stock has done. Because of that we've had stocks in our portfolio do tremendously well and we've had ones that have done very poorly. And yet, I don't know, honestly, do not know, what are the rates of return been on my stocks versus Todd’s stocks versus Arif's stocks. I wouldn't even attribute it to any one of us, because all of us collectively offered huge input. There’re stocks that I'm the lead analyst on, where Arif and Todd offer insights and points that have fundamentally changed how I model the company after I recommended it. And then we go into great gains. Was it my doing, because I picked it or was it they're doing for pointing out that I still had undervalued the stock? So, that's really critical.
But hey, we've spent a lot of time talking about like we did during COVID. This is a moment in time, where the conditions in which we're operating under are enormously stressful and it's going to damage our decision-making effectiveness. To get through this, we need to recognize that and find ways to counter it as we talked about earlier, and we need to constantly reaffirm that like we're all doing this together, we're all doing as best we can, and we have each other's backs. That doesn't mean we'll always support each other's points of view. We have each other's backs that we will always counter other people if we disagree with them. We will affirm if we do agree. We'll go either way and call it as we see it. Having that level of trust with your team, I think is what's key to get through difficult environments.
Bill: Yeah. I've always admired how you built your firm and how you talk about team building. That's just one more example of a great answer.
Sean: I'll tell you something. All of this relates to the shift to remote work. There's more and more. I just read the JPMorgan has been backing off their demand, everybody go back to the office. There's more and more evidence that-- White collar workers, who have the ability to be just as productive in a remote or hybrid environment are going to continue to be remote or hybrid. This is both because they are going to demand it and because if it's true that they can be just as productive, management will realize, “Well, why were we asking for anything else? Our goal is productivity, not to have people in the office.”
Our firm embraced remote work prior to the pandemic, I feel very lucky about that. We didn't forecast a pandemic. We just said, “Hey, the traffic in the Bay Area has gotten so bad. We have difficulty attracting talent, who lives only 20 miles away,” because it's an hour and a half commute or something. We expanded that. Then we brought in Todd, who lives outside of Cincinnati. One of the key reasons was to say, I was born and raised in San Francisco, Silicon Valley person. Arif was born raised in New York City, has lived in Silicon Valley for a long period of time. We know we have a certain lens on the world. So, can we find somebody to add to this team who has a different lens? Todd has lived in very different places than Arif and I have had and he absolutely has brought a different lens. Different lenses at the same problem, I think is a really critical way to look at things and find better answers.
But one thing I have been very surprised by is, how many analysts have communicated with us that they don't think remote work is going to work? I'll give you one particular example. Somebody told us on Twitter that, “The reason what work doesn't work as, for him as an analyst is the way he gets a stock in the portfolio is he runs into his PM in the break room over coffee.” If the moods right and the person is in the right frame of mind, he'll nudge him in and pitch him in stock. In a remote environment, he doesn’t have the opportunity that nudges PM into buying a stock when they're in the right mood. I couldn't imagine a worse way to manage a portfolio than that and manage a team of analysts.
My own take is that what the person is really saying is that we have a dysfunctional decision-making process that is maintained somewhat functionally in office environment. But remote work would break our dysfunctional process. To me that's not an argument that remote work doesn't work. It's an argument that dysfunctional investment management teams cannot work remotely. I think that in five years, intelligent, large asset allocators will go to asset management teams that operate in one building with a team that lives within a short commute of that building and say, “How could you possibly have the best team here when all of you have the same lens on the world? When there's all these talented analysts all across the country and even around the globe who you could be attracting talent, how is it coincidentally possible that you've attracted these people who just happen to live near this one building?”
In my own view, the need to build a skill set to operate as a team in a remote capacity is a necessity of every single asset management team. It's not going to be simple. It's definitely not simple. It'll take time and the value of in person interactions is very high. Thinking about hybrid environments and intentional in person work, all that super important. But I really think that firms that don't appreciate this ability now to source talent from all around the country, all around the globe and have people with different perspectives are missing one of the most exciting opportunities to come across the asset management industry in a very long time.
Bill: Yeah, I like that when you were describing that. It sounds like a political decision-making process, which typically is not the greatest decision-making process. If you feel you got to nudge somebody in the decision, but that's how some of the world works. I don't know. I commend you for zigging while others zag. I guess, we're coming up on time here. Is there anything that you feel pressing to get out that I haven't asked you about or we can always do another pod sometime if you're willing to come back on?
Sean: I really enjoyed the conversation. I think that investors who have spent the last two years thinking to themselves, “Well, gosh, this is an unusual time.” But it's all going to normalize at some point in the future and it's going to normalize in this new way that's going to be really great. Have had those illusions shattered and recognized that. I think about COVID, a little bit. If you drop a rock into a lake, it creates these ripple effects. But COVID was like a boulder being dropped into the lake. The ripple effects have been seen in these dynamics around trends that we talked about earlier in different parts of the economy going in very different directions. At the same time, that trucking companies are saying, “They're falling demand.” Travel companies are saying, “Oh, my gosh, we've never seen demand like this.” No other recession has seen those two industries move in such dramatically different directions.
Those waves, if you drop the boulder in the lake, the ripples are not ripples, they're waves and they crash against the shore, and then they come back and crash again, and they create this turmoil. All of that was going on as we exited COVID anyway and now you have the war. Now, you have all these other instances. I think that it's just important to recognize that there is actually no point in time when investors think to themselves. Well, given everything is so certain and everything is so normal, I'm bullish on stocks. It never happens. At all points in time during bull markets and bear markets, people have uncertainty and things feel abnormal or went off in some way, if you say, “Well, no, I thought things have been really certain a few years ago,” you just weren't paying attention, because there is always uncertainty.
The fact that there's a war in Ukraine now does not mean there was no probability of it last year. You just weren't focused on that probability. But there was always a probability that you could have some war created. There was always a possibility that you could have these different events happen. It's just that they were low probability events that have now risen dramatically. I very much wish all listeners well and navigating the current set of uncertainties. But just remember, when we get through whatever the current challenges are, there will be new sets of uncertainty and I think that needs to be a part of your understanding of the world as you are an investor.
Bill: I like it. That is a heck of a way to wrap up a great conversation. I look forward to seeing you again. Shoutout to John at The Manual of Ideas for introducing us for the first time. It's been a fantastic relationship and I look forward to knowing you for many more years, Sean. Thank you.
Sean: Thanks so much, Bill. I really appreciate your podcasts. You really do a great service for our industry.
Bill: Well, mostly because of my guests. So, thank you for participating. Now, twice.
Sean: Thanks so much.