Value Investing Insights Podcast: A Conversation With Artisan Partners' Craig Inman and Daniel Kane

Sydnee Gatewood: Hello, everyone! Thank you for joining us on GuruFocus Value Insights! Be sure to subscribe on YouTube and Spotify so you never miss an episode.

We are pleased to have Artisan Partners' Craig Inman and Daniel Kane join us today!

Founded in 1994, Artisan oversees more than $162 billion in assets under management as of July 31. Embracing its investment talent, the firm allows its various portfolio teams to operate independently through a diverse number of value-added investment strategies.

Craig and Daniel are managing directors and portfolio managers on the U.S. Value team. In this role, they manage the Artisan Value Equity, U.S. Mid-Cap Value and Value Income strategies.

Prior to joining Artisan Partners in March 2008, Daniel was a senior small-cap investment analyst at BB&T Asset Management. He began his investment career as a domestic equities securities analyst at the State of Wisconsin Investment Board in 1998.

Before joining Artisan Partners in February 2012, Craig was an analyst and trader at Reicon. He began his investment career in 1999 as a trader at ING Investment Management.

Thank you so much for joining us today, Craig and Daniel!

Daniel Kane: Thank you. Pleasure.

Craig Inman: Yeah, thanks for having us. Glad to be on.

SG: All right. So just to start off, please tell us a bit about your strategy. What metrics or factors are you most interested in when evaluating a potential investment?

DK: Sure, happy to do so. Maybe to take a little bit broader step back, I think one of the sentences we always use when defining our approach is that we seek cash-producing businesses in strong financial condition that are trading at undemanding valuations. Part of our contrarian streak that we have in this is that we're typically buying what the market is selling and selling what the market is buying. But in executing our process, we're building a portfolio that's better and safer and cheaper than the index. So value investing as we define it is really the marriage of business quality, financial strength and asking price. We call these our elements of margin of safety. And we think all these criteria are important and necessary ingredients in order to get better results than what the index can offer over time.

And so if you think about investing in and of itself, the future is unknown and unknowable, no matter how much research we really do about individual securities. And so you're going to get things wrong. It's just a given in how it works. And so what can you do about this? It's sort of a strange dilemma. So what we do is we stack the odds in our favor by getting a better balance sheet, a better business and then a better asking price all on our side, tilting the odds toward our favor to go a little bit deeper. The way that we define business quality is that we're seeking companies with strong competitive moats, resilient margins, sustainable returns on invested capital and businesses that generate consistent free cash flow. And most importantly, the management teams are more able to control their destiny in terms of how they operate the business on a go-forward basis.

Financial strength, that second pillar there, is really about finding companies that operate with low levels of on- and off-balance sheet debt within the capital structure. The company, and especially the CFO, gets the benefit of having financial flexibility and liquidity, especially in times of stress, which is when we're typically finding the opportunity to look at that particular company, and then lastly to get the entry price right. We've been in the business a long time and so our experiences really taught us that periods of turmoil, setbacks, disruptions, when fear is on the rise, that's when the bargains generally appear in the marketplace. And so that's oftentimes a place for us to go look for these companies. It's easy, frankly, to find well financed or well-run companies.

But that last piece, that valuation piece is really where it's a bit more difficult because valuation means different things to different people. For us, you know, instead of finding things that are cheap, like many people like to say, we want to find companies that are undervalued and when the market is fearful about those current results, that's really when the asking price is getting weak and it's getting our attention.

And, you know, maybe the last thing I'll add is in terms of how we implement our strategies is we think the markets really have this embedded behavioral inefficiency, one of the few inefficiencies left in the marketplace, because investors are human. Humans have a lot of characteristics that don't make us do desirable things.

CI: We're not totally rational.

DK: Not totally rational. We're impatient, we're fearful. We're prone to overweight current events that we read about in the newspaper. We orient around those news events versus fundamentals of a company from a long-term basis. And then if you look at bad habits, we've got them all where we have this distinct desire for comfort in terms of buying things that are doing well. And so we like stock price charts that are going up. We are overconfident in our beliefs and our judgments. We like this idea called confirmation bias and that we're only seeking the sort of information that reinforces the belief that we already have about a company or an industry. And we have this false precision associated with our ability to operate spreadsheets. We think math can solve most of our issues.

And then maybe lastly, there's this idea of greed and I think that's pervasive in the stock market over the course of years. So it's really at this intersection of all those bad habits and behaviors of market participants where we find our margin of safety and we get involved with things that have really been beaten up and we take a longer-term approach, put that margin of safety on our side and we look to find values when others are most fearful.

SG: All right. Thank you so much for that really in-depth answer. Kind of going off of that a little bit more, how do you generate investment ideas?

CI: Yeah. So I wish there was a, you know, if there was a secret sauce, we wouldn't tell you. There's not a secret sauce. So we can give a little flavor for how we find them. And what's important to know is we operate a little bit differently.

So everyone on this team is an analyst first, even though Dan and I are called portfolio managers. Our job is to be analysts. We started our career as analysts. And so we like that skillset, that experience to be built up over time. We think it improves as you do this job longer. And so everyone's an analyst and then also everyone's a generalist. So what that does is that allows us to cut across a wide area. We run with a small team and everyone's rooting around for bargains that really leads to a wide funnel at the top.

So we're finding ideas. But like Dan said, it's mostly in areas where there's fear and pressure and what we are attuned to, with all the experience in this business, is knowing where the market is having setbacks, where there is disappointment, where there is fear building, maybe there's cycle building, maybe the economy is rolling over. Maybe there's, you know, travel is slowing down, possibly like you're seeing in the last few years, inflation is picking up and it's putting pressure on consumer goods and margins in that space. And so that's where we go to find bargains most often.

Each idea is unique; most of the ideas we get are in that wide funnel and they get thrown out quickly because it's very hard to get a name through our filter. It's quite tight. But if you're just thinking about areas we're looking at, we're looking at spinoffs and restructurings. We're looking at management strategy changes, maybe there's asset sales, maybe there's an industry going through consolidation, we read investor letters, we talk to people in the industry, read blogs. And so there's always this searching far and wide for ideas and it's a little bit like that quote that, what is it? “Genius is 1% inspiration and 99% perspiration.” There's a lot of perspiration in looking for those ideas and trying to find a bargain. So when we only need a few bargains, we don't need a lot. And so there's a lot of leg work there up front.

SG: All right. Thank you so much. How, if at all, has your approach been impacted by the market environment this year?

CI: Yeah, I mean, every year has always got an interesting market environment and this one is not an exception. I did ask compliance, and they said we can confirm that we're not buying all the AI high plays. So I don't know if that's news to your listeners, but we're staying away from that.

You know, the one thing we would say is our approach, the way we operate, it doesn't change in and out of market cycles. So it's consistent over time; it's been applied over the 25-plus years that we've been operating. So we don't adjust our criteria and how we invest and the principles and the foundation of investing based on what the market is doing.

What we do talk about, though, is there's markets in these risk-seeking and risk-fearing modes. Some, you know, you call it bull and bear markets; we call them risk-seeking and risk-fearing. We're in more of a risk-seeking environment right now. That tends to be a tougher environment for our process. We're more conservative around balance sheets, around business quality, around asking prices. So in this type of environment, we do tend to not be as excited, we tend to be selling more than we're buying. So what we're doing right now is generally rotating capital out of names that have been successful. We've been buying; we bought a lot of travel and leisure names in 2020 during the downturn in the pandemic. During 2022, we bought a lot of communication services and some media. During 2023, we bought banking in that first quarter when there were setbacks and a lot of that has rerated and been going up.

We've been recycling that capital and buying into areas like health care, staples, some of the areas where there's been fear and pressure building, even utilities the start before they became AI high plays. We were buying them because they've been left behind.

So you know, we're really more in this environment where risk is on. It's not quite as speculative as 2021. That was probably as crazy as we've seen since ‘99 and 2000. But right now there is that element of excitement. We've been generally more cautious and trying to find one-off situations instead of riding the wave up.

SG: Well, thank you. Now taking a bit of a closer look at your actual strategies, portfolios and your letters. In your latest quarterly letter, you wrote about your recent investment in PayPal Holdings Inc. (PYPL, Financial). Apart from improving its performance and achieving financial targets, what are some things you are hoping the company will accomplish over the next several quarters?

DK: Thanks for the question. I think we prefer to look at a little bit longer time frames than quarters. And I think you'll hear that as we go on to talk about how we approach investing. So we're more interested in what PayPal can do over the next three to five years more than what they can achieve. the little voice in my head actually wonders, “Does anybody even think like that anymore?”

CI: I hope they don't; it helps us!

DK: We've become so short-term-focused in the market that nobody wants to look out a couple of years. But if they can make the things work that we believe are necessary to turn the business in the right direction, the stock will be rewarded in a couple quarters time frame. So that's usually what happens, where the price reacts much more quickly to some of the things that take place on a fundamental basis.

We got involved with the stock a little while back, a few months back, when there was really peak pessimism that was baked into the share price. If you look at the stock price charts, it has been essentially flat for a very, very long time and it got really skeptical around turning the business just a few months back. Largely that was based on the fact that the prior CEO was more focused on building a super app rather than catering to the existing customers. There were some plans for catering to Bitcoin customers and things of that nature. And so we actually passed because we thought that the right thing to do was to be focused on driving the efficiency of the button, driving engagement of customers, adding retailers to the network and ensuring there's that conversion for them to be able to get customers to use the PayPal checkout. And that just wasn't happening in our view.

So new management has come in; Alex Chriss has come over from Intuit (INTU) and it seems he's on a pretty good playbook that he's operating from at the moment. He's really abandoned that strategy of creating that super app.

If you think about PayPal from a business perspective, it's a really big platform; over 400 million users on an active basis. And the customer owns Venmo, which I know all of us here have probably used it or definitely my kids have used the app, often too often. And that's the largest ex-China peer-to-peer network, which is frankly under-monetized. We think there's opportunities to be able to expand the monetization of that service.

They also own Braintree, which is the third-largest payment service provider competing against Stripe and Adyen on the mobile side of the business, which they got into a few years ago. And the business overall really has some core advantages in that there's massive acceptance by consumers and merchants on the platform who find that the business is safe and secure. And so they like that characteristic about it. There's broad, you know, but to that end, the company needs to invest in the core button to ensure the technology stack stays relevant and they can approach next-generation iterations of the product to stay relevant. The core business is really intact, broad distribution, the tech stack currently is in good condition, as I mentioned, there's an expanding profit pool of transactions taking place online and through mobile applications. So we think that the pool of profits there gets bigger over time. And then as you know, we'd expect, we live off the fact that there's a strong balance sheet, lots of cash there for them to be able to do a number of different things and invest for the future.

So if you lay it out on a timeline, I think in the first year we would really like to see some cost efficiencies come into the business and management and right off the bat, they start incorporating stock-based compensation into their guidance, which for a tech company that's pretty rare. But I think it's indicative of the economics underlying the profitability of the business, which we certainly factor in. You know, they're gonna have to clean up their act and invest appropriately for the future in kind in year one. Year two, you're probably looking at a point where gross profits and operating profits kind of reach this point of stability where they've kind of stabilized the platform and are making future investments for growth. And then in year three, we should see some top-line growth that will come with new products and partnerships and frankly, they're accelerating some of that because they pulled some of those partnerships forward.

You know, from the other conditions that I talked about, I think in terms that we're looking at, the balance sheet is in great condition. It generates a lot of free cash flow, it's a good allocator of capital in terms of what they do with that cash flow for shareholders' benefit. And, we think it's, you know, something for trading for like 12 times what's probably a double-digit grower over the longer run. That's sort of classic value for us to do. And the interesting part is that nobody wanted anything to do with PayPal a year or two ago when fintech of any other nature, whether it's high growth but no profitability, no free cash flow; they all wanted that, they didn't want PayPal. But now they're starting to realize that free cash flow actually matters and they're starting to warm up to the idea of a turnaround here.

So that's the nature of our investment in PayPal. And again, it's not very old and we're only a couple of months in the campaign, but we're excited about where we think the business can go.

SG: OK, great. Thank you so much! The Artisan Value portfolio also shows a couple of the Magnificent Seven stocks, like Alphabet Inc. (GOOG, Financial) and Meta Platforms Inc. (META, Financial), among its top holdings. While many of these companies have been investing in artificial intelligence for years, what are some obstacles related to the technology that could negatively affect their business?

CI: Yeah, you caught us. We got a couple of the big tech companies in a value investor portfolio.

DK: Well, they've been there a while.

CI: They've been there a while. I think it's good to address that issue. It's a great question. It's one we wrestle with. It's good to address it as both first and then Alphabet separate because there's one issue affecting both and then Alphabet in particular in terms of how they monetize the business and the risk there.

And from a broad perspective, what we see is both companies obviously are investing very heavily in AI. They're spending aggressively in terms of capital expenditures. Meta will be over $30 billion this year, Alphabet will be over $40 billion. It's way ahead of depreciation, so it's pushing down free cash flow. This is where, as value investors, we're not, you know, tech is a little bit different animal in that we would not be good managers of these companies. We would be concerned about, you know, spending too much. What is the ROI on that? But you have to stay at the leading edge; you have to be ahead of the curve in terms of investments and what they mean for the company going forward.

So we give that an acknowledgment and say yes, we don't always know what will be wasted or what will be well spent in this aggressive spending. But from what we can see in the future, this is going to matter in terms of what the business can do to push it forward and to stay competitive. Particularly for Meta, you want to, it can bring engineering efficiency inside the company. It can bring targeting efficiency in terms of the ads serve. It can make the user experience better.

Alphabet search is clearly going towards AI-generated results. I'm sure you've used them, a lot of users out there have. They're better in a lot of cases than the old model. So with that in mind, we're mindful of the capex investment. We're mindful of that push and how it's gonna push the cost structure. We think it will earn a return in the long run. But more importantly, there's only a few companies who can stay in the game in terms of the total dollar spend and fund the investment and then have it benefit their company. So a couple of pieces there, it's a little bit risky, but it makes sense. And the ROI should show up later in the durability of the franchises.

From Alphabet's perspective, we're a little bit concerned about how search evolves. There is a different monetization there. Would its AI-generated results cause the older model or the incumbent model of search to change, would there be less links, less advertising? And does that AI generator open up a window where Bing and ChatGPT can take market share? That was a concern of ours.

What we're seeing so far is the consumer is not shifting. Also, it was really important when we did our research years ago, we knew Alphabet was a leader in AI. So they were more slow to adopt the technology because they were fearful of its results and how the consumer would respond, some of the regulatory issues, but as it got pushed forward, they were right there, neck and neck with adding it to search. So it looks like it's working for them.

Generally, we're also seeing this search, the generative search, is becoming a new feature, not replacing the old feature. So it's a new way for people to search. It's creating more searches. It's not cannibalizing the core business model. It's just costing a lot more money to set it up and build it and run it. And so we're mindful of that risk. You always have these tech changes that can knock a business off of its moat. We're not seeing that yet. So we've been holding steady with our investment there, but there is a path, there is a window you have to be mindful of what it could mean in the future.

SG: All right. Thank you so much. Your recent letter also discusses Airbus SE (XPAR:AIR, Financial). While the company is currently struggling with supply chain disruptions, what advantages does it have over Boeing (BA, Financial) in the long term outside of the 737 MAX issues?

DK: Good question. Well, thankfully, Airbus is struggling with supply chain disruptions rather than struggling like they were during Covid of not being able to take anybody anywhere. So it's a different set of challenges.

Maybe I'll answer the question in two parts; you know, focus on Boeing and then come back to Airbus. If you think about Boeing itself, it's frankly undergoing a huge challenge with regard to cultural issues that they'll need to overcome in order for the business to move forward. And frankly, that's not present at Airbus. Boeing historically was an engineer-led culture at the management ranks by a lot of engineers who were focused on making quality products. And then, you know, there was a tight alignment there. Back in 2001, they decided to move the headquarters to Chicago and they left the engineering and the manufacturing operations on both the coasts. And at that point, you sort of developed a rift and there's a divergence in terms of priority between defense and narrow-body and wide-body segments. You had these competing parts of the company which really opened up the rift in the culture and it brought up several years of quality problems, which frankly have persisted over the last couple of decades. There was design setbacks and eventually the 737 MAX crash was sort of a culmination of a lot of these issues which have come forward and the leadership has turned over what four, five CEOs in the last two decades. So it's been quite a turnover and the management styles all need to be integrated under new people, which happens for a while and then someone else comes to the forefront.

So Boeing has a number of different challenges. Airbus, on the other hand, we think it's been, you know, smartly and strictly focused on the narrow-body segment of the market for the most part and hasn't had those same cultural challenges.

Airbus has a number of different advantages. For example, their A320 family is really taking significant share of the narrow-body market on a global basis. And the backlog, I think at last count, was over 24,000 planes. So there's significant visibility into the production and the cash flow-generating capability, assuming those airplanes get delivered over the next five or six years. The problems with the MAX will actually extend Airbus' lead potentially as Boeing is looking to develop a next generation, they call it NMA, new mid-size aircraft. I think 797 is the platform. That's been scrapped during Covid and they're kind of back to the drawing board.

So we think there's a potential for Boeing to actually miss out on the entire next-generation of mid-sized narrow-body planes, which will all fall to Airbus if that's to occur. The other thing I think to focus on is Airbus is eminently well capitalized in terms of their balance sheet strength, way more than Boeing. Lots of net cash on the balance sheet even aside from customer deposits and work in progress. Boeing, you know, just suspended their dividend, which is an indication of some financial strife there that they need to overcome.

Airbus has generated free cash flow almost every year. Going back in time, I think 2013 and 2020 were the only years in modern history where Boeing, or excuse me, where Airbus hasn't generated free cash flow, which is a significant opportunity for them to be able to recycle that capital in the business and, again, invest for the long term.

It's owned by France and Germany; about 20% of the overall float is owned by them, so that it's in stable hands in terms of who's an owner of the stock price or of the stock.

And then we think management's really been good stewards of capital and allocators of capital over the past couple of decades.

So the demand for the planes is there. It's really, as you point out, it's a bottleneck with regard to the supply of engines. You've had all the engine suppliers have either had disruptions or failures with some of their platforms. And so you've effectively had a case where Airbus has had to push out their financial metrics a year, which we don't think is really a problem in terms of looking at the long term and the long arc of success for Airbus to have.

I think the other, maybe lastly, the important thing is that despite Airbus being a much better platform and Boeing having struggles, the airlines don't want to consolidate all their purchases, generally speaking, with one airline when they want to play them off of each other. Other than, you know, Ryanair (RYAAY) is a complete Boeing and they're really applying the pressure right now to Boeing to get the best deal they can on airplanes.

So being in a position of strength and operating out of that strength like Airbus is, they're able to avoid a lot of that pressure that the airlines are putting on them to get them great deals on new planes. So we like our position there. I think it's a long-term holding that's gonna do well for us.

SG: Great. Thank you so much.

DK: Sure.

SG: Are there any other investments, whether new or long-standing, you're particularly excited about right now? Please tell us a bit about it.

CI: Oh, yeah. The market might be elevated, but we've always got a few ideas.

You know, one we'll talk about, this is in our large-cap portfolio, that we recently bought this year and followed it and known it for a long time is UPS (UPS, Financial). We've actually been FedEx (FDX, Financial) shareholders since 2018, so we've been close followers of UPS.

One of the phrases we always use when we get involved is “the business is under pressure because,” and that really sets the table for how we find our ideas. And in UPS's case, long-run success, but then Covid hit, which is a tricky period because their mix shifts from business-to-business to business-to-consumer. That puts pressure on margins even though volumes are going up because they earn less on those packages.

So UPS initially is struggling, but then volume is ramping up and they fix the margin issue and the business is in success mode as people are home and ordering a lot of goods to their houses. Fast forward and that ends. And so some of that volume starts to roll down and this is the type of business that volume really matters for margin. And on top of that, inflation starts to pick up. So their labor costs are rising, their truck costs are rising, plane costs are rising. So you've got this dual headwind picking up of revenue falling, costs rising, margins falling over. And then you fast-forward the supply chain issues and consumers start to roll down a little more, but more importantly, UPS now faces an issue with the recontracting of their labor with the teamsters into that period. The business is already struggling a little bit, but the union and UPS can't strike a deal very quickly. And so they go to the end of the timeline when the contract is gonna expire into that consumers can't, or customers are worried about their package being lost in a network where there's no drivers and no shipping. And so because it's so important to get your packages to customers, they start pulling volume out of UPS's network. Peak to trough during this contract period, UPS loses about 15% of its volume, yet they can't cut back service levels because they have to make sure they're ready for the peak season that's coming up that Christmas.

And so it's a real bad time for UPS. They're losing volume, they're negotiating a contract that's gonna raise rates and customers are frustrated that they're not getting this, you know, resolved. It puts a lot of pressure on earnings and stock is weak into this period. Fast forward and they don't recover a lot of volume after the deal is struck and margin and labor costs are still elevated. So the market is frustrated, the shares go from $200 down to about $125 today. What we're seeing, and this is where we use that margin of safety criteria, is what we want to talk about. So now at this asking price, when we look at UPS, we say, “Yeah, this isn't the best environment for them. It's actually a really tough one. It's gonna take a couple of years to recover.”

We go look at the balance sheet. UPS is an A-rated credit; they cover interest over 10 times even in a depressed state, debt-to-Ebitda is about 1.20 times. At the same time, business quality, return on tangible capital, even in a depressed state, is a business earning high-teens returns on tangible capital. Long term, it grows volume with GDP and at prices with inflation. So you've got this mid-single-digit to higher revenue growth opportunity.

And then the last piece, it's a high-quality business. In a normal environment, we think this stock is trading somewhere between 10 and 13 times earnings. So you got a very depressed asking price for a higher-quality than average business, one that throws off a lot of free cash flow, one that has strong management, strong moat. I mean, we think 10, 20 years from now, it's almost impossible to imagine a scenario where UPS and FedEx aren't the major networks around the world delivering parcels to make the economic, you know, they're the grease of the economy.

So it's a nice business. We're surprised it's getting this little respect from the market, but that's OK because we got a longer time horizon and we've been in there buying shares.

DK: Almost impossible to recreate that business.

CI: Yeah, it's almost impossible. We love their, you know, one of their taglines is: “We deliver to 98% of the world's GDP in under 48 hours.” So it's hard to replicate and it's important for all of us that they show up to work every day.

SG: Yeah, we definitely get mad when we don't get those packages we want. All right. Thank you for that. Your portfolio appears to be fairly diversified, but are there any areas or sectors you avoid, and why?

CI: We try to avoid the bad ones or where the ones go down. Ha! But yeah, we're always broadly diversified.

We think it's important to have a lot of different economic drivers in your portfolio. Having one-way bets is just that's ego run amok. So we make sure that we've got a broad economic exposure and if we love something, you know, in terms of being out of favor, we're not gonna bet too heavily.

That being said, we don't exclude any sectors per se. What we will say, though, is we exclude businesses that don't earn their cost of capital. And so we're very stingy. There is not an asking price for a business that we would be involved in if it doesn't earn its cost of capital. So if the business has a 6 or 8% cost of capital over the long run, you won't see us involved. You can think of sectors like airlines, cruise lines, mining, some energy businesses, some chemical industries; those are ones that we tend to avoid because the corollary to that low return on capital is often they are also capital intensive. So they require a lot of capex to spend and make the business operate, which then leads to, because it's cyclical, higher leverage levels. So that's two strikes against that business that usually keep us away.

The main point, too, is there will be times where some of these areas are so out of favor, they might be cheap enough you can get a trade on it. But we still tend to shy away because the reality is, even though our investment horizon is three to five years, we are investing capital over decades. And over that long arc of time, to earn favorable returns, to earn a return over the index, you need that business working in your favor, you need that business to have its returns above its cost of capital. You need that profit pool for the business to be growing. And so we want to put the wind at our back in terms of the business having positive surprises, having outcomes that keep generating more and more cash for the owners of the business.

We have a joke we talk internally about if we inherited this business from someone and they gave us the company just to own as our family business, would we keep it or sell it? And if we wanted to sell it, that's an indication that we are in an industry that or a business type that we don't want to be around. So those are the ones we throw aside.

SG: Yeah, that's a good strategy. I like that.

CI: It's not foolproof. Ha!

SG: Yes, true. But the legendary Charlie Munger passed away last year. In your opinion, what was his most significant contribution to the investment community?

DK: Oh, that's a tough one. Yeah, Charlie had so many insights and common-sense thoughts about investing and actually a whole bunch of topics that it's really hard to choose just one.

You know, we're still sad about it to be honest. We've been going to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) meetings and Daily Journal (DJCO, Financial) meetings for probably almost 20 years now, and so it'll be a different feel on a go-forward basis.

I do like one of his quotes in particular and I won't quote it exactly, but he said, you know, common sense is really an enormously powerful tool, people calculate too much and think too little. I think that's particularly appropriate for the industry we work in because there's a lot of investment talent and a lot of brain power that goes into finding securities and buying stocks. That being said, people often think they found the right answer just by looking at the outcome of a cell on a spreadsheet and they don't manage to spend the time and do the work figuring out the basic tenants of the business and figuring out the economics of the business or something that they want to invest in.

And so, you know, not every stock is a buy no matter if the spreadsheet answer tells you so. Then, you know, that really fits with Charlie's other idea of having a 20-punch card. And then you only have 20 chances to buy stocks over your lifetime. You want to make them count when you actually do so. To me, that deep thinking, second-, third-level order thinking, is really a key component that we adhere to and try to put into practice when we're doing due diligence and research on individual securities. You probably have a different answer.

CI: Yeah, I mean, I've got to chime in on Charlie too because we're admittedly groupies. It's just funny because he always wanted people to stay away from cults and we were clearly in the cult that he started.

So I don't know if it's underappreciated, but his character was one that we always admired; that he kept that same character and integrity regardless of winning and losing. And so we think, I think most people know that and use that, but it's something we admire. That fiduciary mindset, having a can-do attitude even when the chips are down, so good or bad you act the same way. We've always admired that.

But there is something I was gonna admit when I started reading about Charlie when I was young. He used to say this phrase about, you know, he's just trying to not be stupid. And I was so young, I thought, “Well, that's silly. It's easy to not be stupid. There's got to be something more and he's not telling us that there's a bigger secret and he just doesn't want to answer the question.” As I've gotten older and just made a lot of mistakes in my life, I've come to realize, and I think it's important to highlight, that there is a path to success that is about not making big mistakes and it's about making little decisions every day that lead to great outcomes. So it's that compounding of little decisions and staying away from the big mistakes that really leads to a great outcome. And it sounds very simple, but it's very hard to execute and do. And that's something I've just come to appreciate more just as an investor, as a parent, as a member of society. And, you know, he always had that way of putting in these little nuggets that seem so simple, but are they're profound and hard to do. And I just always admired that one.

SG: Thank you so much. Those are both really great perspectives on such a great man. I miss him too. But what is the most important lesson you have learned over the course of your career?

DK: [Laughing] How much time do we have? Well, we probably have different answers on this one as well.

But I think one of the things that I've learned over my career is that things are neither as bad nor as good as they might seem in the present moment. One of the people I used to work for early on in my career had this phrase that said, “All stocks are just one day closer to their next blow up.” She worked in small-cap stocks, so that was totally appropriate. But generally speaking, I think that's how the market effectively operates is that we tend to extrapolate things in the good and in the bad and that gives you deep, deep recessions in terms of stock prices and then super peaks in terms of the overzealousness that people have about extrapolating future expectations over the life of companies.

And so I tend to think that people associate value investors with this sort of negative crowd; we're negative on anything. Stocks are expensive or markets too high or we're rooting for recession. In reality, I think we're actually quite optimistic about the long-term expectations for securities. And in that, when we're buying these things, they're typically under pressure. And so we think the future will eventually sort of normalize and things will get better over time. And today's bad news will turn into tomorrow's good news. So I think not being too beholden to current events or one moment in time for me is really something I try to focus on and that gives you a longer-term perspective about making investments over very long periods of time.

CI: Yeah. I know Dan would agree with this one too, but I can't leave it alone without lending a voice to the idea that overconfidence is dangerous. In fact, in our industry, I think the most dangerous element of any investment mindset is to be overconfident.

We talked about it in the opening that no matter how much research and how much work we do, we don't know the future and we never will know the future. I mean, we have as much agency over our lives as anyone and yet we don't know what the future holds for us personally. So how can we look out there and say, “Oh, well, we've got all this figured out and this is how the stock price is gonna react and how everything is gonna play out.”

And so I think we have a really healthy respect, me personally and Dan and the team, for how unknown the future is and how overconfidence is dangerous. So we work really hard to tamp that down and be open-minded. And so that's an important lesson. It takes a long time to learn because you want to be eager and confident in your abilities as an analyst. But at the same time, you need to realize that even greatness might mean only getting 60, 65% of your ideas right.

That last one I think as value investors, too, we sometimes do get a little enamored with the asking prices and we try hard to make sure we get more wind at our back than in, you know, in our face. And that's something I bet we would tell our younger selves when we're investing is it's fine to have some cheap investments and things that might not be great. But over the course of your career, you want more tailwinds than headwinds in the companies you own.

SG: All right. Well, thank you. Kind of on a related note, what would you say is the biggest concern for individual investors in the current market environment? What advice do you have for them in dealing with this issue?

DK: For me I would say I don't think investors really know what they own. And to extrapolate on that a little bit, you know, the construction of the indexes have changed dramatically over the years and concentration has gotten really high and there's an inherent risk in that concentration and you have to be aware of that at certain points of time. And I think that is one of those times we're experiencing right now. For example, the S&P 500 Index might be a great, low-cost way for people to get exposure to the marketplace. But there's a high exposure to just a couple of sectors; communication services and IT make up almost 40% of the weight. So what started out as a very diversified representation of the overall economy has really morphed into something where it has very high concentrations and high correlations of the individual securities in just a couple of different sectors.

And so, that's gotten worse over time. If I recall correctly, the top 10 names in the S&P have really doubled in terms of their weight over the past decade. So that's a significant change and it was just even a few years ago. And we've seen this before in terms of concentration of certain names. Back in the 1920s, you had a number of stocks that were making up the variety of the overall market cap you saw with the Nifty 50 back in the mid-century and again in the 1970s and then also in the late 1990s in the tech bubble. So I'd encourage investors if they want to be involved in one of those indexes to take a look at an equal-weighted index as a way to offset some of that risk.

Maybe the other point I would make is that I think investors should focus on getting rich slowly, not quickly. Especially since 2020, the market's really amplified its appearance as a casino in many cases.You know, people are investing in meme stocks, short-dated options, SPACs, meme coins, made up coins, just about anything you can think of. These are all speculative and a reflection of the short-termism nature. And so I think people are wanting to play the market and that playing the market is really leaving open a hole where people aren't willing to do the fundamental work of doing individual company research and I think that's really going out the window, sadly.

So, you know, I invoke another Charlie Mungerism there and say, you know, other people are getting rich fast by investing in risky stocks. Well, so what? It's OK. It's not a tragedy. You can get rich slowly and do it in a way that's much safer for your balance sheet on a longer-term basis.

CI: No, I think that point about the indexing is really important. We've been high, and we're generally in favor of low-cost indexing if people want to consistently dollar-cost average and keep fees low and be diversified. I would tell friends to do that and at this point, it's become harder to justify because the concentration issue, not only just in the sectors, but in those securities that are winning in those sectors, the valuations are extended, so you have concentration and valuation issues.

And that doesn't always mean you're gonna have blowups in the future, but it does put a big headwind on returns going forward and what you should expect from those returns. And right now, this is more of an environment with the cost of capital up, valuation dispersions have picked up, their active management and particularly the more value versus growth areas seem that, and of course, we're talking our own book there, but they seem to have a better risk-reward for investors. And so I would lean away from some of the more passive index options that have done quite well over the last 15 years as a result.

SG: All right. Well, thank you. Ending our time together on kind of a more fun note, not that investing isn't fun, but whether they are investing related or not, please recommend three books and three movies for our readers to check out. And could you please also share why you like them?

DK: Hmm, want me to go first?

CI: You go.

DK: All right. Right down the fairway you'd expect a value investor to say that he or she is a fan of Ben Graham. And so “The Intelligent Investor” and “Security Analysis” by Ben Graham are ones I'd recommend there. “Margin of Safety” by Seth Klarman (Trades, Portfolio). I like “Common Stocks and Uncommon Profits" by Phil Fisher and, you asked for three, but I'll give you four. I'm a fan of “Hamilton” by Ron Chernow. Before it became popular in the theater, I thought it was an interesting biography.

The investing books are all common-sense approaches to a very complicated topic and they're not really based upon an academic theory. So I like that approach in terms of how you think about stocks and overall markets should function.

From a movie perspective, I don't know how this reflects on me, but I like “National Treasure,” one and two, “Back to the Future” one, two and three and any of the “Indiana Jones” series.

CI: You're Hollywood's core customer.

DK: Apparently I like science fiction, historical fiction and maybe some sort of escape from reality. If that reflects poorly on me, I'm not sure.

SG: I like all those movies.

CI: Fair enough. Golly, books. The one, I mean, everyone's probably read it who's listening or they haven't, I always think “Thinking Fast and Slow” is just a core book to read for anyone just curious about how their brain works and their biases and just enlightening in terms of how we think, getting outside of ourselves to realize we're not as rational as we believe. So I always read parts of that one and uncover something new that I didn't catch before. So that one's just a classic.

Another one, I grew up playing golf, so I love golf, but this one is also helpful. It's called “Golf Is Not a Game of Perfect.” It's kind of one of the original…it's from Doctor Bob Rotella, who's a sports psychologist who helped golfers start to think a little better and understand the statistics around where you should practice and how you should practice, but then how you should think and mindset around something that, like investing, doesn't have…there's no ability to execute a perfect score or be great. Every time you go out, it's always about process and execution and thinking in that way. So I've always loved that one.

DK: Did you get the yips at one point?

CI: [Laughing] I have never had the yips. I haven't been under that much pressure.

There's another one called “Endurance” on the Shackleton journey that I love. That's just a great story, it's true. And it's about the trip down to the South Pole and they get trapped in the ice and the ship is crushed and sunk and they're left on the ice to fend for themselves. And they have to get to an island crossing the roughest sea in the world. They end up basically being gone three years and everyone thinks they're dead. And no one dies and it's just a cool leadership and it's just a crazy story too. It shows you what people are capable of. So I like those.

My favorite movie is “One Flew Over the Cuckoo's Nest.” That's always been my go to; I just love Jack Nicholson and that whole story. It's a great book too, but he just brings that character to life and I'm not sure he was acting in that movie.

Another one I'd say is “Almost Famous” just as a fun movie. That's one I've loved, I think being a parent, some of the quotes in there, you know, when she yells at her kid, “Don't take drugs.” I feel like my wife and I do that to our teenage boys.

And then “Free Solo” as a movie was one I'd throw in there. Just any adventure movie. That one's always been fascinating to me because the story, we know the outcome. It's true. So it's a documentary and yet at its peak, you're more nervous than you are in a regular movie. And I've always thought that was really just an interesting dynamic. You know he lives and you know he's OK and you know this is a true story, yet your hands are sweating and you're nervous and you want to turn it off. And the last piece, it just shows you again that spirit of how the mind and body can work together and what someone's capable of if they put their brain to it, doing something so extraordinary. I've always loved that movie.

SG: All right. Yeah, those are all great choices and I've seen some of those; some of those I still have to check out. But thanks again for joining us, Craig and Daniel. It was a pleasure to have you both!

CI: All right, pleasure. Thanks for having us.

DK: Thank you.