Henry Reardon - Asymmetric Contrarian
Album art photo taken by Mike Ando.
Thank you to Mathew Passy for the podcast production. You can find Mathew at @MathewPassy on Twitter or at thepodcastconsultant.com
Please leave us a rating in your favorite app store!
[The Business Brew theme]
Bill: Ladies and gentlemen, welcome to The Business Brew. I'm your host, Bill Brewster. Hope you had a Merry Christmas, happy Hanukkah, or anything else that you may or may not have seen celebrated. This conversation is with Henry Rearden. You may recognize that name from Atlas Shrugged. Yes, it is a pseudonym. You can follow Henry on Twitter @integrity4mkts. Markets is M-K-T-S. Henry joined this pod to talk about his Carvana short. Then we went into of his philosophy on how he invests on the long side. I enjoyed talking to him a lot. I think he's an interesting contrarian-type investor and somebody that everyone can learn something from.
This episode is sponsored by stratosphere.io. Stratosphere is a modern financial platform. Some might call it a terminal. I'm going to tell you, it's a great website that has high-quality data. They triple check their data. I like how they have customizable layouts. You can change things from quarterly to annual, percentage, dollar. A lot of this stuff is-- If I were drafting up a financial research tool in 2022, how would I do it? My man, Braden over there has figured it out and I like the product a lot.
You can sign up at stratosphere.io for the free product. Should you want more years of financial information, or KPIs, or some of the more premium features that they offer, sign up for that using the promo code, BREW, B-R-E-W for a 15% off discount. I will note that. Should you not see a KPI? Ping the team. They are incredibly responsive. They update things quickly and they are looking to iterate to make the product as good as possible. I really like them and I like the product and I'm happy that they're our sponsors. So, again, that's stratosphere.io S-T-R-A-T-O-S-P-H-E-R-E dot I-O.
As always, none of this is investing advice. This is for entertainment purposes only. You should do your own due diligence and enjoy the show. All right, have a good one.
So, ladies and gentlemen, I am thrilled to be joined by Henry Rearden, also known as @integrity4mkts. How do you spell markets, M-K-T-S, right, on Twitter?
Henry: I believe that's correct. I should know that. M-K-T-S, that is correct.
Bill: There you go. So, I followed you for a little while and I think you reached out to me after the Cohodes interview. Maybe not. I know that you worked with Mark on vetting the Carvana short idea that you had. And kudos on great work. Well, I wanted to have you on the podcast, because I've listened to your podcast with Brandon [unintelligible [00:03:14]. And I noticed that you're very comfortable to be contrarian, and you're very comfortable to be concentrated, and you're comfortable to swim against the tide. I think that those are all traits that one needs to be a really great investor. So, thank you for saying yes and I appreciate you coming on the show.
Henry: No, I appreciate you having me on here. Giving me the opportunity to present a case of why not all short sellers are evil in the scourge of capital markets. Most of us aren't short sellers all the time. Most of us kind of just tend to try to understand how the world and how people work, and to your point, are comfortable being contrarian or at least thinking independently at a bare minimum. When the facts line up on the long or the short side going with the conviction or following the numbers or the money. But as we'll discuss, it's much different. Buying a stock is not the same as shorting one and they are very different skill sets, which is why I had reached out to Mark and he's been incredible helping me through the last year or two.
Bill: There're a lot of people that listen that know exactly what you're saying and there's some people that listen that don't. So, would you mind discussing a little bit of the different skill sets that go into shorting versus being long?
Henry: For sure. So, at the end of the day, everything is fact-based. It doesn't matter what you think you might know or really understanding the economics of a business is how you can build an investment thesis. And so, for me, everybody does it differently. How I talk about, how a distressed investor talks about, how a value guide talks about, and how Cathie Wood talks about investing is very different. For someone like me, if I'm going to buy a stream of cashflows or a stream of earnings, I really want to know what are the drivers, how sensitive is it? And then, if I'm wrong, what kind of asset value might be there to protect me on the downside?
You might look at a retailer that Amazon is disrupting or that is having some inventory issues and is seeing margins compress, sales go away. You say, "Okay, I can roughly model a scenario, an economic scenario, where it can be a little bit bad, it can be really bad, it can be worse." And then, you say, "Okay, well, what are the assets? Do they own any real estate, how much flexibility is there with the balance sheet?" So, you're always trying to build different scenarios and understand what your downside might be when you're buying a stock, a bond, an option, anything.
On the short side, it's a little bit tougher because you're doing the same work and analysis to try to say fundamentally what is something worth, but when you have an environment where something a story can trade at tens of Billions of dollars or cryptocurrencies can go from zero to a $3 trillion asset class, you just have to be careful and humble. We've seen a number of instances where people might have thought that Tesla was a carmaker and they weren't going to scale, and the accounting was aggressive, and then it went up 20X. For people that thought that AMC or GameStop were dying retailers, and they also reached a meme status and if you thought you knew better that fundamentals mattered, you would have been carried out.
So, there's great value investors that say that, "Buying a stock is an act of real arrogance, implying that you know more than the market or the other side of the trade." To do that, it has to be met with equal amounts of humility. On the short side, it's much more dangerous, especially when liquidity and momentum drive things more than fundamentals, which is the environment we were in. So, you have to size it, use options to hedge if you can, which is how I had done it or use derivative strategies to be a little bit more careful than just-- I like Apple, I like Meta, I like oil and gas producer X, Y, and Z, and I'm going to buy and hold and don't think about it as much.
Bill: Yeah. The other thing that's tough is and what prevents me, part of what prevents me, the other thing is I don't know that I want to put in all the work to be a short seller. But as it goes against you, the position gets bigger.
Henry: That's exactly right.
Bill: So, it's a portfolio management perspective. It's more complicated in my opinion.
Henry: Absolutely. You assume it's similar. You assume that any position, at least I do, anytime I buy a stock, it tends to go down. So, I've often joked that maybe I should launch a Costanza fund as a partner to my original [Bill laughs] that every time I come up with a buy decision, I will immediately short the stock for at least the first 10% to 15%, 20%. I'm sure other guys feel the same way. It's just the way that markets work, because there's so much psychology involved with it. Well, so, if you assume that anything can move 20 to 35 plus-ish percent against you or the wrong way, well, those shorts tend to be one, a little bit more or much more, and they happen fast. They are vicious, because usually, you're not alone in seeing some odd accounting or some irregularities. And so, you have to be mindful of the short interest, you have to be mindful that the promoters of these companies don't tend to throw up their hands and say, "You got me. I was having some fun here, but you got me."
No. They like to do things that make it very uncomfortable and difficult absolutely. I like to say that my investing style is more art than science. When you're shorting, you're watching it night and day. If you don't know more about it and how it trades and the flows are prepared to step out of the way when you need to, then it can be career ending, I guess.
Bill: Yeah. The thing that was wild about Carvana is, I'm just an observer, but I had talked to some people. I think what we are allowed to say, the founder or the father is a convicted felon. A couple of guys that I know were just like, "I don't understand how people see what they see in this." But at the same time, the stock just kept going higher and higher and higher. You were the one that was really public about it. And I'm just curious when it all clicked and then how you thought about putting on the position and then managing against-- I don't know when you put it on, but I assume the stock went against you a little bit. Just kind of how you managed through that and then when you felt like it was time to press the bet.
Henry: Yeah. I'll walk you through the genesis of the thesis in my time with it. So, from working at a prior firm, I was pretty familiar with subprime lenders, companies that originated loans mostly to subprime customers and securitized those assets and relied on the ABS market to do so. I had built up models and valuations from the securitization trust level up. As you know, an opportunistic, value-oriented investor that tends to go where there's sector securities or asset classes that are out of favor, where there's blood in the water. I was also pretty familiar with retail, whether it was auto retail, which is an industry and there's a few businesses in that sector that I love, or brick-and-mortar retail, which were all being-- At least the narrative was, they were being disrupted by Amazon originally and then by a bunch of other players. Carvana, which was-- the false narrative there was that this was the Amazon abused cars subsequently.
I followed it from the time of the IPO in 2017. 2018, I actually wasn't watching the markets as closely because I had left the former fund I was with and was busy setting up my own. And then, in 2019 is when I launched my fund and I started watching it closer. It was the first time that I shorted Carvana. It was a combination of synthetic short, which is kind of risk reversal options type strategy and just outright.
Bill: Yeah, you're long to put and short the call, right?
Henry: Exactly. Or, just outright short the equity. We'll speak about it. But you have to be really careful with those synthetics, because when something can go from, I think, 25, which is where it bottomed in the COVID crash, and my fund was covering that way down. So, I think it bottomed at 25 in March of 2020 and then went to 350 at its peak in mid-2021. You can get offside real fast on those risk reversals, but the options market isn't as liquid. Unfortunately, in this one it was, it can be bad.
The position started in 2019. It was covered in 2020 when markets went down. Carvana, importantly, it was always a negative economic business model. It was always very capital-intensive cashflow, rather consumptive and negative business. So, they were losing money on every car and growing their infrastructure to try to achieve the operating leverage they said or promised would always be there. So, as the company was growing, it was consuming more and more cash and unprofitable.
When COVID happened and capital markets shut down, this would have gone to zero. This would have been one of the casualties of credit markets seizing up, financial markets seizing up, but that didn't last too long. The central banks and governments got out their bazookas and monetary weapons of mass destruction and we flushed the system with liquidity and everything was back. I think in the wake of that, we had one of the biggest speculative manias in modern financial history and we're now in the process of normalizing and realizing that 17 trillion of negative yielding debt was probably not a sustainable thing.
In 2021, I was following it and short and definitely short too early. I remember, I think it was Q2 2021, they pre-announced that they were expecting to be positive EBITDA, which is DUH in the Carvana case, because it is a very massaged noneconomic-- If the Buffett and Munger say, "EBITDA is bullshit earnings," this is-- [crosstalk]
Bill: Set on steroids.
Henry: Yeah, exactly. It's a bad number. It was much worse than the valiant EBITDA, which was not representative of economic earnings at all.
Bill: What made it so bad?
Henry: Well, so, first and foremost, you wouldn't use EBITDA for JPMorgan or for [unintelligible [00:15:16] or for OneMain Financial or Santander. When you require your balance sheet to generate the earnings that you do, EBITDA is a meaningless number. I think I mentioned I was following Carvana for years. So, originally, it was just a curiosity. Why a mostly subprime lender, why a financial company would present itself as disruptive automotive retailer versus really what it was. And so, I assumed it was just multiple arbitrage. You traded a higher valuation, you raise the equity, you grow faster, and then you can maybe become the Amazon of used cars or the Amazon of payday loans or subprime auto loans, whatever it might be.
The company was never raising the equity that they should have. So, there are some big red flags there. So, one, EBITDA for a financial company is not the right metric. It doesn't, in any way, represent the business activity. What your claims to the earnings are as an equity owner, as a shareholder, as well. And then, we're not going to get into it here, because everyone's eyes will glaze over. But Ernie Garcia, the real Ernie Garcia, the convicted felon is a brilliant financial accountant, economic financial engineer, or corporate structurer. He was using the Ugly Duckling accounting shenanigans playbook, which relies heavily on gain on sale accounting.
Bill: So, Ugly Duckling was the first company that he took public, right? The gain on sale basically means that you're selling your loans and then you're booking the gain right upfront in an interest rate environment that goes down at the time perpetually and rates are negative. You could recognize some gains pretty quickly and they could be maybe outsized gains. Is that fair?
Henry: That's fair. The best you could say about gain on sale accounting is that it's a snapshot, it's a point in time. And then, it does lend itself to some massaging and it does require people to think about what that earnings stream might look like over the course of an economic cycle, if people can think that long. Historically, these things have tended to reverse or go the other way. So, gain on sale has become loss on sale for the guys that are more aggressive in terms of how they book it.
Now, there's nothing wrong with it. CarMax has the same retail credit hybrid model and they have guys that they sell the loans to at a premium. There're other ones where it's at face and other ones they take a bit of a hit. But that's the model.
Bill: But to your point, if you have a capital intensive build out and then, you are generating a lot of economics through gain on sale, that sounds very, very dependent on capital markets being accommodative.
Henry: Absolutely.
Bill: Yeah.
Henry: That's what Ugly Duckling was. In the mid to late 90s, it was a darling. Things only went up one way. By the early 2000s, the tide had gone the other way and Ugly Duckling was down 90%. Ernie Garcia. Sr bought it for five cents on the dollar relative to its highs, took it private, rebranded it as DriveTime, and then spent, I guess, the better part of the next 15 years really growing DriveTime, which is a buy here, pay here sort of subprime car retailer lender into a pretty big organization.
Bill: You've had the background following subprime in your past and just whether or not what you saw at Carvana was substantially different from things that you had seen elsewhere. It must have been to a certain extent.
Henry: Well, yes and no. So, I actually really like the subprime business. And over the years, I have owned OneMain Financial, Santander Consumer, [unintelligible [00:19:23], which is a retail credit hybrid model. I've also been short, some of those names at other times depending on where they're valued, because when you understand how they're lending, you can look at what the tangible book value might be, what the returns they're generating, how they're provisioning for losses.
Subprime is shades of gray. If you manage your business well, and I think the guys at OneMain, we can say that we're going through a tougher economic period for the subprime consumer or the subprime guy. But if you manage your business well and I think the guys at OneMain do, which is the former Springleaf or city subprime, then they can be great. They're very high return on equity, return on capital businesses, but you really have to pay attention to that.
When it started with Carvana, I said, "Okay, well, it's not a tech company. This isn't Amazon. This should be some multiple," whether like in a firm or an upstart, you say, "Okay, this is a financial. This isn't a tech company." What had an added layer was the Garcia Sr. angle to it and the way that I think he purposefully structured Carvana to be a bankruptcy remote subsidiary of his company DriveTime and really capitalize it for the outcome that we're seeing now here today.
For me, as you mentioned at the beginning of the call here, it's all about asymmetry and it's all about what if I'm wrong. So, I figured if I was wrong and this was really more like a financial or an auto retailer, I knew how that should be valued and where they might get to and what the economics would look like.
As I was saying as early as probably late 2021, my base case for this business, for this equity was zero and I realized how insane that probably sounds when at the time it was trading at a north of $60 Billion with a B equity valuation. But if you removed that stock price or didn't look at it and just read the financials, I think many people might come to a similar conclusion and then going through the related party transactions coming up with that variant perception helped develop that thesis as well.
Bill: One of the narratives that I think took hold was like, "Look at the unit economics on a business like this." You've been around markets for a while. Do you think that when there is Euphoria, it seems to me that unit economics. If you're losing a ton-- and you're selling your X plus one unit and you're making a lot on that, but you're still losing a ton. It just seems like the concept gets taken too far. I guess, what I'm really asking is, how did public markets miss and/or how did the momentum and trading mentality push a company like this to $60 Billion of market cap, in your opinion?
Henry: Yeah. Well, Beyond Meat was also a $10 Billion company. And there was a point in 2021 when Zoom, which we're not using here, by the way. But Zoom was a bigger company than ExxonMobil. On the one hand, it's always different in terms of the sectors that are in or out of focus or in vogue and the valuation methodologies. But just like the tech bubble and companies being valued on eyeballs, unit economics or TAM, whatever you want to call, it was this cycle's iteration, I think of that.
I did spend a decent amount of work looking at speaking to various auto dealers, public and private dealers, guys who are invested in auto dealers that owns 100% of certain dealers and are the biggest shareholders in public auto dealer groups just to go through the economics of their networks and what the transportation costs were and how these guys might be doing it different, because usually, if you can't reconcile what a company is saying, whether it's unit economics, or adjusted EBITDA, or operating income adjusted-adjusted to the financial statements, the rubber has to hit the road at some point. You're going to run into a problem at some point, those have to reconcile.
Bill: Yeah.
Henry: There was a number of years where people said, unit economics, unit economics. On a consolidated basis, nothing was really getting better. And then, in 2021, when you had auto retailers realizing the best margins that that industry has ever experienced. And now, we're in the process of those coming down 1,000, 2,000 basis points will see and auto lending had negative losses. So, if you were unfortunate enough to not be able to make your car payments and had to hand the keys back--
If you couldn't make your car payments, that's unfortunate. If you were then foolish enough to hand the car keys back, because you would have been able to sell the car for more than that outstanding loan balance was worth, that was also just completely unprecedented. And a company experiencing both the best lending and auto retail economics in the history of both industries barely made money in that environment. You say, "Okay, if not now, when it's done?" So, that helped as well.
Bill: Pretty wild to think of used cars, the asset values being a strong secondary source of repayment, no matter what your LTV is on them.
Henry: That's right. That's a good way to put it.
Bill: That is a wild-wild world we lived in there for a little bit.
Henry: Yeah. Well, markets will produce wild things over time, which is why you always have to be humble and watching closely what your levels or your positions are, because it really is incredible to think. When I started investing, I think my first investment was a pre-revenue biotech company with a $50 million equity value and $20 million cash in the bank. So, a $30 million technology value. I didn't know any better because I was in my early 20s, but my comps and precedents, because I was investment banking and that's what we do said it was a $250 million company.
At the time, you act with conviction, because you say, "Okay, if it's $30 million is my downside, but $250 is what I think it could be worth, that's incredible, asymmetry." I don't know to this point how much I was right versus lucky that the company ended up being bought by Roche for $192 million a year and a half after I made the investment. But if you think about it at the end of the day, this is IP. There's nothing here. What the economics will, or might be, or whether Roche developed the next Avastin or Herceptin from that company or wrote the investment off to zero, I'm not sure. But it's one of those things that could go either way, could be binary.
I get why people might have looked at a Carvana and said, "It is a good customer experience. The world is going online. You want to buy it." But if the founders really thought that it was a better mousetrap, I think the disclosures wouldn't have been as bad as they were and the capitalization wouldn't have been such that it's on the verge of bankruptcy now and here today. So, you always got to be careful in markets, because they can do anything. But looking at the incentives and where the money is flowing usually gives a pretty good indication of where they'll end up.
Bill: I got plenty wrong, and Lord knows I didn't sell everything in 2021, and I've taken plenty of pain. But one thing that I kept asking people that I would talk to is, no matter what the business was, just taking a $60 Billion company, I just hear Buffett in my ear saying, "Okay, that should--" [crosstalk]
Henry: How are you going to do $6 Billion of operating earnings?
Bill: That's exactly right. And then, okay, now, we're not there yet. So, how big does your number have to be on the back end of this to justify the valuation and think it can compound at anything greater than, I don't know, 2%, 3%, or whatever? Even at that, you got to have a real big business. So, it's very interesting that-- I was not professional watching 2007. I experienced it, but not from a market perspective. So, this is kind of the first bubble that I really watched. It was wild to hear the arguments. I think I actually learned a lot from some of those arguments, but I'm glad that I didn't buy into a lot of them.
Henry: Yeah. I had a mentor, someone that I worked with for a while that put it well. In this business, you either stay humble or you will be humbled.
Bill: Yeah.
Henry: Every time you think you've seen something or you think you've figured it out, markets have a way of surprising you. It's good for those that love to learn and see new stuff, but everyone's humbled eventually.
Bill: The thing I like about your first bet that you just described, the biotech company, is one, you knew what you were doing. You might have gotten a little lucky. You might have been a little good. We don't know how to identify that. But even if it was a zero given where you were in your younger career and your earnings potential, I would say, asymmetric for multiple reasons, because you had a lot of earnings potential in front of you too.
Henry: I agree with that point. And it's fascinating to me how different people think about that. I was recently having a discussion with someone about investments that made sense for their kids' college fund. The way they put it was, "Well, it's only the most safe, secure, low risk things that we put in there. So, we would never consider certain investments that are more volatile." If you sit and you think about it and you say, "Okay, you have 15 years." If you take $1,000 and you're able to compound it at 15% to 25% for that 15 years, you pay for half of that first year of college in the US, which is $40,000, a lot more expensive than here in Canada with that $1,000 initial investment. And so, it's interesting to me always how people think about risk versus volatility and over a time horizon that seems to be different from my own.
To your point exactly, I think my biggest strength as an investor, because I'm certainly not smarter than the majority of market participants was, I was fortunate to start young, to start at an early age. Even at that time, my mentality was always, if I'm in my 20s or 30s or now, late 30s, close to 40, I'm a lot younger than the executives that have real money on the line. And so, I'm going to outlive them. My time horizon is longer than they are. So, if you find people that are doing things for the right reasons or you can train yourself to think a little bit longer than the other guy, it shifts the odds in your favor for a lot of things I've found.
Bill: Can we talk about the 11-year-old you as an investor? What were you looking at?
Henry: [laughs] Well, so, I joke about that, because my first asset class was trading cards-
Bill: Nice.
Henry: -that I bought and sold for a profit. I wouldn't learn that this was called arbitrage for another decade.
Bill: [laughs]
Henry: But at a young age, I was fortunate enough to discover what I loved and I've been doing it ever since. My dad was an independent practice lawyer and his best friend from law school who also had an MBA, so law degree, business degree and ended up using a little bit of both, but mostly neither was in the business of selling collectible coins and cards. And so, my dad, who would usually work six or seven days a week would sometimes take me in to the office on a Saturday and just drop me off at his buddy's coin and card store to work/play, I guess, work without getting paid or somewhat play for the day.
One of the activities was taking hockey and baseball cards out of the packages, assembling complete sets, and then giving him any of the inserts or special cards, collectibles that he would sell independently. And so, I made a side business of that at around that time.
Bill: I like that. Trading cards is one of my-- I will never forget my grandfather. It was back in the early 80s, I traded Darryl Strawberry, like Gooden, and a bunch of really good guys. I traded them for a bunch of junk. And I came home and my grandfather absolutely reamed me out. He's like, "You don't understand that the amount of stuff, that's not value right. It's the quality of what you own." That is a lesson that stuck with me. It's one of those funny things how you can learn a really good life lesson through something as silly as kids' baseball cards.
Henry: No, that's fantastic and it's exactly right. Grandfather was a smart man.
Bill: He was. He knew baseball well. We used to watch it all the time. I'm sure when I showed him what I got, he was so mad. I know he was, but I bet he showed me a lot less than he was actually angry. So, do you want to talk about your philosophy on the long side? We've mentioned asymmetry a couple of times, but curious to hear you talk about where you find it. You strike me as a guy that's really comfortable with people telling you, how can you own this? So, I'd be curious to know what kind of longs generally you look for. You strike me as a real value guy. So, you're not looking to the market for validation. Is that an accurate perception?
Henry: I think it is. I'll say that it's never as easy as it sounds and there's definitely a lot of frustration and wondering, because I guess, the way that I would put it is, it doesn't matter how good you are or how smart you think you are. The best investors get stuff wrong and they get it wrong often enough. So, sometimes, you get things wrong. Okay, that's one category. Other times, you get things right and the price moves against you 20, 50 plus percent and then, there's times where you don't know. You don't yet know, if you got it wrong or if you're right and the price has moved against you.
This is why I say, it is more art than science. It is that intersection of economics and psychology. And so for me, I like the puzzle aspect of it. Carvana was a great puzzle a couple of years ago. Dillard's was a phenomenal puzzle in terms of a reasonably run kind of dying brick-and-mortar retailer that refused to have quarterly calls owned 90% of the real estate that was probably worth a multiple of where the enterprise was trading and was hoovering up shares, probably, because they knew that.
Piecing together the puzzles is always interesting. Or, I think my first real big investment was during the last financial crisis, the one that maybe you weren't watching as closely, I think you said. That was a gold company of all things. So, you can find things in any sector or asset class. That was one just-- Before the financial crisis, gold had done reasonably well. Mining was hot. We live in Canada. So, it's all mining oil and gas for financials. And there was a company that was a Billion-dollar company in 2007 decided to grow its production 50% from 200,000 ounces to 300,000 ounces a year and made the short sighted and long-term, or hindsight or not, the short-sighted decision to finance that with $180 million of debt, most of it short term. They had an operational hiccup because that's what happens in mining. The best mines exist on paper and problems occur when you put a shovel in the ground. So, they had an operational hiccup, and then credit markets froze, and yet-- [crosstalk]
Bill: Then they had to roll the debt.
Henry: Well, so, the equity crashed. It was down 90%. But the commodity prices hadn't really changed. Imagine, we'll go back to-- if Carvana was actually making the profits that an auto nation or Lithia was making, but the equity was down 90%, and all you had to do was convince yourself that Apollo didn't want to take over this enterprise. That would change things. So, here the gold price hadn't changed. The equity is down 90%. If you convince yourself that the creditors want to roll the debt that the banks don't want to take over the assets, well, you could pay off all the debt in a year and a half and someone could have bought the whole enterprise for two times earnings. So, I started picking away. And even then, it wasn't until a Russian steel company came in, bought 50% of the equity, and guaranteed the debt that I made it a real position.
Bill: Okay, that makes sense.
Henry: Now. It still took another, probably, five or six years and learning the power of incentives as the Russians tried to squeeze out the minority shareholders and buy the asset for pennies on the dollar before the investment was fully realized. That's why having that long-term horizon is important in this business.
Bill: How did you think about whether or not the creditors wanted to take over the asset? I actually had a similar investment in a company called Intrepid Potash. I think it was 2016.
Henry: I know intrepid. Yeah.
Bill: Yeah. They were like ondesk-- Well, the market thought that they were ondesk store, but I actually knew some of the bankers from my previous job and I knew how the bank thought. So, I actually had an insight there. I obviously didn't call them or anything, but I was able to piece together and then there was pension fund and then I was like, "Pension funds don't want to own these assets. They'd rather roll the debt." I've tried to figure out how would I look at a situation from the outside and make that a similar bet without having the pieces together like I had there. So, I'm curious to hear you think about that.
Henry: I think, unless you have a specific insight, I would say, generally you're right. My experience working at banks, and with bankers, and corporate lawyers, and all of the lenders, and the pension funds is that, for the most part, banks just want to get paid back on their loans and make a bit of a premium. They're not really in the business of taking over potash or gold mines or any of these things.
Bill: Yeah.
Henry: Usually, they will do what they can to get the company to term out the debt, to raise the equity they need to. They don't want to take over the assets. Now, that changes when you get guys like Apollo or more the vulture funds involved. But it goes back to the incentives of the different people at the table always is hugely important.
Bill: Yeah, that's exactly how I think about it. I have a theory and mostly it's because I was at BMO and I know how they work. The groups that are focused on the cyclical industries are fantastic bankers. They understand that a cycle will come, they understand when they should step up. I think very highly of that group and that bank as a group of bankers. I wonder if you find bankers that are like Rabobank would be a bank that I would be pretty comfortable saying they're supportive. I just wonder if you find bankers and verticals that are cyclical whether or not the market misses that sometimes. That would be my null hypothesis.
Henry: Yeah. No, I think you hit it right on the head there. You said it well. I don't know about certain banks. I can't speak to that. But certainly, the cyclical bankers, M&A bankers, guys in real estate, because real estate is really just finance tend to be pretty sharp, understand the puts and takes. So, yeah, I have a lot of respect for them as well. Maybe I'm also just tooting my own horn that was my background as well.
Bill: Yeah. Well, that's maybe endowment bias on both of our [crosstalk] parts. Who knows?
Henry: [laughs]
Bill: What did you think was different? I'm always fascinated by what happened at Sears, because the Dillard's and the Sears thesis rhyme at a very high level. What do you think made those different? Because Sears was always a real estate pitch, right?
Henry: Yeah. There're a lot of differences between the two and how they manage the business and the decline. I guess, what I would say is having your name on the door, having someone back in a corner that isn't willing to give up a fight for reputational, for legacy issues, it means a lot. We're now on to the third generation of Dillard's. And the second generation that are currently managing it, the CEO and the executive suite have been on the board for 50 years. And their name is on every building. If you go into, I'm not going to go down the "have you tried it bro line of arguing." But you do see how people run a business that they care really for the employees in this case, and the retail operations and the profitability, they're not going to be swayed by.
I won't get into Sears just yet, but Coles is a great example. The last few years, Coles has been a pretty good retailer and they've done all of the things that public market participants would have asked or wanted them to do. Slimmed down the box sizes, done more of the store in store, done the Amazon drop off the Sephora kind of broadened the merchandise mix, gone more athletic, allowed under armor to stuff the channels with them, we won't get into that either, done a lot of things you would have wanted. But if you're not the same management team with the long-term focus and the skin in the game and your name on the building, then it's easy to maybe manage for the corner or make decisions on inventory and operating procedures that you wouldn't otherwise.
The nice thing about Dillard's was they said, "Okay, we're going to capitalize conservatively. It'll always be two, under three times leverage. We will focus on the retail operations, because we don't think it's going away. We'll embrace omnichannel and web stuff, but we will do it slowly and try to make sure we're doing it with the economics or return on invested capital in mind. Because we know that our real estate is worth significantly more than the book value or on a liquidation basis, when we trade at a 10% to 20% free cashflow yield, buying back our shares is the best use of capital.
Sears ended up having a bit of the Coles in terms of, you had hired managers as opposed to long-term skin-in-the-game guys that made shorter term decisions. And then, you had a financial engineer moving the pieces of paper that probably didn't help the enterprise as a whole.
Bill: Yeah, that makes sense. What you're describing about Dillard's is what I've always been somewhat drawn to Nordstrom's for somewhat similar reasons. I think they found themselves in a little more problems than I would have projected, but I think they're pretty good at what they do and they clearly care I think for similar reasons. Their name is on there.
Henry: I agree.
Bill: Yeah. When you're relying on something like asset value, I'm just curious to hear how you're thinking about this. The presumption against the real estate value is, this is brick-and-mortar. Brick-and-mortar going away. What's the actual value here? Are you thinking, like, "I'm going to look at precedent real estate transactions and I'll adjust the model each year as transactions occur?" Or are you stressing the asset value and saying, "Okay, where am I at this point and who am I partnered with and how am I going to get the money out?" Because at its core if you're relying on asset values, the assumption is that the management team will eventually sell the asset and get you that value, right?
Henry: Right. So, it's a great question. It's exactly I think the right way to be thinking about it and the answer I'll give you is, you're doing the former to the best that you can, but ultimately, it is the latter. It's the reliance, because you don't have perfect information or even great information that the insiders of the company do and you're not going to get it right. As an example, for Dillard's, it's been a few years since the 2016, 2017 annual meeting where I was actually present and had done the work.
To give an idea, I think it was 300 stores and they own 90% of the real estate, you're saying, "All right, if we go location by location, box by box, you can parse it out in terms of tier A, B, and C malls, in terms of sales per square foot, and where the areas that they're located in." With Dillard's, it was nice because the top hundred locations one third of the assets probably gave you enough comfort to make up all of the asset value. It was high productivity where if they got rid of it, you could do a Nobu, you can do Dick's, you could easily double or triple the rent per square foot.
On the downside, you say, "Okay, so, what about the throwaways in flyover country, in rural parts of the US, where the trading area changes and there just isn't value there. Well, they had some precedents where they had liquidated the asset, and sold it, and it had been redeveloped into call centers or churches or schools. Even there, when you would have thought it was a bad outcome, they were recognizing a gain on where the real estate was being held. So, you're trying to triangulate it to the best you can, but you have to be careful on that asset value stuff. It does come down to-- It's a bit more of the art than science, I'll say again.
Bill: Yeah. Well, it's nice to see them in the example that you mentioned. It's nice to see them monetize the tertiary assets and provide some support and at least let you know, "Hey, we're thinking about monetizing these assets should we ever need to?" It's a good data point, right?
Henry: That's very true.
Bill and Henry: Yeah.
Bill: That makes sense. I'm pretty sure they did as much in EPS as Ted Weschler paid for that entity on a per share basis, which is pretty interesting. What an interesting win too?
Henry: It is. It's funny how all these guys say, it's time in the market, not timing the market. The amazing thing is the guys who say it are really good at timing the market.
Bill: Yeah.
Henry: Buffett is very good. One of my former mentors is the best I've seen at catching the inflection point. There are certain trades you see over your lifetime that really make you go wow. Whether it's the Druckenmiller's or Tepper's that are very good for catching the inflection. It pains me to say-- I'm really happy for the Dillard's team, because they're a phenomenal group there. They're good operators. They're doing the right things for the right reasons. They deserve all the success that they've recently had.
Ted Weschler nailed that timing and call much better than I did. Maybe he had better information because of [unintelligible [00:49:34] and because he's older and smarter, but I knew that that was mine to lose and I did not capture the upside on that one that I fully should have. So, it is what it is.
Bill: Yeah. What do you think gives those guys the insight? I wonder if it's the time in the market gives them the insight. I had Bob Robotti on and he was talking about his biggest loser ever, which he ended up selling much higher and it went much higher and that's why it was his biggest loser, was opportunity cost. But through that process, the stock, I think it was down 85% or 90%. And then, he leaned in at the bottom.
The story that I tell myself is, if you follow things long enough, eventually, you get served up an opportunity and it's the discipline to wait for true asymmetry. I don't know if that's reality or not.
Henry: No, I think that it is. There're a number of examples of that industry. Maybe the John Paulson, the greatest trade ever is the best, where you can be sitting around, doing merger arbitrage with lackluster returns or results for a couple of decades and then have one idea or trade that generates multigenerational wealth. So, it really is about surviving 50% to 70% of the time, doing okay 10% to 15% of the time. And then, if you can really crush it or knock the cover off the ball just a few times, it makes up for a lot. At least, it is how I've looked at it and seen it through others as well.
Bill: Yeah. Well, that's interesting. I appreciate your time. Is there anything else you want to chat about? I'm happy to talk about anything, but I enjoyed very much your podcast with Brandon and I've enjoyed this conversation. So, thank you very much.
Henry: No, likewise. I appreciate you giving me the chance. I don't really talk about positions that are in the portfolio too much, other than ones where I think I'm trying to help and protect people. But these are interesting times. So, I think the perspective-- The good news I'll give to the listeners is I would imagine the next couple of quarters might get a little choppy, but I would imagine the prospective returns from here are probably better than they've been for years. So, stay focused, manage or continue having that long-term view, and you'll probably get some opportunities to have some real home runs in the next little bit.
Bill: Yeah, I think that's right. Too often, people forget the lower everything goes, the higher the prospective returns are. That said, it usually goes up and down when the outlook changes, but the outlook was going to change even when everything looked rosy anyway.
Henry: Exactly. That's exactly right.
Bill: All right, man. Well, should you ever want to come on hit me up. It's been really nice chatting with you and thank you very much for doing the episode.
Henry: No, thanks, Bill. I appreciate it.
[Transcript provided by SpeechDocs Podcast Transcription]