How does Stone House invest super concentrated, Mark Cohen?

Mark Cohen’s & Raphael Rabin-Havt’s Stone House Partners has a fascinating investing approach. Compared to the other investors on this channel, they bring the term “concentration” to a maximum. What does this mean for their performance? The answer is surprisingly good!

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We have discussed the following topics:

Teaser

[00:00:00] Tilman Versch: In this episode, you can get to know two really underfollowed investors Mark and Raphael of Stone House have built an impressive track record over time. And all of this while they are really concentrated in their style of investing.

Introduction & Disclaimer

[00:00:12] Tilman Versch: A warm welcome to the Good Investing Talks podcast. I’m your host, Tilman Versch, and I am very happy that you’re discovering underfollowed investors and underfollowed companies together with me.

Before we jump into the conversation, I want to share the disclaimer with you. To sum it up, it says that this podcast is no investment advice and no recommendation. So please always do your own work.

And now, without further ado, enjoy the conversation. And don’t forget to like and subscribe to this channel.

Introducing Mark Cohen & Raphi Rabin-Havt

[00:00:41] Tilman Versch: The audience of Good Investing Talks, it’s great to have you back at the podcast. Today, we’re really having one of the underfollowed or under-discovered investment firms here. Welcome to Mark and Raphael of Stone House partners. Great to have you here.

[00:00:59] Mark Cohen: Great to be here, Tilman. Nice to see you again.

[00:01:02] Raphael Rabin-Havt: Great to be here, Tilman. Thanks for having us.

[00:01:04] Tilman Versch: You’re both located in the US, I think, on the East Coast, I think, Mark is in Florida and Raphael, where are you?

[00:01:13] Raphael Rabin-Havt: I live in Westchester now.

[00:01:16] Tilman Versch: Okay. It’s very interesting. I’m in Germany. So we have some kind of time difference and also heat difference. In the pre-chat, I talked to Mark and told him that we have snow outside. You don’t have this in Florida? That’s a good thing about Florida.

[00:01:31] Mark Cohen: I’m looking outside right now, there’s no snow.

The name “Stone House” & what they do differently

[00:01:35] Tilman Versch: That’s good. But I hope we make not only cool conversation but also some kind of warm insights into your business and the way you do investing. Maybe let’s start to think about the Stone House you have in your name, because your partnership is called Stone House partners. And Stone House isn’t a typical house if you think about the US, most houses there are made out of wood. Can you please maybe also, to think of this metaphor, name three points where you think your approach is outstanding compared to the typical house or partnership in investing in the US?

[00:02:20] Mark Cohen: Yeah, well, you know, going back to the name Stone House, there’s not much huge story behind it. I love to ski. And, you know, when you’re starting out a fund, this is back in 2010 when I was starting out the fund, you write down all types of names that you can choose. And a lot of them end up being taken, this capital, that capital, that partners. And I found Stone House, it’s just a street up in Vermont on a nearby ski mountain where I like to ski at, and that’s where really the history of the name came from. I guess if we had to think about how Stone House, you know, plays into how our partnership has evolved, we like to think that we have a very good foundation. And I think that comes from, what Raphael and I talk about often, is we’re very lucky to have exceptional LPs who really have embraced our strategy and allow us to invest the way that we think is correct, you know, to go for the exceptional outcome over many decades which is what we’re really going for. Raphael, what would you add?

[00:03:34] Raphael Rabin-Havt: Yeah, I think naming a fund is always an interesting process. I think, for us, our LPs are what allow us, as Mark said, to have the strategy that makes the most sense for us. And so, they are the foundation of what we are able to do. And well, it might not be the reason Mark named it at the time in 2010, I think it does kind of make sense in the context of having that strong foundation that allows us to be somewhat unusual in the industry but you know, Stone House has now been around for 13 years and allow us to have the success we’ve had.

Turning around every stone

[00:04:09] Tilman Versch: Let me stay a bit in this idea of the Stone House because when I was thinking about your partnership, it helped me a bit. I once built a wall with natural stones and to build a wall with natural stones is a tricky thing because we really have to make sure to turn around every stone that it fits in a certain way and then you can build, like, a real wall. Does this kind of turning around every stone till it fits also describe your process a bit?

[00:04:37] Mark Cohen: You know, that’s a very good way of thinking about it, something Raphael and I never really thought. We don’t think about our name too much actually. We’re just focused on the investments and generating, you know, compounding over here. So the name really, you know, we never gave it too much thought, but if I had to think about it, Raphael and I, part of our process is turning over a tremendous amount of stones. I think that one of our favourite, you know, this can get into our investment process a little bit. But you know, turning over a lot of stones but not doing very much in terms of trading is kind of a key pillar of our investment philosophy.

And I think one of the key insights and articles that has kind of shaped our process over time has been the Munger’s Art of Stock Picking speech. And that to us, you know, in there, talks about you just have to keep working and working and working and hoping eventually to have a few insights and find an idea or a situation where the odds are just tremendously in your favour. And then when you find those, you bet heavy and other times, you just do nothing in terms of trading. Raphael, what would you say?

Turning over a lot of stones but not doing very much in terms of trading is kind of a key pillar of our investment philosophy.

[00:05:54] Raphael Rabin-Havt: Yeah, it’s interesting. Especially the top of the funnel, we say, you know, to us, a great idea can come from anywhere. To us, it doesn’t require saying only can come from somebody with an MBA or some specialty. To us, you know, listening to my sister-in-law has been helpful over time in understanding consumer preferences and not that she’s saying in terms of investing, just in terms of her own preferences. And that can drive a research process. So we purposely keep the top of the funnel extraordinarily wide because we really believe you don’t limit yourself at that level. As Mark said, we are very aware that we only think over time, we’ll have… You know, we don’t think we’re going to be able to act frequently. Therefore, we really need to dig deep and understand, kind of situations we fully understand to believe we have the probabilities correct to make the kind of concentrated investments we like to make.

And that goes, as Mark said, to the Munger’s Art of Stock Picking because it goes to the idea that just because something’s the best company doesn’t make it the best stock. And that’s something that sometimes people lose sight of overtime. So we’re really, in the ideal situation, looking for situations not that we just understand, but we can really see that there’s a change happening. Often times, at the company that is often qualitative and we believe will show up down the road in the numbers in the free cash flow per share generation over time and the market, you know, because it’s more focused on near-term dynamics is missing. And those are the situations that we like to turn over a lot of stones to look for that kind of very specific dynamic that could drive for us an exceptional outcome because we think the probabilities are not correctly assessed by the market. 

We like to turn over a lot of stones to look for that kind of very specific dynamic that could drive for us an exceptional outcome because we think the probabilities are not correctly assessed by the market. 

Mark Cohen’s background

[00:07:36] Tilman Versch: Before we go into the analysis of business and your investment process, maybe let’s go a bit in your business history of your partnership Stone House partners. Mark, you started to build the firm in 2010. What have you done before and what was the reason to start a project on your own?

[00:08:00] Mark Cohen: Yeah. So I’ve always, I think since even before high school, I was interested in the market, interested in business, I think sometime in high school, I was turned on to the Buffett letters, which is where I know many people start their journey. And that really resonated with me, a lot of the stuff that was written in there, you know, to the extent even today, I think about compounding. Every day I walk into the office, it’s the first thing I see behind me is a chart of what compounding does to a dollar over many years at different rates of return. And it’s really the first thing that we look at or that I look at every day when I walk in, you know, just to maintain that focus on the long-term power of compounding, which I don’t think people, you know, when they’re starting out really have an appreciation for.

So then I obviously went to college, I studied business undergrad at Wharton. I think a lot of people when I was kind of in that mode of coming out and getting a job either in banking or consulting, and I did banking actually my junior summer in college. I was in a group that kind of serviced the big private equity shops and we were building LBO models and having all these inputs given to us to put in there. And what I realized then and I had an inkling earlier on was I really love to be more focused on finding the inputs through hard work and research and kind of getting out there. Figuring out the inputs and the key variables that are going to make an investment work, be good or not, instead of being given the inputs and building the model that way. And I was always fascinated with public markets. Just the opportunities that I have seen out there over so many years. It’s hard to think of any place where there’s greater opportunity than the public markets to compound capital.

But that takes, obviously, the right temperament and you have to have that and I just prefer that to a situation I was in where every deal was negotiated and maybe financing was stapled to the deal and whoever had the lowest cost of capital was going to win that deal. I was more interested in digging and doing research on my own. I was lucky enough to come out of college and get a job at a long short fund in New York called Force Capital. And everyone starts, you know, first day on the job you think you’re going to get this Bloomberg terminal and access to all the sell side research and really was actually the exact opposite for me. My boss, I learned a tremendous amount from him, came out and gave me a corporate card and basically said, “I don’t want you in the office, I want you out doing field research and coming up with insights, visiting companies. You know, you’re not getting a Bloomberg, I don’t want you talking to anyone on the sell side. I want you kind of do this on your own, and come up with your own opinions.”

And I learned a tremendous amount during the years I was at Force, you know, what was very valuable there was he was so focused on us keeping digging, and digging and digging to get insights, and whether it was cold-calling former CEOs of companies on the phone and trying to try to get insights from them into industries, or just getting out on the road and visiting private companies that compete. I think, you know, getting started at Stone House really goes back to one of the first companies that I researched when I was at Force, was a company called Copart and it was the summer fall of 2004. And this is a company that is in the auto salvage auction business, which has many as your listeners might know, if you get into a car accident, God forbid, and the car is deemed a total loss, more often than not, it ends up at one of these salvage yards where it gets auctioned off on behalf of the insurance companies.

And I just found this business to be very fascinating. I travelled around the country visiting mom and pop salvage auctions to gain insight into the business. And eventually, I went out because Copart was a company we were researching intensely. It didn’t need capital, never came to New York on any sort of roadshow, they were not promotional. You know, to really get an insight, I went out to the annual meeting of stockholders, which almost no one attends, obviously uncontested. And I went up to the founder CEO at the time. This is the fall of 2004. His name is Willis Johnson and he really spent the next several hours with me, teaching me about the business, his history and funny enough, when I first approached and we said, “Oh, are you that banker from New York who was visiting all my competitors?” Because they had called, you know, he’s been in contact with every player in the industry for decades. Eventually, they would sell out to him given he was the leading consolidator and best operator. And we hit it off and ended up owning Copart at my old fund. It was, I think, in the fall of 2004, a two dollar stock. Now it’s in the mid-60s.

So it’s been an exceptional business, but I learned a lot about business, understanding even economics, return on investment. And what I really, really ingrained in me there is the ability to partner with exceptional business operators and exceptional people in the public markets at the click of a button. Anyone could do it. And so ever since then and earlier but I would say that has been really pivotal in starting Stone House. Not to mention when I got the idea to leave Force eventually after a wonderful experience there and you know, what everyone does when they start a fund, they write down on a yellow pad, like I have in front of me today, everyone that they could possibly go hit up for investment and Willis ended up being at the top of my list. I flew out to California to see him and he was a day one investor in the partnership. So that’s just incredibly lucky how that happens. And yeah, that’s how we got started here.

What I really, really ingrained in me there is the ability to partner with exceptional business operators and exceptional people in the public markets at the click of a button.

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The first years at Stone House

[00:15:19] Tilman Versch: You’ve been running Stone House from 2010 to 2017 alone. Have there been any phases, looking back, you could describe in building the investment firm or how would you describe these years?

[00:15:32] Mark Cohen: Yeah, I mean, over 13 years, you try a lot of different things, you kind of figure out, you know, we’ve had a stint of activism in this fund where we went publicly activists on a company. That was way back in 2013, but it really, really taught me a lot of things about investing in public markets and running a partnership. I would say that’s something that I’ve since shied away from and principally, because it taught me a lot about liquidity. I think that, you know at the end of the day, you want to be able to change your mind if the facts change. And I’ll let Raphael jump into it because he’s also been instrumental in our thinking on this. 

[00:16:18] Raphael Rabin-Havt: I think Mark and I talk a lot about, you know, even though we run a concentrated approach, there’s the technical liquidity which we are focused on because we do believe you have to be able to change your mind in this business, facts do change sometimes and you need to make sure there’s the ability just from the daily volume of any given security, that if we needed to change our mind and exit, that we would have the wherewithal to do so. And that factors in to how we think about what we’re going to invest in and I wasn’t around at Stone House when Mark did his stint into activism. But obviously, at that point, Mark had limited liquidity primarily because he had a board representation and I think Mark has changed his view that ultimately working constructively with management is a very good thing. But if it gets to the point of going activist and you have to limit yourself with that, board representation ultimately is not the healthiest thing for us in terms of having the ability to shift capital and change our mind.

Over the last 12 months, we’ve talked a lot about kind of this idea of mental liquidity. Because I think a lot of people, it seems like to us and we are hyper aware of it ourselves, because they’re so public in their names, and talk about them so frequently, that it seems to us, even when the facts do change, they don’t actually change your mind. Primarily because they’ve told so many people that this is a great investment or they’ve told their partners, or whatever it is, that they get so trapped mentally in a name that they’re not able to change their mind. And we think that’s also a very dangerous thing in this business because we do think the ability to change your mind is critical as you have a hypothesis, and the facts start refuting that hypothesis, you have to be able to sell. And so we talk about that a lot internally because we think it’s absolutely critical for us to be able to operate in a way where we can be concentrated but also be able to recognize where we might be wrong. And therefore, not say “Well, we told people it’s such a great investment therefore, we can’t sell.” We’ve kind of become more hyper aware of that over the last 12 months.

In this business, we do think the ability to change your mind is critical as you have a hypothesis, and the facts start refuting that hypothesis, you have to be able to sell.

Tips for the younger self when building an investment business

[00:18:12] Tilman Versch: Mark, if you could go back to 2010 and meet your younger self and tell him some things about how to build investment business, what would you tell him and advised him to better build an investment business?

[00:18:27] Mark Cohen: Yeah, I think something that I did when I was starting out, obviously, you write down all the people that you could approach and try and get investment from. I had no track record of my own at Force. It was one book run by the portfolio manager there and I was just a research analyst. But I think everyone is willing to take a meeting for an idea. Funds are popping up every day and you want to get meetings with people, I think what I did is I created a deck on a singular idea and I cold emailed a bunch of fund managers who I thought would be interested or people that have the ability to invest. And I said, “Look, I have this idea I want to share with you. This will show you some of the type of work that I do. It’s also an actionable idea. I’m not going to make you sign an NDA.”

But just trying to get your foot in the door, trying to get meetings, almost everyone will take a meeting for an investment idea. And so that, I think, is primary in terms of just getting your foot in the door. I know Raphael had a similar experience when he was getting into investing prior to joining Stone House and then I think finding the right LPs. And you find them, you know, by reaching out to them and contacting them, especially with a great well-thought-out investment thesis, I think that is hugely important in knowing who you are as an investor, the type of fund you want to build and starting out with the right capital base that will allow you to invest the way that makes sense to you. I think a lot of people know what makes sense but are kind of trapped into a certain bucket of type of fund that they have to have that totally makes, you know, keep everything aligned. Raphael, what would you say?

Just trying to get your foot in the door, trying to get meetings, almost everyone will take a meeting for an investment idea. And so that, I think, is primary in terms of just getting your foot in the door.

[00:20:28] Raphael Rabin-Havt: Yeah, I think this is a business of ideas and, you know, I met Mark through a mutual friend in 2010 actually, but the reason I joined Stone House was because I had an idea, it was actually a short idea in a company I believed was committing accounting fraud. And I believed it was about to break because of an auditor change that was forced upon the company and that the new auditor was going to ding the company when they had to file their annual report. And so a friend who introduced me to Mark in 2010 actually told me to go reconnect with Mark in 2016 to see if Stone House would scale the idea. And it goes to the idea that, you know, when you have a great idea in this business, people will listen to you because that’s what this business is about, this is the business of ideas and proving out your ideas and then investing the capital based on assessment, assessing the quality of those ideas.

So I think, you know, for me, I wouldn’t have been able to join Stone House, and it’s been now five-plus years, unless it came from an idea I had on the short side ironically. That’s not really Stone House’s MO, but it was through that idea that Mark decided to make me a job offer.

This is the business of ideas and proving out your ideas and then investing the capital based on assessment, assessing the quality of those ideas.

[00:21:31] Mark Cohen: I think Raphael’s being modest. He came to see me, I think we got together in December of 2016 and I think in the first few months of 2017, the stock was down 50%. I had it on my watch list and I said, “Raphael, why don’t you just come sit in the office? We’ll figure something out.” You know, I had extra space and so now, more than five years later, it’s been a great partnership.

Raphael Rabin-Havt’s background

[00:21:55] Tilman Versch: Raphael, you worked before you joined Stone House at the New York Times, which is not like the worst address for journalism. What made you then even like decide to go for investing as a full-time job and switch careers?

[00:22:09] Raphael Rabin-Havt: Yes, I was actually a lawyer when I first met Mark, we were connected, I was a lawyer at a law firm called Ropes & Gray in New York in 2010. And then in 2016, I was working at the New York Times as a researcher for a columnist named Maureen Dowd. And as I was saying, that was a period of time I had the short idea that I wanted to run with, but I caught the investment bug in law school, so later in life, and I had a great amazing law school experience and had a wonderful time at the law firm. But I did know I wanted to shift eventually to investment. So I was able to kind of, you know, after leaving the law firm do my own investing for a period of time.

But this special idea I had, I really wanted to scale and that forced me to go to Mark to see if we can make it bigger. But it was kind of like, truthfully, a self-taught love affair with investing that kind of drove me to where I’m at today. It was not through formal education but it echoes the idea also that my view on investing is great and learning investing obviously, you can do with a very formal approach, but I also think it could be self-taught because I think the concepts are very learnable and obviously, they’re hard to apply, but the concepts themselves are anybody, I believe, could learn about investing no matter what their current career is.

Lessons from journalism

[00:23:34] Tilman Versch: What kind of journalistic or law lens have you still on when you do investing that others don’t have that don’t have the background?

[00:23:44] Raphael Rabin-Havt: I think what has helped me, it’s interesting, so the research process at the time I think was working for Maureen Dowd, as I said, and what she taught me is because she’s been an exceptional journalist and now opinion columnist for many years. I mean, she started in New York Times in the early 80s. She’s been around for a long time, and she tells me, “At the end of the day, we are storytellers, right? She’s a story teller and not that she invests but she finds, you know, she’s throughout her career wrote amazing stories about different people, and often times, politicians.

And when we invest, what we really do when Mark and I get into a research process, what we’re really doing is writing, in our view, kind of a magazine story. And obviously, at the end of the day, we’re going to invest and we put the money down on it but ultimately, our process involves not much different than the journalistic enterprise of saying, “What is this company? What do they do? Who are the people? What are the drivers of future returns?” And kind of be able to just write it out into a story for people to digest and read and understand.

And I think the legal side is obviously, it’s just a lot when you’re learning the law and practicing it, even though it was a short period time I was practicing, obviously, your reading comprehension has to go up by a large factor to be successful in law school and at a law firm. And I think that educational process of understanding logic, and reasoning and improving your reading comprehension is always beneficial. I think the benefit for me, you know, it’s interesting, is I think by not going through the more normal banking or kind of MBA path, which is a perfectly fine place to obviously start your career and go through.

I think I probably came with a little different mindset, a little less preconceived notion to what makes a great investment and I think that that over time has helped me in my own unique way, being a little bit different than other people, I think, by not having a such a formal approach. Growing up with investing, I think I might come at it a little differently. I think that’s helpful for anybody, I think everybody’s got their own path and I think it’s helpful for people to recognize that their own path can be helpful in the sense that, obviously, the concepts are often the same but you don’t want to think like everybody else and sometimes by not being in the same class, kind of process as everybody else, that helps you kind of see the world a little differently.

I think I probably came with a little different mindset, a little less preconceived notion to what makes a great investment and that over time has helped me in my own unique way by not having a such a formal approach.

Changes after Raphi joined Stone House

[00:25:52] Tilman Versch: How has Stone House process changed since you joined the firm?

[00:25:57] Raphael Rabin-Havt: I think Mark would say I’ve been helpful having a little more cynical approach, to push back against certain ideas to have a good sounding board knowing that I look at things a little more cynically than Mark often. And so, especially over the last number of years, there’s been a lot of things we’ve studied very intensely, some names that were part of, you know, the era of certain stocks that were going up, but not making any money and kind of making sure that just because something is good story, do we actually understand the unit economics? We’re always making sure we’re not falling prey to kind of the groupthink mentality that can overrun some of this type of situations, I think, Mark.

[00:26:38] Mark Cohen: I think Raphael’s touching on one of the key things that we guard against, you know, over the last several years, is FOMO frankly. And fear of missing out on, you know, we look at a lot of companies as you mentioned, getting back to the stones, we turn over a lot of stones and you have to be comfortable in this business, I think, allowing and being happy for and clapping for other people that you may know, or other people out there in the market who are making money on stocks that you’ve frankly looked at and researched and gone through your process. You just can’t get there, you know, maybe people are falling in love with revenue growth but not really thinking about long-term unit economics and the stocks are working for periods of time, but at the end of the day, we really have to maintain, and it’s very difficult at times frankly, is protecting against FOMO. But it’s been great, Raphael and I, I think we have a very good way of thinking about that and just being happy for others who can make money in things we don’t understand. 

Three strengths

[00:27:42] Tilman Versch: Maybe let me add, before we jump into investment philosophy, a partnership question. In your partnership, what are three strengths you like about the other?

Or three strengths the other has you like?

[00:27:59] Mark Cohen: I think Raphael, as he mentioned, he’s a very fast reader, he consumes a lot of information quickly, and is able to distil it down to key concepts. He pulls out, I think, key variables that are going to, you know, what we try and do is consume a lot of information and understand all the different information out there that we can gather. But really distilling down an investment to a few variables is what we do. And I think how it makes sense is there’s so much noise out there and so much data you can collect but for the way we invest, distilling down investments to a few key insights or variables that are going to make or break is important. I think Raphael is able to identify those very quickly.

And I would say, third, he is a very hard worker. I think I’ve really been so lucky actually to have Raphael on board. You know, this is a fund that I started and you’re the founder of a fund; Raphael is not the founder but I would say he works as hard as a founder. and this job is a 24/7 job and he has shown to me that he is all in on this as much as I am even though I started the firm.

There’s so much noise out there and so much data you can collect but for the way we invest, distilling down investments to a few key insights or variables that are going to make or break is important.

[00:29:25] Raphael Rabin-Havt: Yeah, with Mark, I think there’s a lot, Mark has a tremendous amount of strength. I think anybody who’s in this industry and has been doing it for 13 years, I think that there’s something, you know, this is a very difficult business. The survival rate’s not very high. I think there’s a lot of reasons Stone House has been around for 13 years but I actually think the number one thing… I guess I’ll combine a number of things together, but basically, Mark has the exact right temperament for being a portfolio manager. We run a concentrated strategy that means there is going to be volatility. You cannot avoid it, it’s just not possible given when you run a concentrated approach. And in order to run that successfully and compound money at a very high rate over time, you need to be emotionally able to handle it.

And Mark has demonstrated to me over and over again since I started working for him that he has that emotional wherewithal to withstand the volatility, understand that if you’re for seller at the wrong time, it can destroy years of hard work. So we don’t just say, “Well, our stocks down there, for a hundred percent, you’re right.” And the market’s not wrong, but it’s more like you also can’t allow that emotion to just force you to sell just because you can’t take it anymore. And Mark has really demonstrated that over and over again.

And I think Mark is incredibly strong in the sense that he knows what he knows and he knows what he doesn’t know. This is a business with a lot of big egos. A lot of people have a lot of success and think that they know everything about everything, or think they have to be the smartest person in the room. And Mark, I think, truthfully is very smart because he knows he doesn’t need to be the smartest in a person’s room always to be successful, that an incredibly curious person who wants to compound at a very high rate for as long as humanly possible. But I think he knows he’s able to do that by being a great listener and knowing that he doesn’t need to be the smartest person on everything, but there’s just a few good insights he needs over a course of years to really generate the return that Stone House has been able to generate.

I think it’s kind of that combination with a great foundation that allowed Stone House to be successful truthfully, because I think there’s a lot of people in this business who are obviously some of the smartest people around. But a lot of times, they either don’t have the right temperament or their ego gets so big that they start allowing themselves to think they can know more than they actually know.

We run a concentrated strategy that means there is going to be volatility. And in order to run that successfully and compound money at a very high rate over time, you need to be emotionally able to handle it.

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If you’re interested in Good Investing Plus, please click on the link below. I’m looking forward to your application.

Filtering through noise

[00:32:04] Tilman Versch: How do you filter out what really matters in the consumption of information? Sometimes there’s this picture used of noise and real facts?

[00:32:15] Raphael Rabin-Havt: It’s interesting. I have a funny thing with this moment. I’ve thought about a lot because I consume an insane amount of information, and it gives me great pleasure in a sense that even if I wasn’t doing this job, that’s just the way I am. For a long time, I love information, and it’s almost like meditative in a weird way for me. I know some people say they need the opposite, they need to turn off the noise, but I actually find myself most relaxed when I’m just kind of over consuming information. So it’s kind of a strange thing. I guess that’s just the way I am.

I think, like anything. there’s a lot of muscles you develop over time, like as a concrete example, something Mark and I focus on a lot is marketing. We think one of the things that people often, I wouldn’t say miss, but they don’t use it as enough of a filter is if a company is spending a significant percentage of revenue on marketing expense and the idea is that someday that needs to lever, I think people don’t put a high enough bar of the odds of that happening. Like, it’s a very difficult thing for a company to just one day shut off its marketing budget and still grow at a healthy rate. Oftentimes, the reason it’s growing so fast is it’s just over spending on marketing. And so this idea, years later, you’ll be able to lever that, it’s something that we often use as a filter to say we can’t invest in this company, we just don’t feel confident that’s going to happen.

And the other way we often find investments now, where we find any company that’s been able, particularly on the consumer side, but it could be enterprise as well, grow without marketing. That to us is a very powerful sign of something that catches our attention from the muscle of saying, “We got to really look into this company very closely because there’s something clearly special going on that has allowed to achieve such success without spending a lot of money on marketing and the product is clearly resonating.” So it’s those type of filters that we kind of take in so much, but then have these strong filters that allow us to say, “Okay, what is actually worth spending?” You know, real time, beyond the initial “This is interesting.”

We think one of the things that people often, I wouldn’t say miss, but they don’t use it as enough of a filter is if a company is spending a significant percentage of revenue on marketing expense, I think people don’t put a high enough bar of the odds of that happening.

[00:34:10] Mark Cohen: It’s interesting, Raphael, you mentioned consuming information but one of the things that we actually don’t do as a firm is subscribe to all sorts of credit card data and try and get short-term type of data on companies. We think a lot of that would just not play into the way that we invest and even cloud our judgment just having too much information based on short-term stuff. Raphael, how would you describe that fact that we don’t use that?

[00:34:45] Raphael Rabin-Havt: Yeah, I think we’ve determined that credit card data and any type of hard data like that, that’s really short term in nature in our view would actually hinder our process because ultimately, we’re obviously making generally long-duration investment, or with the idea of them being long-duration. Obviously, they don’t always work out that way and making long-term decisions based on, let’s say, weekly credit card data sales doesn’t match up to us and so, therefore, we think you have to just decide how you’re investing. Obviously, if you’re investing based on trying to predict quarters, then you need credit card data to even try to do that. But if you’re investing on qualitative change in the company that you don’t think actually show up in the numbers for a year or more, then obviously, weekly or monthly data is not going to help you.

So we come to the conclusion, at least for us, that it would actually hurt us and we try to always consume a lot but always be aware of where you can go wrong. And I think that’s something that marks one of your strengths that we were talking about before, Mark, is that he’s been around long enough to know where you can go wrong and therefore, we want to avoid that because the mental side of the business is so challenging. So if we were sitting with one of our companies that we’ve owned for a while, and we’re looking constantly at the weekly sales reports or the weekly credit card data, it might actually make us so emotional about it that it makes us make strange decisions versus by not knowing it, it helps us keep a more level head.

Being a good portfolio manager

[00:36:11] Tilman Versch: Mark, how do you cultivate and grow this right temperament of a good portfolio manager?

[00:36:18] Mark Cohen: I think it has to do with frankly gathering the right set of LPs and not trying to be someone who you’re not. I know that I’m not someone who can manage a portfolio and not ever be down. I know that the kind of firm we want to build for multiple decades is going to be a handful of concentrated investments at any point in time and you’re going to have that sort of volatility. And when you take on partners who might be expecting something else because they’ve seen a track record of returns that they want to get involved in, that is to me the kiss of death. I think you have to be, at all times upfront about your process. Your investment process is not going to resonate with everyone and it’s not for everyone.

But you know, the select people that have found us over time the either through referral or word of mouth have been the right people. And we’ve had periods in the fund where it has been quite volatile and draw downs and we’ve been able to recover from all that, from all those episodes. And I think a lot of it has to do with not having the outside pressure of something that you promised to someone that is never going to happen. And then it happens and all of a sudden, things go haywire. This is part of investing in Stone House is it’s not going to be a straight line. It’s going to be a bumpy line, but hopefully, over many decades of that, it’s going to pay off handsomely. Raphael, what would you add to that?

I think you have to be, at all times upfront about your process. Your investment process is not going to resonate with everyone and it’s not for everyone.

[00:37:57] Raphael Rabin-Havt: Yeah, I don’t think there’s much else to add. I think having the right partners, having the right foundation, understanding what we’re looking for, building those muscles, like, the money compounds itself over time. We’re trying to achieve a certain thing and having the right people along for the ride is critical because if it wasn’t, then during one of these more volatile periods, we would have to invest a different way and that would ultimately cause problems for our long-term returns.

Finding the right kind of growth

[00:38:35] Tilman Versch: So as business builders, you don’t look for growth in it’s sake that it’s growing but for the right kind of growth, so to say?

[00:38:43] Mark Cohen: Absolutely, I mean, Raphael and I think about this all the time that if we have the partners we have and we don’t raise another dollar in the fund and we compound this at this compounding chart, it’s really quite powerful. But over the next several decades, if we can keep up solid returns, we don’t have to raise any more money, it’ll be a great career. I think that’s what is the big insight and once you unshackle yourself from fitting into a certain box that has to please all sorts of different groups, the real light bulb goes off and you can start thinking in terms of producing longer term exceptional results for people. 

Important metrics

[00:39:27] Tilman Versch: Let us jump to a bit more business analysis, investment philosophy. What are important metrics that you look for in an investment?

[00:39:35] Raphael Rabin-Havt: So at the base, obviously, what we’re trying to do is judge the future free cash flow per share of a business. And then obviously, in our process, as I said, the top of the funnel we keep wide open, but then once we get to something where we think we understand the business, understand how it works and the basics, you know, building blocks that you’re looking for. Like, why are the returns on invested capital sustainable? Why can this business generate real wealth for shareholders over time? We then go into a kind of a checklist approach process where the thing we’re really looking for is, as Mark said, the art of stock picking is something Mark refers to a lot.

We want to just say, “Okay, we figured out this is a great business. But why is it not obviously valued in a way that’s already reflected? And therefore, why are the forward returns not so exceptional?” So what we really look for when we get into that kind of checklist process is we often find our best ideas are involved with situation where there’s some type of change happening at the company or in the industry. Often times that changes people, frankly, but it’s usually some form of qualitative change happening that we can assess in a realistic manner. And then what we like to see because this goes to how high a bar we’re looking for, we find these change situations that we believe will drive a much higher rate of future free cashflow per share than the market is estimating in our view, but it will take off in time to develop.

But we find management teams that have what we’ve come to term ‘a per share obsession’. Because oftentimes, if you don’t combine the two, the results can’t be exceptional because oftentimes, management teams are not per share obsessed. They know how to build a business but then they over time create through dilution or other means harm your forward return. So we look for those two things in combination, where there’s some change that we don’t think the market’s pricing in correctly and a management team that, you know, they have a long-term per share obsession, and oftentimes recognize that their stock might be undervalued based on that change, and neither is repurchasing shares ahead of that change, or just has enough recognition of how powerful the future is for the business. And they want to make sure the per share value is preserved.

We look for those two things in combination, where there’s some change that we don’t think the market’s pricing in correctly and a management team that, you know, they have a long-term per share obsession.

Dealing with debt

[00:41:47] Tilman Versch: In your framework, how do you think about debt? Like I personally tend to avoid debt in companies. How do you think about it?

[00:41:58] Mark Cohen: Debt, I think, it’s a tool like any other. I mean, it’s something that I think obviously, too much of it going into a bad period can kill you. So we’re very aware of that but from a standpoint of only invest in unlevered businesses, I think that’s not one of our checklists. I think it’s not something that we’ll always stay away from as a litmus test. Raphael, what would you say?

[00:42:30] Raphael Rabin-Havt: Yeah, I think it’s something to consider obviously, we don’t shy away from companies that have debt on their balance sheet. But we think from our perspective, it’s really assessing the management’s ability to understand how to manage your balance sheet correctly. And that means that certain companies obviously should have debt and don’t, and therefore, that’s actually a reason why we won’t invest; truthfully, their business is clearly over capitalized. The management team for whatever reason, culturally or other reasons, is actually not per share obsessed and therefore, they are actually not optimizing the business for shareholders. You see that a lot in tech world where you have extraordinary businesses, but the balance sheets are clearly hoarding way too much capital.

And then on the other side, you got to be careful that you’re not in a situation that, you know, calling macroeconomics swings is very difficult and you want to make sure that even if the business has debt, it has the ability to get past any storm. So, it’s something we’re very obviously aware, but when we assess the situation, we assess also management’s ability to understand how their balance sheet should be run over within reason. And I think it’s hard to say without being specific about any specific company, but it’s not something we look at as a negative just because a company has debt.

We don’t shy away from companies that have debt on their balance sheet. From our perspective, it’s really assessing the management’s ability to understand how to manage your balance sheet correctly.

Concentration

[00:43:50] Tilman Versch: You run a very concentrated book and with success. I think the recent performance I saw it was around 20% per annum compounding you did with Stone House Capital Partners, congrats to this. But with this very concentrated book that’s even below, I think, five stocks your own, how do you make sure that you don’t look stupid or don’t make a mistake with the investments you do?

[00:44:18] Mark Cohen: How do we make sure? I mean, I think concentration to us is more of a output of our process than an input. We don’t come into the office and say we have to own a certain number of stocks. Raphael and I are completely invested in the fund, we’re the largest investors and obviously, we want to compound our capital at the highest rate within reason. I think that it comes back to staying within our circle of competence, thinking about the businesses, not necessarily the stocks, the businesses that we own, the underlying free cash flow that we’re owning as a owner of these shares. And in terms of looking stupid, I mean, that’s something that you just have to be prepared for in business. I mean, you have to be willing to look stupid, frankly, for periods of time and that, I think, is what separates your ability to make returns and missing out on huge winners.

We talked about FOMO earlier, you know, you can look pretty stupid for periods of time in this business, but at the end of the day, through your research and building conviction over time, you know, I think there’s nothing like going out, visiting businesses, kicking the tires, touring the facilities, meeting management, you know, different levels of management, not just your corporate CEO, but go all the way down, head of product, head of sales, all the way down the chain and gaining that type of conviction in investment, that’s the way we invest. And we almost think like private owners many times of businesses when we buy something, we basically don’t think about where it’s going to trade in the short term, we’re looking out three to five years typically, when we underwrite something. Raphael, what would you say about looking stupid?

You have to be willing to look stupid, frankly, for periods of time and that, I think, is what separates your ability to make returns and missing out on huge winners.

[00:46:09] Raphael Rabin-Havt: Yeah, it’s going to happen and anybody running a more concentrated approach has to be, you know, you’re not going to be right all the time. I think that goes to the idea why mental and technical liquidity is absolutely paramount for us because we have to be able to change our mind if the facts change. And to be able to change your mind, you have to be able to sell. And therefore, that is something we think about a tremendous amount. So the ability to have liquidity allows you to be wrong and move on to the next idea. It’s very important because you can go wrong a lot of ways in this business. But one way is obviously running a concentrated illiquid portfolio means that you can’t ever be wrong. And our portfolio’s concentrated but liquid.

The human component in change

[00:46:55] Tilman Versch: Mark, you already mentioned a bit the stones you turn around people, can you maybe give some more light in your philosophy or in your approach, you look for change and usually it comes with people or often comes with people. What kind of stones are you turning around to make sure that the change is going the right direction and that you’re investing alongside the right kind of people?

[00:47:18] Mark Cohen: Yeah, I think at the end of the day, Raphael and I talk about it often, you know, expert networks, transcripts, things like that. I think that’s kind of table stakes at this point and oftentimes, if we see too many transcripts popping up on a certain company or doing research on that, it’s sometimes honestly a red flag to us because it just means people are searching for reasons to try and confirm why they might be right about something. For us, it’s trying to get a real insight into people and I what I’ve come to realize is that, after doing this in Stone House for 13 years and then prior to that for a couple years at Force, you know, everyone can sell a good story, you don’t get to the top of a company without being a good salesman generally. Politically, you’ve played well, you’ve been able to step up the ladder and you’re charismatic.

So at the end of the day, we really have to judge people by their actions and not a story they’re telling, or because they’re charismatic. So it’s actions, its results. Do we understand decisions they made at different times in their career at prior experiences? And it really comes down to, you know, are you judged on results or what they’re telling you they’re going to do with X, Y & Z. Raphael, what would you say?

[00:48:51] Raphael Rabin-Havt: Yeah, I think as Mark said, when you rise up in a company, often times you’re a good salesman. So it’s really actions of the people and their histories and decisions they make we judge them by more than how they sound because oftentimes the smoothest sounding person can often be, obviously, good at BSing you. So we judge people more by their actions historically and understanding their decisions versus saying, “Well, they sound good. So that means they’re going to do the right thing.” Because there’s also examples of where you have to be careful because there’s some company managements that talk very good game, particularly on capital allocation, but it becomes almost its own marketing thing for the company versus actually creating wealth for people. It’s a very strange situation sometimes where that’s the sale pitch and it’s not because of their actual decisions.

So we try to judge people by their decisions. And it goes back to the idea of why we go deep into a company. You know, we think if things aren’t obvious as are important, if you have to adjust your model a little bit this way or that, obviously, that means there’s something that’s not there, you can’t get that level of precision. And I saw something funny that somebody said recently, that I thought was so insightful. They were saying, “The old man in Omaha outperformed all the TMT funds over the last number of years by buying the one stock they all hated.” That being Warren Buffett buying Apple stock. And I think you learn so much from Warren Buffett, obviously by his writing, but also his actions. And so is the case with Apple, it’s funny I think about that because it was just such a simple idea of what he saw as a sticky consumer product company that was, at that point at least when he was buying, probably trading more like a cyclical hardware company.

And he took that, it wasn’t because he had the most transcripts or the best data. It was just kind of a simple understanding of the power of the business and then obviously, through Tim Cook showing that compared to anybody, Google or other ones, Tim Cook showed he was so shareholder friendly. He runs his balance sheet much different than other tech company runs their balance sheet in terms of thinking about per share value. So when I saw that, that really resonated with me because it just goes to the idea of what we’re saying, that the simple powerful ideas and the per share obsession can drive a lot of returns and trying to over complexify everything can make… And thinking that if you read another expert network transcript, that will give you the answer, it’s often case the opposite. 

There’s also examples of where you have to be careful because there’s some company managements that talk very good game, particularly on capital allocation, but it becomes almost its own marketing thing for the company versus actually creating wealth for people. So at the end of the day, we really have to judge people by their actions and not a story they’re telling, or because they’re charismatic.

The long-duration game while building trust

[00:51:25] Tilman Versch: You guys seem to look for very deep insights and stocks that not many others cover or invest in, but you already gave this example of the Copart CEO you were talking to, Mark. You did all this work to get to talk to competitors to get this deep insight and if you think about investing as a relationship business, relationships and trust form over time, and this is also the foundation to get these deep insights. How do you think about this time you need to invest to get deep insights and also the time you need to build trust and the relationships for these deep insights?

[00:52:04] Mark Cohen: Yeah, I think building trust, I think that’s most primarily with your LP base. I think that’s essential in this business. I’m not spending our time building trust with companies that we’re going to invest in because while we do like to go very deep, we can’t make like, “Oh, I love this person so much I can’t sell this stock.” That’s not something that we ever want to have constrain us.

But in terms of building trust as you mentioned, Tilman, I think what’s been so helpful to us are investors over long periods of time, and going through different episodes of volatility and draw downs, and coming out of them and having this track record. I think they’ve developed trust with us and have added during periods of time when it makes sense, when we frankly say, “This is a great time to be adding capital to the fund.” And that type of trust is the type of trust we focus on building because it becomes like a flywheel. Raphael, what would you say about going the other way when we invest in companies?

In terms of building trust, I think what’s been so helpful to us are investors over long periods of time, and going through different episodes of volatility and draw downs, and coming out of them and having this track record.

[00:53:15] Raphael Rabin-Havt: Yeah, it’s interesting. I guess in terms of trusting management, I guess I’m…

[00:53:23] Tilman Versch: To have deep insights about an industry and also, information that others don’t have, you have to build relationships and be with the ear close to it. And people usually, in the first talk, they don’t tell you all the pitfalls of the game they play and give you all their insights about the dark stories or whatever stories.

[00:53:44] Raphael Rabin-Havt: I’m not sure we actually have information. In my view, I think oftentimes we don’t have it. It’s not that we have information other people don’t have, it’s more that we assess it differently, the same information other people have. And that goes to the idea, Mark and I are very focused on not following the group. Oftentimes with investments, it’s like people agree with you later, right? It’s like they have the same data, but your investment turned out to be right because people come around to it later. So oftentimes, that’s the situation, so it’s more that we probably rank higher than other people in terms of how we assess cultural things at companies than other people.

And therefore, when we do our research, we often focus on that to maybe a higher degree than other people do. Because obviously, the business quality matters, industry matters, these things obviously drive a huge amount of the return but also, the people matter so much, so we just probably rate that higher than other people. And then, in terms of assessing it, it’s a harder thing. There’s no data on personality types, right? It’s not like you can score people and say they’re going to be good. So I think that comes from a combination of muscle and then also recognizing that you have to assess them based on what they do and not just what they say, because otherwise you can get trapped into very good sales pitches. So I think that’s why, as Mark said, it’s more of an output of our process, our concentration, than an input because finding these handful of situations where everything lines up and the company has a per share obsession and the culture, and all these things that are squishier, all line up in a set way that we really believe we can assess the probabilities correctly of the future free cash flow. It’s only a handful of these that you’re going to really find.

So if we lowered the bar, then we would obviously have more stocks in our portfolio because at that point you can say, “This is a good business in a good industry, who cares about the people? They’ll do okay.” Particularly, to get the exceptional outcome, we think you really need a lot of more things to line up. I think we smartly, and I think, this credit to Mark is really focusing on the culture at companies and the people making these decisions helps us have sometimes more insight than other people who have access to the same level of information.

It’s more of an output of our process, our concentration, than an input because finding these handful of situations where everything lines up and the company has a per share obsession and the culture, and all these things that we really believe we can assess the probabilities correctly of the future free cash flow.

[00:55:52] Mark Cohen: I think Raphael touched on a concept of probabilities. I mean, we’re not operating in a world where we’re going to have perfect information. I mean, it’s not going to happen in public markets and I think that’s something that we like actually because we like doing research, we like building these theses, get going and you start testing them. But you’re never going to have the perfect information. So you’re constantly feeding different information, you know, trying to ascertain these key variables, and then weighing probabilities against price frankly. Probability’s a different outcome against price and building conviction around why these have an exceptional skew, these handful of ideas that we own at any point in time. 

Activism

[00:56:44] Tilman Versch: In your toolbox of working with companies, you don’t use the concept of the loud activism anymore, but you really want to have companies that are shareholder-friendly. And sometimes, management are just humans and they don’t see all the things and you as a shareholder, sees things management doesn’t see. How do you bring this on the table and how do you make sure that there’s a certain shareholder-friendly influencing and not activism happening?

[00:57:11] Mark Cohen: I think, you know, at the end of the day, Raphael said earlier in this interview that, “We know what we know and we kind of try and stay away from what we don’t know.” At the end of the day, Raphael and I have never run a company unless you can call Stone House a company, we are not business operators. I think what we do is when we interview management and talk to them, we try and understand why they did certain things, why this? Why that? And keep asking, why? Why? Why? And you can understand how someone thinks and then you can judge how they operate businesses or previous episodes in their career, how the results have turned out? But we never claimed to have any sort of insight or edge in trying to manage a business. I mean, we’re not going to come up with a great idea ourselves in terms of managing a business.

We want to find these special entrepreneurs and if they’re not the founding entrepreneur, they act like one when they’re running the company and think about it as if it was their own. I think that where we can add some value is behind the scenes showing them some math. If X Y & Z happens as you think it might be in your long-term plan that you’ve release publicly and you think this is your five-year plan in terms of what you think you can do with this company happens and you do this with your capital allocation strategy, what your stock at the end of the day is going to be worth twice as much as it would if you did something else. And either that resonates with people or it doesn’t, and frankly, we want to be invested alongside these great business operators who also can wear the hat of a great capital allocator. And I think that it’s so important to think about because your outcomes can be so different. Raphael, what would you add to that?

We want to be invested alongside these great business operators who also can wear the hat of a great capital allocator.

[00:59:05] Raphael Rabin-Havt: I think Mark’s personality lends itself to very good constructivism. These companies do realize, you know, especially when you become a long-term shareholder that Mark does have some insights into capital application and understanding how to think about whether or not your stock currently is undervalued or not and how to take advantage of that. So I think it’s funny, but there’s a letter from, I believe it was 1984, Warren Buffett wrote where he talks about, obviously, the mechanical aspect of repurchase programs can create a lot of wealth for people if you’re able to repurchase your shares when they’re undervalued, it’s a very attractive way to build wealth.

But he also makes the point that companies with management teams that aren’t willing to repurchase their shares when they’re clearly undervalued are also showing your hand the other way, which means they’re just interested in other things, right? It’s like, they’re not doing the obvious thing. So it’s funny to think for us, we talk about the people and the decisions they make, you know, when we’re assessing a situation and we talked about the per share obsession, if we’re talking to management of a company and they’re capitalizing in a way and also generate free cash in a way that they could repurchase their shares, and we believe their stock is undervalued because of different things happening and they do, but they won’t do it. And you know, we’re never going to be activists in that situation but that’s just a sign that they’re not able to make decisions that make sense to us and therefore we’re obviously not aligned with the right people.

And it goes the other way too, you talk to a management team that might not have that in their toolkit, because it’s just not something they grew up understanding. They’re business people running businesses, they’re not thinking about capital allocation that way, but when you talk to them and explain it to them, and then the light bulb goes off in their head, and they realize that this is how big of an opportunity it is to take advantage of the current situation given the things you’re doing on the business side, that to us is a great sign the other way. Wow, the market hasn’t picked up that how shareholder-friendly this management team is, they recognize that things you’re doing in business are going to have big impacts on the future operating results and they’re willing to buy back shares ahead of all these changes. You know, that to us is a powerful indicator the other way. So I think we, and Mark in particular, is very willing to work constructively with management to help them understand this stuff. But it’s also a helpful way for us to assess their willingness to be good stewards of capital over time and therefore whether or not it makes sense for us to be invested.

Companies with management teams that aren’t willing to repurchase their shares when they’re clearly undervalued is a sign that they’re not able to make decisions that make sense to us and therefore we’re obviously not aligned with the right people.

Working with management

[01:01:42] Tilman Versch: Can you tell us a bit more about how you, Mark, or Raphael is observant, like, how you work with management in this sense? 

[01:01:51] Mark Cohen: Yeah, I think it comes with time, everything can’t just happen overnight. But over time, we’ve made presentations to boards, we’ve written letters and we’ve had different meetings about capital allocation at our portfolio companies. And at the end of the day, it’s literally presenting our ideas, you know, we’re not coming up with any sort of operating plan that’s so far out from what this management team thinks they can do given all the stuff they’ve released publicly to investors. It’s just a couple variables around the edge that can make a big difference and that’s really it.

And you can see pretty quickly whether they’re light bulb goes off because we do want to invest alongside aligned owners of shares themselves who have a significant portion of their net worth in the investment because we’re so concentrated and we have our net worth in the fund. Any investment we’re making, we’re putting a significant portion of our net worth into the investment. We want to be aligned with people who have the same obviously. So if they can’t see pretty clearly how it could be enhanced through some suggestions, maybe it’s not the right team to be backing. Maybe they’re marching to the beat of a different drummer or they don’t really believe the projections that they put out to investors over time. Raphael, what would you say there?

[01:03:40] Raphael Rabin-Havt: Yeah, I think it’s just a good way… I guess you can argue and you asked me before where our information edge comes from. In those situations, we truly might be able to get an edge over other investors where we’re able to be in a situation where we can be in their room explaining some concept to management and it’s not that they can’t disagree with us. That’s actually not necessarily a bad thing. But if you see that they just don’t have the per share obsession, then it’s just like why are we bothering with this investment? I mean, it might be fine, but the odds of it being extraordinary… It just goes to the idea that public markets are a funny thing, companies the way they get built over time are so interesting to study. And yeah, there’s nothing wrong with investing in a company that’s probably more bureaucratic in it’s nature but ultimately, Mark and I funny enough used to have kind of a watch list. It was just to us an interesting kind of metric. What was it again, Mark? it was kind of like…

[01:04:43] Mark Cohen: The crazies.

[01:04:44] Raphael Rabin-Havt: The crazies. It was these very unique companies run by individuals who people either think are amazing or think are nuts in a bad way. So it’s not that we only want invest in those situations, but it goes to the idea that to really find, in our view, exceptional investments, it often requires a culture of entrepreneurialism at companies that people want to truly achieve great things. Because often times, you’re in a company where everything’s fine, everybody can keep their job and get their nice salary and they don’t have to try that hard. And that’s not necessarily the worst thing, it’s just not for us going to be probably the best investment. Therefore, they might be a good investment for somebody, because of whatever reason, it might be a short-term good investment.

But for us, to really create long-term wealth, the odds are not the same. I think that’s something Mark and I talk about as you learned from Willis Johnson so much at Copart, he was the first investor in Stone House but also, Mark over his career, and it goes to the idea of people and culture, realize that… He talks about it endlessly because it’s just such a powerful example to him of Copart being exceptional business, but the people and the culture were just absolutely exceptional. But you couldn’t really fully understand that unless you got to know Willis and his team. 

The crazies. It was these very unique companies run by individuals who people either think are amazing or think are nuts in a bad way. In our view, to really find exceptional investments, it often requires a culture of entrepreneurialism at companies that people want to truly achieve great things.

“Good” and “bad” crazy

[01:06:00] Tilman Versch: In this list of crazies, if you don’t have an answer, it’s fine. How do you distinct think crazy, bad crazy and good crazy?

[01:06:10] Raphael Rabin-Havt: It’s a fine line, that’s for sure. I think Mark could talk more.

We didn’t do an assessment afterwards, admittedly, if you look at the list, it would be a lot of obvious people, you can guess who some of them might be because some of them are famous. It was more just like the clear examples of public companies where there was very ambitious people running it who were out on, I use this terms like on the spectrum of doing things to their own way, didn’t care about people’s perception of them. So we didn’t necessarily say it was good or bad.

It was just saying that these might be interesting companies to look at because they’re clearly doing things quite differently and oftentimes truthfully, it goes back to a concept we talked about earlier, oftentimes those companies, if you look at their marketing spend, we’re actually quite low because it was this kind of product obsessed type of people who were more obsessed with the product and driving demand through obsession over the product versus driving demand through buying Google ads. They fell in that spectrum to it. To us, it was an interesting list in the sense of just thinking about that metric of, like, how crazy is your CEO? I don’t know if that ever made on a checklist exactly, but it’s interesting to think about.

The time between interest and investment

[01:07:25] Tilman Versch: How much time do you give yourself before actually investing? Maybe put it in the picture again, from the first stone you turn around to the final investment stone you start rolling.

[01:07:40] Mark Cohen: Yeah, we keep a running watch list of probably 30 or 40 companies that kind of gets sifted. It’s like a triage, every week we go through and try and see where we should be spending our time based on price and probabilities that we’ve done research on companies. And then sometimes, something happens, there’s some change that, as Raphael mentioned, that we find and we just have to get ramped up very, very quickly. And doing enough work to get us to the place where we’ll put money down and say that this does make sense based on the imperfect information that we have.

Again, you’re always operating in a world of gray. I mean, you’re never going to get to a place where, “Yes, I know I’m buying this today and I know that the stock is going to be up 5x from here.” At that point, it’s kind of weighing probabilities based on information we have at the time and sometimes, you can gather that information and get there very quickly that this bet makes sense based on the price, and where you think it could happen if X, Y, and Z comes out. And sometimes, to build conviction around larger positions, it takes years frankly. Raphael, what would you say?

[01:08:53] Raphael Rabin-Havt: Yeah, I think the joy of constant research is that you build muscles to the point where you can act quickly, but it’s not really that quick because you’ve build up enough muscles that you know an industry at this point, you know enough of the people. It really depends on situation. Some situations require us to spend a long time before we’re able to invest and other times, we’ve just been studying the industry and for a variety of reasons, are studying the company and the people to be able to make that investment quicker. So it does depend on the situation, but I think that the joy of this business is you don’t swing a lot, but it doesn’t mean you’re not practicing every day. And the practice is just learning every day about different businesses and different people. It allows you when the pitch is coming over that you understand to act quickly, in a sense of like, immediate but not feel like you need to spend the next 12 months reading every document that’s ever been written about the company to make the investment.

The joy of this business is you don’t swing a lot, but it doesn’t mean you’re not practicing every day. And the practice is just learning every day about different businesses and different people.

[01:09:51] Mark Cohen: Yeah, when we build a model on a company, if we have to go out a certain amount of decimal places to say if this is good for us or not, it’s definitely not good for us. Precision in that case is the enemy. I think that it has to kind of click before that this is something that makes sense to us.

Challenging each other

[01:10:15] Tilman Versch: How do you, in a partnership, make sure that you control and challenge yourself or each other so that you don’t come off the road or that you don’t make mistakes and run into biases?

[01:10:35] Mark Cohen: Yeah, I think Raphael and I have a very, very good working relationship. I mean, he’s probably the first person I speak to in the morning and the last one at night before I go to sleep. I think we’ve just developed over time the ability to be very honest with each other, you know, pointing out things that don’t make sense or running into different biases that might be out there. We’re constantly shooting this back and forth and having this discussion about stuff.

Multiple expansion

[01:11:03] Tilman Versch: With your approach, you’re looking for change that isn’t seen by the market. But if this change gets seen and the positive impacts hit, usually this leads to a certain multiple expansion. With what kind of multiple expansions are you fine to have in a certain stock because it’s usually a nice thing that drives returns if the free cash flow multiple goes from 5 to 15 or something like this. Where do you see there’s an over expansion for you?

[01:11:37] Mark Cohen: Yeah, Raphael and I, we constantly, I think back to some recent examples, we’re constantly focused on the forward IRR of an investment. We don’t underwrite multiple expansion going into an investment. If it happens, that’s great. We kind of focus on what is in management control which is operating a business and what is the obviously free cash flow coming out of the business over time that we can think about. So multiple expansion doesn’t go into our thought process. If it happens, that’s the double tailwind but I think always focusing on the forward IRR, if something was trading at a certain multiple, and now it’s trading at twice that multiple, and it comes back to probability also. What’s the probability that it’s going to go to three times the multiple than it’s trading at previously?

And keeping that in mind and then everything comes back to thinking things like a private owner of businesses. Like would you want to hold on to a business if you had full liquidity, if you can suck out this much cash overtime or get paid this much today for it versus what we were buying at previously. So it just comes back to that, you know, probabilities, thinking like a private owner, and understanding that the beauty of the public market is you do have liquidity. Obviously, investors can get, you know, as Raphael talked about the two types of it liquidity that we think about, you know, that’s the beautiful thing. Raphael, what would you say?

[01:13:16] Raphael Rabin-Havt: Yeah. Obviously when we’re underwriting and we think there’s a change happening, often that change is going to mechanically increase the return on invested capital of the business. And then ultimately, if you go back and do any type of analysis on when that happens, the multiple usually expands if the market believes that’s sustainable change and a return on invested capital. So we’re not unaware that if things play out as we expect, the multiple expands, we don’t underwrite that going in. I think for our sense, as Mark was saying, we got to make sure if we’re lucky enough to find a situation to invest in where the return on invested capital goes up and then the multiple expands, that’s obviously a very good outcome.

But then recognize that let’s not fall in love with the situation to the point where you don’t realize the forward IRR or the collapse because there’s been investments Mark and I worked on together where we are shocked by the quickness of the market to rerate the company based on something we assessed. And in those situations, you really want to be honest with yourself about what are the realistic forward IRRs and therefore, you have to be able to sell in the situation. That’s hard. I think as some people say in this business, selling is sometimes harder than buying because it’s so easy to say, like you can fall in love with the management team or the company and say, “I know it’s a little overvalued now, but I’ll keep holding.” I think just being constantly realistic about what reasonable forward expectations are is helpful.

It’s funny, we’ve been talking about a lot of industries where we don’t expect the market to ever get so excited about the business from a multiple perspective and how that itself can be a powerful thing over time for compounding because if our assessment on the quality and duration of the business is correct, then oftentimes, management does have this tool where they can be constantly repurchasing their shares at attractive valuations. And one of the problems companies run into is that eventually, if they’re generating a lot of cash and their stock’s trading at a very high multiple, what do you do with all that capital?

But there’s certain industries actually, if you look back historically, where the multiple has stayed very reasonable and management recognized that they’re just in a very good business and just basically retired a significant amount of their shares over a long period of time. So it’s interesting to think about. So we just always want to honestly assess the situation and be honest about the forward IRRs because it’s very easy to fall in love with a name and say, “I don’t have to sell it” even though things going forward are not gonna be as good.

There’s been investments where we are shocked by the quickness of the market to rerate the company based on something we assessed. And in those situations, you really want to be honest with yourself about what are the realistic forward IRRs and therefore, you have to be able to sell.

Reasons for selling

[01:15:45] Tilman Versch: Aside of the forward IRR, why do you sell for other reasons?

[01:15:52] Mark Cohen: I think if you write down your reason for owning something and that’s changed, for example, if you believe that a new management team has come into a company and they can do X, Y and Z, or some sort of change that, Raphael mentioned, a lot of what we do revolves around change that’s not recognized by the market yet. If any of that goes backwards or falls apart, I think that’s a big signal for us to sell and secondarily, it really does just come back to forward IRR. I mean, if you have a situation where you have done all your work, you’re excited about the opportunity and your checklist, things really line up; again, we don’t make that many investments, so we generally invest where things really do line up for us.

And some of that goes wrong, there’s just no reason to hold on when there’s other stuff to do with the capital out there. If your thesis breaks, you have to be honest with yourself and I think Raphael is very, very helpful in kind of always testing each other and making sure that the reasons why we own something still exist.

[01:17:07] Raphael Rabin-Havt: Yeah, thesis drift is very dangerous in this business and it’s something Mark and I have talked about before about the honesty we need to have in each other. Whether the ideas come from me or the idea comes from Mark, if we believe XYZ and then the facts are not playing out that way, you can’t just be like, “Well, XYZ didn’t play out and we’re on to the next letters.” We have a thesis and the facts are going against it, we have to be willing to recognize that moving on to the next thesis and holding on just because you’re being hopeful is not is not a good strategy. 

We have a thesis and the facts are going against it, we have to be willing to recognize that moving on to the next thesis and holding on just because you’re being hopeful is not is not a good strategy. 

The ideal partners

[01:17:42] Tilman Versch: So now as one of my last questions, you have these 12 years of experience working on the foundation with strong partners at Stone House. With what kind of partners does your approach work best, like, from the investors in your fund side?

[01:18:03] Mark Cohen: Right. Our results are lumpy and so people have to be prepared to accept periods when their monthly statement is not what everyone wants to look at frankly. And Raphael and I being the largest investors in the fund, we definitely feel those periods just like everyone else. I think you have to come into our fund, I think that that is what people who have selected into our partnership knowing that it’s not going to be a straight line and kind of understanding that process. And it takes time to build up that level of trust with us managing the capital. Raphael, what do you say?

[01:18:49] Raphael Rabin-Havt: Yeah. I mean, it’s the limited partners who just recognize. They’re obviously not going to invest all their capital with us. Listen, indexing is a very good choice for a lot of people. But if you choose not to index, investing in a lot of different managers that are all diversified ultimately is going to get index-like returns with higher fees. It’s mathematically impossible. It’s important if you’re invested with a bunch of managers and they’re all very diversified. So our investors have self-selected us because they’re looking for people who are willing to concentrate in a handful of ideas that resonate with them for a variety of reasons and they realize that the long term can be quite good, but quite lumpy. And therefore, they go in immediately with the right mindset that they’d rather earn the higher lumpy return than try to get the smooth lower return.

By finding those select handful investors who think like that enables us to succeed because when have a month that’s not great, which is inevitably going to happen when you only own a handful of positions, we don’t get any calls. Nobody’s beating down our door saying what’s going on because they have the right mindset going into investing and I think Mark’s approach to transparency with limited partners resonates a lot with them and the transparency is there for them and therefore it helps them understand our process.

Our investors have self-selected us because they’re looking for people who are willing to concentrate in a handful of ideas that resonate with them for a variety of reasons and they realize that the long term can be quite good, but quite lumpy.

Closing thoughts

[01:20:16] Tilman Versch: My last question is always the offer to add something we haven’t discussed. Is there anything you want to add?

[01:20:24] Mark Cohen: Yeah, I think it’s essential in building up Stone House the last 13 years, you know, transparency, both with our partners, and the companies that we invested in, the management teams that we meet. I think that’s been so critical to what we’ve done. We don’t get many inbound calls from our LPs. When they want to know about stuff, they wait for our letters and stuff. But we’re always kind of reaching out, updating people, letting them know our thoughts, our LPs in the fund. And I think that’s been critical to building trust and getting that flywheel going. Raphael, what would you say?

[01:21:08] Raphael Rabin-Havt: Yeah, I’ve been with Mark now, as we talked about, five and a half years and I think it’s a testament to Stone House and Mark that the level of success Mark has been able to achieve, he hasn’t changed his approach in terms of how he thinks about people and ways we should communicate them. I think it’s an important lesson because obviously, you start off and you don’t have a track record and you might act a certain way. Some people gain a certain level of success and they might change their attitude or how much they have to communicate with people just because now, they’re at a different point in life. But I think Mark, because it’s just who he, has stayed the same. And I think that’s been incredibly important in terms of the durability of Stone House.

Goodbye

[01:21:49] Tilman Versch: And thank you very much for the insights into building Stone House and turning around many stones. Thank you very much for coming on, it was a pleasure to have you. And to the audience, thanks for staying and bye-bye till the next episode. Bye.

[01:22:02] Mark Cohen: Thanks, Tilman.

[01:22:03] Raphael Rabin-Havt: Thanks, Tilman.

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Tilman is a very enthusiastic, long-term investor. Over the last years he has taught himself important investing concepts autodidactically. He tries to combine a positive climate and environmental impact with his investments.
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