Matthias Riechert, what is your compounding concept?

Matthias Riechert of P&R Investment Management was the first guest during the Emerging Managers Day of the RV Capital Meeting 2023.

As a service for our readers, we are sharing the transcripts of the RV Capital meeting 2023 in Engelberg with you.

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We have discussed the following topics:

Introduction

[00:00:00] Rob Vinall: Yesterday was more dedicated to investing and of course, the business owner fund. Today is the day for emerging managers. This came about because when I started the fund and after a few years increasingly I found that younger managers were reaching out to me and saying hey, how did you get started? How did it happen? And rather than speaking to each of them individually, I thought well, wouldn’t it make sense to try and get them all together in one place? Then I can tell them my story or speak to everyone as a group, but more importantly, they can also connect with other like-minded people, potential investors, and their peers. And yeah, service providers are also here.

So that was the original idea and that’s the agenda for today. So there’s going to be 3 sessions. The first one is now with Mathias, who set up a fund, how long ago was it? Ten years ago. Yeah, of course. Yeah, I recently read your 10-year memo. I’ll introduce you shortly, Matthias. Then that’s going to run until 9:45. There’d be no pause. But the coffee is there so feel free to stand up and go and get yourself one if you need it. Then we’re gonna go straight into a fireside chat with Jacob McDonough, who’s the author of Capital Allocation book. He set up a little stand at the back there and will be signing books afterwards if you want to.

And then between 10:30 and 11:00, there be a longer pause for the signing also for continued discussions, and then the grand finale will be a panel discussion between 11:00 and 12:00. We’ve mixed things up a little bit this year. In the past, it was investors in emerging managers who we had on the panel. This year it’s gonna be three investors who very recently started a fund. And I thought their experience would be relevant in terms of how they got started, how they solved the classic chicken and the egg problem if no one knows how are you going to attract capital. But without capital, how are you going to build a track record and get yourself known?

That will be the final session and before we know that will be 12:00 and it will be finished for another year. But I’ll be hanging around afterwards. Several members of the group will potentially be skiing or going for a walk or whatever. So for those of you who aren’t travelling back immediately, there’s plenty to do this afternoon as well.

Meet Matthias Riechert

[00:02:25] Rob Vinall: So Matthias, welcome. Matthias, you’re one of my oldest investing friends. We’ve been talking about stocks for many years. I know you incredibly well. I think many of the group here know you well as well, but I’m sure some don’t. So why don’t you very briefly describe what you do and who you are?

[00:02:47] Matthias Riechert: Yes, so thanks, first of all, for organising this. This is always great to come here and spend time here with a lot of really smart people in the audience. So I hope you can learn a lot from a few things that I might have done well, but a lot maybe even more from the mistakes that I’ve done, so I hope it’s useful for you. So I run P&R Investment Management. We are an advisor to the P&R Real Value Fund, which is very similar to you. A very concentrated fund. We started 10 years ago and have currently 12 positions and we think pretty much aligned in terms of looking for great components, looking for great businesses and holding them for several years, hopefully, many years.

Pre-P&R

[00:03:34] Rob Vinall: Great, thank you. So let’s go back to Matthias’ pre-P&R value. What were you doing? What did you study? What were you doing before the fund started?

[00:03:47] Matthias Riechert: Yeah, so I started in Germany in Asparagas at the Savings Bank, and I thought that’s where you can learn how to invest well. And of course, it was a nice 2 1/2 years, but I didn’t learn anything in terms of investing. Then I applied for a job in Dusseldorf. Back then at an options trading house, Dutch options trading house learned–

[00:04:09] Rob Vinall: So Buffett’s famous weapons of financial mass destruction.

[00:04:12] Matthias Riechert: Of financial mass destruction. But I learned a lot there. I learned arbitrage. Sadly, when I came in the window of opportunity where there was a lot of inefficiency at the Deutsche Tamim Bursa back in the ‘90s, just moved away and so all of a sudden.

[00:04:27] Rob Vinall: This could have been the late ‘90s or?

[00:04:29] Matthias Riechert: That was like ‘96 I think. So George Demos I think started in ‘92 and then there were a couple of years where nobody knew how to price options. And if you had a slight idea about black skulls, you could really do nice arbitrage. So at the end of the day, you didn’t have any risk on your book, but you made quite hefty profits, and I came in exactly at the time when Timber Hill actually started to use computers to do it. And of course, we didn’t know that, so we thought about what was going on in the market. There are so many quotes now and then somebody started to look at charts and somebody else looked at fundamentals and I was confused. I didn’t know what to do and I just knew one thing. I have no idea about the fundamental aspects of a company.

And so after two years, I think faded out or was made redundant or both, I guess, and then I did an undergraduate in Muenster, in Germany and in Portsmouth in the UK, and part of that four years was an internship which brought me to London to Kenilworth, and I ended up taking up a job there at Citigroup in 2001. And that’s where I spent nine years of my career on the trading floor back then 2001 was the largest bank in the world. And so finally I thought, I have arrived that’s where the guys are. That’s where you can really learn how they do it.

[00:05:48] Rob Vinall: The bigger the bank, the better they invest.

[00:05:52] Matthias Riechert: And I think that the big learning is that if you want to learn how to invest, don’t go to an investment bank. It’s a mislabel. You learn how to sell things and construct things and design things, but you don’t really learn how to invest.

And I think that the big learning is that if you want to learn how to invest, don’t go to an investment bank. It’s a mislabel. You learn how to sell things and construct things and design things, but you don’t really learn how to invest.

But I think it always inverts, so over the nine years, I learned everything in investing that doesn’t work. I guess that was quite helpful too.

Good Investing Plus – A warm invite to apply

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If you want to dive deeper and go further down the rabbit hole, you are kindly invited to apply to my community Good Investing Plus. It’s a place that’s very helpful to people who are ambitious about investing and is helpful to investment talent and experienced fund managers. So if you’re interested, please click on the link below.

And now, without further ado, enjoy the conversation.

The Moment

[00:06:18] Rob Vinall: So you went to Citibank probably optimistic about the future, thinking you’re in the right place and I guess over time you realise this is not what I want to do. So what was the kind of moment where that thought crystallised?

[00:06:34] Matthias Riechert: Yeah, usually, it’s these ideas that don’t come in on one particular day. It’s kind of a growing thing, but what I figured was it’s strange that– So at Citigroup, I was responsible for designing investment products and selling them through intermediaries. So you might remember a lot of certificates back up until the Lehman collapse, there were quite famous. There was a huge demand for all kinds of financial payoffs that were packaged within the certificate in Germany or structure products in English, and so I was one of the people involved in this product kitchen and the strange thing was if I was honest, I never wanted to invest my own money in my own products. So I was the cook who didn’t like his own cooking and I thought that was weird.

And of course, you kind of say are there all kinds of compliance reasons why you can’t invest, but actually, you weren’t really convinced because you knew how the product came about. And so I started to read a lot of things. I started to read books about Warren Buffett and then in the evening, I thought this does make sense. And then the next morning I went back to the training, this doesn’t make sense. And it took a while for me to really then figure out what to do.

I was, I think, in my early 30s and in 2007, I think I took an executive class at Columbia Business School in New York for two days with Bruce Greenwald, hefty price, I think £5000 or dollars for two days and I went there. There was a classroom of maybe not just as big as this one, maybe 60 people or so. After two days, I thought, damn, why didn’t somebody tell me earlier that something like this exists? You know that you can learn how to invest and I felt like Neo in Matrix where I take the blue or I know the blue or the red pill and I took the one where you wake up the next morning, damn, this exists and I studied in the wrong place.

And then I thought, OK, maybe I can still go back to school, but I was 30 years old, was a bit old for a full-time MBA but then I figured out there’s this global executive MBA which gives you access to Columbia Business School and all the value investing classes there and also to London Business School. And so I managed to get into that programme and sucked up all the knowledge that I could in terms of learning, accounting and all the things that I didn’t know as a specialised derivative guy.

[00:09:02] Rob Vinall: Sorry, just a question of understanding that was a programme where you were a full-time MBA or that was happening parallel to your…?

[00:09:10] Matthias Riechert: Yeah, so that is designed to work for people who are on the job, whereas I did the full focus approach. So I faded out of my job at Citigroup and that was a lucky coincidence because then I had really spare time and really could spend all my time on studying.

Tom Triforce influence

[00:09:30] Rob Vinall: One of the good friends of both of ours who was a big influence on you from that period at Columbia Business School was Tom Triforce. Why don’t you talk about his influence?

[00:09:42] Matthias Riechert: Yes, so his class is called applied value investing and you don’t know what to expect there. So there were maybe 40 people or so 40 students. And I think after the first session, half of them thought what the heck is this and the other half thought this is interesting and the reason was Tom never spoke about himself. He always took himself out of the equation and he just gave us a good framework. I think it was extremely helpful in terms of analysing businesses in such a way that you figure out what makes the business great, and whether the business you look at has these elements, and I think having such a framework in itself, I think, is a competitive advantage, because if you don’t have a framework, you very often are lost. You don’t know what to look for, right? We all have this idea about of I want to find a business that has great management. But then when you think about it, what does great management actually mean, right? And how does that translate into valuation? So how do you value great management? And so I think we dived into these specific aspects very nicely, and it’s incredibly helpful.

This is interesting and the reason was Tom never spoke about himself. He always took himself out of the equation and he just gave us a good framework. I think it was extremely helpful in terms of analysing businesses in such a way that you figure out what makes the business great, and whether the business you look at has these elements, and I think having such a framework in itself, I think, is a competitive advantage, because if you don’t have a framework, you very often are lost. You don’t know what to look for, right? We all have this idea about of I want to find a business that has great management. But then when you think about it, what does great management actually mean, right? And how does that translate into valuation? So how do you value great management? And so I think we dived into these specific aspects very nicely, and it’s incredibly helpful.

[00:10:53] Rob Vinall: Yeah, I remember you once telling me that half the class were disappointed because they weren’t being told what to do and the other half were ecstatic because they were learning to think for themselves about what to do.

[00:11:03] Matthias Riechert: I think the reason also was Tom never talked about himself, and usually, when you have a class at business school, somebody comes in and teaches you. He says look, this is what I’ve done. I built this business. And then we did this billion-dollar exit, and you do the math. And then you know how much worth this person is and then you know okay, he must know how it works, so therefore I need to do what he tells me, right? And Tom said, well, look if I did that, I can tell you all kinds of crap. And you pick that up because you think I’m successful. So I’m not telling you what I’m doing, where I come from, or whether I’m successful or not, I want you to figure out for yourself whether it makes sense or not.

[00:11:41] Rob Vinall: And Tom once said something to me about you. Matthias is someone who just can’t help thinking for himself. So what a kind thing to say.

[00:11:52] Matthias Riechert: I thought that that was like a. It sounded a little bit egoistic, but take it as a compliment.

Matthias Riechert, how did you get from A to B?

[00:11:58] Rob Vinall: Not of himself, for himself. There’s an important difference, and it’s true. Glad to be clarified that. So you had this aha moment on part of the MBA programme at Columbia Business School. The question of course, which is the most pertinent one for today is having thought, okay, this is what I want to do. There’s a big difference between thinking that and then actually getting the chance to do that. So how did you get from A to B?

[00:12:28] Matthias Riechert: Yeah, so I started the programme already with this dream in mind to hopefully afterwards set up my own thing. I didn’t quite know how to do that, I was just very determined and I think that the driving factor was the fear that one day in my life I look back and I have to admit that I didn’t even try it. And so I think for everybody here who’s contemplating doing something entrepreneurial, whether starting a fund or starting a business can only encourage you to do it earlier than later.

Even if you fail, I would say you have so much more knowledge and so much more learning that you can then use to do whatever you want to do afterwards. And in many cases, people actually manage to go back to their previous job at a higher hierarchy. In banking, I’ve seen that several times, and I think back then there was my driving force really to get this done. And even if you fail, at least you can look in the mirror and say I’ve tried it. And so after the MBA, back then I had a partner, an economist on the macro side because that was 2011, ‘12. And back then I don’t know if you remember there was well there was the financial crisis in 2008 and ‘09. But then there was a Euro crisis and so that taken together left a lot of people being really concerned about the future outlook and we looked into the macro side, we’re concerned about central banks, and I thought it’s a brilliant idea to combine the bottoms up, stock picking value investing with macro, top-down and so on.

On that basis, we started to talk to potential investors and used our existing network, and lots of meetings, phone calls, and a lot of feedback that sounds like sounds really interesting. We come back to you and then you never hear back. So that’s normal if it happens to you but luckily we had built some really good reputations with investors and with individuals within institutions. And we got two tickets, two starting tickets from two insurance companies in Germany and they’re still invested with us now after 10 years. So sometimes you find really good investors and really good nice people. I’m very grateful for that within environments where you don’t expect it, and so that was the starting ticket. We started with 12 million at end of 2011.

Investment Philosophy

[00:14:59] Rob Vinall: Well, well, fantastic. And talk about how your investment philosophy evolved over that period. It sounds like there was a strong macro component at the beginning. How did that evolve?

[00:15:12] Matthias Riechert: Yeah. So my partner back then was Thorson Pollard and Thorson is very good at analysing central bank policies. We were quite bearish overall because we thought all this money printing can’t go well. At some point, people will probably wake up to the fact that the currency they keep in their wallets is really weak. And what implication might that have on investing? How do we invest well in that environment? And that was ten years ago, right? So back then, if you’d told me that in 10 years we are where we are right now. I would have thought, no, that’s unlikely. I think some sort of currency reform or something might have happened in the meantime.

So the difficulty we figured out is how do you translate that into actual investment decisions? And we figure out it’s really very very hard and on the individual stock picking a side on the analysis of companies, I try to focus on businesses that have all the ingredients to cope or are better suited to cope well with inflation, but otherwise, in terms of timing and so on, it’s really, really hard. And to this day I’ve not met somebody who can really plausibly explain to me a methodology on how to do that. And so, over time over the first years, we basically faded out of the macro thinking more and more and became a pure investor in great businesses and then thought and also learned a few years.

Key things to look for in a good investment opportunity

[00:16:47] Rob Vinall: Yeah, so describe how you invest. What are the key things that you look for in a good investment opportunity?

[00:16:55] Matthias Riechert: Yeah, I think whatever you do in investing, there’s just basically one important thing which is the relationship between price and value. You can apply that principle in all kinds of ways. You can apply it in bad companies in mediocre companies, or in excellent companies. You can apply that in any asset class that you can independently value.

I think whatever you do in investing, there’s just basically one important thing which is the relationship between price and value. You can apply that principle in all kinds of ways. You can apply it in bad companies in mediocre companies, or in excellent companies. You can apply that in any asset class that you can independently value.

And so I think that’s the number one thing. The relationship between price and value, and it’s by the way it’s so easy that somehow price makes its sneaky way back into your own intrinsic valuation, right? So it’s really, really a simple concept, but I’m always amazed at how fuzzy thinking is between price and value, right?

If you read an article in some newspaper and Financial Times, it’s always a mixture of fundamentals and then the stock price. If you speak to board members, their idea of valuation is what the city is, I’m based in London, so the city means the stock market, the analysts, et cetera, think about the stock. So they do not have a clear framework in their mind which means there is a distinction between the prices, the current price, and the independent variation of that business you look at. That’s the most important thing.

Matthias Riechert, how do you arrive at the value of a company?

[00:18:18] Rob Vinall: So describe how you arrive at the value of a company.

[00:18:21] Matthias Riechert: Yeah, so just to finish your question. So on the spectrum of value investing. I’m on the quality side as you are as well. So I prefer to look into a great business. I’m excited to learn business stories right? I’m excited to study businesses that have produced tremendous shareholder value creation over time. And I look for these patterns and I look for businesses where I see these patterns. And then we try to look in areas where there’s not so much competition and hopefully find these we call them young elephants a little bit earlier than when they are really ripe and visible to everybody. So let me try… Why wouldn’t the better opportunities be in the worst companies?

[00:19:03] Rob Vinall: Let me sneak in another question because that’s such an interesting thought about there being a sort of spectrum between sort of mediocre to great companies. I guess a counterargument to that might be on balance. Most people prefer great companies to not great companies, so why wouldn’t the better opportunities be in the worst companies?

[00:19:26] Matthias Riechert: It could be. It could be I’m not ruling that out. It’s just I think you have to ask yourself. What do you like to spend time on, right? when you wake up in the morning? Do you like to sift through all these kinds of crappy companies and want to figure out who are the 20 or 30 that I want to invest in on that basis and then hope that statistically, the overall performance is pretty good? Or do you want to spend your time on great businesses? Or do you want to spend your time in special situations? Or some situations where you have to study legal documents, right? It’s really down to your own kind of personality and passion for what you should be doing I think.

It could be. It could be I’m not ruling that out. It’s just I think you have to ask yourself. What do you like to spend time on, right? when you wake up in the morning? Do you like to sift through all these kinds of crappy companies and want to figure out who are the 20 or 30 that I want to invest in on that basis and then hope that statistically, the overall performance is pretty good? Or do you want to spend your time on great businesses? Or do you want to spend your time in special situations? Or some situations where you have to study legal documents, right? It’s really down to your own kind of personality and passion for what you should be doing I think.

[00:20:13] Rob Vinall: Okay, then back to valuation, how do you think about it?

[00:20:17] Matthias Riechert: Yeah, so I mean the math is pretty simple. It’s the present value of all future cash flows from here to eternity that you can take out of a business, so that’s the math, and I think it’s always helpful to look at the business and to start with a lot of questions about the quality. In that area what we are doing and there are a lot of elements that flow into this variation. So you can think of how attractive is the product, and how big is the market. How good are management and we can dive into what that actually means? But everything in the end flows into the final valuation. And that’s what I would call the end product, the financial engine of the business.

And if you think about it, what we are trying to find is we try to find components. So you can really sum up the elements that you look for into how much is the earnings potential of the business you look at, so you can call that the free cash flow currently or on a normalised basis, and how much of that ends up in your pockets through dividends and how much of that is reinvested, at what rates of incremental return and for how long is that period of growth? And then you have to discount those back with an appropriate discount factor to today. And so it really comes down to those five inputs that you have to be good at estimating. Why don’t you pick two companies in your portfolio which illustrate how those inputs can differ?

[00:21:54] Rob Vinall: Let’s get dive a little bit deeper than that, why don’t you pick two companies in your portfolio which illustrate how those inputs can differ?

[00:22:07] Matthias Riechert: The ideal company is of course one where all of the earnings can be reinvested at very high incremental returns, and then you create this beautiful compounding exponential function, right? That’s what we want. And the exponential function, by the way, is very hard for us to grasp, and that’s why you sometimes get opportunities where this exponential function works longer than you think, and therefore the multiple actually should be higher than what you think. And so one example of that could be Moody’s. So Moody’s is a company which is not a young elephant. It’s quite established and I think if Moody’s a little bit that they have this incredibly strong rating business and I think it’s probably one of the strongest modes.

[00:22:51] Rob Vinall: It’s the company that gives the bonds the AAA ratings or whatever.

[00:22:54] Matthias Riechert: Yeah. So if you were working in a Treasury Department and you have to issue bonds, there’s no way you can’t pass by Moody’s, and usually, you go for Moody’s and S&P, right? They’re not even in competition because most of the time you need both ratings and so the difference between having a rating and not having a rating is I think the latest study I read is around 65 basis points on an annualised basis. It’s tremendous if you think about the probably 70 trillion or so of debt that’s out there that’s being rated. So the value creation through that stamp of approval is incredible.

So you think that OK, they have a strong mould, right? So what does it mean for this financial engine? Well, they have incredibly nice margins on that rating business, but the problem is they can’t really reinvest the free cash flow into that same business, and incredibly high returns on incremental capital. So what they’ve done over the past as they reinvested it: A) a little bit into dividends; B) a little bit into buybacks. And then, thirdly, they did acquisitions in all kinds of analytical and research kind of software companies. And that’s called Moody’s Analytics and that’s the second part of that business.

And so if you look at that business or these two businesses normally would say like OK, they might have really, really high returns on capital, and they do. However, what’s really important for you is the return on incremental capital, and so when they bought these analytics businesses. They bought them at market prices, i.e. at quite high multiples. And so when you work out the return that they actually achieve from these investments, it’s probably only at around the cost of capital which is probably I’d say around 10% or maybe slightly less.

[00:24:43] Rob Vinall: It’s not a very mediocre business in terms of…

[00:24:45] Matthias Riechert: Exactly.

[00:24:48] Rob Vinall: So what would be a counter-example to that?

[00:24:50] Matthias Riechert: Yes, so which basically comes back to putting evaluation on a business with a great management team that understands capital allocation and the business team or management team that is not so great. I’m not saying Moody’s management team is bad, it’s just what you see. So another example would be a very small company that we own for quite some time, which is based in London and is called Judges Scientific. It’s a company that invests in small niche businesses that produce and manufacture scientific instruments. And David Sicurella, who founded the company on runs, is a fantastic capital allocator. So what he does is he buys these small companies that typically run historically between four and six times a bit. Now let’s say the average is five times, so if you translate that into return on incremental capital, that finances it, probably at around two turns, so he pays five times, two times from debt, so three times equity. Then you have to subtract a little bit of interest. You have to subtract tax and if you work that out you get to probably around 20, 23% return on equity.

And so if you keep on doing that, if you reinvest 100% of your earnings, your growth rate will be 23%, but it depends on you finding these acquisition targets, and so over time, he has produced incredible shareholder value through doing that. But of course, with bigger size it becomes more and more difficult to find these nice niches cheap companies and but the outcome that you see is a phenomenal track record. I think David has issued the shares at 95P 18 years ago and the stock trades at I think on Friday at £88. In addition, he even pays dividends, so that’s a 30% cagr over 18 years. And that’s a phenomenal compounding outcome, right? So that’s another example of a great financial engine.

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Financial engine model

[00:26:57] Rob Vinall: Yeah, I love your financial engine model and you also have a very simple spreadsheet where you calculate it based on a theoretical $1.00. Why don’t you describe that?

[00:27:13] Matthias Riechert: Yeah, so maybe that’s because yesterday you spoke about great business and great management. I think we often struggle and I guess many of you struggle how do you translate that into evaluation? And so if you think about the business that, let’s say makes $1.00 in earnings and it reinvests this $1.00 in earnings at a 10% return. And it does it for 10 years. And let’s say you discounted it by 10% then the result is 10. So in other words, because you start with $1.00, it’s a. P/E ratio of 10, 10 times. That’s a fair value of it. So let’s say you have the same business run by a very competent and skilful capital allocator, and that management team manages not 10% return. But it manages, let’s say 15% return, right? If you do the same thing, you have 15% growth because 100% reinvestment rate and you discount it you get to something like 14.9. Let’s call it 15, so that’s a 50% difference in valuation. Now think about that.

[00:28:27] Rob Vinall: [unintelligible]

[00:28:28] Matthias Riechert: No, 50. So the first one is 10, the other one 15.

[00:28:31] Rob Vinall: Got it. Got it right.

[00:28:33] Matthias Riechert: So in other words, if you look at the company with the mediocre management team, it’s worth 10 times. The other one, fifth, in that example, 15 times, so 50% more, right? So you can actually put a value on your assessment of the management team, and I think it’s really useful to always try to do that. Always think about valuing things. Always try to think about what’s it worth.

Being an educator

[00:29:03] Rob Vinall: Aside from investing, you also, yourself, an educator now. Maybe inspired by Tom. Describe what you’re doing in terms of the students in London.

[00:29:13] Matthias Riechert: Yeah, so when I studied back in 2010 to 2012. I always thought, gosh, I wish I could speak to somebody who started a fund and who was on this journey and I can ask all these stupid questions but there wasn’t somebody like that there. So when I managed to start it a few years and I thought why don’t I just offer it? And I sent an e-mail to the investment management club at London Business School and just offered a mentorship. And that worked quite well. And since then I’ve been mentoring a small group of people, probably usually only five to seven people. Some of them are here, and that’s a lot of fun because when you teach things, you can really instantly know whether you have understood them or not. So there’s instant gratification also in passing on things and then beyond that, there are lots of other things that come back to you. For example, I found a very, very good analyst, Aakash was now with me since 2019, ’20. And many other really interesting opportunities come up from working with great people and so I’ve been doing this now for the 13th time. And yeah, I can recommend passing on knowledge to other people a lot. It intrinsically makes you happy.

Matthias Riechert’s advice to young aspiring managers

[00:30:37] Rob Vinall: What a wonderful thought. One of the things we talked about in the context of our discussion today is, you know, young aspiring managers. They shouldn’t try to be like you or like me or anyone else. They should try and be something which is sort of a true expression of their own personality and of course, everyone’s personality is unique, so what would your advice be to them to sort of get to where you are today, but not by being you but being themselves?

[00:31:05] Matthias Riechert: Yeah, I think that’s very hard, right? I think not many people, even in their 40s or 50s, sometimes know what they want to do. I can think of a helpful framework. I think it’s in Jim Collins’ book, Good to Great in the chapter Hedgehog Principle. I think it is. So there are three circles and the first circle is what is it that you love to do so when you wake up in the morning and let’s say you have spare time. What do you tend to do? What is really the stuff that you’re excited about? That’s the first thing and write down all the things that come up there and that in that field. The second one is where do you think you can reasonably be really, really good at potentially the best in the world? So if I say I’m very good or I’d love to run a marathon, I would probably never win against Kipchoge or something, right?

[00:31:56] Rob Vinall: I think that ship has sailed.

[00:31:57] Matthias Riechert: So you get the idea and then the third one, the third circle is how can you build an economic engine around those things at the intersection of those three circles. And I think that’s a very good framework for you to really write down all the things that that you can come up with and then find this thing in the middle. And otherwise, I think it’s just really in life about iterating for as long as you need to find your niche. And probably you need to go through a number of iterations to do it and just be open about it.

[00:32:32] Rob Vinall: It’s wonderful advice. The advice you bought typically here is sort of follow your passion, but it’s not very helpful advice. A lot of people at 18 aren’t quite sure what their passion is and to the extent, they have a passion it might not be something that is immediately monetizable. And I like your framework a lot better. It’s a wonderful note to maybe let the remainder of the group here maybe ask one or two questions. We got about 10 minutes left. Do we have a microphone? Who would like to ask Matthias a question? Alright, Claudine at the front.

What changed with the way of thinking

[00:33:22] Speaker 3: I like how you started with the concept of having the right framework as a sort of trail map to get you through the wilderness. In the last three to four years, have you evolved your thinking from the first principles to anything around your central frameworks? It seems like there was a period where you deemphasize that macro thinking. But as you’ve continued to hone in on your frameworks, what’s changed recently for you? If anything.

[00:33:59] Matthias Riechert: I think nothing really has changed fundamentally in terms of that framework. What has changed is your understanding of the individual elements, and I think that’s a lifetime journey to get better and better. So, for example, when you think about assessing management. So one of the questions of the framework might be what’s all the evidence against that management, the Board, and other shareholders are aligned with your priorities as a long-term shareholder? Now when you start out, how much do you know about the board? I mean, you can read their CVS, but what does it really tell you, right? So how do you get up to them? And I always say to my mentees you should look at the list of AGMs in London and just pick a few interesting companies. Just go there, because usually there’s nobody there. There are just some helpers, some financial advisors and some lawyers, but usually no shareholders or maybe just a few. And so it’s very easy there to go up to the board, just introduce yourself, ask some smart questions, have a coffee with them and you get to know them. And so, over time I think I developed a much better understanding of how to answer that question, on how to assess the board for example, and engage with the board and in some instances where you need to and sometimes where you were not quite sure whether there is alignment or not, right? And what can you do to change that, potentially? So that’s an example, you get better at the individual elements of the framework, but the elements themselves don’t really change. They shouldn’t.

[00:35:39] Rob Vinall: Claudine had a question at the front here. Let me give you my microphone.

Input-Output

[00:35:46] Claudine: Thanks, Matthias. I was just wondering about the kind of input-output because my feeling is that you are quality companies that one that has produced quality results.

So how do you look at it like your Judges Scientific? Before they’ve actually produced the results. What is the core that you’re looking for that company has the potential to produce results before they produce them?

[00:36:07] Matthias Riechert: Yeah, so that’s great detective work, right? So you have these questions that I’d like to find answers to and I just gave you one example and essentially what I do with the help of Aakash and sometimes other students that I’ve put on projects with. So here’s one, by the way, Luca, who I’ve worked with. So I tried to find answers to all these questions and I basically collect all kinds of little puzzles and I turn them around and at first, you don’t really see a clear picture. But the more you do, the more you turn around. Then eventually hopefully you see the picture.

And if you find a company that scores very high in all those elements, then the likelihood is high that this company will produce growing cash flows over time and then you can put a value on that and then it’s always down to comparing that value, that intrinsic value that’s independent of the stock market with the current stock price. And if there’s a sufficiently large margin of safety then you’re on to something. And by the way, a lot of these elements you need to really often go out, right? So leave the desk. Go out and speak to people. Go to conferences. Test the product. I’m amazed how many investors never actually test the product. I mean, if you can test the product, right? If it’s a B2B business, that’s a different thing. But if you can test the product. Immersive yourself in the business. Use the product. Speak to people who use it. Speak to a lot of customers and so try to figure out much more than just reading an analyst report. It’s just another opinion.

[00:37:44] Rob Vinall: Question at the front here.

Worst investment

[00:37:46] Speaker 5: Hello. Can you please tell us about your worst investment and what we can learn from it? Your worst investment and what we can learn from it.

[00:38:02] Matthias Riechert: I’m thinking because there are several opportunities to dive very deep into several of those mistakes, and I’m not quite sure which one was the biggest one. So one is Carvana as well, and I guess that’s something that will probably also be covered in his letter. So I give you another one, which is Naked Wines. Maybe some of you might know the company. It’s a company that has a subscription model for wine and there’s an interesting flywheel coming out of that business model, which means that you pay upfront for wine that you might get in the next season, and this upfront payment allows the company to fund winemakers to produce the wine. So they like it, the customers like it because you get the wine cheaper than otherwise and you get access to really some artisan interesting wines and hopefully the shareholder should also benefit from it because the model should be profitable.

And so over the last, well, two years or so they had an incredible upfront in the COVID phase because a lot of people were sitting at home and they ordered wine online. But similar to Carvana they overextended the investments into growth, thinking that will go on forever, and so it didn’t turn out that way. And so now they have a very high-cost structure and the investments into growth into customer acquisitions didn’t return the paybacks that they expected and so that’s an example where when the tide goes out, you see you’ve been swimming naked and you know the name of the company should have given me clue Naked Wines. So that’s one example. I think they have, however, a pretty good chance to get back. And unlike Carvana, I think that is not an issue. There, it’s just really about being very cost conscious and balancing this growth with profitability.

And by the way, in terms of capital location, that’s a very good question in that context, because when you talk to the board or the management, it’s a really difficult question whether you grow yourself out of it, out of the high-cost structure, or whether you pivot back to profitability and let go of growth. I think a lot of companies are at that point right now where they have this have to make this difficult decision and a great capital allocation framework within the whole company is extremely useful there.

[00:40:35] Rob Vinall: Who’s next? Kevin?

Investment approach and changing of mind

[00:40:39] Speaker 6: Hi, what’s the most important thing on which in terms of an investment approach where you changed your mind over the last three years?

[00:40:49] Matthias Riechert: I think it’s coming back to capital allocation and I’ve done a few investments where I thought capital allocation was not so important because the company is on a nice growth trajectory and they don’t need to understand it that well for as long as they understand how the investments in growth have a high return. And we’ve often then learned that once they don’t grow that much anymore, you know, the actual capital allocation question comes up very quickly and then the cash doesn’t end up in our pockets, but somewhere else. Often in some overpriced acquisitions and so on.

I think it’s coming back to capital allocation and I’ve done a few investments where I thought capital allocation was not so important because the company is on a nice growth trajectory and they don’t need to understand it that well for as long as they understand how the investments in growth have a high return. And we’ve often then learned that once they don’t grow that much anymore, you know, the actual capital allocation question comes up very quickly and then the cash doesn’t end up in our pockets, but somewhere else. Often in some overpriced acquisitions and so on.

So I think it’s really that question of how important alignment really is, and clarity about what this company wants to achieve. And it sounds very simple, but the fact is if you speak to a lot of people within the business. So for example, when you analyse the business and you meet with the manager, maybe with some other people in the lower hierarchy, maybe people on the ground, maybe the board, ask them what’s the one thing they think you can be the best in the world at. If you get totally different answers, it tells you there’s no clarity in the company. If you get similar answers, maybe different words, but basically the same kind of thing that they tell you you’re on to something.

So I think it’s really that question of how important alignment really is, and clarity about what this company wants to achieve. And it sounds very simple, but the fact is if you speak to a lot of people within the business. So for example, when you analyse the business and you meet with the manager, maybe with some other people in the lower hierarchy, maybe people on the ground, maybe the board, ask them what’s the one thing they think you can be the best in the world at. If you get totally different answers, it tells you there’s no clarity in the company. If you get similar answers, maybe different words, but basically the same kind of thing that they tell you you’re on to something.

[00:42:16] Rob Vinall: I think we have time for one last question. See your hand at the back there.

Matthias Riechert on Margin of safety

[00:42:28] Speaker 7: Yeah, you just previously mentioned the margin of safety and I was wondering how you go about applying the concept of margin of safety. Do you use it more as a discount from the price you’re willing to pay, or do you think of it in terms of business quality and business quality embedded margin of safety?

[00:42:51] Matthias Riechert: As I said before, you need to translate business quality into some quantifiable number because only then can you really compare different opportunities. So the trick is really to translate these qualitative elements into a number. I think you should use different vantage points in terms of valuation. There’s not just one way to do it. One way, as I said, is looking at the financial engine and then understanding what kind of multiple would be fair for it. And the other way would be just to look at the current earnings power just to say, OK, if this company I’m looking at stops growing, let’s say, and just reinvest enough so that it retains the competitive position. How much earnings? How much cash could I take out of that business right now? And if that amount relative to the price you pay gives you a kind of yield of, let’s say, 10, 12% already, then you’re on to something, right? So there are different vantage points that I would use.

Another one is you could say, How much runway does this company still have in abnormal growth potential? I brought up the example of Moody’s. So Moody’s has a very strong mode and you could say, OK, Am I comfortable to go out five years and assume that over the next five years, the mode is so strong that they keep on extending that period of abnormal earnings growth? Then you might be able to say, well, maybe I’m comfortable even to go out further than that. And then you have an interesting thing which I think applies to Moodys. Most analysts, if you look at their valuation model, only have five years for discrete growth numbers and then it kind of assumes that the abnormal growth rate goes down to some kind of average, so they type in their terminal growth rate there. So if you find a company like Moody’s where you might get confidence in their modes, i.e., meaning, you think they will be able to go further and grow further than these five years. You can find interesting situations like Moody’s over many years I’ve been holding them constantly trade somewhat too cheap, even though the multiple is already at, I think currently it’s probably this year’s multiple is around 30 or so. Optically, it looks expensive but if you really dive deep into it, you see that it’s potentially not overpriced.

[00:45:28] Rob Vinall: Wonderful Matthias, I really enjoyed this. Thank you so much for coming for many years now and it was a wonderful discussion. Thank you very much.

[00:45:35] Matthias Riechert: Thank you.

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