Ep764: Kyle Mowery – Invest in Your Circle of Competence

Andrew Stotz 00:01
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning in our community. We know that to win in investing, you must take risk, but to win big, you've got to reduce it. Ladies and gentlemen, I'm on a mission to help 1 million people reduce risk in their lives. And I want to thank you for joining that mission, especially my listeners in Chicago and in the wonderful country of Australia. Bello risk takers this is your worst podcast host Andrew Stotz from East Dance Academy and I'm here with featured guest Kyle Mallory, Kyle, are you ready to join the mission?

Kyle Mowery 00:44
Ironmen risk

Andrew Stotz 00:48
that's what we want to do. So let me introduce you to the audience. Kyle Maori is founder and portfolio manager at grizzly rock capital and has an 18 year career beginning at Pemko, where he honed his analytical skills. He later delved into high yield corporate securities AT T H Lee senior credit strategies and expanded his expertise and BM o capital markets. In 2012. He established grizzly rock, adopting a fundamental value oriented research approach in small cap companies. Karl's method involves rigorous research systematically identifying mispriced securities with high risk reward potential. With unwavering discipline he navigates market complexities focusing on high conviction investments, a missed amidst information, overload his adeptness in spotting substantial mispricing opportunities sets him apart in the crowded investment landscape. Well, Carl, take a minute and tell us about the unique value that you are bringing to this wonderful world.

Kyle Mowery 01:53
Yeah, Andrew, thank you for having me. We are a small cap manager trying to emulate fundamental strategy, investing strategy free cash flow focused strategy in larger North American equities, and been around 12 years. And now we're SEC registered manager. So just keep on keeping on is the goal.

Andrew Stotz 02:21
And maybe I have a lot of interest in the area that you're in, because I've been doing a lot of comparisons of the US compared to let's say, Asia and other markets. And one of the really surprising things about the US market is how the net listings are negative for last I don't 1520 years. There's more companies, delisting from the US markets, then our listing, what the heck is going on with the head, the center of capitalism?

Kyle Mowery 02:50
Well, simply private equity, private equity has bought so many of the companies that formerly would have been us listed small caps, or micro caps, and rolled up I mean, the amount of money in private equity, the returns have been largely Very good. I'm not in that business. But I got a friend that business and it's a wonderful investing strategy for those who have access to it and who don't need to liquidity.

Andrew Stotz 03:21
Because liquidity is the idea of being able to get in and out. And when something's in the stock market 10

Kyle Mowery 03:27
year commitment, right. I mean, if you're, if you're in a public public stock fund, hedge fund, mutual fund interval fund, you know, you can get your money out within, you know, a quarter at the longest, but in a private equity fund, you're signing a tenure check. So, you know, that works for many, especially on the institutional side. But it doesn't work for all. And so I think, I think there's still, you know, we we, a lot of our companies end up being sold to private equity. And when that happens, I'm very happy because it means I'm doing a good job, right underwriting free cash flow and underwriting you know, sustained a product and service development value and private equity sees that and takes it private, that's good for me. But overall, yeah, does narrow the narrow the field, and

Andrew Stotz 04:14
I'm just looking at a chart, I'm not sharing the screen of it, but I'm looking at it. And what I'm seeing, I'm looking at the Fed funds rate, and what we know, of course, is that the Fed funds rate has, you know, been extremely low, let's say you could say since 1995, we were down at 4%. It popped up to 6%. And then came back down and 2000 where it was back down at about 2%. So let's say over the last 20 years, we've been on an average maybe 2%, one and a half percent. To what extent is the low interest rate environment the really the main thing driving private equity if interest rates had been over the last 20 years if they had been, let's say 5% at the Fed funds rate meaning that the private equity firms would get money and, you know, maybe 6%, or whatever, would that have changed this? Or is there more than just interest rates and access to super low cost funds?

Kyle Mowery 05:13
Well, a higher interest rate, I mean, sure, would have lowered the IRR a little bit. But you know, one of the beauties of private equity and, you know, folks who sit in a public equity seat like me, often, you know, wish we could mark our portfolios that cost or where we think they're worth. Now, we don't get to we get marked every day, we're private equity, you know, the price not changing very much is actually not a bug. That's a feature, right? That's part and parcel of it. But we in the public world have the Quiddity. And in the private equity world, they don't, I would say that early on, equity was really focused on, you know, operational improvements, and they could have a ton of financial leverage. But they found that they didn't have to do as much operational improvement. So they were able to do many, many more deals just on financial engineering, I'd say now, the best private equity comes in, and it's the correct balance sheet, but it's really about growing, growing dividend free cash flow, and really, from an operational perspective, improving the business. And so in that way, private equity is really no different than, you know, any other sort of ownership that is focused on growth, and, and accurate and financial growth reporting and whatnot. So that's, that's something that it's a great asset class.

Andrew Stotz 06:39
It raises a question if the value of your portfolio is not quoted on a daily or weekly or monthly basis? Does that mean that it's less risky? Does it mean even that it's less volatile? When you don't measure it? You know, that's a question that, you know, I think about a lot like, I

Kyle Mowery 07:04
mean, we could, we could have a multi hour debate about that. I think, you know, ultimately the companies are sold and investors receive what companies are sold for. So in the end, it washes out in the middle. The price is not going to move that much. It's going to be quoted at you know, a certain price for a while most times it cost for a substantial time period, which is which can be good can be bad, but you also have, you have illiquidity. So you're bearing illiquidity risk, not so much price risk, where if you turn on the TV, and you own a publicly traded stock, and all of a sudden it's down 10 20%, for whatever reason, all that means is it's the marginal buyer and seller meeting, that's, that's just the price that they happen to quote today. And the price might be set by someone who's thinking about something completely different than your eye and, and that can be annoying. And it is many times especially for someone who runs a long short fund because they're always taking pain on the long or the short side seemingly on a daily basis from market participants who aren't thinking about the world the way that you are. So but but the price there's dislocations that's opportunity. And that's why public, you know, active managers active being, you know, stock pickers in, in public equity can and do outperform when they go into those areas of significant discrepancy and doing something highly unique. The

Andrew Stotz 08:30
other thing that's been interesting, I have a course I called finance main, ridiculously simple. And it's part of my valuation masterclass also, and I have a data set of 26,000 companies around the world, every country I can get. And then I collect that data. And then what I do is I clean it. And I have some standard cut offs, like, you know, getting rid of companies that are, let's say, tiny, or companies that have very low trading volume, because I want a representative sample of companies. When you do a standard measure like that across the universe, you end up having more Chinese companies than American companies now. Yep. On that is fast. Fascinating. So it brings me to the next question, which is, how do you define what is small cap? You know, what does that mean to you?

Kyle Mowery 09:24
Yes, well, as you will find out with my upcoming painful story, I think for a couple of different reasons we've decided to focus on on North America and Western Europe. So we look at North North America and Western Europe. We're generalists though. we're typically looking 500 million in market cap to about 3 billion ish small cap something. These are real businesses, they have real cashflows real products, but they're they're not beholden to one one or two people the way that some nano and micro caps are. And we think that and the last 10 years, probably really proves this statement. Ill timed if not incorrect, but the larger cap securities are more efficiently priced. And so when I was thinking about the best way to add value to client portfolios, what I could do is go into small caps, find unique, uncorrelated assets and invest in them with, you know, rigorous diligence and research. So,

Andrew Stotz 10:27
and there still are a lot of gems in that space. One of the companies that I talk about with my course, is the company called Fastenal. And called fast, which I found, you know, I just find it very interesting. The whole business model is just unique. I mean,

Kyle Mowery 10:42
that's one of the best returning companies in the last 30 years, right. I mean,

Andrew Stotz 10:47
you know, there's something interesting also about that, I went through my data set of all of my 26,000 companies to try to find the most simple company. And I was looking for ones that didn't have equity income, I was looking ones that didn't have goodwill, didn't have, you know, a lot of intangibles and all of that. And that company comes out as the cleanest p&l and balance sheet. Very simple. And that helped me for my teaching that this is my starting company, because I don't have to deal with the complication of you know, what, wait a minute, what's this goodwill item?

Kyle Mowery 11:21
Yeah, no, that's, it's a wonderful company. And you could spend all day in a fastener aisle at Home Depot. But that just tells you I'm a, I'm a dad. That's what that tells you.

Andrew Stotz 11:31
And the last thing is that I just was curious about is like, what is your holding period? And how once you find a company, how long do you stay in it? You know, what, what is that? You know, tell us a little bit about that methodology.

Kyle Mowery 11:45
Yeah, so our, our focus is sort of in between a shorter term hedge fund, it's going to be a little bit more quarterly, focused, and definitely not looking out, you know, a decade plus, like some of the, you know, real, big name growth investors, we're looking at one to three years, two to four years. And we're looking for inflections in business, specifically around operating profit and free cash flow. And so a lot of times Wall Street is pretty good at looking out 12 months, but maybe they don't look out three years, right. And they don't understand the operating leverage inherent in the businesses that understand the way that you know, the debt leverage is going to come down or no, there's going to be a series of catalytic events, a catalytic path that extends over those periods of time, in such a way that you can do the research, you know, which takes substantial effort and time, do it upfront, and then position yourself for a multi year time hold, a lot of our investors are taxable as well. So always, in the US prefer to prefer to hold it for over a year, if possible.

Andrew Stotz 12:54
You use the interesting word inflection or inflection point, maybe it's a significant change, or a point where something's happening, which is different from a catalytic event, as you said, like the catalyst that reveals that maybe to the market. So what you're thinking about when you're looking at something is you're saying, Alright, the free cash flows of this company seem pretty low. But hey, they're doing an inventory reduction program. And I think that that could have a real positive impact on free cash flows in the next couple of years. I want to start building a position in this now and then see their progress in that. And if they have that progress, eventually the market is going to see that, and then I'm going to get the performance.

Kyle Mowery 13:36
Exactly, I mean, you, you mentioned your database, and you know that you can run a lot of different quantitative screens. As a qualitative investor, if I can position myself, you know, I only have 15 to 20 companies at any one time, right? If I can position myself to where I would not hit a screen such as yours now, but then in 1218 months, it will, that's something we're in a passive, a world that likes to invest in a passive way, with stocks and indices. And in a world that's focused more and more on quantity investing, then that's something that you know, you can game the system a little bit, so to speak.

Andrew Stotz 14:17
And how hard is it? You know, I mean, when you think about it, everybody's watching this data. And, you know, on the one hand, sometimes you look at things in life, and you think, but that's really hard, and there's a lot of really smart people. But you know, sometimes really smart people can do really dumb things, and they can all follow each other doing those dumb things. I'm just curious, like, how hard is it for what you're doing?

Kyle Mowery 14:39
I think the key is being intellectually honest, being honest about what are the businesses that you understand? Because you don't need to be an expert on 100 businesses, right? We have a team of three. So there's three of us. All good pedigrees been doing small caps more or less So our whole career, we, you know, we have our long portfolio of 15 to 20 ideas, and they don't all turn over every year. So we don't have to find an idea a month, we're not going to be able to find an idea a month each person, right? Like, it's just not for what we're looking for. I mean, we're looking for businesses that are massively mispriced and misunderstood over two to four years. That's not something that you can just open proverbial newspaper, throw a dart and hit, you have to understand why. And you have to understand it in an asymmetric risk return type framework, right? I mean, we're looking for five to one four to one sort of upside downside, and you want to be really vigorous on the downside. That's the way to compound over time.

Andrew Stotz 15:48
I, you remind me about my Episode 667, with the Srikanth, with one a ton, who has a company called SVN capital in Chicago. And yeah, I know him. He's great. Yeah, excellent. And he, you know, he highlighted the fact that, you know, he highlighted a particular academic paper that was great, that highlighted that, really, it was only a small number of companies that actually lead the true value creation around the world. Now, he's not a small cap necessarily focused. But his point was, you don't need a massive universe. And you've reiterated that you're not, don't need to focus on 1000s and 1000s, you need to narrow it down to, you know, a small number. So one other question, I'm curious about what is the responsiveness or the amount of information that you get out of a small cap, or that type of company in the US these days?

Kyle Mowery 16:40
Well, Reg, FD is really leveled it out nicely. I don't want to date myself too much. But I was not in the business pre Reg FD, I was in the business, pre financial crisis. So the unfettered bull market over the last 12 years minus a couple of months and COVID is, is not my only background. But I kind of worried quite frankly, about market structure and affected so many analysts and PMS have come into professional listing after the GFC. But that's sort of a different podcast topic.

Andrew Stotz 17:16
So as Regulation FD comes in, and basically means that the companies have to uniformly just, you know, disseminate information through their communications to the markets, their websites, that type of thing, there's no preferential treatment, but that also means that they're getting information up on their websites, and they're there, you can easily access, what they're what they're saying.

Kyle Mowery 17:42
Another good. Another good way to understand companies is to understand the culture, right? I mean, it's really hard to understand the culture of reading an annual report, right? 10k in the US. Yeah, talk to management, you can understand, you can study the board's bios and whatnot. But really understanding the culture, I mean, talking to former employees that have been gone a while just for compliance purposes, is a great way to understand the business a great way to understand the people and how they're likely to act in periods of stress. And that's something that you know, you can't you don't want to rely on, but it's something that helps round out the picture of the company, as you understand it deeper than just, you know, you can actually numerically model. So that's something that we try and spend a lot of time on as well. Well,

Andrew Stotz 18:31
it's great to discuss all this stuff, because I know some of my listeners are fund managers, and they're managing money. And some of them are really focused on small and mid cap companies and thinking about how to build something on their own. So I think it's a valuable discussion. But now it's time to share your worst investment ever. And since no one goes into their worst investment thinking it will be. Tell us a bit about the circumstances leading up to and then tell us your story.

Kyle Mowery 18:58
Sure, so our firm, you know, we're here to provide not only high absolute return, and good risk adjusted return, but do something unique and different, right. I mean, that's one of the reasons we ended up in small cap. But I think in a lot of ways, I strayed a little too far outside my circle of competence. It also got it also kind of gets into building the business. And how much leeway Do you Do you as a portfolio manager want to give your team so while this investment was led by others on my team, the ownership of the loss is 100% on me, and ultimately, you know, at every portfolio, whether it's a personal account or a giant fund, there's someone that's got to put their name on it, not one for this one is me. So for us, you know, I hired an additional analyst is we're growing a business in 2016 And this person had a background in small cap, Asian developed market, Asian equities. And I've been following a business at the time, which was called TFS, which is now called Quintus. This is a business that produces sandalwood trees. sandalwood trees are a hardwood, which takes a long time takes about 15 years for the, quote, crop to mature. But, you know, it's a very valuable product for cosmetics, for religious use, even pharmaceutical oils and tinctures and things. So there's, you know, we researched the business in late 2016, and ultimately ended up purchasing shares, believing that the company was on the cusp, or the inflection of significant free cash flow. Now, the company was levered financially, and we were well aware of that. We were also aware that they were on the precipice of going free cash flow positive. That's that's sort of, you know, what management? By the way? I don't I don't know if I'm supposed to go back and re brush up. I didn't, it was too painful is six years

Andrew Stotz 21:17
ago. That's okay. Don't

Kyle Mowery 21:18
worry about that. Yeah. Okay. So this is all my recollection of it. But, but you know, we invested on the basis of the imminent free cash flow, we're going to harvest this wonderful group of trees, we put boots on the ground on my team, they were in Australia, they saw the trees, they saw that, like, that was all very real. And then, and then also, management, there was a founding family that owned between 20 and 25% of the business. So you a lot of times you look for alignment, right, you look for a signal founder owned and run companies, you know, if there's skin in the game, that's certainly meaningful. And so that was another point. So we did our full diligence, and we believe they were about to, you know, sell at significantly higher prices, to different companies and different buyers across the globe. And we did all our research and felt that they were on the cusp. So we repurchase shares. That just never came, some of the sales fell through or fell through at different prices. And the whole thing, eventually, kind of I don't want to use the F word fraud. But the whole thing kind of fell in on itself. And Australia does not have Reg FD. And there's definitely it's harder to check culture, cultural sources, and really deep in to companies where you're not on the ground. So I sit in Chicago, and, you know, so we don't do Asia anymore. Not because there's not a wonderful suite of companies and a lot of economic vitality in Asia. It's just not in our circle of competence. We thought it was we believed it was at the time, was it? It was on the edge. Right. But ultimately, management resigned. So they didn't have to report when they sold their shares, and then the whole thing imploded. And we did sell before it hit zero, but it was a very, very nasty loss. So and

Andrew Stotz 23:32
how would you summarize the lessons that you learn from that?

Kyle Mowery 23:38
Well, I think that and Dustin, your circle of competence, it could be that we understand the business, we understood the products, but do we understand the culture of Australia we in Chicago? Maybe, you know, I think we also put a lot of stock in management owning company, I think I think one can delude themselves. Any of us can delude ourselves, right? We're only human and management saw what they want, you know, they saw some vitality that they wanted to see that they were working hard towards and it just didn't work. So whether they were being you know, I'm not saying they were being blatantly dishonest, they were certainly looking at a rosy picture of the future and look at this, what management does that every company they're, you know, you cannot wake up every day think your business is not going to do well and go in turn the key and succeed you just capitalism doesn't work like that. There's an inherent optimism that we get up and try and make our companies better and stronger and come home to your families and say, hey, you know, we've made progress today. And that's the economic way of capitalism. Right? So I think that was certainly a learning and then look on inflection investing. Maybe see the inflection, right. Okay. You'll pay a higher price. Um, but you'll have a greater certainty. Right? And look, we've gotten them wrong. Since we've gotten them wrong prior, we've gotten them right, since we've gotten them. Right. You know, prior, I think it's all about risk return. And if a zero is on the board is part of risk, you have to think well, and Achille growth criteria and you know, bet size, you just got to make sure the bet size is correct. Right? If you go ahead,

Andrew Stotz 25:29
I'm saying that my takeaway is, I just know how, how difficult it is to run money, particularly, if you, you know, you're starting up, or you're small mid cap, and you're in the space, you really desperately need to be making great investments, and not any, you know, big mistakes. Because the you know, you're that's the thing about fund management is you're being tracked, you know, on a day to day basis. And that's, I guess what I take away is the feeling of how, how, how difficult it can be, you know, if you're a Peter Lynch, like, in the old days, where are you gonna have fun with a, you know, 500 stocks, it doesn't matter if that stock Quintus in this situation, let's say, went to zero. So what I got another one that's going, you know, up by, you know, 100%, but in your situation in mind, and in many people who are running, you know, smaller funds, or, you know, they're starting out, it's such a critical thing. And not that's my big takeaway is kind of the emotional struggle of something like that.

Kyle Mowery 26:44
Well, I think you just have to be true to your parameters are if volatility is risk, as opposed to being a permanent loss of capital, then you just need to be honest with your investors and tell them no, I got friends that run funds with crazy high volatility. I've got friends that run with less volatility than me. It just it fits. It's got to fit one's personality. And it's got to be in alignment with the investors. Right. I think, I think a couple of years after this story happened, COVID happened. And for us as being a free cash flow focused investor, there are certain businesses that are economically sensitive, and we had, we had travel businesses that we owned going into 2020. But those were dramatically affected by COVID. Not all our portfolio was but you know, how do you react to that? Do you know what you own? Do you have a plan? Do you have? Do the companies have balance sheets to get to the other side, right? This Quint is would have made it without the extreme financial leverage, which is part of what we thought we saw in the multibagger. Right. So, you know, I think, decide, you know, some people don't do any debt. Right? Some people will do levered situations, and some people do both. We do both. We have generic companies and levered companies, we can understand credit agreements, I've, I've, you know, structured many credit agreements myself personally. So that's within our circle of competence. But

Andrew Stotz 28:21
yes, so let's since the objective here is to help people reduce risks. Let's now go back in time, think about that moment. And based on what you learned from this story, and what you continue to learn what would be one action that you'd recommend our listeners take to avoid suffering the same fate?

Kyle Mowery 28:39
Now think intellectual honesty, right? The minute things don't align with what you had underwritten. You want to reassess. But the world is a messy place. The economic landscape changes the competitive landscape of competitors changes. It's okay, that your original thesis was invalidated. But if you can be intellectually honest, when it does, you can, if you're wrong, if the thesis is wrong, it's not like you somehow screwed up, it's things changed. And when things change, you should probably think about using the liquidity of the public markets and exiting, right? I mean, that's more of what we have. That liquidity goes both ways. It can be a benefit, and it can be something that's a challenge. So if you're intellectually honest, look, things changed. And that's how we avoided a zero and Quintas. Right. We didn't we took a big drawdown for sure. But we did not own it into bankruptcy and many did. And I think we were just intellectually honest, even though we had really even been public in terms of well, not public. In our, in our letter to investors, we talked about, okay, here's what we see. Here's what you know, and then the whole thing imploded with it. and months, which is really fast for us, so.

Andrew Stotz 30:04
So my next question is kind of an open ended question. But the I wonder if you have any resource, either of your own or any others that you'd recommend for our listeners?

Kyle Mowery 30:15
Um Well, I grew up on margin of safety book by Seth Klarman. You know, that's sort of like the old ways. Now. I know. There are many people who think many things about climbing but I've always joked with my investors that if Boston calls I'm closing the fund and heading out there, I think I think he does a great job. Because what Klarman does well is understand risk versus return. Right? There's a lot of people taking a lot of risks last 10 years, if you took it in, in factor style factors such as momentum, quality and other you know, sectors like tech, you look like a genius. That may or may not be true, overall, or through a full market cycle. But it's certainly been true recently. So I think, you know, for me, that's just I'm a dyed in the wool fundamental investor. And for me, all those the seminal Tomes, you know, the late Charlie Munger, gosh, it's so weird to call him late. But, you know, Charlie Munger is poor Charlie's Almanac and all the things that Buffett and Munger, yes, I know is popular, but it's also valid. And some of you know, monger is just so blunt and so simple that even if you're not a professional, you can find it refreshing and easy to implement, or at least easy to understand, maybe harder to implement. But

Andrew Stotz 31:48
last question, what is your number one goal for the next 12 months?

Kyle Mowery 31:55
My number one, I'll answer professionally. I think there's a wild amount of uncertainty in the market that is not being captured in stock prices. I think 2024 You have elections in many countries, I'm most focused on the United States, because that's where I live, you have inflation, which appears to be beaten, but D globalization is sort of very inflationary, right on shoring of supply chains is inherently inflationary, as is energy transition, as is potential peak oil the next couple of years, when the US shale oil is going down, the curve is going down quickly in the next few years. And it's not something that's well understood out there. So there's a lot of risk out there, I look out and like, as we sit here and tape this in December of 2023, the Russell 2000, which is kind of my focus in terms of not benchmark per se, but as a long term investor, but it's just kind of our sandbox companies we plan it's up 25% in like two months, like that is wild. And it implies a certain outcome. I'm not, I'm personally not sure that outcome of low, low inflation and avoiding a recession is set in stone. So to me, it's about uncertainty. So built, you know, professionally, the goal is to build a portfolio that can manage that uncertainty that can they can perform or not drawdown very far and you know, certain adverse states of the world across a broad spectrum of economic outcomes that's the answer.

Andrew Stotz 33:40
Great, well, listeners, there you have it another story of loss to keep you winning. Remember, I'm on a mission to help 1 million people reduce risk in their lives. As we conclude, Kyle, I want to thank you again for joining our mission and on behalf of East Arts Academy, I hereby award you alumni status for turning your worst investment ever into your best teaching moment. Do you have any parting words for the audience?

Kyle Mowery 34:07
No, I just think you know, investing is a wonderful passion for many of us, I'm sure yourself, and certainly myself included and it's a wonderful lifelong journey. And you get some wrong get some right and the key is to just keep it keep it on sides and keep compounding

Andrew Stotz 34:26
fantastic. And that's a wrap on another great story to help us create, grow and protect are well fellow risk takers. Let's celebrate that today. We added one more person to our mission to help 1 million people reduce risk in their lives. This is your worst podcast hose Andrew Stotz saying. I'll see you on the upside.