GuruFocus Value Insights Podcast: David Rolfe on the Importance of Learning From Mistakes and Embracing Good Investment Ideas

The CIO of Wedgewood Partners approaches investments with the mindset of a business owner

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Feb 15, 2024
  • The guru discusses what he missed with First Republic and shares what it means to have the mindset of a business owner.
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Sydnee Gatewood: Hello, everyone! Thank you for joining us on the GuruFocus Value Insights podcast! You can subscribe through Spotify or your device's podcast app, so you never miss an episode.

We are pleased to have David Rolfe (Trades, Portfolio), the chief investment officer of Wedgewood Partners, join us today!

At the firm, Dave oversees portfolio research, construction and management. He approaches potential investments with the mindset of a business owner, striving to generate significant long-term wealth by analyzing a handful of undervalued companies that have a dominant product or service, consistent earnings, revenue and dividend growth, are highly profitable and have strong management teams.

Prior to joining Wedgewood, he was a portfolio manager with Boatmen's Trust. Dave holds a BSBA in Finance from the University of Missouri-St. Louis and holds the CFA designation.

He has also been a speaker at the GuruFocus Value Conference in Omaha, Nebraska on two occasions.

Thank you for joining us today, Dave!

David Rolfe (Trades, Portfolio): Glad to be here. Thank you.

SG: All right, just to dive right on in, tell us a bit more about your investment approach. What does having the mindset of a business owner entail?

DR: Well, when we think about active management, Sydnee, we believe that all active managers, if they have a chance to outperform their peer group and, perhaps even more importantly, their benchmark, they have to have an edge and it has to be repeatable. And what we mean by that and how we think about that at Wedgewood Partners is we wanna build a portfolio, we wanna think and behave differently consistently over long investment cycles. And the key to that is thinking and acting like a business owner. And specifically what I mean by that is we only, we're a focused manager. We only own 20 stocks, which again compared to most of our peers in the say the S&P 500 is very, very different. On top of that, given that we want to think like a business owner, we don't get consumed by short-term results. We don't get consumed by quarterly earnings. We firmly believe that if we can buy superior businesses run by competent management that are good at capital allocation and all the while invest in these at reasonably intelligent valuations, if not really low valuations or attractive valuations, and then let the businesses do what they do.

Again, circling back to this idea of a business owner, particularly say a private business owner. Private business owners don't get a quote on their business every day, every second, like in the stock market and successful business owners more likely than not take a long-term view when they're running their businesses. And so we think that is a very important trait for an active manager. We're active in the sense that we want to build an active share, differentiated portfolio, but we're not active management in the sense that we're traders. Our portfolio turnover is miniscule compared to our peer group. But again, it all comes down to having that right mindset that in that classic phrase that Buffett likes to talk about the market is here to serve us, to serve you not to instruct you. And so we let the market hopefully give us a lot of opportunities, but we're not gonna force action in the portfolio based on short-term price fluctuation.

SG: All right. Thank you so much. If at all, how has the current environment of high inflation and elevated interest rates affected this strategy?

DR: Well, we are very much in appreciation and applauding some return, a return of normalcy of interest rates. I got into this business of stock picking in 1986. I joined Wedgewood in 1992. Fo most of my career, there's no doubt I've had the benefit of lower interest rates over that full 35 years. But when interest rates are zero, it can change investor behavior significantly. And we saw that with some of these outsized returns of stocks that, again, everything else being equal, stocks are just another asset class that interest rates affect dramatically, you know. Think of a zero coupon bond and how dramatic changes of interest rates or long-term interest rates can affect the valuation of a long-duration, zero coupon bond. Same thing with stocks. And so we saw those stocks that had the prospect of amazing sales growth but not so much earnings or cash flow growth. And those stocks boomed during the pandemic years.

In addition to that, we saw growth companies, when we had a very long period of literally zero interest rates, reach valuations that we had never seen in our career. So what used to be the conversation and now it's back to this. But what used to be the conversation for many years, I'm just gonna make up some things, let's say, you know, you and I, Sydnee, were thinking about a business that's growing its revenues at 10 or 12% and has some margin in expansion. We think it's going to increase its earnings per share growth rate over the next, say, three to five years by let's say 15%. And so we asked ourselves, we will ask ourselves in the context of historically normal interest rates, you know, maybe we start building a position in that stock in, you know,a multiple of say a 12-month forward multiple of high teens, low 20s. And we can hold onto that as long as it maybe doesn't reach say 30 or 32 times earnings because the valuation is just too high. And now we got the classic conundrum: terrific business, but bad stock.

When rates were low, companies that had that relative, that kind of fundamental attributes that I laid out, these were valued at 30, 35, 40 sometimes 50 times earnings. When your discount rate is a low single digit, when your required return is a low single digit, you can literally put a valuation as high as you want. And so, the fact that we are now back to interest rates that and the economy is, you know, the economy is doing fine with these interest rates like it has in many years past, it's just those businesses that were overleveraged that has to refinance real cheap debt at higher rates over the next couple of years are probably gonna feel that stress.

But I can't emphasize enough how we are very happy that we're not in a zero interest rate environment anymore. It just dramatically changed the valuation of companies and we know we don't have an edge competing in that arena.

SG: That's a great perspective. Thank you so much. This kind of piggybacks a little bit off that same focus, but your past several quarterly letters have focused on the Federal Reserve's interest rate decisions and kind of like how they've changed, you know, pivoted a bit. What long-term impacts do these seemingly never ending policy pivots have on the market?

DR: Well, we've used the phrase that we've borrowed from James Grant. We've witnessed since we've been in the business more than a handful of monetary cycles, either tightening or loosening monetary policy. And it seems to us that the Federal Reserve, and this may be a harsh criticism, maybe not, but it seems like on the one hand, in terms of the inflating these bubbles and then deflating them in the, at least in the stock market and you can maybe throw in the bond market, maybe some real estate markets as well, the Fed is actually seemingly is not only an arsonist but also a fireman at the same time. And so we rue the day that we have to talk about the Fed in our client letter. But there's no question that these extremes in monetary policy again, either tightening or loosening, the Fed tends to be very reactionary, at least historically, on quote unquote data-dependent information. The market obviously is trying to be as forward-looking as possible. And so, what we see is that the Federal Reserve typically stays on a current policy initiative far too long and they tend to be far too late in changing it.

We also recognize, let's all be honest and be adults about this, the Federal Reserve for many years now is also a political animal. And here we are in an election year and how the Fed might react or not react is anybody's guess. But the cynic in us can think of some scenarios. So again, this is completely alien, if you will, Sydnee, to this, my first thought of, “Hey, we're gonna take a long-term view.” We're gonna view these businesses as a business owner. And really, I mean, we typically hold our positions for years. We've owned Apple (AAPL, Financial) since 2005. We've owned Alphabet (GOOG, Financial) since 2007. We had previously owned Berkshire (BRK.A, Financial) (BRK.B, Financial) for 20 years. Did the Fed necessarily change that view of holding such companies for all those years? No, not at all. But, you know, the optimist in us, or the realist in us, recognizes that when the Fed is staying the course either too tight or too long, that's gonna give us opportunities.

So, on the one hand, I'm being very critical of the Fed, but on the other hand, they do introduce a significant level of volatility in the stock market that we hope to take advantage of. We just think that it's gone to extremes that were unnecessary in interest rate cycles and economic cycles past.

SG: All right. Thank you for expanding on that a little bit more. I do enjoy reading your letters every quarter.

DR: Thank you.

SG: In your fourth-quarter letter, to follow up on that, you noted that you added to your PayPal (PYPL, Financial) position. Apart from improving margins and achieving financial targets, what are some things you're hoping the company will accomplish this year?

DR: Well, Sydnee, that probably couldn't be a more timely question as PayPal reported their earnings last night, had a very sober conference call and investors did not like what they heard. And as I look over here to my left, PayPal now is down 10.50% as we speak right now. I'll take the pros first and get to the cons.

The pros was the quarter was a pretty solid quarter. Key metrics like total payment volume, the activity of their more active, productive clients was really healthy, but the company admitted, and this is the reason why there's a new management in there, the company and the new management, which has only been in there for a quarter or two, recognize that one of the reasons why PayPal has stumbled over the past year or two, outside of the outsized valuation, was a couple of years ago during the pandemic, was that the previous management was probably too eager. I'm trying to find the right word here. They made too many acquisitions. They got too big. A lot of the parts weren't working together and they have seen their overall profitability diminished to the point that, you know, the stock is literally selling for 10 times earnings right now.

The key reason why the stock is getting pounded today is that the guidance from the new management for 2024, in a nutshell, is we think it's conservative, but it's also realistic in the sense that the initiatives that they are in the middle of, trying to improve their branded product and to improve the margin structure of their unbranded product, which is Braintree, which is basically merchant processing. The branded product we're all very familiar with, that's the classic PayPal app, they're not looking for a significant margin margin expansion until later in the year, perhaps even as late into 2025. And many investors were hoping that as we start 2024, that some of these initiatives would have more of an immediate impact. And so that was a very disappointing guide on what the earning power of this franchise will be over the course of 2024. And that guidance again, it may be a little bit on the conservative side given that management has not included any of these initiatives that they're currently underway within their guidance. And so the net effect is it looks to be a much longer road in terms of resizing this, what we can still consider to be a, a terrific business model. They got to get rid of the fat, they gotta prove to Wall Street that improvements in profitability are here to stay and they're not gonna be just one-off elements of significant cost-cutting or shutting down certain divisions or laying off a lot of people. And so it was a sobering call on that front.

You know, we're licking at our wounds today, but, as you mentioned, we had not so long ago added to our existing position. It wasn't a huge add, but we did add to that position because we were of the camp that we would see more positive metrics that are important to us, particularly profitability emerging sooner in 2024 thanlater. So thanks for that humbling question, Sydnee.

SG: Well, I'm sorry about that, but I hope…

DR: No, no. It's good. The harder, the better. Thanks.

SG: Well, I hope PayPal, you know, will start showing some improvement because it is tough to see your investments not perform the way you want them to.

DR: Welcome to the stock market.

SG: Well, I know your fourth-quarter portfolio isn't out quite yet, but as of the third quarter, your equity portfolio showed several of the Magnificent Seven stocks, namely Meta Platforms (META, Financial), Alphabet, Apple and Microsoft (MSFT, Financial), among the top holdings. While many of these companies have been investing in AI for years, what are some obstacles related to the technology that could negatively affect their business?

DR: That's a very good question. Again, this whole AI, obviously it's very promising. If you think back, if in terms of a transformational technology, if you think back to the the advent of the personal computer back around 1980 or so, you know, first the IBM PC and then of course, we had Apple's Macintosh, you know, this idea that you're gonna have a fully functioning computer at your fingertips on your desktop was revolutionary. And what ultimately, if you think back to that, at least this is the kind of the simple analogy we think of, when you think back to the growth of that, obviously, there are early adopters, but you know, along comes software companies like Microsoft and I'm thinking back in the day, Adobe (ADBE, Financial) and others, when the use cases for individuals and businesses too, but with better software, you were able to increase your productivity, you could do things that you couldn't do before. And then, you think about the advances of Intel's (INTC, Financial) chips back in the day, Motorola was making chips. The computer got more powerful and could drive more powerful software.

And then along came the internet, which again, changed everything in terms of what you could do through your computer. So you think about AI, obviously the poster child of the current incarnation of AI is Nvidia (NVDA, Financial) on the hardware side, their chips and obviously their operating software. They're making most of the headlines and Nvidia's stock is roaring like, maybe I'm gonna age myself here a little bit, like maybe RCA did back in the ‘20s with the advent of everybody having a radio in their house and radio programming.

In our last letter, what we wanted to talk about, because we get this question all the time is, you know, what is it about AI, artificial intelligence? You know, inference, the various elements of artificial intelligence. On the one hand, given the booming Nvidia stock, and we've been out of the stock, we had owned it earlier, we didn't get back in. And so we've missed this terrific run, but it ultimately comes down to again, torturing the analogy, use cases software and using the power of these chips to have the use cases that resonate with users. And as we mentioned in the letter, Meta has been investing in this for years, so has Alphabet. So has Microsoft. I think a very good example, if you think of Meta, if you think back about a year or so ago, maybe a little bit more than a year ago when Meta stock was getting crushed. In one area where they were getting crushed was it seemed that Apple's new transparency policies and programs was basically cutting off a significant advertising signal for Meta and they had a sharp drop in revenue.

It made it more difficult to advertise on their platform, either on Instagram or Facebook, but they've used artificial intelligence to get around that significant element of that, you know, Apple. It's called ATT. It's basically putting up walls to ad tracking and they, and it looks like Meta has completely engineered around that with AI. And so now they're getting signals that they once got before which advertisers love and all of this is very measurable. And so when we think about our portfolio's exposure to AI, while we don't own, you know, the poster child of the day, Nvidia, you know, we own the stocks that you mentioned.

We also have a significant weighting in Taiwan Semiconductor (TSM, Financial), all these wonderful chips that Nvidia makes and Advanced Micro Devices (AMD), Qualcomm (QCOM), you name it. In addition to that, in the case of Meta and Alphabet, Microsoft, they're actually designing their own chips, which for the most part, Taiwan Semi manufacturers. It's interesting Taiwan semi that stock, it's an ADR, it's not in the S&P 500. So anybody who owns the stock has an outsized relative weighting versus the benchmark. So we have a significant AI, I'm doing air quotes here with my fingers, we have significant AI exposure within our portfolio. It's just not, as from a chip makers point of view, Nvidia or AMD. It's these other stocks. And I think what in terms of the consumers understanding the power of AI, I mean if you look at a couple of these videos of Apple's Vision Pro, key elements or AI are used in terms of the user experience within that headset. And so, you know, AI is kind of a buzzword, but I think as these use cases get better, they're probably gonna be much more complex, which makes the interface with humans even more seamless. AI, in terms of that Akerman, it's probably gonna be as ubiquitous and understood like PC is today or the the internet is today.

SG: Great. Thank you so much for that perspective. I really think that there is a lot of potential in AI. But it is funny that people think it's kind of new when it's not, in my friend group anyway. So, shifting focus a little bit, are there any international opportunities, you mentioned Taiwan Semiconductor, you like currently?

DR: Well, again, the fact that we only have a 20-stock portfolio. If we can't find 20 stocks domiciled in the United States, we're probably not doing a very good job. There's incredible opportunity here in the United States. We understand the accounting here in the United States. Different markets, different countries have different cultures in regards to shareholder rights and shareholder transparency and on and on. But that said, we only have a couple of companies in our portfolio that are domestic-only like UnitedHealthcare (UNH, Financial). We own O'Reilly Automotive (ORLY, Financial). They recently made an international, a small international expansion. They're largely domestic only. But that said, we own many companies in our portfolio that have significant international opportunities. And so, when we think about, you know, when we think about how far the international reach, the global reach, some of our companies have, it's significant.

And so, you know, we typically haven't owned a lot of ADRs. Obviously, Taiwan Semi is not domiciled in the United States, but we like to think of Taiwan Semi as probably the most important company nobody owns. So many active managers have to be focused on some benchmark weighting, what's in the benchmark. But without Taiwan Semi, think about some of the big tech companies that they would look very, very different today if it wasn't for Taiwan Semi. Again, we think it's one of the, not only one of the largest companies that we own, but probably the one of the most important companies on the planet right now.

SG: All right, thank you. Yeah, it's a good point. There's lots of exposure to other, you know, countries around the world, especially like, you know, Facebook is everywhere. So, that's good. Let's see. And I know even though your portfolio only consists of 20 stocks, I feel like it's pretty fairly diversified across several different sectors,but are there any areas you or Wedgewood tends to avoid and why?

DR: Yeah, we, you know, given the fact that we're only gonna own 20 stocks and we hope through our analysis, we've identified 20 superior business models that have staying power for multiple years into the future. Said another way kind of in layman's terms, we don't have the time, the space, the energy for mediocrity. So we tend not to own businesses that are heavily regulated like utilities. We tend not to own businesses that are really deep cyclical businesses where the economic fortunes of that business are gonna be largely if not completely determined by the fundamental characteristics of that industry rather than, you know, whatever magic brilliance management might be able to bring to the table.

And so, again, there's also an element, it's really important. Again, we really need to focus, no pun intended, we really need to focus on businesses that we really can kind of put our egos aside is for me and my two teammates. There are a lot of businesses that are terrific businesses that you might think would come under our radar screen, but sometimes they're just too hard to figure out. And that's also one of those elements. You gotta, you gotta be, hey, there's nobody easier to fool than yourself. And we have to have that kind of checking our egos to understand that, you know, we're going to miss opportunities because we just don't have a complete enough grasp of a business model to understand what it's gonna look like three to five years from now. And so, a key to our philosophy certainly is less is more and fewer cooks in the kitchen.

SG: All right. That's great. Yeah, that kind of fits in, I feel, with your circle of competence and even Munger's too hard pile. You know, if you can't understand something, some things just are too hard for you, then don't pursue it.

DR: Yeah, I didn't want to be so obvious to quote Buffett or Munger too much in our chat today. But, you know, I have to admit, both of those two have been significant influences on our philosophy, our strategy, how we think about investing. So if I referenced them a couple of times, I could probably do it more. But I'm sure you're overwhelmed with so many references to the two and rightly so, but, I wouldn't exist today in this business if it wasn't for those two gentlemen.

SG: Yeah. Well, I can go ahead and, I was just gonna save this question for later, but I'll just ask you now since they've already been brought up. Charlie Munger recently passed away in December. What do you think his most significant contribution to the investment community was?

DR: Well there's, I think the 1,000-foot view of so much of what Munger has talked about, what he has written about, you know, he likes to talk about having, you know, a handful of mental models that help him aggregate, synthesize the decision-making process. But taking it one step further, what I've taken away from reading, hearing Munger talk all these years is, I mean, I think a foundational element of his thinking is an education, if you will, to others is his this, I mean, it's hard to find kind of a more cold-blooded, rational thinker, and I'm saying cold-blooded as a compliment. And then recognizing that I think where Munger and Buffett have been joined at the hip so easily, so early on in their friendship was I think they both embraced a signal idea in investing in that if you have a really good idea, embrace it. Don't overthink it and swing and swing a big bet. You can't be an expert on everything, but perhaps you can learn to be an expert on a few handful of businesses in a few industries and act accordingly.

So, you know, without Buffett, there's not a Munger, so to speak. Without Munger, Buffett would be very, very different. The incarnation of Buffett, you know, over the past two, three decades that they've been working together, so the investment community will miss him. But I think he will endure for so many years given that so many investors, new investors, can still learn a lot from him from his readings, videos, the growing videos of past shareholder meetings in Omaha. So, you know, Buffett's influence, and I think this will be a significant, maybe the best tribute to him, is that he will be on the investment scene for generations to come, or he should be. I hope he is. I think I'm sure he will be.

SG: Yeah, I definitely agree. He did have a really significant impact and I think that will continue for quite a while. At the GuruFocus Value Conference this past May, you commented on Wedgewood's investment in First Republic, saying that the firm, Wedgewood being the firm, had looked “at the wrong end of the balance sheet.” How, if at all, has this experience changed how you will evaluate financial companies moving forward?

DR: Yeah, another good, hard question. Yeah, that was a tough one for us, specifically when Silicon Valley Bank, Signature Bank ran into those troubles really quickly over handful of days, over a weekend. When we were looking at First Republic, we were looking at the balance sheet, Sydnee, from the perspective of their credit quality, their loan quality. However, we were not looking through the lens of liquidity. Banks are largely funded by deposits and despite the fact that the company for many years has bragged, and I think rightfully so, bragged about their long-term relationship with their customers that on an average basis, or an average account, you know, it was a couple of decades. And we were completely wrong on that. First Republic was in that cul-de-sac of West Coast banks that caught fire. And when you lose confidence, it can happen quickly.

And so we completely missed the risk that, and what turned out to be, they lost about half of their deposit base in two or three, four really, really quick days. And despite incredible efforts from the industry to try to save this franchise, it just was doomed. You just can't rebuild when you have that level of shrinkage in your funding base. And we were wrong, and it hurt us last year. We were still up last year, almost 30%. But with the hit of First Republic, it would have been more than a few basis points even better. So we lick our wounds. We learned from it and, specifically, to your question of what have we learned about financials. Well, certainly if we ever own another bank again, we will be asking ourselves, you know, what percent of those deposits are assured and insured? What percent is uninsured? What, if any, change in policy when it comes to deposits, changing policies, you know, from the FDIC, etc., might affect that side of the business, the funding side and always, always, you have to look at the credit side. I mean, you know, banks lend money, they should expect to get paid back and through the long history of First Republic, we've never found a better lender that the percent of their loan book over this 20, 30-year period that turned out to be actual losses was miniscule measured in basis points. But that didn't make any difference in this, in this current, you know, back earlier last year when it wasn't about credit quality, it was about depositor confidence.

SG: Well, thank you so much for sharing that perspective on your investment in First Republic. But shifting focus a bit, well, kind of on the same topic, I guess. What is the most important lesson you have learned over the course of your career?

DR: To be even more patient than we are. Outside of our humbling First Republic experience, when the team here at Wedgewood thinks about our biggest mistakes over the years and we can classify them, the vast majority, in one specific area. You know, if we're doing our work right, Sydnee, at the outset of trying to identify superior businesses, you know, we'll typically sell a stock if we're wrong on the future fundamental growth of a business. It's easier when you're starting with high-quality businesses to begin with. Turnarounds are tough. A lot of businesses just don't turn, even though you can sometimes buy them at a really, really cheap price. We really want that long-term compounding in a business that's gonna compound, hopefully, high single digits, low double digits. And so when we think about related elements to that, we'll also sell a stock, again, if, like I mentioned, Nvidia got taken away from us a couple of years ago because the valuation, in our opinion, just got really extreme and it fell pretty significantly. Again, we didn't get back in.

But when we think about times past when we sold a business from a business model perspective, where we believed there were some issues over, let's say, two to three months. Maybe PayPal is a good example. It looks like it's gonna be a lost year for PayPal; kind of a dead stock. A lot of people sell and move on. There have been times where we have either correctly or incorrectly been ahead of that event, thinking,”OK, it looks like there's some competitive elements here that are intruding in a business model that may upset the growth rate over the next year or two.” And oftentimes we've been right, and we've sold the stock and subsequently the stock has declined and we kind of pat ourselves on the back to say, “Hey, we got that right.” But also in terms of this idea of turning a business around, which PayPal is in the middle of right now, the new management is, it is much easier to turn around a better business than one that is average or even poor. And the biggest mistakes we've made, Sydnee, over the years is not getting back into these businesses, these stocks that we sold because of maybe a relatively short period that the business is gonna underperform and we think we can find a better idea somewhere else despite the fact that it's very low turnover.

I mean, the last two years we've only bought one new stock in the portfolio. But when we look back at some of the big winners that we had in our portfolio years ago that have done really, really well after maybe a period of slowness of growth and management has reinvigorated the company, the ones that we never got back in and then would go on to be, to use a Peter Lynch phrase, multi-baggers 2, 3, 4, 5 times where we sold it. You don't see those numbers in our performance numbers. Those are the ones that, mentally, we know. And so because of that, those humbling lessons, we tend to be very, very patient.

But again, even with that, going back to the PayPal example, there's a difference, there's a subtle difference between being patient and being stubborn, being stubborn and not admitting a mistake. And so that is when you think about the art and science of active investing, when those two converge it becomes a craft. One of the great books everybody should read was written years ago by John Train. He's the famous author who wrote the two books, “The Money Masters” and “The New Money Masters” and he wrote a couple of others. But the one that's really good, it's one of the best titles ever, that basically describes in a couple of words what we try to do here at Wedgewood. It's called “The Craft of Investing.” And, again, that's where the quantitative and the qualitative intersect. And we tend to be more craftsmen than quants. And so, when I think about some of the stocks and I'm looking at some of the tickers on my screen here, the ones that we got out of years ago and where I look at them now, I just shake my head. It's like boy, those are big, big lessons. And so we know we're going to make mistakes either by commission or omission. We gotta learn from them, be humbled by them and hopefully not repeat them too often.

SG: Great. Thank you for that. What is your best advice for individual investors in the current market environment?

DR: Stop trading. We think that when we look at these graphs, I'm sure you've seen them, Sydnee, of the average holding period of an individual stock, you know, and how it used to be years. Now, it's basically months. Unfortunately, with all the wonders of modern technology, our clients can see how we're doing instantaneously anywhere they're at on the globe looking at their smartphone. They often get the same information we do at the same frequency and the same time interval. And so when you're looking at a screen, either if you're a professional investor or a lay investor with all the ticks and the movement and the volatility in the stock market, it lends one to trade very often. And if you, and again, if you think about the people, families that are listed in the Forbes, the wealthiest individuals, the Forbes 400 list, you can't find one trader on that list. And if you do, going back decades, maybe one or two. Building wealth trading is almost impossible, particularly in a taxable environment.

And so again, when you think about some of the all-time great investors, they tend to be focused, they've tended to let their winners run. I think that's another reason why it's so difficult to outperform, say, the S&P 500. I don't think it's the fact, given the compression of active management fees over the past decade or so, you know, it's not the case where an index fund you can get for 25 bips and you know, all-in active management fees were 150 to 200 basis points, including trading commissions, when commission and spreads were wider. That was a huge hurdle to overcome for an active manager, but most active managers, and we're even limited that to ourselves, this is a really a key element. We own stocks for years and we let our winners run and we only own 20 stocks. And typically, two-thirds of our portfolio are just 10 stocks of ours. So we're very focused, but we won't let a holding get more than 10% of our portfolio. A lot of active managers won't let a holding get more than say 5%. But think about the composition of, you mentioned the Magnificent Seven. It's probably the fabulous five, the fab four now a couple have kind of fallen off the, you know, back by the wayside, Tesla (TSLA) being one of them.

But what do those stocks all have in common within the S&P 500? The S&P 500 doesn't sell; they let their winners run. And so if you're a small-cap manager and you have to sell a stock because it reaches some market cap top or peak, if you will, and it's now considered a midcap stock, think about that. You're probably selling all your winners constantly. Same thing for mid cap. Oh, we're not going to hold a stock more than $30 billion in market value. You're probably selling your winners when it comes to the large cap indices, you know, Russell rebalances, S&P 500 doesn't. And so when you think about how tough it is to beat an index, you're basically competing against all stocks, including every stock that's booming, that's not gonna have its weighting cut within that index.

And so I would say stop trading, try to emulate the great investors. If you can't do that, and this is gonna be heresy coming from an active manager, buy an index fund and go work on your golf game or work on your tennis or, you know, take cooking classes. If you can't value businesses reasonably well and have the temerity to hold these better businesses through thick and thin, then, you know, it's gonna be very difficult to even nominally be a successful investor for those taxable investors. After tax, it's gonna be even worse.

There's another great saying, I don't know if this is attributed to Buffett or Munger, but it's brutal and it goes something like this: Those that understand compounding, earn it; those who don't understand compounding, pay it. I know that sounds harsh, but that's the reality of the stock market. And so in an environment of online trading and zero-commission trading, and it seems so easy to trade, actually I wish more people would trade because it gives us more opportunity. I know that sounds cynical, but I'm kind of joking about that too. So, sorry to belabor that point, Sydnee, but that's a very good question.

SG: Oh, thank you. But thank you for that perspective. And I hadn't heard that advice yet in my interviews with everyone, but I like it. Just to wrap up our time today, whether they are investing related or not, please recommend three books and three movies for our listeners to check out. Could you also share why you like them?

DR: Sure. So the first one was three books.

SG: Yes.

DR: Well, I'm gonna spin around here. I don't know if can you see that right there, Sydnee.

SG: I can see your books, yes.

DR: Yeah. So I just finished “Boys in the Boat.” The movie is terrific. It's a feel-good movie. The book is five times better and that's saying something because the movie is great, the book is even better and I would highly recommend that you get it through Audible and you listen to it because the narrator does an unbelievable job. They really bring plot and character development to life.

The other one that I recently read was Harper Lee's “Go Set a Watchman,” a controversial book in the sense that it talks about race relations back in the ‘50s down in the deep South where the famed character in “To Kill a Mockingbird,” Atticus Finch, turns out to be a very different person than he once was. It's a terrific book. For those with more modern sensibilities, it's gonna be a more difficult read. But again, I thoroughly enjoyed it and I listened to it, I didn't read it. And Reese Witherspoon is the narrator on Audible and she does a magnificent job.

The other one that I recently finished is “1917” by Arthur Herman. It talks about the confluence of events of the Russian revolution and President Woodrow Wilson's decision-making during the later stages of our involvement in World War I. I love books that deal with geopolitics and history because, oftentimes, you know, what's that phrase? You know, history doesn't match perfectly, but it rhymes. Something like that.

Then you said three movies, right? I'm not a big movie buff. So unfortunately, I, I probably can't name a couple of others that I've seen recently that really I thought were terrific. I'm more of a Netflix binger, like “Sopranos” and stuff like that. Not a big movie-goer. But again, probably the, the easiest read of those three, just off the top of my head, was “Boys in the Boat.” Again, it's a great movie. The movie covers a lot of material that tries to, as best it can, cover the material in the book. But the big takeaway of that is, and so if people who have seen the previews of the movie, it talks about the success of the rowing team and its adventure to try to get into the 1936 Olympics, which were held in Nazi Germany. And the author does an amazing job of talking about the economic situation of these rowers and how most of them grew up in incredibly hardscrabble times. And then when you layer in the geopolitical realities of the mid-30s, it's a wonderful economic history lesson as well as a political lesson and the admiration of what these guys put themselves through to make it to number one on a on a crew, on a rowing boat, much less succeed. It's well worth your time. I couldn't recommend it more highly. The movie or the book.

SG: Well, thank you. Yes, I've definitely heard a lot of good things about “The Boys in the Boat.” I haven't checked it out yet, but I plan to. And the other two books you recommended also sound extremely interesting.

DR: It's a little deeper. They're not all fun and games, but they're both well done for what they set out to accomplish.

SG: That's good. I'm glad. But thanks again for joining us today, Dave. It was a pleasure to have you!

DR: Thank you so much.


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