Christopher Zook — Allocator Series — July 26th, 2023

[00:00:06] Christopher

It will most definitely replace jobs. I assure you; we are not ready as a society to have millions, upon millions, upon millions of people who don’t have a job anymore because AI has replaced them. So we’ve got a lot of work to do over the next several years. By the way, AI doesn’t sleep, it does not slow, it does not wait, and it is going to not wait for us to figure it out. It is going to get there whether we’re ready or not.

So yes, I do believe that AI will help profit margins. I do believe that AI will help earnings in almost every industry, in almost every sector. But I also believe AI is going to destroy jobs, which means it is going to have a dampening effect at the same time it’s going to have a positive effect.

[00:00:54] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:49] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary investors from all around the world. In this series, I have invited one of them, namely, Alan Dunne, to host a series of in-depth conversations on the topic of what it takes to be a world-class allocator.

In today’s world, portfolio construction is fast moving to the top of the agenda of many investors as they tried to analyze and understand the riskiness of their portfolios. With ever-increasing uncertainty around the globe, being well-diversified across many different strategies and themes in your portfolio can mean the difference between ruin and survival when the next crises emerges.

The aim of these conversations is to try and understand the experiences that have influenced these highly specialized allocators and the processes they follow to harness the best returns for their clients so that we can all become better-informed investors. With that, please welcome Alan Dunne.

[00:02:51] Alan

Thanks very much for that introduction, Niels. Today, I’m delighted to be joined by Christopher Zook. Christopher is the Founder, Chairman and CIO of CAZ Investments in Texas. CAZ is an investment firm that takes a thematic approach to investing, curating what they believe to be the best investment opportunities for themselves and for their clients. Christopher is a regular contributor to major media such as CNBC, Fox Business, and Bloomberg. Christopher, great to have you with us today. How are you doing?

[00:03:19] Christopher

Things are great. I appreciate you having me.

[00:03:22] Alan

Not at all. Delighted to have you on. So what we typically do with guests is first of all get a sense on their backgrounds in the markets, what their own journey has been in terms of getting to their current position in the market. So if you wouldn’t mind, give us a sense and how you got into financial markets and how you got into setting up CAZ Investments.

[00:03:40] Christopher

I appreciate it very much. Going back to school, I learned about financial markets there, helped put myself through school trading commodities and futures to help pay the tuition, books, and room and board. So I learned very, very quickly about a lot of things not to do and I learned a lot more things to do. I enjoyed that a great deal.

I entered the investment business straight out of school and then proceeded to start my firm in 2001 with the backing of several prominent families in Texas and elsewhere. We have become just a very focused thematic investor in basically anything, anywhere, anytime. That’s a blessing and a curse because we can invest in anything. At the same time, we look at over 1500 investments a year and that obviously means we have to be very good at culling through that herd to identify what really is truly differentiated.

[00:04:38] Alan

Interesting. So it’s pretty much about kind of investing your own capital and finding the best opportunities and then offering that to your clients. Is that fair to say?

[00:04:47] Christopher

That’s exactly right. Everything we do, the first dollar in it is my family’s and then our shareholders and our team are very, very heavily invested. We have over $600 million of our own money invested in our own vehicles so we are very aligned with our investors and the investment advisors who utilize us for their clients.

[00:05:09] Alan

Okay, good stuff. I took the opportunity to read your latest quarterly investment letter today. I know you are somewhat cautious on the opportunities in capital markets at the moment. So maybe you could start off by giving us a sense on your current views on markets at this juncture.

[00:05:27] Christopher

It’s a fascinating time because of the fact that the stock market is a forward-looking animal, and so it is anticipating what it hopes is going to be a pause and then an easing by the Federal Reserve and other central banks around the world, and that we’re going to be off to the races again, inflation will come down, earnings will grow to the sky. If you can tell out of my voice, I’m not exactly a believer of what the market thinks right now.

But the market could be right, and this soft landing could be navigated by the Federal Reserve and then maybe we really can get into a slow growth environment again. However, we look at the dichotomy between the stock market and its rally and the bond market which is clearly telling us that there’s a recession coming and it’s going to be a doozy. So either the stock market is wrong or the bond market is wrong.

If we look at history, especially when you look at the inverted yield curve and its predictability of recessions, I’m going to definitely be more in the camp that the bond market has this one right. That means the stock market is likely being a little bit overzealous and a little bit ahead of itself and is likely to have a day of reckoning pretty soon.

[00:06:40] Alan

In terms of that confidence about a recession coming, it’s been the most anticipated recession arguably, and been kind of remarkable. We’ve had 500 basis points of Fed rate hikes and nothing has broken. We had a wobble and challenges in the banking sector of which have been papered over or fixed, depending on your perspective. But have you been surprised at how resilient the US economy has been in the face of this tightening cycle?

[00:07:11] Christopher

It has been a little surprising and actually pretty impressive. It shows the power of that pent-up demand that was coming out of COVID. If you go to any hotel or you try to travel at all, you’re going to get sticker shocked not only at the pricing, but also, you’re going to be surprised by how busy things are. So I do think that that pent-up demand has shifted through other areas of the economy, not necessarily all used car prices like it was for a while, but now it’s hospitality prices, which don’t show up near as much in the GDP numbers, etc.

What I will tell you though is that if we look at this tightening cycle compared to history, and we’re a big-time student of history as a firm, is that this has happened so fast and the Fed has slammed on the brake and nothing has really happened yet other than Silicon Valley and the other things you mentioned. But it’s been so quick that it’s likely to still be yet to come.

You’ve got credit card rates right now for the average consumer United States over 21%. You obviously have the mortgage rate challenge where people have less disposable income. You had a wave, a massive wave, of not only commercial real estate, which gets a lot of press of maturities or loans that are coming, but you also had enormous amounts of adjustable rate mortgages that are not yet adjusted on residential mortgages.

That is still going to happen primarily between 2024 and 2027. That’s when we expect that there’s going to be a lot of readjustment to spending habits, which of course is the biggest component of GDP, as well as the fact significant amounts of defaults that are going to come in the real estate world which is going to lead to immense pain in the regional banks.

We do believe that Silicon Valley Bank was the canary in the coal mine, and that that problem can be managed through but not easily and it’s going to have an impact on the economy.

[00:09:06] Alan

Okay, interesting, because obviously, a lot of people have been talking about the fact that certainly households have come into this recession with good balance sheets or with balance sheets in good shape, and corporates as well. So that’s something I’ve been thinking about is a lot of people locked in some favorable rates, but certainly on the corporate side, they eventually will have to be refinanced.

So you’re thinking that the 2024 to ’27 period is where a lot of this refinancing happens, and I think in your letter, you touched on real estate in particular, you think that’s the time span where it’ll really bite. Is that right?

[00:09:43] Christopher

Very much so. ’24 to ’27 is when most of the commercial real estate… And a lot of people don’t understand the why behind that timeframe. The reason why is that 2019 to 2021, you had this enormous surge of borrowing that occurred all at extraordinarily low interest rates. Most of those loans, not all of them, but most of them were done on a 20 or 30-year amortization, but they had a five-year bullet, meaning they had a maturity in five years when you had to refinance them.

So ’19 to ’24, obviously ’21 to ’26, ’27, that’s when we expect the majority of that to come to pass. But the thing I don’t think is getting enough press right now is the impact on the consumer because so much of the loans that were done were adjustable-rate mortgages. You’re right and people are right in that the balance sheet for the average consumer is much better coming into this recession than really we’ve ever seen. The same would be true for corporates.

But most people, especially in the United States, are living as close to paycheck to paycheck as they ever have in spite of that healthier balance sheet. Well, they’ve just effectively lived off of the stimulus and now that stimulus is gone. So they’re still living off of now savings and that savings is basically almost gone. So now they’re rapidly increasing their credit card debt because they don’t want to adjust their lifestyle, but they’re going to have to.

When rates get high enough for long enough that they have to pay, they’re going to have to tighten their belts, they’re going to have to reduce their spending, that slows down the economy. When you add the other factors to it, it bodes for a very strong, significant recession over the next probably 18 to 24 months, and maybe sooner.

[00:11:29] Alan

So it sounds like it’s just an accumulation of the impact of the tightening as opposed to any particular catalysts you’re looking for in the short term. Is that fair to say?

[00:11:39] Christopher

That is definitely fair to say because that’s the only thing we can say for sure with predictability. I will tell you, I do believe that China is going to invade Taiwan at some point. I don’t know if that’s ten years from now, two years from now, or two months from now. But it’s likely to happen. When that occurs, I’m hopeful that it does not lead to significant hostilities. But I do believe it’s going to lead to tremendous sanctions and it’s going to lead to tremendous economic impact. That economic impact is not being factored into this market.

We still have this guy called Putin who is still an issue and a wildcard in the overall global macroeconomic environment, not to mention Iran, and the saber-rattling that’s going on with Israel, which of course is always going on but it feels like the rhetoric has gotten even a little bit more extreme. So when you take the regular recession being the likely outcome and then you overlay it with the possibility of a very significant event, it creates a very poor risk-reward and we feel like investors need to be thinking more about defense right now than offense because of the fact that defense wins championships.

[00:12:48] Alan

It’s interesting you touched on the fact that we’ve had this disconnect between stocks and bonds. Obviously, we’re talking about the pessimistic case here. Obviously, the stock market is looking at something else. If we were to go back last year 2022, a tough year for both stocks and bonds and probably stagflation, that kind of concern was really the big driver of markets.

That seems to have gone out of markets to an extent, but I get the sense reading your letter you still think that’s a risk. At the same time, a lot of optimism around AI seems to be boosting technology in particular. So I’m curious to get your perspective on both of those two themes, stagflation and AI.

[00:13:31] Christopher

Stagflation first; Stagflation is real, it’s here, it’s not coming. We have a stubbornly high inflation rate. It’s likely to stay that way for a foreseeable period of time, particularly as you have a lot more onshoring of significant manufacturing, etc. That’s going to create some real significant pressures on inflation. At the same time, we have a stagnant economy. We certainly are not seeing a spike in the unemployment rate yet, but that is likely to not also be a strong tailwind for the economy either. We’re not going to see a lot of job growth either.

So when you look at those two together, it leads to a likely continued stagflationary environment. As you mentioned, the worst possible environment for stocks and bonds combined is stagflation. If we end up with an inverted yield curve for an extended period of time, which would be very unusual, but it’s possible, particularly if the Fed can manufacture this soft landing, then you’re going to end up with a period where it’s going to be very, very difficult for stocks to be able to have pricing power, companies to be able to have pricing power to raise prices to keep up with inflation causing profit margins and earnings to decline.

At the same time, it’s unlikely that you’re going to see, as a bond, investor significant returns either. That’s a recipe for maybe over the next five years, a 4% to 7% interest rate or total return on your portfolio. That, of course, means that you’re likely to have a positive real rate of return after taxes so you’re going to be seeing a decline of your purchasing power. So that’s the stagflationary environment. We are in that camp. It has proven throughout history to be a very bad environment for stocks and bonds.

The shining star right now is AI, and AI, make no mistake, will change every fabric of human society. It will definitively create efficiencies inside of companies. It will most definitely also replace jobs. Therefore, that is stagnating of the economy or deflationary to the economy. Maybe that brings down inflation and the Fed doesn’t have to. We’re a long way from that happening, and I assure you, we are not ready as a society to have millions, upon millions, upon millions of people who don’t have a job anymore because AI has replaced them.

So we’ve got a lot of work to do over the next several years. By the way, AI doesn’t sleep, it does not slow, it does not wait, and it is going to not wait for us to figure it out. It is going to get there whether we’re ready or not. So yes, I do believe that AI will help profit margins. I do believe that AI will help earnings in almost every industry, in almost every sector. But I also believe AI is going to destroy jobs, which means that it’s going to have a dampening effect at the same time it’s going to have a positive effect.

[00:16:29] Alan

You mentioned being a fan of history, a student of history, and people have drawn parallels obviously. Even before we had the AI rally this year, the previous rally in technology stocks had parallels with 1999 and, obviously, the AI move now, different views. Some people see it as the next bubble and want to participate because they think it’s going to carry on for many years. Equally, I guess with the internet bubble and burst, it did ultimately prove transformative, but that’s not to say we didn’t have a big bursting of the bubble first. Do you see a parallel there or is that parallel too superficial?

[00:17:09] Christopher

No, I think the parallel is a very good one. I think it may be not quite as widespread. When we think about the tech bubble in ’99 and then again the SPAC bubble and the Reddit boards and the crypto and those kinds of things that happened in 2019 to 2021, the differences between them are that everything went up in an extraordinary way whether it deserved to or not. You had companies like in one of my letters, we talked about Rivian.

Rivian right after its IPO was trading for more than all of the other auto manufacturers combined other than Tesla, and yet it had no revenue yet. They make some fantastic cars and trucks but it’s still a long, long way from being worth what it was worth then and it’s down 90% or so from its peak, or was down 90% from its peak. So that kind of bubble, we will see in AI. there will be some fads, there will be some companies that have no business actually being valued at incredible numbers. That is when the bubble itself will be a problem.

Today, it feels like the market is putting too much of stock, if you will, into what AI is going to do for earnings and so it’s getting ahead of its skis related to its actual impact in calendar ’24, calendar ’25, calendar ’26. There’s the old saying that we tend to overestimate what is going to be impactful in the short run and underestimate what is going to be impactful in the long run. AI feels like that as well.

[00:18:46] Alan

The other factor that’s been really an important driver of markets I believe in the last one to two years where we’ve seen a change in the market microstructure is in options trading and zero days to expiry options. This run up we’ve had in technology stocks and equities generally in the last couple of months has been associated with strong call buying, etc.

I know your own background, as you touched on yourself, started off trading commodities and I think you did a lot of focus on options in your early days. Is that something that you think is an important driver of some of the short-term moves we’re seeing in markets now and how you’re thinking about that? I guess maybe it doesn’t impact your longer-term investment decision making, but do you think it is a key driver in the short term?

[00:19:35] Christopher

It definitely is a driver in the short term. One of the things the Reddit board bubble taught investors is that if you really want to make a big bet, it’s better to buy calls than it is to just go out and buy the stock because you can get more leverage. We all know that that leverage cuts both ways, and most of those people, it cut badly when they were wrong and they were left with no chairs to use the analogy when music stopped. So those people really, really lost a lot of money, but they lost the premium that they paid for the options and nothing else.

So what has happened is instead of people getting overleveraged with margin and getting margin calls which ultimately then takes them to bankruptcy, what they were able to do is they were able to speculate and speculate with call options, and then when the calls expired, they just simply lost what they put in, and effectively, they looked like they were playing quote with the houses money. Well, that has emboldened investors today that whenever the retail investor and the momentum type investor feels like they’re catching on to a trend, they are really accelerating their bet with the options market where they can control a lot more shares with a lot fewer dollars.

That has a bigger market impact, as well as the way the short sellers got abused in early ’21 has caused short sellers to be a lot more concerned and a lot more cautious. So you have these more short-term indicative moves caused by things that really don’t have anything to do with fundamentals. They’re purely just supply-demand factors because of just an extreme amount of call buying. Obviously, that usually ends badly. We’re seeing a lot more of that. It’s a good contrarian indicator.

But the market can stay irrational longer than you can stay solvent is another statement that comes to mind and so it doesn’t affect what we do long term, but we have to pay attention to it in the short term.

[00:21:36] Alan

Maybe shifting gears a little bit to talk about asset allocation from the big picture first, and then we can get into maybe some specific ideas. Obviously, the macro backdrop you paint, as you say, looks challenging if we’re talking about stagflation, potential margin compression for companies, and at the same time, the Fed could be challenged in terms of their ability to pivot if inflation remains high.

I know your business is much more opportunistic, thematic, picking particular segments. But from a high-level asset allocation perspective, what would you be saying to people in terms of how they should be thinking about building their portfolio for this type of environment?

[00:22:18] Christopher

We use a very simple scale, 1 to 5. A 3 is a normal risk/reward. To be very clear, this is not a market timing tool. This is strictly a way to try to state what we believe the risk-reward looks like in the market. So 3 is the normal market environment, a 4 is a really positive environment, and a 5 is what we call the backup the truck environment. The risk-reward is so good, it’s March 9th of 2009, it’s the COVID lows and March and April, it’s those kinds of times when you can really, really get paid well to take risk.

Just the same, a 2 is a very negative risk reward and a 1 is something where you just not really well paid for the risks that one is taking. So to be abundantly clear, we are not saying that people should go out and sell everything right now, but we are a 1, and we’re a very passionate 1 because we believe the risk-reward right now is as bad as we have seen it since January of 2022. We see it as bad as it was back in January of 2007, 2008. It’s just a very poor risk-reward. That doesn’t mean the market can’t go higher.

But when we have that rating, the reason we do it is if someone has institutional investors, individual investors, whatever, has a band they’ve accepted in their investment policy statement. Let’s say that their large-cap exposure can be no less than 40%, no more than 60%, we believe they should be at 40 or close to it at this point. If we’re at 5, we tell them to be at 60. We don’t want somebody to go out and put it all on black or all on red. That’s not what we’re saying.

But if someone has more flexibility in their mandate, we would encourage them to be thinking about defense, not offense, and to focus on the preservation of capital and how they can get returns without having to take market correlation at this point in the cycle.

[00:24:19] Alan

Just to be clear, what are the factors that go into that? Presumably, it’s the macro and backdrop valuations, etc. But if you could give us a sense on some specifics around that that’s driving it to be a 1 as opposed to a 2.

[00:24:33] Christopher

The main factor by far is valuation, and it’s the, call it, 80%, 90% of the algorithm that goes into it if you will. So valuations right now, if one looks at it on a historic basis, it’s expensive no matter what metric one wants to look at it by when we start talking about the stock market. Then we also must factor how that valuation compares to the risk-free rate. So if someone is able to get a 5 in change and a T bill, then they can get a 6% or 7% expected return in equities. That’s not enough risk premium to be justifying the risk that one would take.

Again, maybe for the next three months, they can stay long and they can do better. Maybe they can, maybe they cannot, who knows what happens tomorrow? But what we do know is that they’re not being paid well for that risk. We would rather focus on things that are less correlated, that have more revenue durability, more operating margin stability, more things that have pricing power in an inflationary environment if this continues to persist. With that, there’s very little in the stock market that makes us excited today.

[00:25:45] Alan

Interesting. I tend to agree with everything you’re saying. One thing I do wonder about though is that we’ve gone from a period of very low nominal GDP growth. In the last decade it was low inflation, low growth into a period now, okay, it is higher inflation, but the flip side of that is higher revenues, higher everything in nominal terms. I guess it comes back to your point about pricing power. That’s not universally good. Some companies can take advantage of that and some can’t. Is that what you’re thinking of?

[00:26:20] Christopher

No, that’s true. One of the things that I think a lot of people lose sight of is that a higher inflationary environment is not necessarily bad for stocks because of the fact that if nothing else (just using Coca-Cola as a simple example), what I paid for when I was a child is a lot different than what I pay for a Coca-Cola today. So the raw numbers obviously get bigger as inflation is higher. That can take stock prices higher.

But ultimately, if our purchasing power is getting degraded by that same inflationary input, that obviously means we have less money to spend on an equivalent basis. We have less dollars, our dollars go less far and we can buy less stuff (to be real technical with it). So naturally, for investors, we may continue to see earnings grow but it has to be looked at relative to interest rates. That’s the part right now that I think the market is being very cavalier with.

It doesn’t mean the markets not going to be right, but the market is being cavalier when you’ve got a 5% plus T bill rate and saying okay, we’re going to pay close to 20 times earnings for equity returns, that’s a 5% cap rate. That’s effectively the risk-free rate. That doesn’t make any sense. Even if it was 15, it’s still too high relative to history. Now, the thought process is the Fed is going to pivot and start lowering and so look at the 10-year which is at a 375. Well, 375 compared to 7.5, that’s not bad. That’s a pretty good risk premium.

That is a big assumption that, right now, the Fed is going to cut rates, and when they do, stocks will look okay valuation-wise. We think that is potentially a fool’s errand and we think that people should be more defensive and be looking more for companies that are not going to have as much valuation risk to them.

[00:28:15] Alan

Okay. So maybe to get into them in a bit more detail, firstly, in this type of environment, what types of specific opportunities are you looking at? I guess it sounds like it’s in the private markets much more so. It sounds like you’re saying that the stock market, public markets are not offering those opportunities. So where do you see the opportunities?

[00:28:38] Christopher

There are pockets of the public markets that are interesting primarily around energy and primarily around some of the asset management investments that we see there. But really, we see so much better opportunities for both of those in the private markets. There is still a very significant public market premium, as there should be because of the liquidity, that you pay for those assets.

We don’t think that for those investors that can, they should be satisfied with just investing in the public markets because the private market offers different things that we can’t get in the public markets and better valuations by far, along with more stability, more predictability, less volatility, and I could go on. The key factors we’re looking for today are either assets that have been materially dislocated and they’re just really inexpensive and there are some pockets of that, and then the other side of the equation, which is persistency.

Persistency is the most underrated tool in all of asset management in my opinion. We want to find persistent revenues, persistent profit margins, and persistent profits as a result of that. That is very easy to find in some sectors. Owning professional sports teams, as an example, is an area that we have been very involved in lately and love it because of the persistent revenue streams that are there. I can come back and elaborate on that.

But then also, GP stakes, owning stakes of private asset management firms where the revenue is contractually obligated and the profit margins are as big as anything in the world other than enterprise software, which is why it feels a lot like enterprise software. We love enterprise software. Right now, it’s priced much better on the private market than the public market.

But we certainly like certain pockets and there’s some private opportunities in the public markets, at least there was a couple of months ago. They’ve gotten a little more expensive now. So we really are focused on durable revenues, long-term trends and themes that the wind is at our back and we expect it to stay that way for a long time, or things that are completely dislocated and have been completely ignored, things like energy as an example.

[00:30:51] Alan

Okay, interesting. Well, maybe to get into those in a bit more detail. Obviously, you talk about sports teams, and I know that’s been a focus for you. That is something that seems to be garnering more attention around the world, over this side of the world in Europe and over in the UK, a lot more interest from investors in football teams and a suggestion that maybe the people are overpaying for assets in that sphere.

I know the FT did an analysis on Man United’s valuation and they couldn’t reconcile the bids. But curious to get your perspective. Clearly, you don’t see any valuation concerns there, but do you do see structural tailwinds in terms of investor interest, I guess?

[00:31:41] Christopher

So the interesting thing is if one looks at the historical ranges for valuations on sports teams, they actually haven’t really changed much over time. The dollars certainly have because these businesses have grown very significantly. What I will tell you is the theme, first and foremost, is cord cutting, and that is people going from broadcast and cable to streaming services such as Netflix, Amazon, Apple TV, etc.

The reason why that is such a strong theme is because everybody knows it’s happening, but it also is something that’s really difficult to profit from. Yes, somebody can go out and buy Netflix or they can buy Apple and directly benefiting from that. But that’s still got a lot of difficulty because it’s really a content game. Well, what we decided to do is to bypass that layer entirely and go straight to the content itself.

The only place that the advertisers can reach their audience is by going directly to live events, because otherwise, people will choose to fast forward or ignore or completely not be willing to watch commercials. So that leads you to live events, and 92% of all the top live events in the world are professional sporting events. Therefore, there’s a significant captured audience.

Here in the United States, there’s also another big trend, which is sports betting. Most States are having a lot of difficulty with their financial picture. In Texas, we don’t have that. But there are more, and more, and more States that are facing deficits that they don’t know how to fund. They don’t want to raise taxes directly on the consumer and so they’re passing sports betting legislation, which obviously increases fan engagement and increases the ability for those live events to even garner more sponsorship dollars, etc.

So the theme itself is definitively cord cutting and sports betting. What we know is that these are also legalized monopolies. They are allowed to operate without competition. It’s different in Europe to an extent. The teams have effectively created their own monopolies. But in the United States, it is literally legal and maintained by the League to where there is no new competition allowed. Therefore, you have a lot of recipes for investors to do well from that durability of revenue and then ultimately seeing the valuations of these assets continued to go higher.

Now, to your question on valuations, there are definitely some pockets of overvaluation in the sports world. Only time will tell if people that are paying those prices are doing so with a long-term view in mind and they’re going to be rewarded handsomely for taking that risk. But we also see, in many other places in sports there are not as dramatic, an overvaluation or extended valuations. We’ve seen a couple of things that have traded in Europe. They definitely have a lot of what we call blue sky in them.

It’s not like you’re looking at the past cash flows to value the asset. It is all based on what you think it’s going to do in the future. Some of those investors are brilliant savvy investors who will make that blue sky happen and be very well rewarded for doing so. Other investors will not be, and they will have paid too much, they will not be able to execute on their business plan, and they will have overpaid for those assets. It doesn’t mean they’ll lose money necessarily, but they won’t get the target rates of return.

The other thing that’s a little different in Europe is there’s a lot more leverage that can be used. As opposed to the United States and the North American sports teams, you’re not allowed by the League to use extensive amounts of leverage and that means it’s very difficult to see how those investors don’t make at least a reasonable return on their investment compared to in Europe. You could have some of those European football teams actually have to go into a restructuring of some kind if people overpaid and over-borrowed as well. But we love that space and we think that’s a multi-decade-long opportunity for investment.

[00:35:57] Alan

Assets like those, are they less sensitive to the economic cycle or do you just structure it in such a way that your own exposure is less sensitive?

[00:36:06] Christopher

The thing that most people do not fully appreciate about sports teams is how durable the revenues are, because they think about the economy and that less people will go to the ballpark or to the pitch and so they’re not going to spend as much money. What we know is that that actually is not the case. They may not go to Tahiti on a trip, but they’re going to go watch the local sports team with their family of four and pay a very large amount of money. But they’re still going to be willing to do that compared to the big trip that they might wait on or the big refrigerator or the new car. So it’s actually very durable from that perspective.

But the most important reason is that most of the media contracts are 5 to 10 years long. The stadium naming rights, in some cases, are 15 to 20 years long. The local media rights are anywhere between 10 and 20 years long. So regardless of what’s happening on the team, with the team, on the field, etc., those are contracts that are going to be honored. Then of course you have season ticket sales, which, depending on the team, can ebb or flow, but for so many teams, they are well subscribed for their season tickets, year in and year out, and that’s another durable revenue stream.

As we know, last time somebody went and got a beer at the ballpark, they probably paid more than the last time they were there. So there’s a lot of inflation protection as well as the fact that most of these professional sports teams also own the real estate around their facilities and so there’s also some real estate hedge as well against inflation. But it’s just a really predictable business model compared to what a lot of people think.

[00:37:39] Alan

Okay, interesting. In terms of crafting that exposure and getting access, are you looking across all of the different sports or have you particular favorites in the US? What does access look like? Is it partnering with a specialist? Is it via a dedicated PE fund? How does that work?

[00:38:01] Christopher

The answer is yes, and yes, and yes, and yes. There’s only one league in North America that currently will not allow institutional investors at this time, and that is the NFL, the National Football League, American football. So that league right now, they still utilize the two-legged rule. If you don’t walk on two legs, you can own it. So until that rule changes, institutions like us cannot own pieces of the NFL franchises.

All of the others allow it and all of them allow it in very specific, very unique situations and only in those unique situations, so it’s very difficult to get access to it. It’s not something that really most can do. It does require strategic partnerships. It does require strategic relationships. We’re just blessed that we have some excellent relationships in that space, that we can partner with folks that have those approvals.

[00:38:55] Alan

Okay, good. The second area, you mentioned that they have those characteristics of durability in terms of revenues and profit margins was GP stakes and the asset management industry, so good to get a sense on that.

[00:39:08] Christopher

So most people think of the asset management industry, they think of mutual funds, they think of hedge funds, they think of separate accounts, ETFs, etc., and of course, those are absolutely part of the asset management industry. But the part that people know a little bit about but not as much as they likely do the others would be the private equity, private credit, private real estate and real assets. Those sectors are all structured (almost all), as partnerships. So you have the limited partners who are the investors in the fund, and then you’re going to have the general partners who manage that fund.

The general partner, in the classic sense, is going to charge a 2% management fee and 20% of the profits. They’re going to put up a good chunk of their own money themselves to show that they’re committed to the strategy, so that’s what we refer to as the GP balance sheet. When you combine the nature of those management fees streams with the optionality that comes from the carried interest and the performance you can expect from the balance sheet, it creates an incredible three-legged cash flow machine that is an asset management business in the private markets.

The management fees for most people, unless they’ve been involved in a private equity fund or private credit fund, they may not appreciate that those are contractual obligated management fees. So if the Teacher Retirement System of Texas (as an example) makes $100 million commitment to a private equity fund, it doesn’t matter what happens, they still have to pay the 2% management fee or whatever the fee is they’re paying on that $100 million for at least five years typically, and sometimes as long as 10 to 12.

So the manager of that fund is going to make, just from Texas Teachers, $2 million a year on that illustration for at least 5 years to 10, and they can’t get fired. There are very, very few businesses where you could do a very mediocre, even lousy job and not get fired. That is true for a private asset management firm. Now, hopefully, they also do a good job and then they get 20% of the profits so that $100 million, from Texas Teachers, turns into $200 million. Well, then obviously the sponsor is going to make $20 million in revenue off of that $100 million that they created for teachers.

Then on top of that, most likely, the general partner will have put a big chunk of money themselves in the fund that also doubles in value. Well, naturally, they’re not charging themselves a fee or carry, and so they’re going to see a double of their money from their balance sheet as well. So when you combine all of those together over a full market cycle, you have the predictability of the management fees, you have the upside optionality of the carried interest and the growth of the balance sheet, which gives you usually anywhere between a 15% to 20% cash flow type yield over a cycle with hopefully a 20% plus internal rate of return.

It’s very difficult to get that anywhere else, especially when you consider that just from the management fees, that most of these firms are going to run between 40% and 70% operating margins, not including the carried interest revenue, not including the balance sheet growth in value. So it starts to feel a lot like enterprise software in that way. But even then, it’s better than most enterprise software because most enterprise software contracts are year to year, maybe 2 years, maybe 3 years, sometimes 5, but rarely 10 years.

So you have all the stickiness, but you also have the profitability, and you have the scalability. Because if you raise a billion-dollar fund, you’re not going to need twice as many people to raise a two-billion-dollar fund. So you get a lot of operating leverage, as well as the fact that it’s very capital un-intensive. You don’t need a bunch of property plan and equipment, if you will, to go out. It’s a very much of a value add by people.

[00:43:00] Alan

Sounds fantastic. It makes you wonder, why are the GPs willing to give up such lucrative returns?

[00:43:09] Christopher

It’s the first, second, and third question that anybody should ask. If these really smart people are sellers, why would I want to be a buyer? The answer is because they’re selling usually 10% to 15% of their entire company and they’re keeping 85% to 90% of their entire company. They’re doing so because of the fact that they fully expect that they’re going to grow the business faster with that strategic partner than they would have without that strategic partner. It’s something that we’re very open about.

We sold a stake in our firm to Tony Robbins in 2021. Tony was an investor, a client of ours first, he wanted to learn more about what we were doing, then proceeded to own a piece of our firm. Well, we did that because the balance sheet capital that Tony and others put on the balance sheet gave us the ability to grow faster than we would have been able to on our own, as well as the fact there’s a lot of opportunities available to us that would not have been available to us prior to him being involved.

[00:44:07] Alan

That partnership value, is that in terms of a bigger network of clients or is it presumably some capital for working capital purposes?

[00:44:17] Christopher

It can be. I’ll take it away from us and talk to the industry, as a whole, for a second. So in our particular case, it was definitely balance sheet capital. But that is very often the case for other sponsors that would sell a GP stake. So let’s just say that as an example, you raised a billion-dollar fund and you put up $20 million of your own money. Well, that’s a significant check, but you can handle it. then you raise a $2 billion fund, you’ve got to write a $40 million check, and you haven’t gotten the $20 million back.

Now you’re at $60 million that you’ve committed, and then you have the opportunity to raise a $5 billion fund, but you’ve got to put $100 million of your own money in it and you haven’t gotten the $60 million back. Well, that means at some point, the size of your balance sheet will constrain your growth. If you instead sold 15% of your company and got that cash on the balance sheet to make that commitment, you could now raise the $5 billion fund that’s $100 million in revenue, that has got the potential to earn 20% of the upside on $5 billion instead of growing slower.

There’s a lot of other strategic reasons but one thing is for sure. If somebody is looking to go to the beach, if somebody is looking to just cash a check, we don’t have an interest. It’s not why we’re in it. We’re in it because we want to participate in firms that grow dramatically after we make the investment and to also help them grow dramatically after we make that investment in their firm.

[00:45:41] Alan

Okay, interesting. You’ve spoken about two particular opportunities, I guess, in the whole private space that look compelling. But obviously, the private space is enormous, private equity, VC, private credit, private debt, and there have been concerns raised about private markets more generally. Basically, I suppose the concern or the question is maybe historically, banks participated as an intermediary and that process has shifted more to private investors so when things turn down, is there something lurking in the shadows that’s going to be a problem for capital markets more generally, kind of summarizing very broadly there.

But is that a valid concern or do you see pockets of the private markets industry where those concerns could be valid?

[00:46:32] Christopher

There’s definitely always bad actors in any industry. There’s also just not wise investors in every industry. So there can be no question that, to quote, Mr. Buffett, when the tide goes out, you find out who’s wearing a bathing suit and it is something to where there will be some firms that do get hurt because of the fact that the tide goes out and the recession is very significant. That said, when you look at private credit specifically, which is where most of those concerns revolve around, because it’s pretty obvious what’s happened in private equity.

If there were firms that overpaid way too high on EBITDA multiples with way too much leverage, well, those companies are going to have to go through a restructuring. They may be good businesses, but they have bad balance sheets and they’re going to have to be restructured. When people are afraid of the boogeyman, if you will, is that the private credit, there’s some embedded massive leverage that’s going to derail the system (similar to what subprime mortgages did in 2008 when we shorted subprime with John Paulson).

The answer is right now, we do not see that. We did not see that anywhere for a couple of reasons. Number one, because the banks in many cases were making really unwise loans because they were effectively packaging them and selling them to someone else who was going to end up holding the bag. In the private credit world, they keep it. They keep it on their own balance sheet. They have to report to their own investors. They have to perform or they’re not going to be able to raise more money. So they tend to be much more disciplined.

There are some out there that got undisciplined in ’21 just like so many other people, but systematically, we did not see that occur. Those firms in many cases retrenched very quickly and they’re going to probably be okay, they just wont to have great returns. But on the other side of the equation, you’ve got those businesses that have received those loans. In many cases, they were given a lot of leeway. They were given a lot of flexibility that will give them time to work things out.

But even if they don’t, the private credit world will be able to be better positioned than banks would to be able to help those businesses restructure, to reorganize, and ultimately, survive to fight another day, if you will. The other thing that most people do not fully appreciate is private credit is almost all floating-rate debt. So the interest rate rise that we have seen is actually massively beneficial to those private credit managers because maybe their default rates as an industry go up a little bit, and that’s bad.

But if instead their profitability is up 500 basis points simply because the Federal Reserve has raised rates by 500 basis points, well, that offsets a number of mistakes. So we specifically have positioned heavily in private credit because we love the fact that they’re doing no more work than they were before. They’re taking no more risk in their opinion than they were before. But yet, they’re making in many cases almost twice as much money. What was a 7% loan is now a 12% loan or a 14% loan because of simply the Federal Reserve’s behavior over the last 18 months that we’ve seen it.

[00:49:46] Alan

I guess maybe what I’m getting to is something we’ve been talking about on this podcast a little bit that very often you look at the asset allocation plans for endowments or public pension plans or these long-term investors and it might be public equities, private equities, VC, real estate, private credit, infrastructure, real assets, and maybe a little bit of diversifying strategy. So it feels like lots of shades of economic risk or equity-type risk wrapped up in different structures.

Now, obviously, these are long-term investors. So they say, well, we can withstand the ups and downs in the cycle. But if you were to look at a portfolio like that, is that fair enough do you think, is that reasonable, or do you think those types of portfolios are too levered on a similar type of risk?

[00:50:37] Christopher

I’ll answer the question two ways. Number one is, Governor Abbott was kind enough to appoint me to the State of Texas Pension Review Board and so I chair the investment committee there and I get to see what all 100 plans in the state of Texas are doing from an asset allocation standpoint. So I have a really good feel for that. What is consistently true is except for all but a few, they are very underweight alternatives and private assets specifically.

So they actually have a little bit more beta risk in the portfolio generally speaking, or a little more stock market risk and certainly bond market risk which hurt them really badly in 2022. So we do see a need for institutions to continue to diversify themselves. What we also encourage them to do, and we certainly can’t control them, but we encourage them, as well as the other institutions that we talk to, investment advisors that we talk to, is all of the above strategy is wise.

Ray Dalio obviously talks about the holy grail of investing being 8 to 12 non-correlated return streams. That we are very, very big supporters of, and we believe that some of those return streams need to be completely at least zero correlated or potentially negatively correlated. We have a risk mitigation strategy as an example that we employ, tail hedging is probably a more common term, because of the fact that just like I have insurance on my home, I have insurance on my car, I have insurance on my life. I certainly don’t ever want to have to cash a claim on any of them particularly in my life, but I know that I need to have it in place in order to be wise and to be prudent to take care of my family.

The same is true for investment portfolios. Every investment portfolio should have some portion of protection against the what if, of Tel Aviv, heaven forbid, lighting up like a Christmas tree one night because of something from Iran, or Putin doing something crazy in Europe or the China-Taiwan situation we talked about earlier. I don’t know if or when and I pray they don’t happen, but if they do, I sleep better at night, knowing that I have something that is going to protect me in that kind of a what-if scenario, and every investor should do so.

It might be 1% of the portfolio, it might be 3%, it might be 5%. It depends on the allocations they have, but we feel like they should have that.

[00:53:01] Alan

In terms of risk mitigation, you mentioned that kind of tail hedge. You also mentioned your early days in commodity trading. Commodity trading advisors, trend following, those types of strategies, do you see those in the same bucket as diversifiers?

[00:53:17] Christopher

So they’re definitely not the tail hedge, but they are very good diversifiers and so we have utilized commodities. I have personally used commodities and experts in that space for all of my 30-plus year career because of the fact that I definitely like the one is zigging the other zagging concept. It was very, very difficult for people to stay the course. Just the same as in Houston, there was a lot of people that canceled their flood insurance a year before Hurricane Harvey thinking it’ll never be needed and then obviously their home was wiped out. It was tragic.

People need to look at it as truly an asset allocation decision. This is x percent of my portfolio, it’s hopefully going to make me a profit over time. But even if it doesn’t, it’s going to reduce the standard deviation of the portfolio in a significant way. We look at tail hedging as more of a true convexity, positively asymmetric return stream. But the commodities act in a very strong way as that diversifier to provide hopefully positive returns but also less correlation or negative correlation.

[00:54:28] Alan

Obviously, as you construct all of these investment ideas and strategies, it strikes me that you’re pinpointing particular areas where you do see value and compelling opportunity. When you do that, how do you think about who are the right people to partner with? How do you select managers, how do you select partners, and what’s the thought process around that?

[00:54:51] Christopher

Number one, two, and three rules are to find the specialists, the best in that space. We’re very fortunate because of the size of the checks that we write to where we can write a $5 million check or we can write $1 billion dollar check. So that gives us access to just about anybody that we want to invest with. So the number one thing for us is to find the right partner who is truly the domain expert. We tend to like and prefer sector specialists as a result of that. If someone is in enterprise software, that’s who we believe in.

We want to be in the best enterprise software. If that’s all they do, we feel like they have an information advantage over most of their competitors. Same would be true in multiple facets of technology or healthcare or energy, etc. We don’t really like people that are tourists. If you look at the energy world as an example, we can tell you story after story of firms that thought, oh, we can do energy, it’s easy, but they didn’t have the geologists, they didn’t have the petroleum engineers, and they absolutely left Texas with a tail between their legs because they realized it’s hard, it’s not easy.

So, therefore, if they are tourists, they tend not to do very well. We’d rather be with those that are truly the experts in that space, and that usually comes with sector specialists. The other side of it is what you described. When there’s multiple players that are truly outstanding, what is it that differentiates them? For us, there needs to be some discernible edge. It could be an information edge, it could be a sourcing edge, it could be just the team edge, it could be a background edge. What we look for is persistency.

Persistency, I mentioned it earlier, is to me the most underappreciated word in all of finance. Persistency of returns is better than just absolute performance because they may be hot today and are hot/cold tomorrow. I’d rather have the steady, solid performer, not boring, not average, but somebody who’s excellent and they’ve proven that they have that edge that allows them to deliver persistent returns, which usually comes from a persistent playbook that they apply to their area of expertise.

You look at commodity traders of all history, the ones that have the best systems, that are the most disciplined following their systems tend to be the best. Not the ones that one day, they’re a trend follower the next day, they’re counter-trend, and the next day, they’re fundamental, and the next day, they’re technical. We need somebody who can say I can I do this every single step of the way. It doesn’t mean it’s going to work every day, but I’m going to stick with a strategy that’s proven that we know is going to work over time.

That’s true in the private markets, it’s true in the public markets. Ultimately, it is incredibly important to us to believe that it’s going to be able to be persistent into the future.

[00:57:42] Alan

Okay. Is that something you’ve always got right or you’ve always known or is that something… Have you learned some lessons over the years in terms of that manager selection, that partnership selection process?

[00:57:57] Christopher

Absolutely. We all learn more from our mistakes than we learn from our successes. One of the things that I tried to do, and I still try to do, and we try to make sure everybody in our firm does, is to be that student of history, because it is a lot less expensive to learn by other people’s mistakes than our own. But we have made mistakes, and we learn from those mistakes, and we’re hypercritical of ourselves when we make those mistakes.

But when we look at history, one of things I tried to do is I tried to read every single thing I could from every top trader, every top investor of all history. What you see is patterns that are consistently applied and that you can identify when you’re talking to potential managers, potential partners. Then from there, being willing to admit when one makes a mistake, do so quickly, move on from that mistake the best way that you possibly can, and then simply try not to repeat that same mistake.

The definition of insanity is doing the same thing over and over and expecting a different result. We want to not make that mistake by looking at what are our processes, how did we evaluate, where did we get something wrong, and that was true whether it’s hiring a manager or hiring somebody for our team. We know we’re not going to be perfect, so we want to make sure that we hire slowly and we fire quickly. We’re going to want to do the same thing with investment managers that we’re going to partner with.

[00:59:19] Alan

Just thinking, obviously, you’ve touched on two quite interesting but quite distinct opportunities, GP stakes and the sports teams. You describe the characteristics in terms of durability of revenues and profit margins, etc. But what is the idea generation in the team to kind of say, well, what are the next two or three thematic ideas? Do you have brainstorming sessions? Do you have dedicated processes for trying to leverage the ideas of all of the people on a team? How do you try and go about finding what’s the next big thing?

[01:00:03] Christopher

So the thematic approach is going to be much more of a traditional top-down view of the world and coming up with what’s happening in the space. Sometimes, it is going to be something that we lead the charge on. If we’re looking for something in a specific area, secondaries as an example, or energy, the areas we’re looking at in venture lending right now and distressed credit, we are actively out there looking for managers that we don’t know, that are specialists in that space.

At the same time, we know hundreds of sponsors and have great relationships with hundreds of sponsors after 22 years of doing this, and so we are always talking to them. I love to ask the question of each of the people that we meet with, I ask everyone two questions. Number one is, what do you see in your world today that is different than it was a year ago and how is that going to continue to evolve and change in your sector? Then you can identify forward-looking themes.

The second question that I love to ask everybody is what is the greatest challenge in your business today? Not a problem, but what is the greatest challenge? You learn a lot about what they’re struggling with or what they’re identifying as challenges that they’re going to need to overcome. Not directly to your question, but I think it’s something for the audience to benefit from.

The other side of it, though, is once you develop these overarching themes, is you just begin to test them. You start to say, okay, what is the positive unintended consequence of cord cutting? What is the negative unintended consequence of cord cutting? Who’s going to get hurt? Who’s going to benefit? How do you avoid getting involved in the third derivative? How much can we get closer to the first derivative?

When oil prices went down dramatically in 2014, ’15, there was a lot of ways to try to take advantage of that. What we tried to do is to get as close as possible to the thing we thought we could predict the most, which was the price of crude oil. If you buy credit, if you buy equities, you might get right on crude oil and you may get wrong on the investment itself. So we ultimately decided to do something specifically with crude oil because that’s what we had the most confidence in.

The same thing would be true today with what we’re seeing in energy, also in secondaries, etc. Venture lending, another great example. There’s just significant opportunities there that didn’t exist 18 months ago. That is the ability for us to identify, go find that. Sometimes, it doesn’t happen that often but it does happen some where some of our partners come to us and say, “Christopher, you’re not paying attention. You need to be focused on this area. It’s the best opportunity we’ve seen in a long time.”

Now, that may be them talking their book, but if they have a compelling enough argument, we’re going to listen to it and then we’re going to ultimately decide if we agree with them or not and take advantage of it if we feel like they truly are onto something.

[01:02:51] Alan

Okay, very good. I’m conscious of time. A couple of things I wanted to ask you before we wrapped up. One was you mentioned Tony Robbins and how he had taken a stake in your firm, I believe you said. I read somewhere else that that was one of the biggest influences on you personally, professionally. So tell us a little bit more about that.

[01:03:13] Christopher

I’ve followed Tony’s work since literally I graduated from college and was 21 years old at the time. So I’ve really always followed what he does. I set a goal 10 years into the future, literally when I was 21 years old, to open up my own firm named CAZ Investments and it was going to be an investment firm and ultimately what it has become today. Sure enough, nine years and nine months later, not a coincidence, I opened up the firm.

Tony is so known for what he’s able to do for personal development. Obviously, he’s helped me tremendously in my personal development, but he’s also very well-known for his business acumen. He’s one of the smartest, most savvy investors as far as understanding marketing and where themes are going and trends are going and the ability for him to be able to see how to explain things in a way that is very unique and differentiated.

One thing Tony has a tremendous gift of which is to be able to take something extraordinarily complex and to make it understandable to the vast majority of people. So he’s been really, really helpful in that regard. But I’ve said it before, I’ll say it here, other than my wife and my faith, there’s no impact on my life that’s had more of a positive impact or just an impact in general than then Tony has had.

[01:04:31] Alan

Very good. Well, that brings us to the final question and it’s just around advice you would have for other people, new entrants into the industry or investors generally. You did mention how you read I think you said all the top traders and the mistakes and to try and learn from them. Any particular standouts from all of that reading in terms of things you would recommend for people to have a look at it as part of their investing journey?

[01:04:58] Christopher

Number one is read everything you can. I’ve read, on average, over my 32-year career and going back to school, over a book a week for that entire period of time. Number two would be everything in this world really comes down to attention to detail and work ethic. If somebody focuses on the details and works their tail off, usually, good things are going to happen. It’s just hard to mess up. If somebody is really a student of history and really a student of what’s going on in the world and works their tail off and has great attention to detail, they’re usually going to be successful. But specifically, most of the people I see that aren’t successful is they don’t have a plan, they don’t stick with that plan.

It’s so critical to begin to borrow from the Seven Habits of Highly Effective People: begin with the end in mind and then work your way backward to where you are today and how it is you’re going to build a path to get you to that outcome that you are committed to and figure out a way to persevere through all the challenges that one will encounter.

Ultimately, just go make it happen because life’s too short to sit back and wait and let it happen to us. We need to go make it happen for ourselves and our family and our friends and our clients, etc.

[01:06:18] Alan

Christopher, this has been a tremendous conversation. Thanks very much for doing this today. So make sure you follow Christopher’s work because you can tell it’s a very uncertain macro and investing landscape. So very important to know how to allocate capital in this environment. From all of us here at Top Traders Unplugged, thank you for tuning in. We’ll be back soon, so stay tuned.

[01:06:42] Ending

Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today’s episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you’ll be sure to get all the new episodes as they’re released.

We have some amazing guests lined up for you and to ensure our show continues to grow, please leave us an honest rating and review on iTunes. It only takes a minute and it’s the best way to show us you love the podcast. We’ll see you next time on Top Traders Unplugged.