00:39:43 · Dean Pernas, Mikk
[00:39:43] S2: I would just say incentives aren't really a panacea for management making good decisions. Like, you can't be like, oh, because they're well incented, they are going to make the right strategic decisions for this company. Endo, for instance, the CEO owned 40% of the company. Like, he was as well incentivized as anybody on the planet, and yet he made just horrible decisions. And so, yeah, you can be incented to kingdom come, but but that still won't save you. Unless it's truly egregious, it's it's really not a a huge signal. It's like... As long as a comp has has got some share... Shares, some owner... Some some options, and there's some key KPIs there, total shareholder return, As long as it's in that ballpark, it's... You can have an entire range of combinations, and it's it's okay. [00:40:27] S0: Now I also read that you guys pay unusual attention to working capital. Why is that?
00:40:27 · Mikk, Dean Pernas
[00:40:27] S0: Now I also read that you guys pay unusual attention to working capital. Why is that? [00:40:34] S2: Yeah. So working capital is... It's it's vital in two in two different scenarios, and the other one's not so much. It's it's one's small companies that are growing very quickly that don't really have access to the credit markets, and so they have to rely on their own cash flows to to kinda survive. An auction is is or cash flow is like auction for those companies, especially for very small ones. So, essentially, a small company is growing very rapidly. They have to take all their free cash flow they generated and then plug it into working capital to support future revenue growth. And so if there's any type of hiccup in demand, they run out of cash very quickly. And then number two, it's for companies that have a lot of working capital needs relative to the revenue of the business, and working capital needs are going to change due to some step change. So it could be COVID, for instance, the supply chains... Because supply chains got disrupted. All of sudden, retailers needed to have two x as much inventory on hand as they did before. And so all of a sudden, they need to plug that up with cash because they require more inventory days on hand. And so those are the two instances in which it's pressing to care about working capital. [00:41:46] S0: Deiya, you learned bankroll management from poker. Could you could you talk more about the lessons and using this while analyzing those businesses today?
00:41:59 · Deiya Pernas
[00:41:59] S1: Yeah, as far as bankroll management, it really applies to kind of how we think about our own portfolio management process. Bankroll management poker, it's essentially like if you're trying to make money playing poker, trying to build capital playing poker, it's like you start off with a certain amount of money, but whatever it is. Say, you can even start off with a $100 if you're just playing online and playing small games. But whether you have a $100, a thousand dollars, or a a 100,000, the whole thing is the same. It's like, okay. Well, I have a thousand dollars. What game should I play? Should I play games where I have to put up, you know, you know, 50¢ dollar where I have to buy in for a $100, or can I play games where I can buy in for $5,000? And the rule of thumb in poker is that you should generally only play play a game if it's, you know, essentially what we're setting your bankroll is what you should sit down table with. And you learn very early on as a poker player because, you know, especially, you know, a lot of poker players are young, and they don't have the discipline to only sit down with 1% of their bankroll. A lot of people, it's called shot taking poker where it's like, okay. Well, usually, I play a game where I buy in for a $100, but I'm gonna... Now I'm gonna buy in for I'm gonna play a game where I buy in for a thousand dollar. And you quickly learn, like, if you're if you're undisciplined, no matter how good you are at poker itself, you can be the world's best poker player in the world. You can understand game theory. You can understand probabilities. Can understand all the exploits in the world, but you're going to go broke. You're guaranteed to go broke if you are not disciplined at bankroll management. So bankroll management in poker is a lot easier. The the heuristics are a lot easier. But what you learn is, like, playing poker for a very long time is just how important it is. And I don't know what philosopher said it, but there's a difference between, like, blood knowledge and, like, mind knowledge. It's floating around in your head. But once you've made all these mistakes in poker, it becomes part of your DNA to understand what do I need to do to stay alive? What do I need to do to protect myself so I can keep playing this game for many, many years? And in portfolio management, it's it's a very similar mindset.
00:44:10 · Deiya Pernas
It's like, okay. What are all the ways that things can go very, very wrong in portfolio management? Well, you know, concentrated positions, especially in illiquid type securities. There's shorting where, you know... Well, there's shorting and, you know, leverage where if the position that you're putting money in moves against you, it could become a bigger, bigger problem in the portfolio. There's average down, which can also be an area of what they call convex risk, where if the position moving gets you, it starts become a bigger and bigger problem because you're averaging down very aggressively. So there are all these areas of pitfalls that you have to be very, very, very careful in portfolio management. You And know, coming from the poker world, you just know that, hey. I'm just never gonna take that risk. I'm not gonna put myself in that situation. And it... It's it's a way to ensure kind of your survival, essentially, no matter what happens and stuff. We can have another 2008 and our portfolio is gonna be fine. Yeah. Sure. We're gonna take a hit, but then we're not... We're certainly not gonna blow up, you know, just because we understand kind of these certain rules and it's very it's very visceral, our application in this course.
00:45:20 · Mikk
[00:45:20] S0: Now when it comes to portfolio management and and in poker, the bankroll management, I mean, if you have this heater, you're you're you're playing well, a lot of tailwinds, hands are going as as expected and and better. You're winning those flips, which you should you should maybe lose statistically. When should you double down or or or what's the conversation maybe with... Between you two, like, okay, a stock is... You knew that... You know that it's... It keeps going up. You've made right decisions. So do you add... To buy more or what's what's the thought process there?
00:46:02 · Deiya Pernas
[00:46:02] S1: So when it comes to averaging down where stock is moving, you know, the opposite way that you thought it might move and you're considering adding, there's two things that kinda come together. And one of them is just kinda just discipline. Like, you have to you have to understand that, look. How much do I add to a position that's going down? You can either add... You you can do whatever you want. Like, let's say, a position goes down 50%. You can put the whole portfolio in it if you want, but it's not if if you're if you're trying to stay alive for the long term, it's not a a good decision because you could end up being wrong and obviously end up lighting all your capital on fire. So how we think about it is we have certain guidelines that we just... We follow. It's modeled after the time and scene... Zeno's paradox where, you know, you have an infinite... Because there's... In theory, you can add add... Average down an infinite amount of times as the stock keeps going down. And then what we do is we usually follow a guideline of, like, Zeno's paradox thing where it's like an infinite series adds up to a finite sum, like, a dollar plus a fourth... Oh, I'm so sorry. One plus a half plus a fourth plus an eight plus a 16 plus a thirty second. If you keep mapping out to infinite series, but if you add all those numbers together, it's a it's a finite sum, which is two. All that being said is that we create a guideline for ourselves that no matter how much we're averaging down, the total amount of the averaging down is our risk is defined. We can only lose a certain amount of money because we follow this kind of Zeno's paradox guideline. So for us, it's just that we average down and each time we average down, we average down a small amount essentially. Kind of how we protect ourselves. Again, this just guideline. We can definitely stray from it if we need to, but we we need to have a very exceptional situation in order to do so. There's a p l... If have a butter bash down, just kinda knowing yourself. I I think a lot of people get fooled by... There's a lot of thesis creep, and maybe some new information comes out, kinda stuff go down. Maybe you didn't think was was in the cards, but it ended up coming to fruition. And then you're like, oh, well, that's not a big deal for x one z reason. So you really have to understand yourself well.