HOW STEVE KNOWS THE GUEST

Jonathan and Steve are personal friends and they try to meet for a coffee or something stronger on Jonathan’s regular visits to London. Jonathan came to dinner at Steve’s home some time ago and talked about his childhood to a fascinated table.

Contents

Jonathan Tepper’s Unique Background and New Book

00:02:32

Growing Up in Madrid’s San Blas Slums

00:03:37

Learning Economics and Reading Widely as a Child

00:06:51

The Emotional Journey of Publishing His Memoir

00:09:33

From Home-Schooled to Oxford Rhodes Scholar

00:11:47

Boot Camp at SAC Capital and Macroeconomic Insights

00:16:02

Founding Variant Perception and Writing ‘The Myth of Capitalism’

00:18:31

The Rise of Monopolies and Industrial Concentration

00:20:21

Identifying and Investing in Natural Monopoly Platforms

00:24:56

Margin of Safety and Avoiding Overpriced Tech Stocks

00:30:32

Overcoming Hurdles to Launch an Investment Fund

00:33:21

Concentrated Portfolio and Smart Capital Allocation

00:35:55

Deep Research for Investment Decisions and Forensic Accounting

00:41:41

Learning from Mistakes in the Alcohol Sector

00:43:30

Long-Term Goals and AI’s Effect on Platforms

00:48:30

Inspiring Quote and Podcast Conclusion

00:58:18

Transcript

STEPHEN CLAPHAM: Hi, I’m Steve Clapham, and welcome to the Behind the Balance Sheet podcast, where we meet leading investors and commentators and educate ourselves about the world of investing and the world. Our mission is to remove some of the mystique around investing and improve our understanding of successful investors’ strategies and tactics.

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STEPHEN CLAPHAM: Our flagship analyst academy helped one young analyst land a dream job as a partner of a major London hedge fund and helped another, a successful entrepreneur, improve his investing confidence. He made a seven-figure sum in year one. Check out the school on our website, BehindTheBalanceSheet. Com, where you can also find the show notes to this podcast.

STEPHEN CLAPHAM: And while you’re there, don’t forget, sign up for our popular and free weekly sub-stack. Hit the sign up button on the top right of the home page. Jonathan Tepper is a friend of mine and we recorded in London on the day of the launch of his new book, Shooting Up, a memoir of his childhood in Madrid.

STEPHEN CLAPHAM: His parents were missionaries and launched a charity to rehabilitate drug addicts, many of whom became his friends. It’s a wonderful book which Jonathan discusses in our interview. Along with his university days, he was partly homeschooled. And essentially self-taught, yet ended up as a Rhodes Scholar in Oxford.

STEPHEN CLAPHAM: He explains how he went on to set up the successful sell-side research firm, Variant Perception, while he wrote The Myth of Capitalism, a book about monopolies and the death of competition in the United States, before founding his own investment firm, Prebac Capital, in 2020.

JONATHAN TEPPER: Whose philosophy is in part founded on the principle of investing in companies with limited competition. Jonathan is a true original thinker and has a wonderfully sharp mind. I’m not sure if his success has come in spite of or because of his upbringing, but I know you’re bound to enjoy our conversation.

STEPHEN CLAPHAM: So Jonathan, look, I always welcome my guests by saying I’ve been looking forward to talking to you. And it’s actually always true because I only invite people that I want to talk to. But you’re very different because we’re personal friends. And I’m really excited about this because you’ve got your book coming out, shooting up.

STEPHEN CLAPHAM: Is launched today as we record in London and tomorrow in New York. And it talks about your childhood. And you came to dinner at our house and you told the story of, at eight years old, being sent into a heroin den by your father. Just talk a little bit about your childhood and the book.

JONATHAN TEPPER: Sure. So almost all the shooting up and heroin was happening outdoors, like in parks and by Gypsy Village. But the The background is that my parents were Christian missionaries and moved to Spain in 1983 and settled in the neighborhood of San Blas. And at the time, that had the highest rate of heroin use in Europe and one of the highest rates of juvenile crime.

JONATHAN TEPPER: And addicts would come from all over the city to buy their heroin. And initially, my father and mother wanted to work with students and be a university chaplain. But the need was so great, they started helping addicts. Sending them to centers outside of Madrid because there were almost none in Madrid at the time.

STEPHEN CLAPHAM: So your parents were missionaries?

JONATHAN TEPPER: Yes. Yeah. And they realized that the need was so great, they needed to start a Drug Rehab Center in Madrid. So my brothers and I, and it was like from seven, eight, nine before the center started, were out handing out flyers with the number and address of our home. And our living room basically was like a grand central for addicts wanting to get off drugs. And the drug center started in 1985 with one addict.

JONATHAN TEPPER: Forty years later, it’s in 20 countries with over 2,000 addicts in the program, and it’s helped hundreds of thousands over the years. But the story is a very personal story of love and loss because the early addicts shared needles and through that became HIV positive. So the early generation died of AIDS, and they were like brothers and sisters to me and my brothers.

STEPHEN CLAPHAM: And what was that like experiencing loss at such a young age? How has that affected you?

JONATHAN TEPPER: So I think that I was chatting yesterday with someone who had just lost his sister about two years ago. And, you know, he was asking, like, you know, how long does it take to get over grief or be back to yourself? And I don’t think you’re ever yourself again. I think you’re a different person.

JONATHAN TEPPER: And I think that particularly grief is hard when you’re an adult, but it’s, I think, that much harder when you’re young and a lot of your personality is still forming. And, you know, so I think it makes you everyone reacts differently, but at least in my experience and my family, I think it made me much more serious, made me realize that our days are limited and you have to try to live a life of quality over quantity.

JONATHAN TEPPER: And I think it made me also much more introverted and studious. And so I think that accounted for some of the academic drive, you know, and where I channeled some of that.

JONATHAN TEPPER: I don’t know what to call it exactly, maybe angst, energy or sadness. I wondered, I mean, did you know when you were growing up that you were poor? I mean, did that lead you to investing?

JONATHAN TEPPER: No. So, sorry, you asked a two-part question. So first, yes, very aware that we were poor. My father had studied economics at Cambridge, got his MBA at Harvard, but then had a religious experience and became a missionary. And, you know, I could see going back to the United States, visiting like his parents and friends that, you know, we definitely were poor.

JONATHAN TEPPER: And then in the 1980s, if you remember, there was the dollar had some pretty big moves. It peaked in 85. Yeah. So it got very, very strong in 85. My parents, even though they were poor missionaries, lived very well. And then, you know, the dollar lost about half its value versus the peseta over the coming two years. So my mother ended up.

JONATHAN TEPPER: Teaching us, homeschooling us because they didn’t even have money to send us to like the small missionary school for about two years. And my father would draw diagrams on the back of napkins. And so I learned all about that was the time the economists had come out with the Big Mac Index.

JONATHAN TEPPER: And so I remember like learning about purchasing power parity theory and so he just taught me economics and accounting and you know, on the back of napkins at the dinner table. And so I think the it wasn’t the being poor that drove me to economics and investing. It was just the intellectual curiosity to understand sort of how markets and, you know, whether it’s currency or stocks move.

STEPHEN CLAPHAM: And your parents, especially your dad, used to read to you, didn’t they? And you describe in the book an astonishing variety of material. You don’t just read the Bible. We read Dante’s Inferno, John Bunyan’s Pilgrim’s Progress, St. Augustine’s Confessions. I mean, it’s a remarkable range. Are you I know you’re still a voracious reader, but is this still I mean it’s varied.

JONATHAN TEPPER: So my reading tends to vary by year.

JONATHAN TEPPER: I’ve previously written like The Myth of Capitalism, which is a book on monopolies and oligopolies. And then shooting up, I probably went away and read like 100 memoirs, National Book Award winners, Pulitzer Prize winners. I probably won’t read a memoir again in my life. I think I’ve overdosed on that one.

JONATHAN TEPPER: And so I tend to read a lot. Tied to like when the Privat Capital my fund when we’re investing in an industry i’ll try to go away and read as many books as i can on the history of the industry ceos company histories so my reading tends to go in spurts but there’s like a lot of reading and it tends to be tied to whatever i’m.

STEPHEN CLAPHAM: Doing and you had a brilliant line in the book schedules are the tyranny of small minds and you said there were a few clocks in your house and your dad’s church services often didn’t start in time.

STEPHEN CLAPHAM: Well, I mean did this give you sort of enormous freedom as a kid?

JONATHAN TEPPER: I was like sort of the opposite of my father. I was always like annoyed that things weren’t starting on time and that’s what he would respond and he’d say that things will start when they need to. And I do think that there is some tyranny of 9 to 5 or whatever the hours are that people work. And for some people, I think that’s good.

JONATHAN TEPPER: They enjoy that. But for me over time, I think I I wouldn’t say I’m lazy, but I tend to do periods of very intense work and then need a break and go back to it. And so I’m not particularly scheduled in the way I work. So I probably inherited that from my father, even though I disliked it at the time.

STEPHEN CLAPHAM: And I mean, this book is very different from your previous books. But can you just talk about why you published this book now?

JONATHAN TEPPER: So I had written this when I was working at SAC Capital in New York of 03 to 05. It was probably late 04 that I I went into Barnes & Noble on the Upper West Side and saw this beautiful book called Flying Over 96th Street. And it was about a it’s called Memoir of an East Harlem White Boy.

JONATHAN TEPPER: And his parents had moved him to East Harlem in the 1950s, grew up around black and Puerto Rican kids. And he was a blonde-haired, blue-eyed boy. And I just thought this is sort of my story of parents taking me, putting me somewhere, roping me into their mission. And it was just such a beautiful book and it evoked a time and place in the civil rights movement in the 60s and his friends who had passed.

JONATHAN TEPPER: And I just thought someone needs to do this for my friends because many of them had died. And so I wrote it. The book got rejected in quite a few places, which is like normal for the publishing industry.

JONATHAN TEPPER: And so I just put it to a side and over the years had started Variant Perception, which provided research to and provides research to hedge funds, family offices and others and then started Profat Capital. And so it just sort of sat there. And then I had lunch with a mentor of mine and he told me he said, you really should to get this published before you’re.

JONATHAN TEPPER: Father passes i hope he lives many long years but he’s 79 and and i just thought you know what like i should do it so i i worked editing it a little and then got the contract and little brown is is publishing it so i’m glad that he my mentor sort of just pushed me a little to get it published finally and i mean it’s.

STEPHEN CLAPHAM: It’s a very personal book. So writing it must have been very emotional. Was it quite painful?

JONATHAN TEPPER: Parts of it were. And I think that good memoirs are honest. And so and the reader I think has a bullshit detector and realizes whether the writer is trying to either make themselves look good or exaggerate. So I think you have to be honest and vulnerable.

JONATHAN TEPPER: And then because it does deal with loss and then my father is a A very charismatic, visionary, but complex person. And as a kid, we resented a lot of the readings at the dinner table and discipline. I tried to capture him as he was and be honest. And I’m sure if my son wrote a book about me one day, you know, it’s not all perfect.

JONATHAN TEPPER: And so I wanted to make the characters real. And so I think some of that certainly dealing with the loss was painful. And then.

JONATHAN TEPPER: I wrote it and showed it to my family and sometimes it leads families to break apart or at least resent it. And a few memoirs come to mind. My father thinks I was too hard on him, but he loves the book and thinks I told it as it was.

STEPHEN CLAPHAM: Your father is very proud of the book. I mean, yeah, your father is an amazing, amazing guy. So you went to university in the US. You’d been homeschooled and you then went on to become a Rhodes Scholar and went to Oxford.

STEPHEN CLAPHAM: How did you achieve that from, I mean, even when you were at school in Madrid, it wasn’t like the best school.

STEPHEN CLAPHAM: Was it just this homeschooling and the education and the reading?

STEPHEN CLAPHAM: And what lessons have you taken away from that?

JONATHAN TEPPER: Sure. So… My mother homeschooled us for two years, so I wasn’t homeschooled all my education. But we went to a very small missionary school with eight kids in my class and, you know, with almost no resources. And so almost all the education I got really came from one, reading what was on my parents’ shelves.

JONATHAN TEPPER: And then secondly, when my brother, older brother went off to college two years before me, he sent me all his books from college. And so by the time I entered college, I had taken about 10 advanced placement tests. I placed out of almost two years of college and took more exams when I arrived to be able to skip classes.

JONATHAN TEPPER: So I could have gone through college faster, but I thought it’s the only time in your life where you get to read a lot and you don’t have responsibilities. So I ended up like writing two honors theses and doing quite a lot of independent studies and getting fellowships and just pursuing very random things.

JONATHAN TEPPER: I ended up studying Ladino, which is 15th century Spanish mixed with Hebrew and got a fellowship to go off to Israel and New York to do that. So I just took advantage of the time, but I was also like writing an economics thesis on optimal currency area theory.

JONATHAN TEPPER: So, and the thing I love about investing, I have to say, is that, you know, good investors, I think really are in a way, in a continuing mode of being self-taught, right? Like you’re always looking at companies or industries, digging in deeply. And so the ability to sort of teach yourself is one that’s ongoing as an investor.

STEPHEN CLAPHAM: But did you always want to be an investor?

JONATHAN TEPPER: No, I think it was my father studied economics and then went to Harvard Business School and the Drug Rehab Center ran businesses to provide for free rehab. So I always grew up around businesses. But for me, I think it was just very theoretical and abstract.

JONATHAN TEPPER: And so even purchasing parity, which we were discussing earlier, or optimal currency area theory, a lot of these things are they don’t help you pick companies. And be an investor. The investing bug really hit me after I left Oxford and some of my friends were working at hedge funds.

JONATHAN TEPPER: And when they were telling me about their day where they were like going off to Japan to analyze companies and industries, I thought, and doing different things throughout the year, I just thought like, this is an extraordinary job where you could, you know, get paid to go learn things. And so that was the thing that made me want to do it.

STEPHEN CLAPHAM: And… You went to work for SEC Capital. What was that like?

JONATHAN TEPPER: So I was there years ago and it really was like very sort of high pressure, intense. I was working for Gabe Marschank who went off to Greenlight afterwards and Andy Cohen. And they taught me an enormous amount about investing and I was the junior guy. So I was like building tons of financial models. So I probably built I think about 100 financial models.

JONATHAN TEPPER: But I learned like what are the the drivers for different industries and businesses and the key variables to look at. And then did an enormous amount of like channel checks where you’re just trying to understand, you know, what do the customers think about the company or suppliers and things like that. So it was a great boot camp and education.

STEPHEN CLAPHAM: You wrote two books on… Macro economy on debt cycles, monetary policy, systemic risk.

STEPHEN CLAPHAM: What led you to the interest in the macro? I mean, you started off at companies and then you went to macro.

JONATHAN TEPPER: So I had gone over to Bank Of America and was on the prop desk there in London. And at the time, I was doing almost all my work on like the U. S. Subprime lending and then on the European banking system and the high-yield market. And so A lot of the macro basically came from the bottom up where I was looking at things like countrywide financial or allied Irish and others and the Spanish banks, which I wrote about as well.

JONATHAN TEPPER: So that was the impetus for that. It was more just coming across these ideas and then realizing that there was I wrote about the Spanish banking crisis in the summer of 2009 when everyone thought the banks were safe. And I left Bank Of America, you know, in part they wouldn’t allow us to at least my desk, they’d when I joined, I was supposed to be doing equities and then they pulled that.

JONATHAN TEPPER: And so I was doing rates and currencies and I just thought like equities is what I enjoy. And furthermore, like I was trying to get permission to put on some of the trades that I just mentioned. And so I left and was just trading my own money. And my dear friend, Turi, and I started a user-generated newswire because I had sort of gone off the investing world for a while.

JONATHAN TEPPER: We sold that to Corbis, which Bill Gates owned. But I just kept on writing these sort of weekly and monthly notes and then that turned into Variant Perception and a lot of our clients were hedge funds and family offices. And so through that, I learned an enormous amount from our clients too and continued essentially in that vein.

STEPHEN CLAPHAM: And what was the idea behind Variant Perception? There’s a gap in the market you spotted.

JONATHAN TEPPER: Well, one, it was just like for me the sheer enjoyment of writing about these things. And so for my own investing, I would just write. About whatever it was that I was trying to do. And so that was basically the genesis of it. You know, I think it’s sort of churlish to regret things in life because you can’t go back and change them.

JONATHAN TEPPER: I probably should have stayed on the buy side rather than, you know, write research. But I really did enjoy it and, you know, made terrific friends and have great relations with a lot of the Variant Perception clients who I’m still in touch with. And some of them are investors in ProVac Capital when I launched it.

STEPHEN CLAPHAM: And did you have a sort of plan at any point? I mean, this has just all happened serendipitously.

JONATHAN TEPPER: No, no. I think if I had had a plan, it might have been more brilliant. But no, a lot of it was serendipity or just sort of life events where you do something and then it acquires a life of its own. And I think that’s one of the things with entrepreneurs. You know, you really are making a commitment in a way to your colleagues.

JONATHAN TEPPER: Clients and I did know that I wanted to stop writing and manage money. And so then I when I wrote The Myth of Capitalism looking at monopolies, duopolies and oligopolies and the rise of industrial concentration, that and then I was doing an enormous amount of work on all the various industries. So it’s tons and tons of work.

JONATHAN TEPPER: But that was basically when I decided to go start Prevent Capital which launched in officially in May of 2020, but obviously it was a work in advance setting it up. So what led you to write that book, The Myth of Capitalism? What was the impetus? So I was trying to I remember very specifically.

JONATHAN TEPPER: I was trying to understand why corporate profits were so high relative to history and why some industries and companies had higher profit margins than others and ones particularly that were stable because clearly you have like some very high profit margins briefly in some cyclical industries, but I was trying to understand the persistence of it.

JONATHAN TEPPER: And so that’s what took me down the rabbit hole of rising industrial concentration and the rise in monopolies in the United States. By monopolies, I mean duopolies and oligopolies too. And so that was the impetus for I tend to not think by writing, but I tend to clarify thinking by writing and that was how the myth of capitalism came about. And This idea about, I mean, market concentration today is higher than historically, and it looks like it’s only going to increase. I saw David Solomon speak, the CEO of Goldman Sachs, and he was very excited about his pipeline of deals. He said CEOs want to get deals done under this administration.

STEPHEN CLAPHAM: So you were worried 10 years ago. And it’s going to get worse, right?

JONATHAN TEPPER: Yes. So I think that the concentration or the reversal of it really happens in a long pendulum. And so it’s like a multi-year, almost multi-decade thing. And there was quite a lot of antitrust enforcement in the post-Roosevelt. And it was really in 1982 when they changed the merger guidelines.

JONATHAN TEPPER: In the United States under Reagan where there was the whole it kicked off a merger wave in the US. But then you had sort of a succession of merger waves after that. So almost any market boom was generally associated with a high level of M&A.

JONATHAN TEPPER: And there were fewer and I document it in the book obviously with quite a lot of charts. But there were fewer and fewer challenges to mergers. And then the Biden had been opposing quite a few mergers. There’s even Trump in his sort of had also been condemning mergers. But I think things are probably moving the other way.

JONATHAN TEPPER: It’s more probably a zigzag, if you will, than a straight line from a highly concentrated back to more antitrust enforcement. I don’t really follow the policy as closely now that I’m running the fund. It looks like they seem to be giving a green light to mergers now, and I don’t think it’s a good thing.

STEPHEN CLAPHAM: I was just thinking about the sort of opportunities versus the risks. So there’s obviously there’s a risk that if you enter into a stock that’s involved in an oligopolistic situation, you’ve got the risk of political intervention or the imposition of regulation. Do you think that is more important or less important relative to people undervaluing the duration that you get from owning a monopoly?

JONATHAN TEPPER: Well, I think the worst…

JONATHAN TEPPER: Mergers are sort of mergers to monopoly and also ones that are in highly regulated industries. And the regulation itself creates barriers to entry. And if you look at, for example, the US healthcare and insurance sector, it’s become extremely concentrated with basically escalating prices. And it’s sort of a back and forth or tug of war between sort of the payers, in other words, the insurers and the hospitals and drug makers.

JONATHAN TEPPER: And almost everyone’s worse off in the end. And that’s why I think the US spends more on healthcare as a percentage of GDP than almost anywhere. So those are the worst cases. There are some industries that if it’s not very concentrated, you can merge and you’re not going to get much market power.

JONATHAN TEPPER: And in some, if there is ease of entry and exit, then it’s not going to matter. But it’s much better obviously for a company to be able to acquire higher market share through providing a great product or service that the customer wants rather than via mergers, which often are just unnatural ways to try to increase market share and power.

STEPHEN CLAPHAM: And I mean, do you think that big tech companies are monopolies like the canals or the railways? I mean, is there a parallel?

JONATHAN TEPPER: I think so. And I mean, if you look at like the, you know, particularly Facebook, right, where they acquired Instagram and… WhatsApp. And you can see that they’re and then Google basically rolled up the whole almost all the online ads, the buying parts of what are now the Google ad ecosystem.

JONATHAN TEPPER: So like DoubleClick, for example, a lot of these shouldn’t have been approved or allowed to happen. But the government and judges seem reticent to reverse it.

STEPHEN CLAPHAM: And so are you attracted to those stocks because of the monopoly?

JONATHAN TEPPER: Are you worried about I don’t own them.

STEPHEN CLAPHAM: Are you worried about the imposition of regulation?

JONATHAN TEPPER: Well, the companies that we own do often have a high market share. But the ones that and I refer to them as natural monopolies in a different way than an economic textbook would. An economic textbook would talk about electrical utilities, for example, where you don’t want to lay down two sets of copper wires to every home in London or water utilities. And those rightly are.

JONATHAN TEPPER: Regulated and have the pricing capped and they get a return on their assets. The ones that I like are one where the delivery of the product dictates few players, right? So for example, like online platforms, in general, they have strong network effects and you have sort of the demand side and the supply side.

JONATHAN TEPPER: The fund, Provence Capital that I run, we’ve owned we bought it when the fund launched and it was in the middle of COVID, but we’ve owned Booking.com since the beginning of the fund. That’s one where they’re clearly adding value to the hotels because room nights, you can’t store them. You can’t resell them. If a room is empty tonight, it’s never sold again.

JONATHAN TEPPER: And then particularly in Europe where the hotel market is much more fragmented, if you want to attract global customers who are tourists, the way to do that is an online platform like booking. And so it has a reason for existing. It adds value to the consumer. It adds value to the hotel. And hotels might complain about paying bookings take rate, but they’re translating your page into 30 languages.

JONATHAN TEPPER: They can accept payments in any form that you want. The average hotel in Europe wouldn’t necessarily be able to do this. So that’s like an online platform that does have high market share but that I think is terrific and it didn’t really get there via acquisition. Obviously, they bought it was Priceline bought booking. The origin of their market share comes from the performance.

STEPHEN CLAPHAM: Yeah, I know. And it’s got competitors. I mean, it seems bizarre to me. You know, there’s certain areas of the United States. So telecoms. So I was in New Jersey last summer. And I was having something to eat at a bar and I was talking to the barman and he was telling me that his phone bill was over 100 bucks a month. And I was thinking, that’s bizarre because I pay like 10 pounds a month, so less than 15 dollars a month.

STEPHEN CLAPHAM: And I bought a mint subscription, which is like 20 bucks a month and works in the States. And I was thinking, why is that barman paying 100 bucks a month when he could be on mint? Why have these companies been less successful and why are the dominant players so effective at obstructing competition? There’s not a logical reason for it, right?

JONATHAN TEPPER: Yeah, I mean a lot of it and I do write about it in one of the chapters in The Myth of Capitalism. I think a lot of it has to do with lobbying and regulation. And it happens across industries where you try to restrict new entrants or you make it very difficult for You know, have high switching costs is another. So there are certain there are things in Europe obviously that counteract the rise of prices in telecoms for example.

JONATHAN TEPPER: So you have like number portability and they cap cross-border calls and there’s all sorts of things like that. You get a lot less of it in the US and like cable in the US basically is like a local monopoly and they can almost price with impunity. Now, they’re obviously losing on the, you know, customers on the linear TV side, but like they’re making it up on the data and data side. But you don’t really have a choice there.

STEPHEN CLAPHAM: It’s interesting. You were talking about people don’t lay two sets of copper wires. Down my street, there’s two sets of cables. So we’ve just switched broadband. But obviously, in central London, there’s enough customers there. So is it… I was astonished.

JONATHAN TEPPER: Well, I tend to avoid for investment purposes a lot of these industries because they’re very capital intensive. Yeah. And so the ideal business as an investor is one that has low capital intensity, high returns on capital. And then obviously which is fairly obvious. But the and then the hard part of investing is obviously trying to buy these at a discount to their value. And sometimes they’re like booking.

JONATHAN TEPPER: We were able to buy very attractively. During the COVID period where it was mispriced. And so we try to not only find good companies, but also try to buy them in periods where there’s some temporary reason why the market hates them. Or they might not even be down all that much, but they might just be unloved and trading at a discount to the value of their future cash flows.

STEPHEN CLAPHAM: So we’re recording this in the end of February. There’s quite a few. Companies that used to be better loved, but very unpopular right now.

JONATHAN TEPPER: Well, I think that’s the, one of the very difficult things of like overpaying and investing in technology is that some of the ones right now that are the most hated were the most loved in 2021. Like SaaS was all the rage in 2021. And now SaaS is viewed as being like the big loser from AI. And I mean, how do you manage that?

JONATHAN TEPPER: So I think Boy, the… Classic value investing is obviously you have to try to have a margin of safety. And so, you know, if the future is uncertain, then it seems slightly irrational to me to go out and pay very high multiples for things, right?

JONATHAN TEPPER: You either have to have extremely high growth embedded in the price or, you know, you’re basically making the assumption that things aren’t going to change at all for a very long period of time.

JONATHAN TEPPER: You know, when you’re paying sort of 50, 60 times or something, you know, and particularly in technology where you can’t really see around the corner. And then. Technology companies often do have quite a lot of cash, but that’s because technological change is an existential risk that they have to protect against.

STEPHEN CLAPHAM: So when you set up PrivatCapital, you had a background as a macro commentator. How difficult was it to persuade people to back you? I mean, I know. People would have realized you’re very smart. But there’s a difference between being very smart and being a successful equities investor. So what was your pitch?

JONATHAN TEPPER: No, so I had started my career at SAC Capital doing individual stocks. I continued investing personally doing individual stocks. At Variant Perception, we would put out industry reports.

JONATHAN TEPPER: People tend to remember only the negative ones, the short reports, because they seem to attract more attention. But we also had, you know, many sort of positive.

JONATHAN TEPPER: Long reports on industries, like owner-operator firms, sort of concentrated industries with attractive moats. So I had done quite a lot of very deep industry work and then spent a couple of years working on the myth of capitalism. I also wrote another book that will never see the light of day, which is like our sort of internal Privat Capital Guide, where we have hundreds of pages of research on industries and companies.

JONATHAN TEPPER: So there’s like an enormous amount of work that had gone on before starting Prevent Capital. And we’re extremely transparent with our investors and potential investors. So our website has like many hedge funds, has minimal information about us because we don’t market to the average public.

JONATHAN TEPPER: But if a family office or endowment wants to see what we’re doing, we can send them very detailed industry value chains, write-ups on the companies, financial models on the companies that we own. So people can see the depth of the research and the thinking that goes behind it.

STEPHEN CLAPHAM: And do even serious investors spend much time looking at the depth of the research?

JONATHAN TEPPER: Yes, I think well, you described them as serious investors and so I think those do. I think there are some investors who and it’s unfortunately part of human nature, which is that a lot of people just don’t do due diligence, right? And You find this with things like FTX where no one looked at their accounts or the assumption as well of Sequoia invested then it’s good enough for me.

JONATHAN TEPPER: And I think there is some of that that goes on in the hedge fund world. But we have a very close relationship with our investors and even prospective investors where they do read through and have detailed discussions about what we’re doing. So they’re not the kind that sort of skip the due diligence.

STEPHEN CLAPHAM: But there’s a big difference between writing a great piece of research and making money in stocks.

JONATHAN TEPPER: And I mean So we’ve been running now for six years, right? Yeah.

STEPHEN CLAPHAM: So I was meaning more at the start. So when you started out, you know, you rock up to somebody that’s been a client of you, of your previous firm. And you say, I’m now going to do individual equities.

JONATHAN TEPPER: Well, I think quite a lot of the early investors had obviously seen the research and the recommendations. And, you know, they worked out well in terms of on the short side and the long side. And so I think there is that even if it wasn’t actual money, I think they saw, you know, that the approach was thoughtful and one that could generate returns.

STEPHEN CLAPHAM: Obviously, you’re a very smart guy, right? So, I mean, I just would have imagined that it was a big hurdle for a big endowment to put their money down with somebody that didn’t have a track record.

JONATHAN TEPPER: Yes. No, I think that’s true. The only thing that you can do as a manager is run your fund, generate a track record, and then they can look at specific reasons why you may have bought or sold something and the rationale for that and what is your investing philosophy.

JONATHAN TEPPER: And that’s all you can do.

STEPHEN CLAPHAM: Oh, sure.

JONATHAN TEPPER: There’s a chicken and egg issue which you identified, and I think that’s the biggest hurdle for small funds, one to start. And then two to actually achieve a critical mass to succeed because about a third of funds fail in the first three years and about half fail by year five. And we’re approaching year six.

STEPHEN CLAPHAM: All right.

STEPHEN CLAPHAM: A lot of people listening to this will be thinking about setting up their own funds. I was just curious as to if there were any lessons as to how to be successful. And obviously you were in an unusual situation in that you didn’t have a track record as an investor, but you had a track record.

STEPHEN CLAPHAM: As a Southside firm. I wanted to talk about, I was very interested because I am, obviously I’m very familiar with the work of Variant Perception and this idea of combining the macro thinking with the bottom-up analysis. And they’ve got very interesting frameworks for doing that. How do you do it at Privat?

JONATHAN TEPPER: So the top-down really doesn’t go into it almost at all.

JONATHAN TEPPER: For Privat Capital, we really are trying to identify a concentrated and A group of companies so we’ve averaged about 16 to 17 companies in our portfolio over the life of the fund that are that we think that we can own for the long term and would generate free cash flow that will come back to us either in the form of dividends or if their shares are undervalued via share buybacks.

JONATHAN TEPPER: So we really focus obsessively on free cash flow yield and so it is very much bottom up and trying to understand the companies and the industries.

STEPHEN CLAPHAM: And why 16 or 17 companies?

JONATHAN TEPPER: There’s no magic to the number. One, like if you do have a diversified group of stocks, beyond a certain point, your marginal stock’s not really adding much. And if you had 50 positions and equally weighted and one of them doubles, the contribution to your fund is not gonna be all that great.

JONATHAN TEPPER: So we wanted to have concentration and then a very easy sort of rule of thumb, which is like, let’s say you wanna have a concentrated portfolio and… You have 20 stocks and you also don’t want to make yourself an insider in any company.

JONATHAN TEPPER: You don’t want to go over 5%. And so it creates a very nice symmetry between sort of the smallest stock you can invest in in the AUM of the fund. And so we have 16 to 17. We can go up to about 20 and that’s a self-imposed cap.

STEPHEN CLAPHAM: Twenty is a cap.

JONATHAN TEPPER: Yeah. It forces us to have conviction in the stocks that we own and sort of not own too many stocks. Sort of dilute our research and returns.

STEPHEN CLAPHAM: But it must give you some sleepless nights

JONATHAN TEPPER: I actually sleep well, I now have a two-year-old son who wakes me up at night. But no, I actually sleep very well. I know what we own, why we own it. Particularly when companies generate quite a lot of free cash flow, if their share prices go down, they can buy back more shares cheaply.

JONATHAN TEPPER: But companies don’t do that. No, that’s not true. Booking, for example, in 2022, travel was roaring back, but the market was down. And they had gone close to where they were during COVID in terms of the share price. And I think Glenn Fogel is probably one of the best CEOs in the world. And he bought back about 7% of their shares that year.

JONATHAN TEPPER: Our number one position right now is CarGurus. It’s an online platform for car listings in the U. S. And Jason Treveson is the CEO, and he’s a very thoughtful capital allocator. Last year, the stock was down by about a third and there’s overreaction to after one of their earnings reports and they bought back about 6% of their shares.

JONATHAN TEPPER: I suspect they’re going to be buying back quite a lot right now because the stock is down, not just their stock but all the online platforms where the fear is that AI agents are going to disintermediate the platforms.

JONATHAN TEPPER: And so you’re in this sort of wonderful position where even when things are going down, if you do have a very high-quality company they have a lever that they can pull to create value. So I do tend to sleep well at night. I think I’d sleep poorly at night if I didn’t understand what I owned and I thought that the companies were run by bad capital allocators.

STEPHEN CLAPHAM: But it’s easier to say than to do. Okay, you’ve given two good examples of stocks that you own, but it tends to be an…

STEPHEN CLAPHAM: Exceptional manager who, when things are going against the business, things are going against them in terms of share price, that’s prepared to go and buy back stock. Far more frequent is to see people that buy back stock when things are going swimmingly well and they’ve got lots of cash flow and the shares are high.

JONATHAN TEPPER: Yes. And quite a lot of that happens. And particularly, I think, in the tech industry where a lot of the buybacks are purely to offset stock-based compensation and dilution. And so they They tend to be essentially sort of pro-momentum, pro-cyclical, which to me is value destructive. And I don’t think there’s ever any one right capital allocation policy.

JONATHAN TEPPER: It really depends on what are the potential returns that you might get from the various things. And so if your share price is overvalued, you shouldn’t be buying back shares. And dividends, likewise, obviously if companies generate a lot of cash, it’s There’s quite a lot of research showing that dividend payers do better.

JONATHAN TEPPER: But if you start paying out too high a dividend, you’re going to trap yourself essentially by you’ve attracted shareholders who want the dividend. And then you will continue to do that whether it’s the best use of your capital or not. So we try to when we engage with management, try to make sure that they have a flexible approach and try to pursue the one that makes the most sense at the right time.

STEPHEN CLAPHAM: It seems to be a sort of attitude in America that dividends aren’t very attractive. I’m not sure that I understand.

JONATHAN TEPPER: I think some of that’s driven by tax considerations. Obviously, dividends get taxed, the income rate. And then if you’re not a seller of equity, then the buybacks. But we’re actually one sector. No, no, sure. I don’t, you know, is down a lot.

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JONATHAN TEPPER: Well, what’s been the worst mistake you’ve made since starting the firm? So I do tend to be contrarian by nature, and we had made a significant investment in the alcohol sector. So basically, You had this boom-bust cycle, not just in alcohol, but in many different industries. So during lockdown, people didn’t do very much of one thing.

JONATHAN TEPPER: And then people thought there were shortages, so then they ramp up production. This is across many industries. So alcohol had a similar one where and during COVID, people thought no one was going to drink at bars. People actually drank quite a lot.

JONATHAN TEPPER: And you have like a three-tier system basically in the United States and many other places. And so it’s difficult to gauge demand. So the… Middlemen and suppliers were demanding even more alcohol because they feared shortages. And then once COVID ended, people drank quite a lot. I mean like the drinking volumes went up a lot.

JONATHAN TEPPER: And then there was essentially a hangover where then everyone was sort of overstocked. Everyone had more than enough alcohol and then it came down. And so we had bought the shares were already down. It was like 40, 45 percent when we bought. We had bought them about two years ago.

JONATHAN TEPPER: The main fears about alcohol beyond the sort of inventory to sales issue was that there were some structural factors at play that were not turning the tap off on demand completely but at the margin having an impact. And so you have GLP-1s where people just drink and smoke less and eat less when they’re on these products. You have some cannabis and young people drinking less. And so there are some societal changes.

JONATHAN TEPPER: To cap it all off, you have Trump and the tariffs, which has sort of created a massive headache. And so I think that on the margins, it meant that the turnaround in the inventory to sales cycle is going to take much longer. And I do think that the industry probably they were relying on what they call premiumizing, which is to say that you sort of age the spirits a little more, but you raise prices.

JONATHAN TEPPER: And so you’re offering a better product at a higher price. And I think they probably took that too far. And so people can trade down. And so the turnaround in the alcohol names took much, much longer. And they continued to move against us. And I do think that humans are going to keep on drinking.

JONATHAN TEPPER: And I do think that it’s probably more cyclical than purely structural. But at the same time, we’ve exited the position. And, you know, and partly now just because you’re seeing just some terrific companies with, you know, very clean balance sheets and phenomenal business models. Of being sold off irrationally with this AI mania.

JONATHAN TEPPER: I’m always trying to improve the quality and the valuation of the portfolio, not hyperactively, but thoughtfully. And so we have exited Pernod Ricard and we have bought some new positions that I think have even better valuation and even better balance sheets and are terrific. So you have to sort of be objective and move on when you find better opportunities.

STEPHEN CLAPHAM: Quite difficult to do though, isn’t it?

JONATHAN TEPPER: Yes, I think that unfortunately I mean there are many obviously cognitive biases and people can read books about them if they want. But I do think that you end up tying your ego into positions often if you’ve been writing investor letters.

JONATHAN TEPPER: And there are some great managers I know who for that reason don’t write investor letters or keep it to a minimum because you’re then sort of not painting yourself into a corner where they’re like, well, last letter you wrote to me about that. And then you’re incapable of changing your mind or taking advantage of better opportunities.

STEPHEN CLAPHAM: And how have you overcome that?

JONATHAN TEPPER: I think the simple answer is you have to, I think, be humble and be willing to be wrong. And so probably like humility and lack of ego, which I hope I can have, but it doesn’t mean that I am perfect or that I won’t make future mistakes. You just have to try to minimize them.

STEPHEN CLAPHAM: And your childhood, has that helped with the humility and lack of ego?

JONATHAN TEPPER: I hope so.

STEPHEN CLAPHAM: And your dad?

JONATHAN TEPPER: Well, my father and mother, I think, were extraordinary examples. They ran the Drug Rehab Center for 40 years. My mother passed away a couple of years ago, but they never really sought any attention for what they did. They, you know, there are almost no press articles about what they’ve done and they’ve helped hundreds of thousands of people.

JONATHAN TEPPER: And so I think like you don’t really need to do it. Like, you know, I used to do podcasts to, you know, talk about various things that Variant Perception. Like when reports would come out or when I had a book out. But I’ve done one podcast with Ted Seides since this one.

STEPHEN CLAPHAM: I had not heard of him.

JONATHAN TEPPER: Yeah, and he’s a terrific friend and mentor. And then I’m doing shooting up interviews to promote the book right now. But once those are done, back to the fund in terms of trying to keep my head down and focus on work.

STEPHEN CLAPHAM: And what’s the goal ultimately for the firm? I mean, what do you want to build?

JONATHAN TEPPER: I would like to just compound capital at a high rate for decades. That’s the goal. And I think that investing really is an ultra marathon. And, you know, the way numbers work, you know, you can easily overestimate what you’re doing in the short run and underestimate what you can achieve in the long run.

JONATHAN TEPPER: And the longer you compound, the more it matters. So, you know, I set up the business to be one that can. Go on for years and we have a great team of analysts. We’re small, but we have a great team and I hope we can all work together for a very long period of time and multiply the capital of our investors and our own.

STEPHEN CLAPHAM: And Stacey, your wife, who’s lovely, is an analyst at a different firm. And I just wondered, do you talk shop at the dinner table?

JONATHAN TEPPER: No. So she had been working with another fund and then Nathan was born and she has not been working since.

JONATHAN TEPPER: You’d be surprised. We actually don’t talk about markets or investing almost at all. We’re generally trying to just be parents with Nathan who has more energy than both of us put together.

STEPHEN CLAPHAM: Well, that’s quite funny. And I mean what’s been the biggest surprise since you started? What didn’t you expect?

JONATHAN TEPPER: It’s difficult to say. I haven’t really thought that through. I think You always have the business side, you know, which is you have to go out and raise money and talk to allocators. And then you have the investing side. Both are very different. I think allocators are very thoughtful, right? And they have very important jobs.

JONATHAN TEPPER: But I think they’re ultimately human too. And so, you know, when we’re underperforming the index, you know, we get no love. And when, you know, we were ahead of the index, we got quite a lot of love in terms of people wanting to meet and talk to us. And that to me was a little surprising. But again. Like it is what it is.

STEPHEN CLAPHAM: And why did that surprise you?

JONATHAN TEPPER: Well, because I think they have pretty broad, diversified portfolios themselves. And so, you know, there’s a we’re trying to do something. You know, there’s a certain niche to our activity. And I would imagine that, you know, we can fit into that or that.

JONATHAN TEPPER: And I understand it quite often allocators, you know, they have their own.

JONATHAN TEPPER: Constraints, right? So for many of them, they have very long relationships with funds. And it’s sort of like the New York Philharmonic where, you know, you’re not going to play first trumpet until the first trumpet retires or dies, right?

JONATHAN TEPPER: And so you have to wait till there’s an opening there. And so learning about the allocators’ positions has been eye-opening and leads me to have a lot more respect and appreciation of what they do.

JONATHAN TEPPER: But, you know, it’s the ebbs and flows of you know, the interest that I was a little surprised by. And then on the investing side, I can’t say that they’re like big surprises. It’s just more, I think it’s a constant learning, you know, markets.

JONATHAN TEPPER: I think maybe the surprise, or maybe I’m not cynical enough, or even if I’ve read a lot of financial history, just the, you know, SAS we were talking about earlier, where how investors change, you know, within a year or two or three to, you know, like most love sector in 2021 to most hated now. And that’s just very interesting to me to see shifts in investor sentiment.

STEPHEN CLAPHAM: And that’s affected CarGurus.

STEPHEN CLAPHAM: What made you get into that stock? Because it’s kind of changed its spots, right?

JONATHAN TEPPER: No, so CarGurus is fundamentally an online platform. So it’s not a software as a service.

JONATHAN TEPPER: You have a couple in the US. They are by far the largest and they have close to twice the visitors. As an ex-competitor. So you like Cars. Com, AutoTrader, which is not the UK one, but it’s owned by the Cox family. And CarGurus at the time, the stock had gone down quite a lot because they had made an acquisition of a company called CarOffer, which they’ve since wound down.

JONATHAN TEPPER: And there that CarOffer was essentially taking a title of the vehicle and it was doing wholesale between dealers. And so it was distorting their financials where you basically had a sort of high gross margin, capital light business. Where they never take title of any delivery. It’s just listings to suddenly having it all muddied and messed up with the car offer.

JONATHAN TEPPER: And so I think many investors sold the stock and it was down very significantly. And we were looking at it and thought, well, their online core platform is totally fine. And car offer in the end, they shut it down. So the bleeding stopped and I think they learned from the lessons. And we spoke to Jason Trevisan, the CEO and management.

JONATHAN TEPPER: We felt that they overall were actually good capital allocators. And sure enough, the free and then free cash flow obviously we thought would be growing over time, which it has. I don’t think they’ve exercised much pricing power at all. And you can see that like AutoTrader in the UK has much higher margins and the online platforms tend towards monopoly or duopoly.

JONATHAN TEPPER: So it was very clear the direction of travel I think for car growers, which sends more leads and better leads to dealers in the United States. And they’re clearly taking market share from their competitors. But I think one fear is that basically AI agents are going to disintermediate the platforms.

JONATHAN TEPPER: And one thoughtful investor, he’s an investor in my fund, told me that he thinks booking could go to zero, where you could decide to ask the agent to go book you a hotel in Paris if you’re going next weekend. Now, I’m a little bit doubtful that that’s going to happen for a variety of reasons.

JONATHAN TEPPER: But I think the online platforms themselves, if you look across the board, not just car gurus, but many are down 50% or more. From their highs 12 or 18 months ago. So there clearly is an overreaction in my view when you can start picking these up for low teens, multiples of free cash flow, enterprise free cash flow.

STEPHEN CLAPHAM: But there isn’t any obstruction to me going on chat GPT or whatever.

STEPHEN CLAPHAM: I don’t actually. Use ChatGPT that much, but one of the platforms and saying, okay, I’m going to Paris in three weeks time. Can you find the best offers? And even if that facility isn’t available today, that facility may be available in three months time or three years time.

JONATHAN TEPPER: I mean, so the, and you do raise an important point where it’s like, it is possible that this will happen. But there’s a couple of things that I think. Work against that, which is one, why is, why booking your Expedia not going to use AI to like make their own product better or offer you that agent versus having a separate agent doing that?

JONATHAN TEPPER: And then like, where is this listing coming from? And what are the ratings of the other people? You know, like they have a long history of ratings on their site of other people who’ve been to the hotel will tell you what, what it’s like.

JONATHAN TEPPER: So they’re basically assuming that like from scratch, some AI is going to start pulling in all this data and then booking, by the way, It translates it into like 30 languages. And no matter which country you’re in in the world, you can use your preferred payment method. So if a Chinese person wants to go to Paris and book, they can use payment methods that are used in China.

JONATHAN TEPPER: And so you have to start replicating all of that to provide a good experience for the user. And then furthermore, in general, humans like to compare things. And so it’s not just go book me a room. It’s like you want to go online and actually. See what some of the options are.

STEPHEN CLAPHAM: No, sure. But I mean, one of the things that the AIs are very good at is planning trips. So they’re very good at taking trips, mathematical constraints. You know, I’ve got 13 days. I want to visit these. And, oh, by the way, I’ve got to go from here to here, and I don’t know where to stop overnight.

STEPHEN CLAPHAM: I mean, that’s what I’ve used them for. So there’s a logical extension in these huge markets. So a logical extension of that is to say, okay, well, let’s create a database of all the hotels and interrogate that, or not even create a database, but just go and do all the searches and do them really quickly.

STEPHEN CLAPHAM: What gives you conviction that a bookings or a… Car gurus that they’ll be able to do that better than.

JONATHAN TEPPER: I mean they already have, for example, relationships like in the case of booking with all these hotels already. Car gurus already has relationships with the dealers. They already get access to the listings and can book the rooms or send the high intent car purchase leads.

JONATHAN TEPPER: Like all of this basically has to be recreated from scratch by AI. And so it’s not to say that AI is not going to matter, but I think it’s far more likely in my view that a lot of these models perform very similarly where the models turn into commodity and the net benefit is to people who can use them.

JONATHAN TEPPER: And there’s no reason why online platforms or even some software companies aren’t going to be the ones that benefit from AI themselves. And you find this in software or payroll providers are down quite a lot, right? Good luck to…

JONATHAN TEPPER: Someone thinking that AI is going to manage all their payroll when you have to deal with an enormously complex set of local and national taxes, plus garnishing wages for divorce payments or student loans. And it seems that people are throwing the baby out with the bathwater and just very binary thinking about some of these companies.

STEPHEN CLAPHAM: Interesting. So I love the quotation in your book. We’re the sculptor of our own minds. That was amazing.

JONATHAN TEPPER: And that is a quote that comes from Santiago Ramón y Cajal, who was the first Spaniard to win the Nobel Prize in medicine. And that quote was at the entrance to the hospital. Ramon Y Cajal was named after him. And I used to go visit my friends who were in the infectious diseases ward. You know, they had AIDS in the 80s and 90s before I went to college. And that quote really… Always the inspiration for me to learn.

STEPHEN CLAPHAM: Well, it’s a fantastic quote, and you have been the sculptor of your own mind. I hope that we’re going to be doing this again in five years’ time. What will we be talking about then?

JONATHAN TEPPER: I mean, we might comment on other great investments that were hated and unloved. I think the thing that excites me is finding something that I think is misunderstood or mispriced and taking advantage of bargains. You know, investing ultimately is about buying something for less than it’s worth.

JONATHAN TEPPER: So I hope there’ll be more examples of, you know, booking, which has done very well for us. And no, and then I honestly hope not that much changes. I hope the analysts are still happy and we’re all working together and doing well. So that’s my hope. Jonathan, thanks so much. Thank you.

STEPHEN CLAPHAM: I’ve spent several hours talking to Jonathan. I always come away having learned something. And amazed by the depth and breadth of his knowledge. That phrase, you are the sculptor of your own mind, is particularly applicable to Jonathan’s life. His father, Elliot, is a hero of mine, and has achieved a more fulfilled life than almost anyone I know.

STEPHEN CLAPHAM: His has been a life full of sadness and loss, yet he retains a deep religious belief. He is an inspiring character, And I know Jonathan won’t mind. If I end the show with this tribute to his dad and two requests by Jonathan’s book shooting up, you’ll enjoy it immensely. And please visit bettel.org. That’s B-E-T-E-L dot org forward slash donate and gift the charity a little money. Thank you.

DISCLAIMER: Behind the Balance Sheet and affiliates and podcast guests may own shares or have an economic interest in securities discussed in this podcast. Which is aired for your education and entertainment only. Nothing in this podcast should be construed as investment advice or relied upon for investment decisions. Always do your own research.

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