TIP731: Owning Best-in-Class Businesses w/ Joseph Shaposhnik
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You're listening to TIP. On today's episode, I'm pleased to be joined by Joseph Szypacznik to discuss the launch of his new ETF, Rainwater Equity. The Rainwater Equity ETF just launched on June 18th under the ticker RW, and its objective is to compound capital at an above-average rate by investing in publicly listed recurring revenue businesses. The fund Joseph managed at his previous firm compounded at 16.7% since 2015 and

versus the S&P 500's 13.1% over that same time period. It was also the top performing fund out of 343 in its US large cap core equity category. During this episode, we cover what Joseph learned from spending a day with Peter Lynch, why the active management industry is broken and how Joseph has set out to fix it, why Bill Miller provided a cornerstone investment for Joseph's new ETF,

why recurring revenue is the ultimate business model, whether any of the magnificent seven companies fit into Joseph's recurring revenue framework, the role that valuation plays in Joseph's investment approach, Joseph's top stock pick to hold for the next 20 years, why he likes the aerospace aftermarket industry, and so much more. As a host here at TIP, I search far and wide to try and interview the very best investors, and Joseph certainly fits the bill.

Also, Joseph will be joining us at our summit event in Big Sky, Montana. This is a special gathering that TIP will be hosting in September for a small group from our audience to network, share ideas, and enjoy great company in the mountains. There's limited spots, so if you're interested in joining us, you can click the link in the show notes. So with that, I really hope you enjoy today's episode with Joseph Siposhnik.

Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Fink. Welcome to the Investors Podcast. I'm your host, Clay Fink, and today we bring back Joseph Shapochnik. Joseph, as always, great to have you with us. Great to be with you, Clay.

First of all, I just want to say congratulations. By the time this episode goes live, the Rainwater Equity ETF will have launched under the ticker RW. And the official launch date is June 18th of 2025. And I know we've been in touch for a while now. So I know this required just a lot of effort on your end to get this going. So congrats. Thank you so much. I couldn't be more excited about it.

So before we get to the ETF, I wanted to be sure to mention your recent discussions with Peter Lynch. You spent much of your career working with and studying the greats. You're at Fidelity working alongside people like Will Danoff and Joel Tillinghouse, and you've met Peter Lynch a number of times, among a number of others we can mention here. How about we start with Lynch? Talk about your relationship with him and the impact he's had on you.

I got to know Peter Lynch back in my Fidelity days. He was a mentor to the analysts when I was there from 2005 to 2008. I'd gotten to know him a bit back then, but I had this great opportunity to spend a day with him at an investor conference and it was just so much fun being able to watch the great Peter Lynch in action, interviewing companies, meeting with management teams,

talking with him about businesses. He doesn't do very many interviews, so it was just a pleasure to be able to spend that much time with him doing what he does and watching him in his element. And there are a lot of interesting takeaways. First, he's just the nicest human being and he's very engaged with his family, which is special, I think, in our industry. But there are a lot of interesting takeaways. I think the first is that he's very engaged with markets.

He's so intense. He's up every day. He's talking with his analysts. He's investing for his foundation. And he's very, very engaged. He's very focused on small caps. And I think he talked about that in multiple books where he believes that the opportunities for alpha are in the small and mid-cap category. And when I say small, I mean, he's going very small. So he's looking at billion-dollar companies, sub-billion-dollar companies.

And we were at a small cap conference and the companies that we saw were all billion, $2 billion market cap companies. And his knowledge of those businesses was just remarkable. I mean, he knew the details. He was into the details. We were meeting with management teams and he was getting right down to the core issues, to the controversies and getting to the facts and asking all of the questions you might expect from somebody

who's an investor, a portfolio manager, and in his case, a legend. Also, just talking with him about investing and the ideas he was most interested in, Peter Lynch, he's both a growth guy and a value guy in the same person. And so we were meeting with growth companies, fast-growing small companies, and I'll get to the kinds of companies he was most interested in in a minute.

He has the talent to be able to look at the fast growth businesses and see where they could be in a number of years. And he also had the interest and the ability to go way into value land. And I'm talking about cyclicals, steel companies, metals, troubled companies,

companies where the CEO was knocked out and there's a new CEO and the stock is down 50%. He was very interested in looking at those kinds of companies. So his spectrum was so wide. It was so fun to talk to him about how he thought about going across the spectrum of ideas. And he had an interest in all of these things. And if you can imagine...

the spectrum within small cap. So, I mean, just some of the most troubled situations he was interested in exploring and in talking with the management teams about. So that was just very refreshing. Peter Lynch could go across the spectrum even today to find great ideas. It was also interesting, he talked about this in the book and of course, in person as well. He's very interested in the restaurant industry, very invested in restaurant stocks. And so we talked about how

We talked about hibachi shops. We talked about other types of restaurant themes. I think that he is very interested in these kind of box-like business models that can be rapidly replicated across the country, that can scale up very rapidly, and where if the model works in a couple of core markets, you can bring that model across the country quickly to scale up those businesses.

I think he was very successful in doing that with hotels, very successful doing that with retailers, very successful in doing that with restaurant companies. So it was refreshing to talk about Korean barbecue and burgers and all of the kind of interesting new themes that are out there today. There've been some recent restaurant IPOs that have been very, very successful businesses. I think of Kava from a couple of years ago that we looked at and

He was up to speed on all of them and it was such an interesting discussion. And his framing and the way he thought about compounding was very much oriented toward these types of business models where you can build it once or twice in a local market, see if it works, and then scale it up very fast. I think what was also interesting was from my perspective, being a quality investor,

It was interesting to see that he could step into controversial situations, situations that I probably wouldn't be comfortable in. And he saw opportunity and he saw the value in those situations. I can think of one situation where a CEO was tossed out for, I think, bad behavior or this was kind of a founding CEO of a company.

stock was down 50% or so, and he was very interested. He was looking at it, he probably had invested in it, and he was spending time interviewing the new CEO, the interim CEO, and talking about the situation, and very interested in how that turnaround might materialize and take place. And I think that's very interesting because when you think about

the books and the lessons that he shared many, many years ago, one of the lessons I took was to wait for the fundamentals to turn before you make the investment. In this case, he was kind of going ahead of that and investing ahead of the turn of the fundamentals or the turn of the management team. So it was interesting to see him step into controversy, which I think is very unpopular these days.

there's a great popularity and a focus on quality investing and investing in businesses that are performing really, really well. Well, he took the opposite approach. He was willing to go to businesses that were not performing well because I think he thought there was a lot of upside. So it was an incredible day with him, the nicest person you could ever meet, so engaging, so focused on family and spending time with family and just a pleasure. I think that

Other interesting aspect that was common between my experience with him and Will Danoff, both of which are incredible investors, is not just to focus on small caps where there's a lot of opportunity, but where we've had success and they've had success and have been great advocates is to focus on new issues and the new issue market. So the IPO market, there's a lot of opportunity in IPOs.

And maybe we'll talk about that later on in the podcast. But there are a lot of businesses that come out that are great businesses that are under followed, that have had great track records. And those are great opportunities because the market goes through a discovery process.

And you can get ahead of that discovery process if you're doing the work and you're reading the prospectuses as the businesses come out. Most of them are not great, but on occasion you find these great businesses that are early in their life where you can start the compounding process very, very early. And so that's an area he was focused on. That's an area that other great investors have been focused on. And certainly that's an area that we focus on. So it was a great time with him and-

a lot of lessons learned and a lot of lessons reinforced. Yeah, the point on new issues is certainly interesting given that Buffett has always avoided new issues. And of course, the ones that catch the headlines often tend to be the most frothiest in the market. And it's interesting to hear just on Peter Lynch that the intellectual curiosity and the passion is clearly still there. Here this morning, I was just revisiting William Green's book in the section on Will Danoff. And of course, it tied in

Peter Lynch and Danoff is definitely another investing legend that is much less well-known than Lynch. But one of the points he made on Peter Lynch is in the investment business, you're either all in or all out. And he had an early retirement, but clearly the passion for investing underneath is still there.

Most certainly. I mean, he's getting up and he's got calls going on with his team of analysts. He's all over Bloomberg. God, does he know his businesses like nobody else. It was so apparent.

And like Peter Lynch, you have just an excellent investment track record. The fund you managed at TCW compounded at 16.7% since 2015 versus the S&P 500's 13.1% over the same period. And your fund at TCW was also the top performing fund out of 343 in its US large cap category. And I'm sure that life was good for you at TCW while managing that fund and outperforming your peers.

What led you to step away from TCW to go out and build Rainwater? I had a great time, a great experience at TCW. The reason I left is I have the firm conviction that the actively managed equity business is broken. And it was my passionate desire to

to create a business and a fund that people could believe in again. In the industry, generally, if you look at the data, the average mutual fund, I think 90% of mutual funds underperform their benchmarks on most measurable periods, one year, three year, five year, 10 year since inception. I mean, that's a huge failure rate, 90 plus percent failure rate.

And I had spent a lot of time in the industry, and I think I understood the reasons for that failure rate. And it was my passionate desire to build a fund that could help advisors and individuals outperform the market over time by implementing the approach that I had been implementing for a number of years. And I wanted to be able to communicate that to investors on a regular basis and in an unfettered way.

And so when I look at the industry and why these thousands of funds underperform, to me, it comes down to a couple of key elements. The first one is that most fund managers obsessed with their benchmarks. And so they spend all of their time making decisions relative to their benchmark.

And that obsession, I think, causes them to miss a lot of great businesses and creates a dynamic that is nearly impossible to succeed in. If all you do is spend your time hiring teams and teams of MBAs to research 500 businesses in your benchmark and then hope to make a decision on each business, this is an impossible construct.

And that's what most of the industry does. And I firmly believe that that is a recipe for not success, the recipe for creating that 90% failure rate. Because from my perspective, most businesses can't be predicted. If you deploy the best MBAs from the best schools, I think the data tells you that they can't outperform and predict where businesses are going to be.

Just as an example, as an aside on the topic of predicting and why we go about investing the way we do, it's so difficult to predict the future of companies. Perfect example. If you go back to 2022, Nvidia stock went down 50% in 2022, 50%. Over that period of time, management sold, I think approximately $3 billion worth of stock. This is 2022.

This is not like 10 years ago. This is not 20 years ago. This is in 2022. Management sold $3 billion worth of stock as the stock was going down 50%. One year later, Nvidia was up tenfold. It was up tenfold in one year and management had sold $3 billion worth of stock, not like 10 years ago, one year prior. And there's no doubt this is one of the smartest management teams in the world.

and they had a sense for where orders were going to be, you would think, a year or two years out or even six months out. And they did not know where the stock would be a year later. It goes to show how difficult the industry is, the businesses in the business of forecasting stock prices. And from my perspective,

reinforces our general view that most stocks can be predicted. So let's just focus on that narrow segment of the market that can be predicted. And we think that's recurring revenue businesses. That's why we have that view. I think the other reasons the industry isn't working is that

There is this overconfidence in being able to forecast the benchmark constituents if you put enough brain power behind that. And then as we kind of talked about initially,

view that you must have an opinion on all of these benchmark constituents. And then let's underweight or overweight each one of these constituents to build a portfolio. I think that approach is so flawed and challenging to execute. And I think that's been proven. We don't take that approach. We don't think you need to have an opinion on each individual business in an index, and we don't think that's going to work. I think the other key element that is underappreciated is...

A lot of fund managers look at, and investors, they evaluate a situation, they evaluate a business, they evaluate the multiple that you might pay for the company, but they miss the importance of evaluating management. And you hear about this all the time. You've had just a legendary investor who was on the podcast not that long ago. He reminded me of this concept where

phenomenal investors. They have great frameworks for investing in companies, but oftentimes they have to sell because the idea isn't working. And the reason they give for the idea not working is, well, management decided to do an acquisition that we thought was value destructive, so we're going to sell. Or management decides to enter a new industry that we think is a low return industry and is risky, so we decided to sell.

I think that the industry under appreciates the importance of putting management upfront as one of your most important criteria. We're focused on investing in good businesses and in growth rates and in these hot markets that are going to grow for long periods of time and the earnings are going to follow and everything's going to be great. But at the end of the day, for all of that to work out, you have to have phenomenal people that are executing the business model.

and hopefully doing that in a way that will create value for shareholders, not doing it in a way that creates value for them and not value for the shareholders. Hopefully those two things are linked. So I think the industry underappreciates the importance of management and overappreciates the importance of business models, growth rates, large markets, and the like. And so there's this

that gets created because there's an underappreciation of the importance of management. We think it's very, very important. I think also in the mutual fund industry, and I came from the mutual fund industry with my background, Fidelity, TCW, and those incredible places. The mutual fund industry has created a situation which is very difficult for it to surmount. And that situation is focused on fees and taxes. The

The average mutual fund in the United States creates a performance drag of 1.8% because of the taxes created by trading. So every single year, the investor starts out in an actively managed mutual fund with performance drag of on average 1.8%. That's before fees. Let's say you throw a one percentage point fee on top of that, the investor is starting off

with a 2.8 percentage point deduction that the fund manager has to then overcome. That is a huge burden. And I think one of the reasons the industry is suffering and is broken. Clearly with the ETF mitigates the performance drag from taxes and trading. And that's, I think, a huge benefit to investors. And then in general, I think that professional investors engage in too much trading and they don't allow investors

their ideas to compound and the management's great execution and the business models to grow over time. And that really requires a lot of patience and it requires, I think, the ability for the investor and the advisor to suffer as businesses go through what they go through. I think Buffett talks about how Berkshire has declined 50% on three occasions.

And the average company can go through that type of experience. And it's hard as an investor to sustain that, but I think you need to be able to generate great returns over long periods of time. So those are the reasons I think the industry is broken. And of course, with Rainwater, we're focused on a strategy that we think mitigates the problems of the industry.

And we think we'll generate very good returns as we have in the past for long periods of time. And that for us is a focus on only investing in recurring revenue businesses, only investing with exceptional management teams and holding stocks for the long run. That's the key. And that's what we think will differentiate the strategy from all of the other strategies that are out there in the market. We don't think that we can...

have an opinion on every single stock out there. We think that only those businesses that are predictable and generate recurring revenue are the areas we want to focus on where we think we can do well.

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All right, back to the show. Based on my very limited knowledge of ETFs, I would think it's very expensive, one, to start an ETF, and two, to manage one year to year with all the recurring expenses and whatnot. And that leads us to Bill Miller. He anchored the fund with a cornerstone investment. Bill Miller needs absolutely no introduction to our audience, obviously one of the greats. He's not only had an amazing investment track record as well, but he's also backed

other extraordinarily successful investors, such as someone like Nick Sleep, for example. Yeah. So how about you just talk a little bit about Bill Miller and that cornerstone investment that helps get the fund started?

Well, as you said, Bill Miller, an incredible investor, outperformed the S&P 500 15 years in a row. Unbelievable record and probably one of the greatest investors of our time. I met him in 2006 or 2007 when he came to visit at the invitation of Fidelity's portfolio managers, came to visit Fidelity to talk to Fidelity about investing. Can you imagine that?

He was so prominent and highly respected that Fidelity invited him in 2006 to talk to the entire research team and portfolio management team about investing. It was very special, obviously a very special meeting with him and getting to know him a little bit back then. I've gotten to know him over the years, and I'm so honored and pleased that he

He had the confidence in us to make this cornerstone investment and to back Rainwater and the Rainwater Equity ETO. I've had the opportunity to bounce different ideas off of him and to talk to him about different investment strategies that he's followed. And I think one of the reasons he's been interested in our fund is that it's just so different than what he's been investing in for a number of years. And I think he was attracted to

the different approach that we're taking and have taken to investing. And as I said, I'm just so honored that he's decided to invest with us and to be somebody that I can talk to on a regular basis.

Robert Leonard : You've mentioned a few times already that the foundation of the strategy is to own great businesses with a high level of predictability and high levels of recurring revenue. And I took a look at your deck that showed the projected top 10 holdings for the ETF, and eight of them are estimated to have a recurring revenue of 70% or more. So definitely sticking to that strategy. How about you talk more about just recurring revenue in general and what makes the

these types of businesses the ultimate business model? I think that we start from this position of humbleness, where we think that businesses are in general very difficult to predict. And if you can't predict where a business is going to be in a year or two, you certainly can't predict where it's going to be in a couple of years. And if you can't predict where it's going to be in a couple of years, you don't have a really good chance of valuing it.

So we try to take that kind of humble approach to investing. And so we step back and we say, well, what can we predict? Well, the businesses that have

90% recurring revenue tied to long-term contracts. Businesses that are exchanges like stock exchanges, where they're this national asset, this toll booth for activity, that you kind of can predict. Credit bureaus where there's only a couple of them and in order to have commerce occur, you need to have them operating. Well, that's kind of something that you can predict. It's not very pleasurable, but the waste management industry,

There's going to be wasted at all times, good economies, bad economies. Unfortunately, there'll be lots of waste created. Maybe with AI, a little bit less waste, but I think still quite a lot of waste that'll be created. But those are the kinds of businesses with a lot of recurring revenue. The waste industry has these monopoly markets that we like. And those kinds of businesses you can predict. And what we found over the years is that these businesses, they produce fewer surprises, negative surprises.

they're just easier for the management teams to manage. And so it's easier for a management team to kind of match expenses with revenues because they kind of have a sense as to where the revenues are going to be. They also, from an investor's and an analyst portfolio manager's perspective, we have a much better sense as to where the cash flows will be in a year, two years, and three years, because the revenue stream is so durable and predictable and tied to subscriptions.

And I think lastly, obviously in recessions, these businesses will hold up much better because they sell in this important product and the customers are tied to these contracts. So you kind of know where cash flows will be in a recession. And so it's easier for the investor and for us kind of hold those businesses because the businesses will decline less and be more durable in recessions. So that's kind of a nice...

added benefit to investing in recurring revenue businesses. But I think the last key thing that's somewhat underappreciated is that these businesses give management the confidence to make great investments because the investments are more likely to pay off

So as an example, if you think about a steel company or an oil extraction company, it's much more difficult for them to take the cash flows that they generate, like for the first time in five years, they're generating free cash flow, to take that cash flow and invest in the next great acquisition or the next great project, which will create more compounding if the returns are strong.

That's difficult because they just don't know when the cash flow will come. And they may have to service the debt of their existing business. They may have to engage in other projects or maintenance capbacks. But for the recurring business,

the software company, the credit bureau, the stock exchange, the waste collection business, the aftermarket parts manufacturer, they know that the revenue will be there next year. They know what their costs will be next year. And they can take that cash flow and do something which will be value creating for the investor and for their business because they have the confidence to know that the cash flow will be there next year.

the following year and the year after that. And so you have this added benefit of capital allocation being your friend with the recurring revenue business. And with the other business, you kind of don't have it there because it's so unpredictable and unknown where the business is going to be in the not too distant future. So putting together this recurring revenue business with the right management team, the

and the right financial incentives for the management team is this magical combination that we're always trying to do. Can we find that great recurring revenue business that has growth with the right management team, with the incentives aligned? And that combination is a great combination for the investor because when we analyze incentive plans, what we're trying to do

is incentivize the management team to play offense and compound free cashflow, but at the same time constrain them against their worst instincts, which is to grow the company at all costs without an awareness of generating high returns on capital. So can we find an incentive plan which incentivizes both, protects the investor on the one hand, incentivizes growth on the other hand, and the right types of growth?

put that together with a great business. And now you kind of have this engine that can continue to generate cashflow and do it in a way that will create value for shareholders.

This strategy, I think, is a little bit counterintuitive in a way because more recurring revenue brings more certainty to a business. More certainty means lower risk, which you think would bring lower returns alongside that. And yet, you manage to continue to beat the market over long periods of time. My take might be that the market generally is just underestimating a business's potential and where it's going to be five, 10 years down the line. Many investors, like mutual funds, are

trading in and out of this and playing a bit of a different game. I'm curious to get your take on why this strategy can simultaneously bring less risk yet higher returns. It's a good question. I think that the Hendrik Bessemer study made this so clear. For lack of a better term, most stocks die.

And when I say die, what I mean by that is the study said that over 50% of all stocks generate a negative return. I was shocked when I read the study. Half of stocks generate a negative return? Wow. I mean, that's just shocking. I think one of the reasons why the strategy works is that it keeps you out of bad situations. And the challenge for the portfolio manager isn't always generating

good ideas that will deliver a lot of value or go up a lot, but it's the stocks that blow you up. And how do you deal with that? And invariably, this is the constant challenge for the portfolio manager and for the investor. How do you generate good returns while building a diversified portfolio and not blowing yourself up in these individual stocks? Because it's very difficult to have 20 good ideas. I mean, our fund has 20

20 stock portfolio. It's focused. I really like what we own, but you're always trying to prevent being in businesses that will blow you up or have these really negative outcomes. The Bessemer study says if you hold stocks long enough, half of them will generate a negative return. That's counterintuitive. You'd think that if you give businesses enough time, they will dig out of their problems. The activists will come in and change management. Something good will happen, but a lot of times nothing good will happen.

So I think the first key point is that these businesses die less frequently than that of the average company. So your starting point is better. I think the second key point is that investors underestimate the power of capital allocation. And so while these businesses tend to generate somewhat lower top line revenue growth than most companies,

or then some companies, maybe the fastest growing companies, they can make it up with capital allocation. And that means buybacks, acquisitions, or other activities, which at the end of the day will generate free cash flow compounding at a rate that exceeds that of the market. We're targeting a mid-teens rate of free cash flow compounding for the portfolio, which means the portfolio constituents need to have

on an individual basis, the ability to get to a mid-teens rate of free cashflow compounding. That's not so easy for a 5% growth, 90% recurring revenue business. So you have to find situations where either there's operating leverage that's massive, which can definitely be the case, or the capital allocation somehow will get you there. Or there's a cannibal situation where they're buying back enough shares to where you've got some leverage at the operating line,

and then you've got more leverage with the buybacks, and that gets you to bottom line compounding rate of 15% or something like that to get you to that outcome. But what I would also say is there's probably a misconception that these businesses all have to be boring and unexciting and not particularly high growth. There are opportunities all over the place in recurring revenue businesses. It's such a great category and focus area because

We invest in Broadcom. I think we talked about it on the last call a year ago. That's a phenomenal recurring revenue business. It's like 50% recurring post-VMware. And they're one of the great beneficiaries of AI, of all of the AI stocks. Broadcom is going to be generating $40 or $50 billion of revenue in AI over the next couple of years. So you can find...

great growth businesses that meet this stringent recurring revenue strategy in all parts of the market. They don't have to be the boring, non-growing parts of the market. And you can find them outside the United States. So you've done a great job of profiling these great businesses outside the United States. And we're looking outside the United States to find somewhat less expensive stocks because the United States, the US market is expensive today. And

We're finding though, so you don't have to be constrained by the United States. You can find great growth businesses that are recurring outside the United States and there's lots of opportunity. So I think those are some of the reasons the strategy has been able to generate significant outperformance despite it being somewhat counterintuitive. It is counterintuitive. It's like we're delivering a more predictable outcome with lower volatility, but with better performance.

And I think that's what advisors can get behind. And most investors, hopefully, almost everybody has some index allocation. This is a great diversifier to your index allocation because we don't own these in big index positions. And it provides this kind of a nice level of diversification with somewhat lower levels of volatility associated with it.

Yeah, I definitely think that a number of your holdings are just great businesses that do fly a bit under the radar. I don't think Waste Connections, for example, is going to be on CNBC every morning like Tesla and Nvidia. You just alluded to this, that you're not holding the top names that are held in the indexes like the Magnificent Seven. So Broadcom does make the list. It's a trillion dollar company, but I think a lot of people couldn't really tell you what Broadcom's

Broadcom does. And they've had just exceptional performance over the past few years. I'd be curious, just the Magnificent 7 in general, are there any companies that would fit into this predictable recurring revenue type model and potentially enter the portfolio?

It's very possible in general. Some of the MAG-7 in my mind are in the too hard, too difficult to predict category. Some of them don't generate recurring revenue. So that puts them outside of our fund and our strategy, but some of them do. And we're constantly studying them. As you know, we

invested in Microsoft when we started the last fund in 2015 and held it the whole way. And that's an example of a incredible recurring revenue business. I can't think of anybody who's going to be canceling their Microsoft 365 or Office 365 subscription. I know now as a business owner what that feels like, but it's so important. Who's canceling that? Nobody's canceling that. So Microsoft...

along with Azure and its other phenomenal recurring revenue businesses, is up there for consideration. It happens to be going through a very capital-intensive part of its growth cycle. So we're evaluating it. We're thinking about it for sure. And we'll see what happens. There are others. Google is certainly one of the companies that can fit. But the question is,

I think it's an open question. Is AI an assistance to Google or is it a threat to Google? And I think that that question is uncertain. And I certainly believe that AI is a huge factor that will impact all businesses, definitely impacting technology businesses. The adoption of AI has been

so rapid it is setting records. So you may have seen this, but there's basically been no technology that has been more rapidly adopted than AI. And I think the data says that GPT has reached 365 billion searches in two years.

It took Google 11 years to reach 365 billion searches. So the adoption rate of AI is remarkable. And the question is, who benefits?

and who is threatened by it. And I think that we're trying to invest in situations where we don't have to make heroic assumptions about the future of companies. And so we're very comfortable with Broadcom because we're pretty convinced about its future and the durability of its cash flows. But with some of the other businesses in the Mag7,

They either don't fit the recurring revenue strategy, or we're not sure whether AI and technology is a benefit to them or a mortal threat. Man, I just did a quick search and it looks like GPT is doing around a billion searches a day. That's just mind-blowing.

It's mind-blowing. And I mean, we're using it every single day as basically an assistant, as a part of our research process. And you can ask GPT to do so many things, gather so much information and organize it for you. It is just incredibly helpful. And I think in our industry, in the investment industry, there are so many opportunities to adopt technology and artificial intelligence as an assistant and an adjunct to what we do and

It'll be interesting. We're spending a lot of time studying and implementing that, but we'll see how that evolves and impacts the industry, but it'll impact all industries for sure. Now, there's definitely a focus here on recurring revenue businesses, which we've highlighted time and time again here on the show. And I think a lot of investors love to talk about what they do, how they invest, how they're better than everyone else. But I don't think enough investors will talk about what they don't do. So how about we touch on that here as well?

Well, I think what we don't do is we don't spend time timing the market.

we'll stay fully invested. And the reason we don't do that is because we don't believe we can time the market. And we don't believe that we've met anybody that can actually time the market. It was funny. I was having a conversation one time with Will Deonoff and I asked him about the macro. And he said, the macro doesn't matter most of the time. And when it does matter, nobody knows. I think he meant to say, nobody knows which way to go and nobody knows which way the macro is going to go.

So we spent some time thinking about the macro, but we don't allow it to overwhelm the investment decision-making. We don't time the market because as I said, we don't think that we know the direction of the market. So we stay fully invested. We want the portfolio to compound and there will be dips and valleys and peaks. And that's the natural state of markets and businesses. And to jump in and jump out is really not our strategy. We think that that will hurt returns.

We also don't charge performance fees. And I think that performance fees and fees in general, it can be a huge drag on investors. So we don't charge performance fees. We don't time the market. We don't hug the benchmark. We've talked about the benchmark and we're cognizant of the benchmark that we would like to exceed and outperform. But we're not there looking at the individual benchmark constituents, like a lot of fund managers and trying to decide, well, are we going to be buying a little bit of this or a little bit less of that? And

We're not hugging the benchmark. All we're trying to do is find these great recurring revenue businesses that we think can compound at a mid-teens rate and give them the time and space to do their thing over a long timeframe. Let's take a quick break and hear from today's sponsors.

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I can imagine many investors just looking at your portfolio and just immediately saying that a number of your holdings are too expensive, let's call them. If we just look at maybe one of the more extreme examples, if we look at Lyft Co., for example, they're growing revenue and low to mid-teens. It varies a bit from year to year, but their PE is now over 50. While its historical average is closer to half of that. Talk about the role that valuation plays in your investment framework, because obviously you know as well as anyone that

It's still an important part of the process. It is an important part of the process, but it's so frequently talked about.

And I would say over-talked about. Because how many times do you see a situation where the valuation seems to be attractive and one year later, the earnings are actually 30% lower? So valuation is important and I'll get into how we think about valuation in a second. But I think the quality of the company, the durability of the cash flows and the...

talent level of the management team have a much greater impact on the outcome of the investment. Because you could have a business which is trading at this high multiple, let's say 30 times, 25 times, these high multiples, and a great management team can make an acquisition that will totally change the cash flow.

of the business, not five years out, one year out. And so valuation is important, but it's not everything and it's not every factor. And so we lean a lot more on the quality of the business, the durability of the cash flow, the talent level of the management team, more than anything, that to us is what's important. From a valuation perspective, what we're trying to do is we're trying to gain as much compounding

as high a rate of free cash flow compounding as we can get for every point of free cash flow multiple we're paying. So we're looking for the most durable businesses that fit the framework. But what we're also doing is we're trying to trade off the multiple that we're paying for cash flow with the rate that we expect the cash flow to grow in the future. It gives you an example of valuation and stock prices that I think is interesting. When I first got to know the

Constellation Software Story. I went to go visit the management team at its annual meeting in 2016 or 2017 in Toronto. They had the annual meeting in a law firm's office. It was like a conference room for their law firm. They're very frugal people out there in Toronto. So I was out there and Mark Leonard was standing up in front of maybe a couple hundred people, maybe less, maybe 150 people in this tightly packed conference room.

And he was talking about his business and he said that he thought his stock was overvalued. The stock was...

$600 a share or something. And the stock had gone from an IPO price of $16 or so 10 years prior to 600. And I thought to myself, "Geez, that's been a huge run. I mean, maybe we've missed it." But what could be interesting about the story is that the CEO was saying that the stock was overvalued at 600. You rarely find CEOs say that their stock is overvalued. And when you do, my experience is you should pay attention.

I went back to the annual meeting because Mark doesn't really do any other meetings outside of the annual meeting the next year. And the stock was 650 or 700. And again, he said he thought the stock was overvalued. And when you look at the stock chart from 2006 to 2016 on your Bloomberg screen, it's literally like this. It's like a vertical line.

And when we entered in 2016 or 2017, the stock was trading at a multiple that was kind of in line with that of the S&P 500. So not particularly expensive. And we thought we were getting all of the capital allocation for free. So if we were looking for situations that approximate the multiple of the S&P 500 from a free cashflow perspective, and if we can get the capital allocation for free,

That's a great situation to be in. Some businesses trade at very high PE multiples, but much lower free cash flow multiples because the businesses we tend to invest in have lower capital intensity than most, and so they're more reasonable on a free cash flow basis. But in general, that's generally the way we're looking at it. We're trying to pay a multiple that's not a lot more expensive than that of the market from a free cash flow perspective. We're trying to get a lot of compounding with that.

and we're trying to make sure that the compounding in the free cash flow stream is very durable.

I'm definitely reminded of your comments there talking so much about compounding free cashflow per share. Will Danoff said time and time again that stocks follow earnings. So he invested early in Starbucks. He met with Howard Schultz at the IPO in 94, held onto it for 20 plus years. And then you mentioned that Starbucks earnings compounded at 27%, the stock compounded at 21%. And then if you looked at the earnings for the S&P,

Earnings are compounding at 8%, and then the S&P compounded at 8%. So over time, valuation tends to work itself out, assuming you are paying crazy high prices at the initial outset. You just mentioned consolation software there. The projected top holding in the ETF is consolation over a 10% weight. I just wanted to tee this question up for you. We'll see if it's consolation or not. If you had to hold any stock for 20 years in the fund, what stock would you choose?

Out of your holdings.

It would be Constellation. And the way I think about it today is it's the Berkshire Hathaway of our modern times. Buffett used float as a way of amplifying returns and driving a lot of capital allocation into other great businesses. The opportunity that we have today with Mark Leonard and Constellation Software is you have

one of the greatest capital allocators of our time, who still is allocating capital in one of the most attractive industries you can allocate capital to, which is software. And he's using his float, which is software, you could say paid in advance maintenance contract revenue, I'll call that float, to reinvest that in other

very high margin, high return software businesses. Unlike Berkshire, who had to diversify because of size, because of the opportunity set, because of multiples, diversify into other market segments, some of which are not as good as insurance, some of which are not as good as the core assets that he started with. Constellation still has this long runway of being able to allocate to its core business

which is the best business of all businesses. And that runway, I think, is underappreciated and will be carried forward for a long period of time. And I think what's most unique about the Constellation story is that they have the ability, unlike the other great compounders, to allocate that capital globally. Most of the compounders, the decision-making is done

out of Cleveland, New York, South Florida, wherever headquarters is. So all of the investment perspectives, all of the write-ups, all of it's got to come to headquarters. A handful of people, a group of people, a kitchen cabinet of geniuses sits there and looks at the presentations and decides, okay, this is the deal we want to do. This is a good one.

That is a very cumbersome, slow, and inefficient process, which at the end gives you relatively few options. And generally, if you're only able to look at big deals in the United States or in your core market, you're confined to the multiples that you have to pay to get things done in your core market. But the remarkable part of the Constellation story

is that they have a culture and a management system which trusts the people far away from headquarters to allocate capital to deals that make sense in that country, all around the world. I can't think of another example

of a culture that is approximate to that culture. And the importance of that is it really allows the company to broadly find opportunities around the world and do that rapidly, efficiently. And it gives the company the opportunity to maintain high rates of return, acquire businesses at lower multiples,

and do that for a much longer runway than most of the compounding stories that we evaluate and that we focus on. So I think this is the Berkshire Hathaway of the next 10 or 15 years. The CEO is still relatively young by Buffett standards. I think he's going to be doing it for a long, long period of time. And I think with investing, it's important not to overthink situations. This is a great situation.

Most of the listeners know the core thesis, so I won't go over it, but it's a business with 75% recurring revenue. It's a business run by one of the great capital allocators of our time with an incentive structure, which is the most attractive to investors that you can find. And it's a stock that you can hold for the long run. That's what we look for in companies. And we think that this is going to be the stock of the next 10 or 15 years.

which is why we've invested in it.

Robert Leonard : Yeah. It falls right into your theme of a winner that tends to keep on winning. And many of our long-time listeners are going to know I also own shares in Constellation Software. And when I first looked at it and read Mark Leonard's letters, I thought in a very similar light to you where people allocate a portion of their capital with Berkshire Hathaway, trusting Warren Buffett. And I saw Mark Leonard the exact same way. And what's also interesting about Constellation is after the Trump tariff announcements, I saw the stock sell off very

very sharply, very quickly, 10%, 20%. And I'm like, this doesn't make any sense. Tariffs aren't going to really impact them. And then when it comes to things like inflation, which is top of mind for investors nowadays, they're able to take up prices in line with inflation, no problem in a lot of cases. And I think that really ties in well with your overall portfolio, that tariffs and inflation, they seem to be well-positioned in that regard as well. Robert Leonard

That's right. One of the nice things about recurring revenue businesses is that they tend to be more insulated from all of these political factors and all of the noise that happens in our country, which can impact the actual cash flows of companies. But with software businesses, with capital light businesses, these businesses tend not to be affected by tariffs.

What's also nice is our businesses tend to sell inside of the countries that they operate in. So most of our US businesses operate in the US, waste collection business tends to be a local for local business. Our investments outside of the United States, they tend to be selling local to local. So our European investments have heavy exposure to European customers, very little exposure to selling it to the United States. So it insulates

the portfolio from the impacts of tariffs. And as you mentioned inflation, a lot of the businesses, because they're selling a critical product and it's tied to these long-term contracts, which have inflation built into the pricing of the businesses, well protected from the impacts of inflation. So just by the nature of the recurring revenue models, they just tend to be better protected from the impacts of the outside world.

Last year, we had the IPO of Lore Holdings. I knew that was a company in the aerospace aftermarket industry. I had reached out to you at the time to see if this one was something you're going to look into. You let me know that you were interested in it. Then I look at the projected top holdings. It's number two on the list, right below Constellation. Another company that I know you're familiar with that's in the aerospace aftermarket industry is Heiko. Many listeners have probably looked into that one.

So for those that aren't familiar with this industry, you can think about things like aircraft maintenance, repair, overhaul, and then just manufacturing of replacement parts for aircraft. So it's interesting that something like airlines is something someone like yourself is going to want to steer clear in most cases. But there's these companies within that industry that sort of have their niche and can be attractive investments. So how about you just talk more about the aerospace aftermarket industry? Robert Leonard

Well, Clay, you're giving away all my secrets today. Hopefully, I'll have something left. I'll give you kind of a brief summary of that threesome of companies, Lohr, Transdive, Heiko. You might throw GE into that business. GE is now an unbelievable company run by an unbelievable CEO. But the common thread here is that they're selling these critical components to the airlines

have, generally speaking, few replacement parts available for them. They're generally a design that is specific to that particular application and is very difficult to alter once it's on the airplane itself.

And I'll just give you a brief example of that. A number of years ago, Trans9 acquired a company called Amsafe, which makes seatbelts. When you go on a plane next time, flip the back of the seatbelt and you'll see on the back of the seatbelt, it will say Amsafe on it. And what makes this industry so attractive to investors is this. Trans9 acquired Amsafe. Amsafe has 90% of the seatbelt market. And the reason it's attractive is Amsafe

If the airline who buys the replacement seatbelts wants to change Amsafe for another supplier of seatbelts, they have to go to the FAA and they have to have this seatbelt that the new supplier is creating certified by the FAA.

They then have to certify this seatbelt with the seat model itself with the FAA. And there's multiple suppliers of seats out there. There's probably four or five major suppliers of seats. They have to certify the seatbelt. They have to certify the seatbelt with the seat itself, the model, the chair. Then they have to certify the seatbelt with the chair and the seat location on the plane with the FAA.

The level of certification on an airplane is so sufficiently high that it makes the switching costs so painful for the airline. It's like nothing changes. So the strategy for these companies is, can we just get on the airplane? Just get me on the airplane. Once you get me on the airplane, I'll be selling the recurring product forever.

for the next 30 years. And it'll be very difficult to swap me out, particularly if I'm delivering the product well and on time and with high quality. So the overall thesis for the industry, and we've been investing in the industry for quite a long period of time, is that the switching costs are very high. The aftermarket part is very high margin and very cash generative. And

the ability to allocate capital to the industry continues to be plentiful and attractive. So we like the industry, we like the durability and the recurring revenue nature of all of the businesses. The part sale is tied to the number of passenger miles that are flown. That number is very predictable and the part usage is also very predictable and recurring.

And in the businesses we've invested in, there really isn't a replacement part

for the part that our company is making. That combination is very attractive to us. Also, it just so happens that the management teams of these businesses, the Mendelson family, Nick Howley and Kevin Stein, and of course the team at Lohr, they happen to be very, very good operators that have a long track record of success. And so with Lohr,

That's one in the same family of businesses that's come out. I'm not ready to reveal our investment thesis on it yet because I think it's underfollowed and a great opportunity, but maybe next time we'll get into that a bit. But it follows in the family of the same types of businesses that we've liked for a long period of time. And obviously we think they're going to do very well.

Yeah, that's excellent. I was just going to ask more about lore, but I think I'll hold off until next time we bring you on. I had a few more questions just related more to portfolio management and managing your firm. So one question I had is that since an ETF can easily be bought and sold by investors from day to day, I'm curious if that makes the portfolio management side different to you relative to, say, managing a fund where you don't need to worry too much about

redemptions and whatnot. Talk us through how that works from your perspective.

It's not a lot different. The operational management of the ETF is pretty similar to the mutual fund. Now, as you may know, we converted the old mutual fund to an ETF at my prior firm. I've got experience with the conversion itself, running the old one, and then also running the converted ETF or the new ETF as well. The process for managing those vehicles is not a lot different.

but the benefits are vast for the investor. The ability to defer capital gains is a huge advantage for the end investor. It's one of the reasons that I decided that the ETF was such an attractive vehicle for investment advisors, their clients, individual investors. The ability to defer capital gains is just huge.

When you say deferred capital gains, that means if you were to trim a position and reenter something else, the investor in the ETF is not incurring capital gains in that process. Is that a correct interpretation? That's a correct interpretation. In the mutual fund, when you trim a position,

and you've created gains, you will create capital gains for the investor, which will be delivered to them at the end of the year. Now, as you're trying to do that and you're trying to create losses or take losses to the extent it makes sense in the mutual fund to try to manage that process. And I think we did a great job of doing that in the prior mutual fund, not passing along capital gains for multiple years, which is very difficult to do. But the flexibility

to be able to do that in the ETF vehicle and protect your investors from capital gains at the end of the year is extremely, extremely useful and generates at the end, because at the end, what you care about is the net return, net of taxes, net of fees. What does the investor get? We want to make sure they get the most we could possibly deliver to them without all of these frictional costs associated with them. So the ETF, from a management perspective, doesn't change much

It's basically very similar to the way we were running the old fund, but it does have these real strong advantages.

So I think most investors are used to working with a current portfolio, gradually making changes over time, having to think about things like capital gains. But launching an ETF allows you to start totally fresh, determine all the portfolio weightings from the outset. And you know as well as anyone that a few stocks in the market are going to drive a vast majority of the market's gains. So the more concentrated an investor is, the more they can potentially benefit from the biggest winners.

You mentioned 20 holdings in the funds, and it looks like your typical position has a 4% to 5% weighting. A few of them are a little bit higher than that. How about you talk through how you went about determining portfolio sizing of positions?

Well, the sizing of positions is associated with our conviction in the durability of the investment. So we take somewhat of a counterintuitive approach to portfolio sizing. In general, as we talked about earlier, we have a investable universe, which comprises the businesses that we think fit our investment process, which is only investing in recurring revenue businesses.

only investing with exceptional leaders and businesses we think we can hold for a long period of time. What we're then doing, as we talked about before, is optimizing our expectation for the rate at which each business can grow free cash flow against the multiple we have to pay for. When we think about sizing, going from that point to getting in the portfolio to sizing it up or sizing it down, what we're thinking about is the risk of material loss from the individual investment.

We're not optimizing for highest return, highest projected return. We're trying to optimize for which businesses will be the most durable and can still deliver reasonable rates of compounding, which is why Constellation has been our largest position for probably six or seven years in the old fund and is going to be projected to be the largest position in the new fund. We think it's the most durable. So in general, we're sizing things

based on durability and compounding rate and our confidence in the teams. That's the way we think about it. And it sure seems that the strategy is very similar, if not the same, as what you did at TCW. So maybe I just want to give you a chance to highlight if there are any differences from what you were doing with the prior fund to Rainwater. It is to some degree different.

We in the new fund have committed to only investing in recurring revenue businesses. In the old fund, I operated with a somewhat wider mandate, but with the new fund and having six months to reflect

what I think would be best for investors, the world in which we're operating, which is an expensive US stock market, a less expensive outside the US market. The new fund is more exposed to outside the United States businesses because the multiples are more attractive there.

And the new fund will also focus exclusively on recurring revenue businesses and not other types of businesses that we had invested in in the past that we think are less durable by their very nature. Aside from that, it's somewhat similar levels of concentration, kind of moderate levels of concentration in the new fund. Maybe a couple more names to provide a little bit more diversification to the portfolio.

But aside from that, there's a lot of consistency with the old fund. And just like the old fund where I had the vast majority of my money invested in it, the new fund, same thing, will be very, very heavily invested personally in the new fund. And unlike the prior world where I ran three or four different funds, global, space tech, and the domestic fund, our ambition is to run one fund and do that really, really well.

We're not trying to launch an investment company to launch three or four or seven different funds and raise as much assets as we can and build this far-flung diversified investment firm. That's not what we're trying to do. We just want to focus on generating great returns in one fund, which we think will be a great compounding vehicle for advisors, individual investors, and everybody in between.

Excellent. I think we hit on everything here, Joseph. So thanks a lot for joining me here. Congratulations on the launch of the Rainwater Equity ETF. Before I let you go, please let our listeners know what else they need to know or anything we missed and what they need to know about the launch of the ETF here.

So we will be launching the ETF on June 18th. For those that would like to find more information about it, they can go to rainwateretf.com. The ticker is RW. And if they want to get in touch with me, obviously they can find me on LinkedIn, Twitter, and most of all the other social platforms. We're thrilled about it. And as always, thrilled to be on the show with you, Clay Fink, in the Investors Podcast.

Wonderful, Joseph. And I'll be sure to get all those links in the show notes. And I'll also quickly mention here that Joseph is going to be joining us at our summit event in Montana. So we're going to have 25 to 30 listeners of the show up in the mountains, enjoying great company alongside other like-minded value investors. So I'll get that linked in the show notes as well. With that, I think we'll close it out there. So thanks a lot, Joseph. Really enjoyed the opportunity yet again, and excited to chat again in the future. Great to see you. Thank you.

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