VALUE: After Hours (S08 E18): Value Investing with Options: Selling Puts to Buy Wonderful Businesses at Better Prices

Interested in Buffett-style options strategies alongside long-term value investing?

Value Options Letter focuses on conservative options strategies around undervalued businesses, including cash-secured puts, covered calls, and disciplined “getting paid to wait” opportunities inspired by Warren Buffett’s approach to risk and valuation.

Disclosure: This article contains an affiliate link. I may earn a commission if you subscribe through it.

Value Options Letter is a research publication and not personalized investment advice.

TRANSCRIPT

[Tobias] We’re live. This is Value After Hours. I’m Tobias Carlisle, joined as always by my co-host, Jake Taylor.

Special guest today, Tim Travis, CEO of Value Options Letter. How are you, Tim?

[Tim] I’m doing well. How are you guys doing?

[Tobias] Really well.

[Jake] Good to have you back, Tim.

[Tobias] Good to have you back.

[Tim] Thank you. Thank you.

How Value Investors Use Options To Generate Income And Buy Stocks At Lower Prices

[Tobias] We’re talking value options. Just in case folks don’t know, do you want to give us a little explanation?

[Tim] Yeah. Basically, we’re value investors, naturally. We’re looking to buy businesses that are trading at large discounts to intrinsic value based on extensive fundamental analysis.

Then, when we’re talking about value options, it’s using simple strategies such as covered calls or cash-secured puts to generate income and reduce risk. We’re limiting ourselves to stocks that are already undervalued. That’s the critical element of this.

It’s value investing. That’s the strategy. The way that we utilise options are just tactics.

For instance, if you like a stock and you would be willing to buy it here, but maybe you’re concerned about the overall market or you just like to make it a little safer even, you might sell a put, a cash-secured put on that stock. That creates a situation where there’s two outcomes, heads or tails. Heads, if the stock’s above that strike price where you sold the put at expiration, you make your return.

We target over 10% annualised almost always. Tails, you end up buying the stock. If the stock’s below your strike price where you sold the put at, you end up owning it.

Now, you have all the upside, the dividends. You could sell covered calls on it, however you want to deal with it from there. That’s the basis of value options.

Cash-Secured Puts Explained: How Buffett Used Options To Lower His Entry Price

[Tobias] There are two things that I like about it. One is that you can choose your entry and exit price for stocks. You’re not necessarily guaranteed to get that entry or exit price, but that’s the other side of the equation that you can make sure you’re getting a sufficient return on.

When they’re cash-secured, if you want to go long a stock, you sell a put, which I know is a little bit inside out the way that people think about it. You buy a put for protection, for downside protection. You sell a put, so you’re underwriting the stock if it falls below that particular strike.

The nice thing is, and there’s an example of Buffett doing it with Coca-Cola in the early 1990s after it established its position. It’s trading at $39. He buys a at $35 and he gets $1.50 per contract. If he gets the stock put to him, it’s $33.50 against the $39 stock price. In that instance, I guess he thought that $33.50 was a good price to take the stock because the premium that he got was only enough to give him about a 6% annualised return, which is pretty thin for the cash that he had to put up. You may not have done it cash-secured, but you would recommend doing it cash-secured.

You got to put the money into your account and the premium gives you a little discount. Basically, that’s your return for the period of time you have it there.

[Tim] Correct. Correct. Exactly.

It’s an attractive way to layer into a stock. Everyone wants to buy stocks at cheaper prices. It’s hard to do that mechanically.

Sometimes people will dollar-cost average. They’ll have certain limit prices that they’re willing to buy the stock at. But when you’re selling puts, you’re manufacturing that in a way where if that stock doesn’t drop to your level, you’re still able to profit.

Because sometimes you’ll be buying, let’s say, Google or Meta or something like that, and the stock runs away from you where you can’t buy that full position that maybe you wanted. Maybe it had already run up. You get in, you establish a foothold in the stock, but you haven’t built the full one.

You’re just a little cautious on it. You’re expecting it to drop at some point, but you might not get that chance. When you sell puts, you’re able to create a heads-you-win, tails-you-win situation as long as you’re willing to own the stock.

That’s the key difference.

[Tobias] It’s not necessarily heads-you-win, tails-you-win. You’ve got to make sure that you win on both sides before you put the trade on.

[Tim] You win in the sense that you want to buy the stock cheaper. It’s a stock you want to own, so you’re able to manufacture that cheaper entry price into it, but 100%. It ultimately comes down to, is the stock that you’re buying good?

You still have similar loss dynamics if a stock goes to zero on you, of course.

[Tobias] It’s true on the other side, too. If you own the stock and you want to sell, it’s just the reverse process. You sell the call.

You’re not necessarily getting hit, but you generate income in the event that you don’t trade all the way up.

[Jake] Why do you think that these securities get mispriced in the option market? Is it more likely to be mispriced than the underlying?

Why Option Volatility Can Create Mispriced Opportunities For Value Investors

[Tim] I think that at times that is the case. I think it’s because, just like there’s the efficient market theory where volatility is equated to risk in some academic circles, and I know that someone like Buffett or Charlie Munger would disagree with that, and so would I personally. Same thing with options.

Options are priced off a bunch of mathematical algorithms, including volatility as being a big component of that. If a stock drops a lot, the price of that option might be very, very high, but that doesn’t necessarily mean that the underlying stock is extremely risky or that the option position that you’re building is risky. We see things where you might have a real estate investment trust that’s trading at 50% of its net asset value, and it’s got a good balance sheet.

Obviously, there’s headwinds, right? Because why is it trading so cheaply? But even now, I mean, even high quality ones are trading at 15%, 20%, 25% discounts to NAV just because real estate is so out of favour with rates going up.

Using Options To Build Margin Of Safety Into Investments

[Tim] Then they’ve taken a big hit, so volatility is pretty high. You’re able to sell puts way, way out of the money, so creating a much, much, much larger margin of safety to what you already see is a pretty big margin of safety. So you’re kind of benefiting two ways.

You have the mispriced stock, and then you have the option that’s just really based on the mathematical principles of how far the stock’s dropped and what amount of time and the perceptions of short-term movements with options. And I think it gives the advantage to someone that’s patient, that’s willing to own the underlying. And that’s one of the things that we do at Value Options Letter is that we break down the mathematics for subscribers so that they can see, okay, we’re targeting 13% on this trade.

Worst case, you’re going to manufacture an entry price 25% below the current price. This is why this stock looks attractive. These are the fundamentals behind it.

And then those subscribers also get input on when good exiting opportunities would be, so it’s easier to track the options.

[Jake] Summarising what you’re saying there, then basically if people are using math to value something and they’re using the inputs of volatility as one of the primary drivers, that can become disconnected from the fundamentals of the business, which allows you to take a different view on the security then.

[Tim] Precisely. I would agree. I think you summarised it much more eloquently than I did.

[Jake] Well, I had time to think while you were talking.

[Tobias] Can you give us a worked example? I know you’ve done that previously, but we can work through. You gave us Blue Hour last time.

I think Blue Hour’s kind of interesting because it’s in the news, lots of headline risk, lots of people feel strongly about it one way or another.

[Jake] People selling their sports franchises.

[Tim] It is a good example because when you’re talking about OWL, the asset management company that has the vast majority of their assets under management are permanent capital. And so there’s a certain stability to the fees that they’re bringing in. And they have a variety of different verticals where they’re raising assets, whether it’s real estate, whether they’re in the data centre type stuff that’s being built.

They also have the private capital. They have the publicly traded private capital, which is different. So they’re in the headlines for all the wrong reasons.

But the reality is the business isn’t that risky at all. It’s an asset management business. So I don’t think that, I mean, it’s an investment grade credit for a reason.

They generate a tonne of free cash flow. They’re paying a really big dividend. But that’s one of those where because the stocks dropped a lot, the options are really volatile on the put side and the call side.

So you could sell puts at really high returns, way out of the money. You could sell calls, really high returns, way out of the money while also collecting the dividend, which is like nine and a half percent or something like that. It’s very high.

ServiceNow, Amazon, And AI: Using Options To Find Value In High-Quality Growth Stocks

[Tim] But we did that last time. But where we found some opportunities lately are on some of these software as a service stocks. So it’s interesting.

I mean, that’s not the normal purview of some value investors, but we look at growth and value as being intertwined. And so stocks that have just gotten demolished, but their underlying fundamentals are pretty strong, like ServiceNow, for instance, was one that has done pretty well lately, but it got absolutely demolished from its 52-week highs. But we actually look at them as being a beneficiary of AI because of where they sit in the IT infrastructure and helping companies kind of bridge that gap and navigate things and get the appropriate permissions and all of that stuff.

And they’re still growing their revenues. They’ve got a really good balance sheet. Management seems to finally want to start taking some medicine on the stock-based compensation, which is a big problem for them.

But you’re buying it at multiples that it’s never been available for. And the options are priced very attractively as well. But of course, we’re willing to own the underlying stock.

So some of those are really good. I mean, even Amazon, when Amazon dipped to 200, that was a great opportunity. We look at Amazon as good of a business as there is in terms of the future and the assets that they have.

If you think about it, you have obviously the retail operations, but AWS is the crown jewel. You have the advertising business, which is bigger than YouTube and growing rapidly and is perfectly situated with where it is. You have them now entering logistics, third-party logistics, competing with UPS and FedEx.

And there’s so many different ways for them to win. And you look at the valuation, yes, free cash flow is getting crushed. So on a price to free cash flow, it’s going to look horrendous.

But this is money that they’re going to earn a fantastic return on in our estimation. I mean, if I was CEO of Amazon, I’d want to be throwing a lot into this because the reality is the AI is that good. It is that powerful.

And I was sceptical, but the more you engage with it and the more you see what you can do with it, it really is. I mean, there’s very, very high limits to how much computing power and stuff like that that they’re going to be able to sell. So I thought that was attractive.

So you’re able to sell puts on really high quality companies like that and manufacture attractive entry prices into the stock. Or if it runs away, then you made a really nice profit too.

[Tobias] Tim, a couple of good questions from the crowd. What’s the expected return on this approach? That’s difficult to quantify, but how do you measure the risk in this method?

Is Selling Options Safer Than Buying Stocks Outright?

[Tim] Well, I mean, how do you measure the risk when you buy a stock, right? So I mean, the number one risk we’re concerned with is mitigating permanent losses of capital. So that’s the big difference in how we use options versus many people is that a lot of people use options where either they’re buying options and they have unlimited potential, but limited risk, but the odds are stacked against them.

Or they’ll do things like technical trading and they’re doing spreads where if it goes against you, yes, once again, your risk is limited, but you’re locking in permanent losses of capital. And you might’ve been just been wrong on the timing. You might’ve just gotten the timing wrong, but ultimately that’s the issue.

With this, we’re targeting double digit returns on the option trades that are put out and published on the site. And then if you end up owning the stocks, it also lists the target price. So a lot of these are 40, 50% below the target prices for the stock.

So I would say this, I think it’s a safer strategy than owning stocks outright. It’s a risk reduction strategy. There’s different types of risks.

So like, as you mentioned earlier, Toby, if you own a stock and you sell a call 25% above where the price is at, current price is at, and let’s say that option’s a year out, which sometimes we’ll do. If that stock doubles, well, you still made a great profit, but you didn’t double your money. So that’s another risk where you’re capping the upside on some of these.

So you want to sell calls, covered calls at prices that you’d be willing to sell the stock at. And conversely, you want to sell puts on prices that you’re willing to acquire the stock at. But I would say this is a risk reduction, income enhancement strategy.

I think it, once you understand how to do it, and that’s really the genesis of the value options letter. This was a concept I’ve wanted to build for 20 years. And obviously, I have other businesses that I’m involved in that I’m not really talking about that are related to investing, of course, but trying to keep those separate.

But the idea is options are such a valuable tool when you know how to use them in an intelligent business-like manner. And so I want to democratise that and make that easy for people to understand and incorporate it into what they’re with their investments, because you can have a lot more wins when you’re doing something like this. But you’re going to have losers too.

I mean, of course, there’s pros and cons to any strategy, but I think there’s huge value the more educated people become on this subject.

[Tobias] So I have a couple, two questions, I guess.

How Covered Calls And Cash-Secured Puts Generate Income In Choppy Markets

[Jake] One, are you then in this strategy rooting for choppy markets? Is that good for this?

[Tim] It’s definitely not bad. If you were to do a relative performance type thing versus the S&P, that’s a very good scenario. Really, any scenario, I think it all depends on the stock selection and whatnot.

But even if you’re doing this on an S&P index, which we don’t do, but if you were doing it then, the markets that run away to the upside where it’s up 25%, 30%, those are the ones where you’re going to underperform the most. If the market’s down a lot, you’ll still lose money, but you should lose less, right? Because we’re building that bigger margin of safety with the options and yeah, choppy.

So yeah, I mean, so there was periods like after the tech crash and then going into the financial crisis where there was a lot of stability, a lot of range bound trading. And a lot of these types of strategies did quite well, but they weren’t, honestly, other than Buffett, there’s not a lot of people that you see talking about, and he doesn’t talk about it a lot either, and it’s not in the news that much, but talking about using the options as a tool to manufacture a cheaper entry price into the stock. It’s not just an option, it’s a value option where the key part is the value investing principles, the research behind it, and then just using the tools like a hammer and wrench.

You’re just using, I wanna create a situation, let’s say you own a thousand shares of a stock, maybe you wanna layer out of that at different prices so you could sell calls 20% above, 10% above, that sort of thing. And if some of it gets exercised, great, you’re reducing your position like you wanted to. If none of it gets exercised, well, you just made a lot of money that you wouldn’t have made anyways.

A lot of people that work at companies that have a tonne of one stock, I see that all the time, what a great tool to reduce that risk without just blowing it all out at once. There might be tax consequences if you just blow it all out at once, so a lot of value there.

[Jake] I guess the other thing too- Sorry, Jason. Sorry, sorry, Teeming. If you are trafficking in names that are very power law driven, it seems like that this would not be good for that because the big winners are carrying most of the weight in that type of portfolio.

But if you’re looking more to do singles and doubles and not trying to hit home runs, so you’re focused more on batting average than slugging percentage, let’s say, then this would be a good way of focussing on that.

[Tim] Yeah, I would agree. I would agree with that. I mean, there’s definitely stocks that will run away from you.

But I think that, yeah, it’s a lot easier to find opportunities to get those targeting double-digit annualised returns. And if you’re in a market, and we’ve talked about this before, but I remember in 2010, 2011, after we had had two major bear markets in 10 years, buy and hold was considered debt, right? Like annuity sales were up, gold coins were up.

I bet people wish they would have held onto those nowadays. And it was buy and hold was debt. And now we were talking about it before the show.

In my career, I’ve never seen more optimism on buy and hold, where it’s just like, set it and forget it, very little risk, valuations, who cares? You know, NVIDIA at five and a half trillion, like it doesn’t matter. And so, you know, the pendulum swing both ways.

And so as you get more range bound markets or more negative markets or just not as robust markets, adding some of these additional tools to generate income and reduce risk in your portfolio can make a lot of sense. And most of the people that gravitate it from my experience, and I’ve been doing this a very long time, are like engineers, business owners, lawyers, doctors, educated people that are like, well, that makes a lot of sense. Like, why wouldn’t I do that?

You know, and it’s the reason why people don’t is their advisors might not know how to do it. You have to keep track of a lot of stuff. You still have to, you or someone else has to understand the businesses that you’re investing in.

But those are kind of the solutions that we tried to solve with the valueoptionsletter.com.

[Tobias] If you’re short a put, if you sell a put, it’s sometimes called a bull put. The way to think about that is it’s your downside is like being long the equity because you’ve underwritten it, but you’ve got a little bit of a discount already with the strike and you get a little bit of additional padding with the premium that you take on. So that’s your downside risk for a sold put.

But there’s also this sort of other risk on the other side where you sell the put and you get the premium. And then it’s on a stock that goes on this incredible run. So you miss out on the upside of that stock.

So how do you quantify the benefit of a cash secured put versus buying more stock?

[Tim] I think position sizing has a lot to do with it. So if you think that a stock is going to double, I would suggest owning the stock. Zero day expiration.

That’s what I would say. Yeah, right. But I would suggest owning the stock.

I mean, so that’s why that’s why it’s important to have things like target prices and that stuff that we provide. So if we think a stock’s going to double, you definitely want to own some some shares in it. But maybe you’re also saying, well, if it drops 10 percent, I want to buy more.

And so that’s where you could sell puts or you say, all right, if it rallies 25 percent, I want to lighten 25 percent of my stock up. So so the idea is, you know, if a stock doubles, there’s going to be so many different times when as an investor, we’ve all been through this, where, OK, should I hold or should I sell? Should I sell some?

The exact same principles apply. Right. Because, I mean, I mean, we’ve all had stocks that that met as a great buy at 100, 100, and then it gets to 200.

And it’s like, oh, I mean, we just doubled our money. Let’s take profits. And now it’s at 600.

Right. So so it happens if you own the stock, it can happen with options. It’s just being disciplined and understanding that that you’re taking you’re making business like decisions with your investment portfolios.

That’s something that I’m a firm believer in, knowing that not every business decision is the correct one, but there’s the strong rationale and logic behind it will lead to good outcomes. It’s a sound process that that can lead to good outcomes. And I think less risk overall, if you’re implementing it in the way that that’s kind of suggested by the by just like operationally, because I’ve never really tried this before, but like how much of your bankroll do you keep available versus written?

[Jake] You know, let’s say especially like on the put side.

[Tim] So the benefit with the cash secured puts is that is that you have to allocate the capital for the full amount. So if you’re selling a fifty dollar put, that’s one hundred shares. You’re going to collect a five hundred dollar premium.

The capital required be about forty five hundred dollars. So you’re not going to get a margin call if you’re doing cash secured puts. You’re going to do it like you’re doing it stock.

So that means that you should expect stock like returns. And that’s why at the value options letter, we just sell puts that generally target that double digit threshold. So so it can be it also kind of depends on just the outlook.

I mean, if you have a lot of if it’s 2009 and you’ve got just really fertile grounds for investment, buying stock is is fantastic. And the website does make recommendations of just buying stock when it makes sense to do so. But maybe maybe you’re looking at the current investment climate and it’s not that attractive to you.

Maybe you want to overweight towards some of these more conservative strategies where you’re still targeting double digit returns. And what’s nice is even if the market’s kind of flat, you can you can still potentially generate returns with that.

[Tobias] When you say you’re targeting double digit returns, what you mean is that the premium that you’re getting relative to the cash that you put up that is secured on an annualised basis works out to a double digit IRR.

[Tim] Correct, exactly. So so the target profit. So if you sell a put, you’re going to collect a premium up front.

And let’s just say in that example, five hundred and on a fifty dollar stock, your maximum risk is five thousand minus the five hundred you collected. So it’s forty five hundred. So that’s your return.

Low, low double digits. And it just depends on the time frame. You know, I mean, the website has stock or option trades that are targeting 40 percent annualised returns and it has some that are targeting 10.

And even on some, if it’s like a super safe stock, the hurdle gets lowered a little bit to like nine. But, you know, I’ll I’ll pose this question. Like, I think it’s interesting if you look at like Berkshire Hathaway, because it’s it’s oh, well, we’re not buying back stock at, like, let’s say one point six times book value, but at one point four times book value, we’re buying stock.

And at one point three, we’re really backing up the truck or one point two, whatever. But what I like about using these types of strategies is that you can create that where, look, you’re backing up the truck at one point two times book value. It’s not hard to figure out what price that would be at.

You set the strike to that level. And then over time, if you’re investing in good companies, it’s going to be worth more over time. The Amazons, the Google, the Metas, the Microsoft’s, you know, so we want to focus.

We’re focussing on on on high quality balance sheets, undervalued stocks. This is not like a get rich quick method. It’s it’s a tactical business like approach and very educational approach to help people navigate the options market.

The Wheel Strategy Explained: Selling Puts And Covered Calls For Long-Term Investors

[Tobias] Tim, do you want to just discuss a wheel? Give folks an idea.

[Tim] Yes. Yeah. Yeah.

So a wheel is a really cool strategy and it’s great way to kind of articulate the value of the site. So let’s say that you want to acquire, let’s just say Amazon stock. Let’s use that.

We’ve talked about it a few times. And and so Amazon right now is trading around 260 as we record this. Let’s say that that you want to buy it at 200.

OK, and so you’re going to sell a put at 200 and you’re going to you’re going to target a a double digit return. Now. Now, this is just totally hypothetical.

Realistically, Amazon is so high quality. There’s I’m sure that there’s not a 200 dollar put that’s that’s targeting 10 percent. But I just want to use as an example stock that everyone knows.

So basically, you’re in a situation where if the stock’s above 200, you’re making 10 percent. If the stock’s below 200, you’re buying it at a discount, a sizable discount to the current price and a discount to your strike price because you’ve collected the premium. Now, let’s assume that Amazon just tanks and now you own the stock.

Well, your options probably underwater a little bit, just depending on how far the stock dropped. But now you own the stock at at whatever the break even is. Maybe it’s it’s 180 or whatever, whatever it is.

And now you have all the upside or downside with the stock. What you can do with this strategy is then you can start selling calls. So maybe you sell a call at 240 and and it expires.

Then you sell another call. Or if you want to if you’re like, I kind of don’t really want to own Amazon as much as I thought I did, maybe something changed fundamentally. Maybe you just want to sell that call kind of at at the strike.

You sold the put at 200. You can do that. And you’re making money on both sides.

You’re making money from you’re you’re you’re reducing your cost basis by selling the put. And then you’re making money on the calls that you sell. So once you get exercise, as long as it’s a stock you want to own, it’s really the beginning of the game.

And so that’s what the wheel is. It’s continued covered calls on existing positions. And that’s the value.

So if you’re trying to do this on your own, it’s hard. There’s a lot of layers to it. You’ve got to analyse companies.

You’ve got to analyse option chains. And then you’ve got to track all these things. So it’s very, very, very hard.

And that’s why I’ve tried building this website for 20 years. I’ve hired two developers. I’ve paid over $60,000.

And none of it just came out clunky. It wasn’t the right user experience, but we finally got it right. And and so that’s the beautiful thing of it is it attracts the trades.

Users place the trades with their own brokerage. It’s not an advisory. It’s a publication, a research publication.

But but it it issues, it publishes suggestions on on when to exit and stuff like that and when to sell additional calls on the wheel strategy and things like that.

[Tobias] So what’s the what’s the website, Tim?

[Tim] Yeah, it’s www.valueoptionsletter.com. And there’s right now it’s priced 50% off. So it’s just $100 a month, $99 a month.

And there’s a sale where it’s $999 for the full year. So very cheap. That price will double soon because it’s new.

We really look at kind of founding subscribers as partners in this because they’re they’re putting trust in us and and in the method and in the process. But I think it’s I think it’s a great value and we’re excited about. And there’s also a free seven day trial.

So if you’re interested, try the free seven day trial and see if you like it. And I think you will. But three to five trades come out every week on average.

Lately, there’s actually been more than that. And especially because we have new subscribers and we really want them to get the full multitude of what the site does.

[Tobias] So Tim and I have partnered together on this. We’ve also written a book together called Value Options. It’s really short, easy to read, just discusses everything that we’ve said here.

All of the stuff that is in the book is free on the site, too. So you don’t need to buy the book. You can just go and read the stuff that’s on the site or buy the book if you prefer to do it that way through Amazon.

JT, let me do some. Do you have some veggies? Let me let me do a quick shout out around the horn and then we’ll do some veggies.

Gothenburg, Sweden, first in the house. What’s up? Valparaiso, Indiana.

Lausanne, Switzerland, Philly, Boulogne, France. Welcome. Petit Ticva, Israel, Tallahassee.

The market rates woodshed. I hope you’re OK. Boise, Toronto, Snohomish, Helsinki, Finland, Limerick City.

His favourite, St. St. Patrick. His favourite poems are Limerick. Oregon City, Oregon, Bethesda, London, Chicago, Cincinnati, Havertown.

Thanks for joining us, folks. We appreciate it. JT with some veggies.

[Jake] All right. So we are going to attempt something never before tried, which is connecting railroads and everyone’s favourite, the octopus. So stay with me on this.

[Tobias] Yeah.

[Jake] So one of one of them is thought commonly as a repulsive, conniving creature with no soul, slippery, hard to pin down, will strangle you if it gets a chance. And the other one is an octopus. All right.

But underneath the jokes, they’re solving the same problem often, which is how do you keep flow moving through a complex system without the whole thing falling apart? So let’s start a little bit with what railroads used to look like. And for most of their history, North American railroads were less like factories and more like a jazz band.

Local managers would make these judgement calls. Trains would leave when they were just full enough, basically, in the opinion of that person. Rail yards acted like these giant buffers where they would soak up a lot of uncertainty and delay.

And it was organised in a very improvisational way. And for a long time, that worked because competitive pressures just weren’t really that intense. But then trucking got better.

Deregulation finally arrived. And investors started demanding higher returns. And then we come to this guy, Hunter Harrison.

And he’s one of the most divisive operators in transportation history. He ran four class one railroads in his career. And unfortunately, he died three weeks after taking over CSX in 2017.

But the basic story with him was he would come in and take over. And all of a sudden, the operating ratios, which is basically just like profit margin, the term that they use in railroads, would just continue to keep improving. And he would take a company or a railroad that was earning two pennies on every dollar of revenue and bring it down to 40 cents of profit margin.

Just absolutely huge. And he did it four different times in different locations. And this philosophy that he implemented was called precision scheduled railroading, PSR. And you might have heard Buffett talk about this at different points. And there’s a common argument about this. So what PSR actually does is it takes what the traditional railroads used to do was wait for the demand to show up and then ship something. PSR forces the customer to adopt to the schedule of the train is leaving, get your stuff on there.

Otherwise, sorry. The train leaves on a clock, whether it’s full or not. And they try to run fewer trains.

They run longer trains. And the whole point is that less idle equipment, less dwell time is what it’s called, where a railcar is just sitting motionless in the yard. And this whole network is then tuned for one continuous thing, which is just flow.

And the railroad stops behaving like a freight company. It really starts looking like a circulatory system, which is where we’re going to go back to the octopus. And believe it or not, an octopus has three hearts, two pump blood to the gills, one pumps oxygenated blood throughout the body.

And more importantly, an octopus is this profoundly decentralised organism. No rigid skeleton, eight arms that are operating semi-independently. A huge percentage of the neurones live in the arms themselves, not in some central brain.

And each arm can then solve problems and react locally on its own. But there’s this famous problem in anything decentralised, which is how do you coordinate? And the octopus solved this by building a circulatory architecture that keeps this flow synchronised across the whole organism.

Multiple hearts are managing pressure. And the body functions then as one system, even though the intelligence is spread out. So this is what PSR is trying to do for a railroad.

Decentralised assets, but centralised circulation. And the network is this organism. The flow is the point.

But there’s a trade-off here. And the octopus, when it swims really hard, its main systemic heart actually struggles under that load, which is why octopuses prefer to crawl, typically, rather than swim. It’s very expensive, metabolically, to swim.

And they weren’t really built for it. So that same trade-off sits inside of PSR. Traditional railroads actually carried a lot of slack. They had extra crews, extra locomotives, extra yard capacity.

And on paper, that slack looks like waste, of course. But in practise, it’s a bit like biological fat reserves. It absorbs shocks.

And PSR strips most of that out. The financial results are amazing. And the operating ratios drop to be attractive.

Assets get more productive. Free cash flow gushes. But you also have removed this buffer.

And one delayed train then can pressure into the next. One congested yard creates downstream choke points. And the same synchronisation that produces efficiency can also then amplify fragility.

So the investing version of this that we’ve seen relatively recently was in Japanese auto parts in 2011 with a 9.0 magnitude earthquake hitting Japan. It was a triple disaster because you had the quake, the tsunami, and Fukushima meltdown. And these manufacturing companies in Japan were really like the gold standard of just-in-time delivery.

Toyota basically invented this. And the average Japanese manufacturer at the time held only three weeks of material inventory. So really lean balance sheets, lean warehouses, single-source suppliers look like this super-efficient industrial system.

And of course, MBAs rejoiced at how well they were taking working capital out of it. But then it stopped. And production fell 78% year-over-year in April of 2011 because of this earthquake.

And it wasn’t that Toyota’s own plants were even destroyed. It was actually their suppliers’ suppliers’ suppliers were destroyed. And that then chokes the whole system.

So manufacturing actually dropped across Japan completely 15% of March. It didn’t recover for like six months. So after that, Toyota rewrote their business continuity plans.

And they now require key suppliers to hold anywhere from two to six months of inventory minimum. And they moved away from single-sourcing many of their things. And there’s some irony in the fact that the firm that invented just-in-time voluntarily put slack back into the system.

And they sacrificed efficiency on purpose. So I’ll try to wrap this up here. There’s this kind of uncomfortable point, which is that all this efficiency in PSR is visible, but that the resilience is often invisible.

And you see these lower operating margins or better operating margins, I should say, in PSR. And you get all this working capital that’s released. And you can count fewer locomotives being used, fewer crews. But what you can’t see is the train that doesn’t get delayed because the crew was available, the factory that doesn’t shut down because inventory was available, the portfolio that doesn’t have to sell at the bottom because cash that looked lazy for five years is available to do the things that you want to do.

And so Mother Nature’s octopus understood all these trade-offs long before we did. They have this distributed intelligence that’s useful, and then this centralised circulation system. But the organism survives because it has more than one way to keep the blood moving.

And the real underwriting question in any business or supply chain, railroad, whatever, is not how efficient is this under normal conditions, but what happens when one of the hearts stops?

[Tobias] Good one. Have you seen the conspiracy theory that octopuses are octopods, aliens, because they don’t fit into any of the other…

[Jake] Like normal schema.

[Tobias] Families, yeah. Yeah.

[Tim] Have you seen my teacher, the octopus?

[Tobias] I didn’t see that one, yeah. I purposely not watched it. I avoided it.

[Tim] Yeah. That’s a little uncomfortable.

[Tobias] I like the taste too much.

[Tim] I know. You fall in love with the octopus and the guy’s great too. And then he doesn’t defend the octopus while it’s getting eaten by sharks.

It’s hard to watch for sure. I think globalisation though, I think similar… I remember reading, and I remember it was actually Bill Gates of all people that recommended it, but it was like a book by Vaclav Smed or something.

[Jake] Smed, yeah.

[Tim] Yeah. And it talked about globalisation, but just how vulnerable we were because we had outsourced so much of our manufacturing. And so you get to war times or now you see it with rare earth minerals and things like that, where obviously when there’s peace, globalisation is very efficient.

But we’ve seen that collapse multiple times now. So it’s interesting. It works in smaller scale, like railroads are still big or even on the global economy.

[Jake] It is surprising that so many countries kind of willingly ceded their energy independence and military independence so easily.

[Tim] It’s crazy to think about. It really is.

[Tobias] Years of peace, years of no conflict, no huge global conflict. Two generations nobody remembers.

[Jake] Can’t happen here.

[Tobias] I saw a YouTube documentary on BYD and a level, clearly cleverly run. And the guy’s, Manga says he’s a visionary on the level of Benjamin Franklin, but they’ve also been enormously subsidised by China along the way. China subsidised a lot of those industries.

And so I just, because you and I visited China, we looked at those EVs, they’re beautiful EVs, they’re much cheaper than EVs in the States. And we were concerned that you unleash these on the US and then how does someone like Tesla compete with these guys? But it seems like they are pretty heavily subsidised, subsidising a lot of different industries.

So I think that probably tariffs are a reasonable response to that.

[Tim] Anybody want to jump on that grenade?

[Jake] Touch that third rail.

[Tim] I mean, very unpopular topic. World War II, what happened? We had to convert the auto manufacturing into war production and war equipment like tanks and stuff like that.

So there’s huge disadvantages from allowing all these countries to have all the manufacturing of key things. So I think that there is logic behind that, but it’s obviously super painful and not easy and communication and whatnot.

[Tobias] I mean, it goes to optimisation.

[Tim] It’s tough though, right?

[Jake] Because yeah, you get the consumer wins over most of that time period until they get enslaved by the other country. Is that bad? Is that, yeah, was that the right trade?

[Tobias] I for one welcome you, Ant Overlords.

[Jake] Yeah.

[Tobias] What do you guys make of this massive rally that we’ve seen since March 31?

[Tim] Well, it’s a barn burner. Yeah, it is. I mean, a lot of it seems like it’s Nvidia and some of those other Microns and the Sandisk of the world.

It doesn’t seem like it’s that broad of a rally overall. So it’s interesting. I just think that when I have a stock screener that I look at, a stock ticker thing with Schwab and it’s hundreds of names.

And I feel like through most of the rally, probably 65% have been red most of the time. Whereas, but then you have like Nvidia gapping up five bucks, which is a huge market cap number. I mean, last I looked, it was a five and a half trillion dollar market capitalisation.

So I think people are rightfully looking at AI and the more you engage with it on the more sophisticated things, it’s very clear that it’s going to dramatically transform a tonne of industries. It can be fantastic or devastating for small and big businesses both. But you could see why the demand for the chips is as high as it is.

But it’s interesting because I feel like there’s even more competition getting in now with Google’s chips and Amazon’s chips that might be a little more energy efficient than Nvidia’s chips. But right now it’s a tailwind for all of them, it seems.

[Tobias] Never been a better time to be a solo entrepreneur because the Claude or ChatGPT is just so powerful.

[Tim] Efficiency is insane. I mean, you can have it working overnight on a project and exactly. I mean, even things like accounting and you really can automate so much, but more and more you’re hearing kind of the horror stories where people that thought they had job stability are realising that they absolutely do not.

And I’m sure it’s going to create a tonne of new jobs, a tonne of new businesses. But it’s, I mean, right on par with the Internet, if not exceeding it as far as impact, in my opinion. I see it having used it a lot.

I see I see that, in my opinion.

[Jake] To what extent do you think that companies are going to, how much DIY vibe coding do you think is going to happen in most companies? I guess, do you think that that’s a real, you don’t think that’s a big threat for maybe, you know, VMS, mission critical?

[Tobias] I think it’ll be individual, I think it’ll be solo providers, solo guys, because there’s no incentive in a big company to go and build something.

[Tim] Yeah, I mean, yeah. And how expensive is it? You know, I mean, I was reading something where the Constellation Software guys were talking about when they lose clients, when they lose customers.

And it wasn’t cost that was the issue. It was the customers go out of business or they get bought by someone that’s not a customer of one of Constellation Software’s divisions. And so, you know, if you can create a cheaper CRM, for instance, or ERP, is that really going to drive you away from using Salesforce or Workday?

You know, maybe if you’re a small business, if you’re a big business, that’s a lot. You’ve already invested so much time training these people. You know, everyone’s familiar with the system.

So I do think that the fears are a little bit overblown on some of them. Clearly, you know, some smaller companies will be impacted and everyone’s going to be impacted in some way. But most of them are embracing AI, creating their own agents so that they can enhance their user experience.

Because I mean, I use HubSpot, for instance, as my CRM. And I’ve been tempted by other things. I don’t love all of it.

But it’s a big project, like to move that to something else. You have a lot of integrations built into it. Everyone’s comfortable with it.

It’s not like something that’s really a high priority for me.

[Jake] Do you think that puts pricing pressure, though, on like, knowing that you could do it yourself if you wanted means that they can kind of only charge you so much before you squeal and defect? Do you think that’s true in software in general? I don’t know.

[Tobias] There’s always been other competitors out there. There are other options. And the same problem has always existed that you have to switch from one to the other.

And it’s a massive time consuming project to get that done.

[Tim] I think they have to invest more into R&D. Because I mean, if you’re not, I’m sure that these big Salesforce software companies, their customers are asking, OK, like, how are you the best solution in this new age of AI? And so you need to have that AI formula.

Well, we’re using it in these ways to make your life easier. This is why you wouldn’t want to just try to create this on your own. And it’s not that easy.

I mean, you can you can create some pretty cool things. But I mean, these companies have phenomenal software developers and they know what their customers want. So I don’t know.

I just I think now some of them are attractively priced. I mean, even like you look at a stock like Adobe, I mean, it’s very, very cheap. You know, it’s a low, low, low double digit multiple when it used to trade at thirty five, forty.

And you could see why there’d be more competition and why. But but it’s not directly you’re not seeing that in the financial results yet. And there are a lot of reasons why it’s easier just to maintain them as part of the infrastructure for what they do.

So we’ll see.

[Tobias] We’re seeing increasing numbers of layoffs. I mean, I don’t know if we’re seeing increase. I just see that I see the headlines.

And so and they’re always big numbers like Meta comes out and says it’s eight thousand and then blocks out with like seven thousand, like big numbers whenever they come out. I wonder to what extent it is a I causing them or if that’s just a convenience scapegoat for what really happened was that they massively overhyed through twenty, twenty, twenty, twenty five. And there were lots of articles about, you know, they used to what happened to all those tick tock girls who do the day in the life where it was basically just them getting mash a green tea and a smooth like just showing up late and eating.

And like there was no sign of any work being done at any stage of the day, maybe like crack the laptop open and type an email or something and then close. And it looked like a great day, but hard to imagine that there was much value for money there is probably reducing those jobs.

[Tim] I think I think you have you have the big hyperscalers investing hundreds of billions of dollars of capex. Where’s that money going? Data centres.

Right. I mean, I mean, like I have friends and clients that are involved in that business. And and I mean, there’s so many different facets, so many different companies that that are benefiting it from.

So a lot of the job growth is is related to where all of that money is going to. But yeah, I mean, it’s a K-shaped or whatever you want to call it economy where there’s haves and have nots. And and especially with oil prices where they are, there’s there seems like there’s a lot more have nots.

[Tobias] It feels like the top end of that K has been white collar, though, and the bottom end has been blue collar. But it feels to me like that’s going to switch pretty hard here if AI comes in. Like, you know, in 2020, we said it’s a shame that it’s like all the all the blue collar guys got to go out and actually risk their lives.

All the white collar guys on their computers are home and fine. But the reverse is about to happen with AI. Like now AI maybe can do all those jobs.

But, you know, to wire a data centre, you actually got to go to data centre and wire it to grade the land, like to do all the work that requires to build a data centre. You need to be physically present to do it. Maybe it’s a blue collar on top of the K for a while.

[Tim] Well, and imagine if stocks drop, you know, for a prolonged period of time. That’s not going to happen, Tim. Yeah, yeah, you’re right.

[Tobias] That’s impossible. Can’t be done.

[Tim] We’re so reliant. I mean, remember the Buffett indicator?

[Tobias] Like, what is that at right now? I looked at that today. It’s actually, you know, 200 or something.

[Tim] Where are we at?

[Tobias] The numbers I looked at, I went to the D short because they have the value. They track all of them, like Cressmont. They track the indicator to its own number.

They track Schiller PE, Tobin’s Q. And then they lump them all together. And then they look at it on an arithmetic basis and a geometric basis.

[Jake] And basically, it’s just smoke coming out of your computer at that point. Or what was it?

[Tobias] It’s off the scale, like the chart caps off and you can’t see the top of it. They couldn’t imagine that it could get this high. But it definitely came off a little bit from Q4 last year.

But there’s been this violent rally. I think one of the things that’s really interesting, I tracked two series to get an idea of to what extent it is the top end of town that is driving all of this or if it’s more broad based. And one is just equal weight versus market capitalisation weight.

And that one in particular has gone to new all-time highs as of like last week. Maybe it’s come off a little bit over the last couple of days. But that one surprised me a little bit because the other one I look at is OEF, which is the S&P 100.

So that’s the biggest 100 versus the 500. So in that instance, if you think of RSP as being the more broadly based one and 500 as being the big end of town, in this one, it makes the 500 the more broadly based indicator and the 100 is the big end of town. And what’s interesting is that that 100 hasn’t bounced as hard relative to the 500 as the 500 did to the equal weight.

And I’ve noticed that for the last few weeks. I don’t really know what that means. But it doesn’t seem to me that it really is the very biggest of the big that’s driving it.

And it’s the average biggest stock. I don’t really know how to articulate it. And I don’t know the reason why, but I’ve just seen it.

I think it’s interesting little phenomenon. The 100 hasn’t bounced as much as the 500 relative to its more broadly based comparison.

[Tim] Other than NVIDIA, the other ones haven’t bounced as much. Amazon had a big rally a little bit earlier. But Meta and Microsoft, they bounced a little bit from their lows.

But it’s really like the last couple of weeks, it’s NVIDIA going from 195 to 225. I mean, that’s a $30 move on the largest company in the world. It’s probably pretty big.

And then you have the memory ones, like the Microns and the Sandisk and all that.

[Tobias] Those are value stocks every now and again. You wait long enough, the cycle turns. The multiples are low.

Value stocks couldn’t get a bid. Yeah.

[Tim] The multiples still aren’t high if earnings are stable. I think Microns sold out till like 2028 or something like that. I heard something like that, but don’t quote me on it.

[Tobias] I tracked Bagman, which is like Mag 7 plus a few others. I guess Broadcom’s the B. I was going to say, what’s the B?

Broadcom, AVGO, the ticker is. Yeah. Broadcom, Amazon, Google, Microsoft, Apple, NVIDIA, maybe Netflix as well in there.

And that rally since the start of the year is in the order of like 22% last time I looked anyway. So it’s definitely run up more than the rest of the index. It’s just been a violent every day.

It’s up a few percent. Until the last couple of days.

[Jake] Good to see those guys finally winning a little bit. Yeah, it is. It’s nice.

[Tobias] It’s like George Clooney selling Casamigos for a billion. Good to see that bloke have a win.

[Jake] Finally catch a break.

[Tim] Yeah. Apple’s had a big move too actually. Apple’s gone up to like near 300 and now is at 260 not long ago.

So I mean, that’s another, just some of the biggest are huge. The big end of town is running.

[Tobias] I think the funniest thing is…

[Jake] Running to where?

[Tobias] To the moon.

[Jake] Okay.

[Tobias] Make it to the moon if you have to crawl. I think the funniest thing is energy stocks have come in since the war.

[Tim] Yeah, multiples. Oh, and the multiples you’re saying.

[Tobias] Yeah, the multiples. Well, they haven’t reported yet. So I mean, there hasn’t been much report.

They haven’t all reported yet. Right. Yeah.

[Tim] I mean, I know the pipelines have had a big run. It just seems like this war is dragging on a lot longer. So it’s a pretty good environment for energy generally, of course.

[Jake] But two more weeks to get to the next two weeks.

[Tobias] I thought that was supposed to hit long duration. I thought higher rates hit long duration. Actually, that’s one interesting thing that I’ve been tracking.

You know, I track the 10-year and the three-month. That spreads at an all-time, sorry, not an all-time high, a high for this cycle. It’s like 93 at the moment.

Having been negative, like not that long ago.

[Jake] We’re not inverted. We’re back to normal.

[Tobias] We’ve been un-inverted for about six, like if there was anything going to happen.

[Jake] Where’s the recession?

[Tobias] It’s not here. It’s probably going to fade that little metric in the future. But the 10-year has been running up a lot.

I think the 10-year is as high as it’s been since 2007. The front-munch, which the Fed, the three-month, which the Fed controls has been falling down. You know, they pinned it, ran it all the way up.

They’ve dropped it back down. 10-year is now high since 2007. And that’s not unusual around all of the developed countries in the world.

All of those rates have run up to as high as they’ve been since the mid-2000s, as high as they’ve been in 20 years. That might be more impactful than anything else, although nothing stops the Mag-7 train.

[Tim] I mean, think about it for housing. It’s huge. Mortgages are priced off that.

So you have a tonne of people that were waiting out the market trying to get lower rates to be able to buy or sell their homes. And a lot of homes are just sitting on the market for a very long time. And so that’s definitely going to exasperate the situation there.

But yeah, it’s a big deal. It’s a big deal.

[Jake] If things are so rosy, though, let me ask you this. Why are we still running trillion-dollar-plus deficits then?

[Tobias] Where’s it going? Well, that’s assuming that you’re doing that Keynesian priming the pump when… I don’t think it’s as thoughtful as that.

Is it like that was the… You run… No.

[Jake] We just gave them a licence to spend on whatever they want, basically. And gave them economic intellectual cover to spend as much as they want.

[Tobias] And then when it didn’t help anymore, they just dropped that quietly, dropped that policy. Doesn’t matter anymore. I don’t know.

We’re like grumpy old men at this point.

[Jake] People are tired of hearing it at this point from us, I think. We’re going to be proven one out of… We’ll have predicted nine of the last one hard patches.

[Tobias] I find the 10-3 one kind of interesting because it’s such a funny run. It’s probably… If something is to happen to validate that, it has to happen pretty soon, I would think.

But it doesn’t seem to me like there’s any… Unless rates are the thing that just strangle for whole.

[Jake] Eight out of nine is not bad, right? Isn’t that what it would be at?

[Tim] That’s true. It shows how dynamic our economy is, though. We’ve been through housing bubbles and busts, and we’ve been through oil booms, but then you have other areas picking up steam.

But this one’s so big. These tech companies are so big now that it has such a disproportionate impact.

[Tobias] Yeah, that’s a massive…

[Tim] I’d be curious to know where this ranks in terms of the concentration of the economic impact between other… You had railroads before. It’s probably similar as shocking as it feels.

[Tobias] Private stimulus. And this is probably the only other version. Maybe it was the fibre build-out in the early 2000s.

[Jake] As a percentage of GDP, we’re still pretty far south of railroads.

[Tobias] That’s good work, JT. That’s how we get you here. Fellas, we made it.

We hit the time. Tim, give us a where to folks find Value Options Letter.

[Tim] Yeah, www.valueoptionsletter.com and hit that trial. Give it a try, and I think you’ll like it.

[Tobias] JT?

[Jake] Be good to each other. That’s all I got.

[Tobias] Folks, we’re off next week. I’m in Australia for my 30-year high school reunion. It’s terrifying.

[Jake] Let’s go.

[Tobias] Yikes. And then I’ll be back the week after that. We appreciate you being here.

[Jake] Quick little value run heading into that just so you feel good when you show up.

[Tobias] I can separate my personal from my professional.

[Jake] Talking about the kids a lot.

[Tobias] Yeah. Thanks, guys. Enjoy.

[Tim] Safe travels. Thanks for having me.

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

VALUE: After Hours (S08 E18): Value Investing with Options: Selling Puts to Buy Wonderful Businesses at Better Prices

Read next