After some time on the sidelines, Co-Portfolio Manager Gareth Brown is back in the hot seat, joining CIO Steve Johnson for the latest episode of Stocks Neat as they delve into lessons from the recent Berkshire Hathaway meeting.
They reflect on the meeting’s evolution over decades, how size has impacted investment decisions and the increasing conservatism in Berkshire Hathaway’s investment strategy.
Additionally, Steve and Gareth revisit a topic previously explored at the beginning of the year – the underperformance of small-cap stocks. They examine the current valuation differential between small and large-cap stocks, with relative valuations for US small caps at their lowest levels on record. They shed light on what this means for investors and discuss the potential for a change in sentiment towards small-cap stocks as we enter, and ultimately emerge from, any recession.
According to recent research from Global Alpha Capital Management, small caps tend to underperform going into a recession. But that underperformance typically stops right around the onset of a recession. From that recessionary onset, small caps have outperformed large caps over the following 3-4 years in all 6 US recessions for which the company had data.
Pour yourself a glass of whisky and join Steve and Gareth as they explore these topics while sipping on a glass of Super Nikka Japanese Whisky.
Just a quick reminder, this podcast may contain general advice, but it doesn’t take into account your personal circumstances, needs, or objectives. The scenarios and stocks mentioned in this podcast are for illustrative purposes only, and do not constitute a recommendation to buy, hold, or sell any financial products. Read the relevant PDS, assess whether that information is appropriate for you, and consider speaking to a financial advisor before making investment decisions. Past performance is no indicator of future performance.
[00:00:39] SJ: Hello and welcome to episode 18 of Stocks Neat. This is take two. We’ve already poured ourselves a whiskey because we just recorded 15 minutes, where yours truly had not hit the record button. Anyway, I’m Steve Johnson, Chief Investment Officer here at Forager. I’m joined by my longtime podcast partner, Gareth Brown, who’s back in the hot seat after a bit of time on the sidelines.
[00:01:01] GB: Thanks for having me, finally.
[00:01:03] SJ: They’re trying to sideline you but they’ve been very popular some of the Harvey Migotti podcasts. So you better up your game a little bit here, Gareth.
[00:01:11] GB: Yes. We’ll see.
[00:01:12] SJ: This is Stocks Neat, a Forager Funds podcast, where we talk about the world of stock markets and try out some whiskeys. Today, we are doubling up on one that Harvey and I did back in January, which was a generous gift to us from our friend, Greg Hoffman. Gareth’s been desperate to try it, so we thought we’d bring it along today and save a little bit of money.
[00:01:32] GB: Thanks, Greg.
[00:01:32] SJ: Financial markets are tough out there, so we can’t be buying a new bottle of whiskey every month anymore. Today, we’re going to talk about the Berkshire Hathaway meeting which took place just a couple of weekends ago, lessons that can be learned from that or maybe not as the case may be. Then we’re going to come back to a topic that we touched on at the start of the year, and that is small cap under performance around the world, and today talk about what it might take for that underperformance to start correcting itself.
So it was the Berkshire Hathaway meeting a couple of weeks ago. Buffett and Munger holding court to thousands of Berkshire shareholders that go along to hear some wisdom. I have to say, both talking to friends reading the media, colleagues at work, there’s been less talk about the Berkshire meeting than I can ever remember. Maybe that’s just me. Or do you think that there’s something more at play here?
[00:02:27] GB: I think there is. I think both of those are true. I think that you’ve moved on and I’ve moved on. In a way, I will always look up and watch them. But I don’t feel I’m getting anything new or anything I can sink my teeth into, if that makes sense, that I don’t already know. But, yes, the portfolio has got more conservative. Yes, they have some big swings still. Apple was something that a CNBC kind of interviewer will be very interested in talking about, I’m sure. But I feel like that there’s not the real contrarian elements to discuss, and I think that’s – yes.
[00:02:59] SJ: Yes. It’s a bit more conservative maybe, just in terms of them I think not necessarily wanting to create headlines about topics. They’ve always been very, very free and open with their thoughts. Yes, there’s still some good comments about cryptocurrency. I thought there was a really good one-liner from Buffett. In the 58 years, he’d been running Berkshire. I’d say there’s been a great increase in the number of people doing dumb things, and they do big dumb things. Yes. He was arguing that there’s still plenty of opportunities out there for them to take advantage of people doing those dumb things and make lots of money.
But it doesn’t really gel with the past 20 years, right? Where the returns from Berkshire have been pretty close to what you would have got from investing in an index. You touched on Apple as a big new investment for them. But there hasn’t been a huge amount of change. Or there’s been some big acquisitions in dollar terms. But relative to the size of Berkshire, nothing that’s really changed the nature of the beast here in terms of what Berkshire is.
Yes, I feel like there’s a number of things that play there that are forcing them to be more conservative, and maybe that’s creating less interesting things to talk about as well.
[00:04:08] GB: Yes. He’s got the firepower. Is it partly the result of the fact that they’re too big, and there’s too few things that they can do? The other thing that I think is a factor here is the way that central banks and governments intervene in crisis now has taken away a lot of the purpose of carrying a big elephant gun, as Buffett used to call it. There are times in the GFC and when there’s COVID panic that maybe he could have put a lot of capital to work in really interesting ideas.
But whenever anything gets into trouble, along comes the government or the central bank to pump money into the system and try and resolve the problem, rather than those assets changing hands to the salvage buyer. I think that’s sort of – there’s been something working against Berkshire Hathaway. This could have been its moment in the sun with lots of cash, too big to fail. The opportunities haven’t been there, even though there’s a lot of dumb things being done around the world.
[00:04:59] SJ: One other thing that I’ve picked up on over the past few years, Berkshire owned a bunch of airline shares into COVID. I’ve got some appreciation for the general thesis there that there’s been a massive consolidation in the airline sector, and it’s not the cutthroat competitive industry that it used to be.
[00:05:16] GB: It’s a carbon copy of the railway argument from a decade earlier.
[00:05:20] SJ: Yes. Then COVID hit, and they sold all of their airline shares at what now looks like fairly depressed prices, given where things are at the moment. More recently, I noticed some headlines about them exiting banks as well in the middle of a banking crisis. They’re both sectors that we’ve had a pretty good look at, spend some time on because there’s so much distress about them. It feels to me a bit odd that –
[00:05:43] GB: It’s running from turmoil rather than to it. It’s sort of – yes. I don’t want to tell him he’s making a mistake.
[00:05:48] SJ: Oh, of course. Yes.
[00:05:51] GB: I don’t have that position. But it doesn’t feel like the Buffett of the past– does it?
[00:05:56] SJ: No, no. It is more conservative, and I think that’s pretty clear about everything that they do. It is a more conservative beast than it used to be many, many years ago. There’s very, very good reasons for that. They are older. They’ve got all of their wealth tied up in this. They’re thinking about multi-generational asset protection here rather than the 40-year-old Buffett of 50 years ago that was just trying to optimise returns and grow his wealth very, very rapidly. Everyone should go through that phase in their life, right? They should get more conservative as they’ve got less capacity to recover lost earnings over time.
[00:06:29] GB: Well, that’s – but Buffett would tell you rationally Berkshire shouldn’t go through that phase. That he maybe should go through that phase but that the entity itself should be managed with a really long-term view. There’s a couple of additional complexities there with Combs and – Combs? Combs.
[00:06:46] SJ: Combs and Weschler. Yes.
[00:06:47] GB: Combs and Weschler managing money that maybe some of these decisions are theirs to panic.
[00:06:51] SJ: So these are two people that Buffett employed maybe 10 years ago.
[00:06:54] GB: Yes. A bit more, I think.
[00:06:55] SJ: To run a portion of the listed equities portfolio on behalf of Berkshire.
[00:06:59] GB: Yes. So maybe it’s them panicking. We don’t know. The really big ones are Buffett’s. But we don’t know who’s panicking.
[00:07:06] SJ: Or potentially and I never would have bought this, right? It’s something I’ve really noticed as trying to build a funds management business, rather than just being an investor yourself. You need to try and build structures and philosophies, and try and employ people that are like-minded too. But when things go wrong in an area that you might not have done it yourself, it’s really hard and important, I think, not to feel that emotional angst about, “Oh, I wouldn’t have done this. Therefore, we shouldn’t have done it.” Who knows what that dynamic is like there?
[00:07:35] GB: Yes.
[00:07:35] SJ: They’ve brought them plenty of good ideas, right? I don’t know if they’d own Apple in the size that they do without those two guys.
[00:07:40] GB: Yes, unlikely. Then the other thing that – this is purely subjective on my part. But I just wonder if he’s trying to keep – He’s 93 years old. At some point, he’s not going to be able to run this. He’s passing the baton over to the new guys quite quickly, but there’s still a whole lot here that he’s responsible for. I’m wondering if duration is part of his thinking here.
Something like an airline, yes, the trends have been helpful the last decade or so. But basically, you have to nail the – you have to get out at the right time and get in at the right time. I’m just wondering if he’s looking for longer duration investments at the moment so that Berkshire is at least fine on that portion of the portfolio for the first decade after he is unable to run the portfolio. So that is just a guess.
[00:08:24] SJ: How many times have you been to Berkshire?
[00:08:26] GB: I’ve been four times.
[00:08:27] SJ: What would you say? Is there anything that’s come out of that that’s changed you as an investor or the biggest lessons that you’ve learned?
[00:08:33] GB: No. It’s the sort of you just need to go and visit the cult sometimes I think. The writings are there, and the understanding is there. Buffett was immensely helpful to me when I was forming an investment thesis, an investment framework really in the nineties. So I started buying shares, and then I read some books on Buffett maybe 12, 24 months after I started investing.
It helped me a lot like, “This is what I need to be doing.” I made some investments that I would not have made that worked out spectacularly well. But I also made some really stupid mistakes. I’ll go and buy an Australian reinsurance company, just because Buffett owns a reinsurance company. Only a 20-year-old could make such a silly mistake. But it was helpful to form that way of thinking about stocks.
Going in 2002, which was the first year I went, it was really about just sort of almost like I just – it had such an impact on my life the five, seven years prior that I just had to see it for myself. I did that on my own coin. I wasn’t even working at Intelligent Investor at the time. It was a really good thing to go to. Then I went three other times with Greg Hoffman; ’04, ’05, and ’07. That meeting changed a lot over that time.
So the first year in 2002, it was in Aksarben Conference Center or whatever it’s called, which is Nebraska spelled backwards. I think there was 15,000 or 17,000 people. Five years later, by the time I went the last time, I think it was in the 40,000s, and one of the things we’ve discussed before. But you’re a contrarian, and you’re coming and meeting forty thousand other contrarians to have a big meeting about contrarianism. It’s a little uncomfortable. It’s like I don’t feel that this is the right home for me anymore because I’m trying to be contrarian. This term, it’s just – this is not new news to anyone.
[00:10:21] SJ: Yes. We had that tagline for a while. The easiest way to be the smartest person in the room is to find a room with no one in it. It does not feel like that when you’re at Berkshire. I actually found that particularly uncomfortable. It’s quite a beautiful little town.
[00:10:32] GB: It’s a great town.
[00:10:33] SJ: The town center’s great, and I really enjoyed that aspect of it. But I found the actual meeting itself, and there’s just something quite uncomfortable with it. I actually think it’s a bit of a shortcoming for me as an investor that I really gravitate towards things that other people – I don’t think a lot of people are thinking about.
[00:10:51] GB: Steve hates copying other people’s ideas.
[00:10:53] SJ: I do and that’s not necessarily a good thing.
[00:10:55] GB: It can be a very, very useful way to find good ideas.
[00:10:58] SJ: Yes, exactly right. But I think one thing that is true is that the more people that have an idea, the less likely there is to be a unique one. That doesn’t make it –
[00:11:06] GB: I think if you turned up to a Berkshire meeting in 1978, it was probably filled with gold. I think by the time 2000s came around, it was less so, and maybe even less so now. It’s –yes. I mean, Charlie’s 100 next year. Part of me still wants to go and say hello and see it, but we’ll see.
One of the things for me was it was sort of already evident by the time I went to my first meeting. But definitely by the time I went to my last one was this idea that Buffett does this. So therefore, we should all do this. I’m setting up a straw man here, of course. Not everyone feels that way. But it’s just dangerous. It had become very, very evident to me that Buffett, if he was managing a small sum of money like I was, would be doing things very differently.
He literally said that in 2007. He said, “If I were working with a very small sum, and you should hope this doesn’t happen, I’d be doing almost entirely different things than I do. Then the rest of of it is about how he’d be probably looking at smaller caps fairly concentrated, fully invested, idiosyncratic, and maybe a bit more volatility as well. But it would be a very different-looking portfolio.
I think we sort of – what we want to emulate is what Buffett would do if he was in our situation, rather than necessarily what he’s doing to make the most of this giant behemoth, which is, obviously, going to have to be invested very differently.
[00:12:26] SJ So you’ve evolved beyond it basically is what you’re saying.
[00:12:28] GB: Yes.
[00:12:29] SJ: Latrell Mitchell was on a podcast this week, NRL player, for those who don’t know him. He said, “If I was a 14-year-old running around in Taree these days, I would definitely idolize Latrell Mitchell.”
[00:12:40] GB: Bang on. Perfect analogy.
[00:13:25] SJ: Okay. What do you think of the whiskey? This is supposed to be where we taste it, but we already had to taste it because we’d not recorded the first half of the podcast.
[00:13:32] GB: Always got to be careful with the words that I’m always using. This is very easy drinking, very nice.
[00:13:37] SJ: Smooth.
[00:13:38] GB: The Japanese whiskey, sir, like they’re too expensive for me nowadays. It’s a little bit like some of the Tasmanian one as well. I don’t tend to explore a lot of Japanese whiskeys. This was hand-delivered from Japan I believe. Yes. It’s a nice, nice whiskey. But they don’t tend to be experimental.
[00:13:53] SJ: No. There’s lots of blends over there, and this is another blend. This is the Rare Old Super from Nikka. It’s not crazily expensive. It’s not cheap. It’s not crazily expensive. I think about 99 bucks a bottle. I Googled.
[00:14:04] GB: Jesus.
[00:14:06] SJ: But it’s a blend, so it’s a mix of different whiskeys, and there’s nothing too extreme about it. You’re right. How do you –
[00:14:13] GB: Thank you.
[00:14:14] SJ: Gifted a bottle of Ledaig 18-year recently, and that was a delicious whiskey. But it’s all gone, so I couldn’t bring it in for you to drink. Let’s move on.
We talked back in January about the case for small caps in 2023. It has actually been a pretty decent start to the year for our portfolio. We’re sitting here fairly positive. But the index has been positive as well, and that has mostly been driven by large caps rather than small caps.
We did a webinar earlier in the week, and we talked about the valuation differentials. If you plot the P/E ratio of a US small caps index versus the larger S&P 500, it’s currently trading at about a 30% discount. So the P/E on the larger index is about 17 times. It’s about 13 times on small caps index. It’s fairly significant discount.
For most of the 20 years that we’ve got recorded data for this, they’ve actually traded at a premium. They tend to offer better return to grow a bit more and –
[00:15:15] GB: They’re better returns because they grow more, right? There’s slightly higher starting point P/E. They grow quicker on average.
[00:15:22] SJ: More volatility and a bit more return has been the case over longer periods of time in the past five years that has unraveled. They currently trade at a very big discount. We were using that as a case for investing with us and investing in small caps in general. The question that we didn’t really answer, though, and that I wanted to talk a bit about today is what does it actually take for sentiment towards these type of businesses to change.
I thought we talked about a few interesting case studies that were individual that we might be able to expand to some general thinking about how these things tend to unfold and have unfolded historically. So maybe let’s talk about Open Lending first. We own a little stock called Open Lending. It has been absolutely hammered over the past couple of years. They have a platform that provides insurance for automobile loans, and the insurance is provided to people who are not quite prime borrowers.
[00:16:20] GB: This is for used automobiles, by the way.
[00:16:22] SJ: Used automobiles. So you want to buy a used car. But they do have a new part as well. They do the main drivers. But the main driver is people who are borrowing from a credit union to buy a used car, and they’re not quite prime credit rating, this company has over many – over a couple of decades built a platform that allows them to select a cohort of close to prime borrowers that they think are not going to default at the rate that everyone else assumes.
They’ve been able to attract insurance companies that will provide insurance to the credit union on that loan defaulting. For the past 20 years, everyone has been doing pretty well out of that. They’ve been able to cherry-pick these loans. But –
[00:16:59] GB: It was a structural imbalance, I would say, in the industry prior which has created this opportunity as well, right? There’s sort of like if you’re a US borrower, you get stamped prime or subprime, right? If you’re prime, you go to one of the big banks. You get a pretty good rate. If you’re stamped subprime, you go to Credit Acceptance Corp or one of the other ones, and you’re paying like 22% per annum or something like that.
Even when rates were zero, close enough to paying 20-plus, that business – I don’t want to disparage our business in the slightest. But within those subprime categories, there are very different capacities to pay. The job of Open Lending is like we’re going to target the people that ride on the cusp of being prime and give them something in the middle, right?
[00:17:42] SJ: Yes. So you pay – 12 prime borrowers paying seven. You pay 12. There’s enough profit in the difference between the 12 and the 7 split up amongst the insurance company, Open Lending, and credit union. Anyway, the business was going really, really well up until 18 months or so ago. Then auto production has been absolutely hammered. But far more importantly, interest rates have risen really quickly, and demand for used auto loans has fallen.
[00:18:13] GB: The price of used cars has exploded upwards on the lack of supplier, which is making it out of reach for sort of the marginal borrow, let’s say.
[00:18:22] SJ: It’s out of reach, and it’s the main form of security for people that are lending money to these types of borrowers. It has historically actually been a really, really nice asset class because you can go and get the keys to the car and sell it. So lending money for someone to buy a car that’s 50% more expensive than it should be is quite a risky –
[00:18:37] GB: Yes. It’s the first thing the bank is looking at, right? If the price is normal, then my recovery is X. But the price of these things have gone up 40% in the last two years. What recovery assumptions am I going to make? They’re going to be based on history, not off the current price.
[00:18:51] SJ: Yes. We really like this business. We completely underestimated how hard it was going to get hit in this type of environment. But the company is still very, very profitable, reporting huge profit margins. We think when that cycle turns, it will do very well. That’s not the interesting part of the story, though. It has just released its Q1 results. They were the worst quarterly results that the company has issued in terms of profitability since it listed a couple of years ago. The share price is up 40% since those results were released.
It is pretty clear from what they reported that it’s probably the worst that they are going to report, or at least it’s very close to it. I think that dynamic is the most interesting piece about what’s happened there. The share price has just been going down and down and down, while people have been revising their estimates of the earning is lower. It reports the worst result. The reason it’s probably the worst is because there’s a part of their business that shrunk to zero that –
[00:19:45] GB: The refinance.
[00:19:46] SJ: Is going to recover at some point. But it’s just been amazing to me how quickly the market has gone, “Well, okay. The worst is now in. Now, I want to buy the stock.” I think that dynamic has some wider implications to the sector.
[00:19:57] GB: It’s something that new investors in particular, it’s something that’s very difficult to explain to them. Here’s a bad result. Stock’s up 40%. They don’t understand how expectations is the key driver.
[00:20:08] SJ: Yes. I think you retweeted or you posted on internal Slack a quote from Gavin Baker that was a very clear explanation of what’s going on there.
[00:20:17] GB: It’s clear. It’s a bit complicated, but this is a manager of money in the US. He said, “Over the short term, stocks trade on the second derivative,” right? Second derivative being the acceleration or deceleration, basically, of revenue EPS and free cash flow and ROIC changes along with beats and misses.
When he talks about beats and misses, he’s saying the expectations of particularly the brokerage community, whether they were better than expected or worse than expected. Valuation is driving whether how big the up or down is based on that second derivative. But over the long long-term return on invested capital and growth in free cash flow per share drive all of performance.
I’ve shared that in our internal Slack chat because it was something that was just nicely worded. But it’s the old chestnut that expectations in the short run are the mover, and cash flow is the mover in the long run. Really, nobody’s ever said that better than Ben Graham, when he said, “In the short run, the market is a voting machine. In the long run, it’s a weighing machine.”
[00:21:20] SJ: Yes. I think it’s actually – you will notice a lot of stocks in our portfolio where we’re actually trying to use that dynamic to get a bargain. It’s a business where we’ve got a pretty good idea what the long-term cash flows are going to look like. Sometimes, that’s not that unique in terms of our ideas and our appreciation for the business. You can go and look at the consensus views of the company, and they’re not that different.
But we’re waiting. At some point, right, that relationship needs to come unstuck about the expectations. Or the expectations need to bottom. It’s trying to be a bit before those expectations and bottom in the share price pops. You get to buy the great business at an attractive price because everyone’s focused on the shorts.
[00:21:59] GB: Yes. We’re not trying to hope that didn’t come across this way, trying to play that same game but be quicker. It is we’re trying to play the long game. We’re trying to play the weighing machine game, and we’re specifically looking for opportunities where the voting machine is going to get very depressed.
[00:22:13] SJ: Yes. It sort of leads me to a wider – that auto space is sort of the early recession, right? They had their recession before everyone else has had theirs. But I do think there are wider implications for the market as well that we almost need this recession that everyone is so worried about to come.
[00:22:29] GB: Yes, 100%. Yes. Sorry. It’s a bit of a tangent. But the UK Gambling White Paper that’s been weighing down all the betting stocks in the UK for the past 18 months, it was – it’s now buy the rumour, sell the fact. Everyone’s just been waiting for it. It almost didn’t matter what was in that paper. There was going to be some pain, or there wasn’t going to be pain. But the market – it’s the uncertainty that I hate, right?
[00:22:51] SJ: Yes. Some of our worst-performing stocks of late have been reporting really, really good results. We own a company called Janus. We’ve talked about it in a previous podcast. But they do a lot of construction activity for self-storage rates. Everyone knows that market is going to slow down, and they’ve been reporting great results. They’ve been upgrading expectations. Everyone goes, “Oh, we’re still waiting for the downgrade.”
[00:23:15] GB: It’s almost like, “Oh, these result is too bloody good.” That means the downside is going to be worse, right?
[00:23:19] SJ: Yes.
[00:23:20] GB: That’s what they’re trying to do. It’s not entirely irrational, right? There’s probably a certain amount of stuff getting done over the next 10 years. If more happens today, it might not happen tomorrow.
[00:23:30] SJ: Yes. I don’t know that that means the price should be lower than it was a year ago. But, yes, I think this recession that probably is coming needs to come. Then investors start looking at the other side of it and saying, “Well, these businesses that are actually doing better than people expected there is –”
[00:23:48] GB: You had a data point around this, right?
[00:23:49] SJ: Yes. I actually talked about it in the previous podcast. So if you go back to that January podcast, the case for small caps, you can hear more about some of that data there. But this is a US-specific study. But in six previous recessions in the US, within three months of the recession starting, small cap started to outperform large caps. That was a really, really consistent repeatable behaviour. I think you can just see it in investor psychology that once we’re there, people are going to start looking to the other side of it and saying, “Well, what do I want to own out the other side?” That is probably what is required for performance to recover but –
[00:24:25] GB: Yes. I mean, you’ve seen that. You’ve got to be careful looking at historical patterns but that was –
[00:24:29] SJ: Past performance is no guarantee of future performance.
[00:24:30] GB: Yes. What is it, ’02? When the market bottomed after that NASDAQ blow up and the S&P was down 50% 2000 to mid-2002. It was value but it was also small. It really drove things for probably five years, probably right till the GFC, right? I don’t have the numbers in front of me.
[00:24:48] SJ: That was the other interesting thing we talked about that it went on for a long time. It went on for – because you’re starting.
[00:24:51] GB: Yes. Well, that’s – the first two years of that is probably the catch-up that you’ve been waiting for the whole time. Then the next two years is the extrapolation into the era that is just normal part and parcel of being in markets, where they just extrapolate, right?
[00:25:08] SJ: All right. Well, you are off camping, I think, Gareth, in the Blue Mountains somewhere.
[00:25:12] GB: I am, yes. No, Snowies.
[00:25:15] SJ: We better let you get out there and start making sure the tent doesn’t have any holes in it. It’s going to be cold.
[00:25:20] GB: It’s actually forecasted to snow, so yes.
[00:25:23] SJ: Oh, that’ll be enjoyable, something unique.
[00:25:25] GB: Yeah. I’m looking forward to it.
[00:25:26] SJ: Great. Well, you have a fantastic weekend. We will be back in June for the next episode of Stocks Neat. Thanks for tuning in. We just hit 1,000 downloads on one of our previous podcasts. It was actually that case for small caps podcast. So the podcast is going well. We really appreciate your support. Don’t forget to rate it on your favorite podcast app, so more people find out about us. Thank you very much for tuning in.
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