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Two Components of “Edge” in Investing

September 28, 2017 in Letters

This article by John Huber is excerpted from a letter of Saber Capital Management.

Every so often, it’s helpful to outline Saber’s basic philosophy. Since we have a number of new investors who have yet to be indoctrinated, I thought it would be a good time to make a few comments on our approach.

Saber’s investment strategy focuses on making carefully selected investments in high-quality businesses at attractive prices. This ubiquitous description of a well-trafficked investment philosophy does not take away from the soundness of the approach, nor does it compromise our ability to capitalize on its merits, for two main reasons that I’ll describe below.

Some of the key tenets to my investment approach are:

  • Understanding the business model and how a company makes money
  • Considering the value customers place on a company’s product or service
  • Focusing on durable businesses with predictable cash flow
  • Preferring a management team that thinks and acts like owners
  • Demanding an obvious gap between price and value (margin of safety)

When it comes to stocks, simplicity and common sense work well. I try to focus on restricting our investments to companies that implement a business model that makes sense to me. I want to not only understand how the company makes money, but I want to understand the value proposition it offers its customers. Good businesses have good economics such as high returns on invested capital and consistent free cash flow, but they also provide a product or service that offers value to the buyer on the other end of the transaction (the customer).

As I’ve learned over the past few years watching debacles such as Valeant and SunEdison, a business with good economics that is coupled with a business model that extracts value from its customers (rather than adds value to its customers) is not a good business. The financial metrics might appear attractive, but a parasitic relationship with customers usually ends up destroying shareholder value at some point. So guarding against this type of business risk is a major focal point at Saber.

Also, while my twin two-year olds would quickly challenge this assertion, sleeping well at night is a must, and so I like businesses with strong balance sheets and preferably without much debt.

And since my economic crystal ball has never worked well, I look for durable businesses that can withstand a variety of economic headwinds, which are certain to occur over time.

Two Important Advantages (Our “Edge”)

Finally, I believe there are two requirements in order to implement this approach successfully:

  • Maintaining a long-term time horizon
  • Focusing on only the very best investment ideas

Both principles are often preached, but very rarely practiced. Institutional constraints and good old fashioned human nature can make it very difficult to actually utilize those two advantages. This difficulty is the reason the advantages exist, and I believe—since human nature is here to stay for a while—these advantages are permanent for those who can capitalize on them.

The Long-Term Advantage

The first is to maintain a long-term time horizon, which I believe is now a bigger advantage than ever. Fifty years ago, the average stock was held for 14 years—today it is disposed of after about 11 months. The short-termism that is pervasive in the stock market creates lots of irrational buying and selling for all sorts of reasons that have everything to do with the short-term direction of the stock, but nothing to do with long-term value of the business. By the very nature of the ever increasing focus on the next quarter, I believe this long-term mindset—when actually implemented—is a sustainable advantage, and one that is likely to strengthen over time.

Technological innovations over the years have vastly increased the breadth of available information, the speed at which the information travels, and the ease with which that information can be obtained. With so much human and physical capital spent on trying to gain an information advantage, it’s best to bypass that short-term focus completely, and quietly consider the bigger picture. This helps identify the key variables that really matter, and those variables are rarely the consensus estimates for next quarter’s EPS or the decimal-point accuracy of the gross margins.

Predicting an acquisition based by tracking the cities that an acquirer’s executive airplane travels to, or using satellite imagery to track the number of cars in a retailer’s parking lot to better predict this quarter’s revenue numbers (two things hedge funds have done recently to try and gain an information advantage) is not a game that I can (or desire) to play. But the fact that so many resources are focused on competing in this short-term arena leaves an opportunity for those who can look out past the noise and think about the situation from a different view.

Capitalizing on others’ desire to avoid volatility is what makes this strategy work. Dealing with this interim volatility is the price of admission, but it’s more than a fair trade.

Waiting for Great Ideas

“I just wait until there is money lying in the corner, and all I have to do is go over there an pick it up.” –Jim Rogers

I’ve always felt that Rogers, who helped build the foundation for one of the greatest investment track records in history during the 1960s and ’70s, perfectly encapsulates this second main pillar of my investment approach: do nothing until there is something really obvious to do.

Charlie Munger said that it isn’t possible for humans to know “everything all the time”. But, he said, it is possible to occasionally find something of value. When that happens, it’s important to capitalize on it in a big way. But the other variable to this equation that is probably even more important is to avoid investing in less-than-great ideas just to fill out a portfolio or meet some sort of arbitrary quota for diversification.

The benefits of focus investing are well known (and talked about ad nauseam), but there is a dichotomy between what investors say and what they do. Portfolio managers have a bias toward activity to justify their high fees. They also would much rather act conventionally (make frequent investments and own lots of stocks) than risk their jobs. The drumbeat of “what have you done for me lately” is very rarely muted in professional investing circles. Unfortunately, individual investors succumb to many of these pitfalls as well. This conventional wisdom is like a powerful magnet that eventually attracts most market participants. Social proof is a powerful force.

Everyone knows that to obtain results that are different from the crowd, you must behave differently than the crowd. But the reality when it comes to performance is that 90% of the people will make up the bottom 90%. I think it’s imperative to recognize the reasons why this is the case, especially since we desire to be among the 10% of the people who are in the top 10%.

I really believe that, unlike in years past where investors’ main advantage was finding hidden gems or uncovering information that others didn’t have, the biggest advantage today is to leapfrog the short-term noise by maintaining a multi-year view and to patiently wait for great investments to present themselves.

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Disclosure: Returns are based on the “Saber Capital Portfolio”—a real money account that is managed alongside all other accounts. I also refer to this as Saber’s model portfolio. Performance data of this account is produced directly from Interactive Brokers. Returns are not audited. It is important to note that each client may experience slightly different results from the model depending on the timing of deposits, withdrawals, the opening/closing of the account, the fee structure specific to each account, other timing issues, etc… The valuations of your investments at the time of purchase may be significantly different than the valuations at the time of purchase in the model because of these timing issues. I expect the net results of the model account to roughly equal the results of client accounts over time, although there can be no guarantee because of the timing issues referenced above. The gross returns of the Saber Capital Portfolio are taken directly from Interactive Brokers. The net returns are estimated using a 1% management fee and 15% incentive fee. Your net returns could vary from the model depending on the fee structure of your account. Your personal account statements with your account specific performance net of all fees will be coming in the mail each quarter, and can also be accessed anytime online. Please note that any performance fees earned during this year will show up in the following year’s 1st quarter’s statement. Also note that the time weighted return (TWR) on your account specific performance summary is net of all fees.

Tools We Use to Forecast the Future Prospects of a Business

September 27, 2017 in Letters, Skills, Tools

This article by Michael Shearn has been excerpted from a letter of Compound Money Fund, LP. Michael wrote this piece after John Mackey returned to Whole Foods as sole CEO in late 2016. Whole Foods was acquired by Amazon.com in mid 2017.

We would like to introduce you to a few of the tools we use to forecast the future prospects of a business and to determine whether a leadership team is building a competitive advantage. First, some background. When I started my career in the investment business my skills had been developed by taking courses in Finance and Accounting. I was taught how to calculate financial metrics such as return on invested capital (ROIC) and learned the differences between LIFO and FIFO when accounting for inventory. The tools I was given to value a business were measurement tools similar to rulers and calculators. Later I learned that using rulers and calculators to analyze numbers tells you about the past but investing is in the future. Therefore I needed additional tools to help me forecast the future value of a business.

Placing the Odds in Our Favor

I have always been curious as to what makes some forecasters (those in any business of prediction) successful versus others and spent some time researching this area. One key theme emerged. I learned the most successful forecasters always place the odds in their favor in some way, especially those in ancient times who would often pay with their life if they were wrong.

So how do we go about putting the odds in our favor when investing?

We start with choosing business models that have certain characteristics that help us make predictions about their future cash flows. The best way to explain this is to think about two extremes in business models. At one extreme are those business models that are easiest to predict. Typically these are businesses that have long-term contracted cash flows with stable counterparties. For example, a large percentage of Brookfield Asset Management’s cash flows are contracted for long periods of time, such as its long-term office leases in its Class A Manhattan office buildings or the electricity it sells to utility customers generated by its hydroelectric dams.

On the other extreme are those businesses that are most difficult to predict. Examples would be businesses whose revenues are tied to commodity prices (e.g., oil and gas companies) and other cyclical businesses (e.g., construction equipment leasing firms). As some of you know, I operate a privately held oil and gas business (inherited from my late father) and every year I am reminded how difficult it is to do business in this industry. First of all I never know what I will be paid for my product on a year to year basis, yet I am expected to make long-term investment decisions. I basically am always operating in the dark and am restricted in making any realistic forecasts.

Building a Competitive Advantage

When looking for business models that are easier to predict I used to solely focus on businesses that had a competitive advantage I could easily identify. What I later learned is most value in a business is created when a competitive advantage is being built not after it already has one. Think about the big gains in Microsoft’s stock. The highest returns went to the early investors who were involved as Microsoft was building its competitive advantage. Since Microsoft has become the monopoly software provider, its returns have been mediocre for more than two decades. The same has held true with many of our past investments in businesses that had competitive advantages I could easily identify, such as Western Union, which has underperformed the S&P 500 since it went public. To remedy this Ann and I set out to identify a series of questions we could use to help us determine whether a business is creating a competitive advantage. The first series of questions we ask are shown below:

  • Is the product or service solving a genuine customer need?
  • If the business did not exist anymore, would anyone notice or care?

The best businesses are so good at solving problems for their customers that they become indispensable. Think about products or services that you can’t live without today, such as Amazon or Google.

We believe our portfolio holding Shopify is building a competitive advantage by solving many of the problems customers face when they set up an online retail business such as designing a website, managing inventory and discounts, or simply accepting payments from a variety of sources such as Visa, Square or Stripe. Shopify’s products are so easy to use that most customers can setup an online retail business on their lunch hour. They can then spend most of their time focused on their products and outsource the painful activities. Shopify performs this service for a very low monthly fee which starts at $29 per month and averages $52 per month for most customers. The combination of a low price and easy to use solutions makes the service indispensible to its customers and is what contributes to its 100 percent customer retention rate (this figure does not include customers going out of business). The leadership team is also continually increasing the size of their competitive moat by reinvesting excess free cash flows to solve more customer problems such as making product shipments easier.

Now let’s contrast this with software company Oracle which has been highly successful in the past. Oracle basically handles data storage for a company, such as organizing all of the customer information a company collects. Even though they provide solutions to many of the problems businesses face they also make life hard on many of their customers by requiring them to invest a lot of time learning how to use their software. Oracle also makes it difficult for their customers to switch to another provider, and goes to great lengths to ensure any product outside its ecosystem is not compatible with its software. This often creates additional complexity for customers as it does not allow them to use the best solutions. We believe Oracle is losing its competitive advantage as the cloud has made it easier for new entrants to offer competing solutions which are easier to use.

Another question we ask to determine if a business is creating a competitive advantage is:

  • Are the products or services good for the customers?

It never ceases to amaze me how many products and services are not good for customers even beyond the usual things that are not good for our health. We believe the reason for this is most leadership teams try to extract as much value as they can from a customer as they attempt to maximize shareholder value. Most are able to get away with this because they have limited competition or have some form of competitive advantage that dissuades others from entering the business. We view these as unsustainable advantages which will eventually erode as technology changes or new competitors enter the market with a better product offering.

We believe pet medical insurance provider Trupanion is offering a good product to its customers in an industry that has historically taken advantage of its customers. Trupanion’s competitors are divisions of traditional insurance companies that make their money by tightly controlling the medical emergencies they will cover for a pet. In other words, they are always placing their own self-interest ahead of the customer.

Trupanion instead has adopted a different business model whereby it aims to charge a certain markup on all of its products and then pass on any cost savings to its customers beyond this amount. This is very similar to Costco Stores which marks up all its products by 15 percent whether it is a diamond engagement ring or a box of cereal and passes on most of the cost savings to its members.

Trupanion also provides a lot of value to veterinarians because instead of following the typical insurance model of delaying payments for more than 60 days in order to extract as much value as they can, they pay for the cost of a visit within 30 days or the day they are invoiced if a veterinarian installs Trupanion’s software.

Because Trupanion provides so many benefits to both its customers and to the veterinarians, vets recommend this product to most of their customers. In fact, vets are the largest referral source of customers for Trupanion even though these vets do not receive any form of compensation. As a result of providing a great product, Trupanion’s revenues are increasing at a high rate and they are building a strong competitive advantage. Thank you again Josh Tarasoff for this wonderful idea!

Another question we ask is:

  • Does the product or service create optionality for its customers?

Imagine a software coder that only knows one computer language and suddenly that language becomes obsolete. This software coder will have less value or no value in the job marketplace because he or she is not proficient in new software programming languages. Now let’s imagine another software coder who is familiar with lots of computer programming languages, including the newest ones. This person has lots of options when it comes to coding and as a result has more value in the job marketplace. The same holds true for a business. The more optionality a business provides its customers, the more value the product or service will have for them.

Arista Networks, a provider of switches and software that helps companies like Netflix push its movies out of its door to your TV screen, was founded because the leadership team wanted to provide more optionality to customers versus existing offerings. Arista does this by creating software that can be easily integrated with third-party software providers. On the other hand, its chief competitor Cisco prefers to limit its customers to software that it decides to allow within its ecosystem, usually earning a fee for this right. This makes the Arista platform extremely valuable to its customers because they are free to choose the best solutions and as a result Arista is taking market share away from Cisco at a rapid rate, continuing to build its competitive advantage.

Another question we ask to forecast business prospects is:

  • What are the common patterns for the longest lasting businesses within an industry?

For example, in the oil and gas industry those producers who are able to generate the lowest cost per barrel of oil are the ones who tend to survive industry downturns and are also able to generate the highest profits when the price of oil rises. If you are looking to invest in an oil and gas firm (don’t worry we will not but I like the example) you would be best served identifying those with the lowest cost per barrel of oil because this would put the odds of discovering the best businesses in your favor and more important help you decrease your downside risk.

Recently, we have been researching the luxury goods industry because it is has been out of favor. As we narrow down which luxury companies we will spend time analyzing we are asking one simple question to select them:

  • Which ones don’t discount their products?

At the most basic level, luxury goods manufacturers thrive on exclusivity. Luxury products are often used to signal to others that one has money and belongs in a higher echelon in society. If a luxury company starts discounting it becomes more difficult for their customers to signal to others. Is the consumer the one that bought the item at the discount mall or did they pay full price? You get the drift. Discounting always degrades the exclusivity of a luxury brand. For example, we were able to predict the decline at handbag maker Coach when we watched them first begin to discount their items. We knew they were violating the fundamental principle of a luxury brand – DON’T DISCOUNT! We are currently researching LVMH Moët Hennessy, Richemont (owner of Cartier), Hermès and clothing brand Brunello Cucinelli: all brands which have historically not discounted their products.

Watch Decisions Being Made Today

One of the keys to successfully forecasting the future value of a business is not allowing past results to influence us. Whenever we are looking at the financial results of a company we recognize that these results were due to decisions that were made by the leadership team 1, 5 or even 10 years ago. Instead of focusing on current results, we need to carefully examine the decisions the leadership team is making today and simply ask:

  • Will these decisions increase the value of the business or decrease it?

Our goal is to get a general sense of the direction of value, whether it is positive or negative instead of trying to quantify the magnitude. For example, we began to reduce our position in Whole Foods Market at a time when it was reporting positive same store sales growth and its rising stock price indicated the business was healthy. The reason was we witnessed the leadership team transition from making decisions focused on innovation (e.g., creating animal welfare standards or expanding a new organic product category) to instead making decisions to match the prices of their competitors. As the leadership drifted further away from innovation, we knew their decisions would create less value in the future and as a result reduced our position. Fast forward to today and same store sales are declining compared to prior quarters and co-CEO Walter Robb has stepped down from his position.

Founder John Mackey has returned as sole CEO of Whole Foods Market and we believe innovation will return. This is why we added to our position toward the end of the year. Welcome back fully engaged John!!!

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This document is for informational purposes only. It is intended only for the person to whom it has been delivered. This document is confidential and may not be distributed without the express consent of Time Value of Money, LP. The information contained herein is subject to change; however, we are under no obligation to amend or supplement this document. This document is not intended to constitute legal, tax, or accounting advice or investment recommendations. This document shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of a security in any jurisdiction where such offer, solicitation or sale would be unlawful prior to issuance of an offering memorandum. An investment in Compound Money Fund, LP involves a substantial amount of risk. Investments should only be made by investors who fully understand these risks and can withstand a loss of their entire investment.

Reciprocation Tendency

September 27, 2017 in Human Misjudgment Revisited

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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Reciprocation tendency, including the tendency of one on a roll to act as other persons expect.

“It is so easy to be a patsy for what [Cialdini] calls the compliance practitioners of this life…a very, very powerful phenomenon.” “Wherever you turn, this consistency and commitment tendency is affecting you. In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think.”–Charlie Munger

Munger cited the example of a study that asked members of an academic campus to take juvenile delinquents on a trip to the zoo; he got one in six to say yes. Then he asked others to devote two afternoons a week to taking juvenile delinquents to the zoo, and everyone declined. But after making the initial request he backed off and asked if they would at least take them to the zoo one afternoon. Then he got half of the respondents to agree. He got three times the success by going through the “ask-for-a-lot-and-back-off” strategy.

Zimbardo’s Stanford prison experiment is also an example of not just reciprocation tendency but also commitment and consistency tendency too. The actors’ actions themselves pounded in the idea.

Update

“Kantian Fairness Tendency” is an important corollary – Kant’s “categorical imperative” required people to follow behaviors that, if followed by all others, would make the surrounding systems work best for everybody. Examples include voluntary traffic mergers, cooperation at intersections and tunnels with no traffic signals, orderly lines even in “first come, first served” situations, and the abolition of slavery.

That is not to imply that reciprocation is dead, or even diminished. Why does every salesman have an entertainment budget? Concerts, sporting events, golf, holiday parties – they’re all designed to encourage reciprocation.

The brilliant financial writer Matt Levine often harps on his idea of the “gift economy” in finance. Banks and broker-dealers will give you “free” research, conferences and management meetings, tickets to the U.S. Open, etc., and in return they expect overpriced trading commissions and investment banking mandates. Wouldn’t it be easier to just price the underlying business reasonably and skip all the reciprocal dancing?

One of Munger’s original examples was Sam Walton’s practice of never letting his purchasing agents take so much as a handkerchief from a salesman. Fast forward a few years and Walmart finds itself enmeshed in a full-blown bribery scandal involving multiple government officials in multiple countries. It will likely have to settle for hundreds of millions of dollars and the total legal and compliance bill is already stretching toward $1 billion.[25] It’s easy for big companies to lose their culture over time.

Environmental factors in general probably get too little attention, especially in the investment industry. Noise levels, screens with blinking lights, ringing telephones, open floor-plan offices – everything seems designed to distract.

The Buffett-Munger system at Berkshire Hathaway is one giant feedback loop of reciprocation used for good. Berkshire has had remarkable success in motivating its hundreds of managers and its hundreds of thousands of employees by intentionally cultivating a “seamless web of deserved trust” and populating it with people who find it attractive. Berkshire’s managers speak frequently of feeling the need to live up to the trust Buffett and Berkshire have placed in them. Other sprawling conglomerates would have long ago succumbed to sclerotic bureaucracy. Buffett also goes out of his way to praise publicly by name – notice that he is always careful to praise specifically and criticize by category. Reciprocation is everywhere within Berkshire. And conversely, a culture that is dominated by policy manuals and rote procedurals may be sending a subtle message of distrust that is – by the anecdotal evidence, at least – often reciprocated. Berkshire has also remarkably free of scandals and misconduct for a company of its size operating in industries that have tripped up many peers.

In Munger’s updated version, he focuses on the negative aspects of reciprocation. Human history suggests that turn-the-other-cheek behavior is not programmed into a natural algorithm, and it takes a lot of mental effort to overcome our genetic tendencies to avoid turn-the-other-cheek behavior. And the standard antidote is to train oneself to delay or defer any negative reaction. “You can always tell a man to go to hell tomorrow,” to paraphrase Tom Murphy of Capital Cities and Berkshire fame.

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[25] https://www.bloomberg.com/news/articles/2017-05-09/wal-mart-said-close-to-resolving-bribery-probe-for-300-million

Disrupting the Communications Industry — Implications for Investors

September 26, 2017 in Audio, Communication Services, Equities, Featured, Information Technology, Interviews, Latticework, Latticework New York, North America, Transcripts, Venture Capital

Elliot Noss, president and chief executive officer of Tucows (Nasdaq: TCX), joined the MOI Global community at the Latticework 2017 summit, held at the Yale Club of New York City in September. John Lewis, noted value investor and managing partner of Osmium Partners, moderated the wide-ranging keynote Q&A session.

Under Elliot, Tucows challenged how software was distributed in the 1990s and how domain names were offered and managed in the 2000s and is challenging how mobile phone service and fixed Internet are provided today. For nearly twenty years, Elliot has championed the Internet as the greatest agent of positive change the world has ever seen. Through his role at Tucows, his involvement in ICANN, and his personal efforts, he has lobbied, agitated and educated to promote this vision and protect an Open Internet around the world.

We are pleased to share a transcript of the session.

The following transcript has been edited for space and clarity.

Shai Dardashti, MOI Global: In a previous life, I managed a fund. After I closed the fund I worked for John Lewis at Osmium Partners. I’ve seen John in different contexts, and I’ve seen the way he invests; I’ve seen him handle different personal dynamics. John is a phenomenal human being. I’ve also previously invested in Tucows, and Elliot Noss will be joining us in a few moments to share a bit more of how he sees “Intelligent Investing in a Changing World”.

We don’t give “CEO of the Year” awards, but Elliot deserves one. He has an element of Henry Singleton’s DNA in terms of share-buyback behavior. There’s also quite a bit of pure Charlie Munger-style long-term business development creativity in what he’s building.

John Lewis, Osmium Partners: One of the big takeaways we’ve seen as investors is how hard it is to win in the capital markets. The winners really win. In our investor presentation this year, we showed that from the IPOs of both Netflix and Amazon both stocks are up 1000x. We’ve looked at the math behind the biggest winners in public equities. The winners win disproportionately. This goes back over a hundred years. One hundred stocks have made up almost 40% of index gains since 1925, while 50% of companies ultimately died.

I first met Elliot in 2007, and he has been an extraordinary value creator. He’s in the early innings of having a remarkable long-term run. Elliot has executed eight Dutch tenders and repurchased 50% of the outstanding shares at about one tenth of the recent price. He has paid about one times EBITDA on this year’s numbers. We’ve seen him make one smart investment after the next. You’ve been CEO now for twenty years?

Elliot Noss, Tucows: Over twenty years, yes.

Lewis: Would it be helpful to give a quick overview of your three businesses?

Noss: We are the largest wholesalers of domain registration in the world. GoDaddy is the largest domain name registrar. We made up this creature, “wholesale domain registration” nearly twenty years ago. That is essentially a platform business, a relatively low-growth business — if you want to talk about mid-single digits as a growth business. It’s a platform business that spins off loads of cash.

We’re an MVNO, which means we buy capacity from — we’re not legally allowed to say it, but if you go and search the coverage map, you’ll see the magenta map and you can figure it out. The MVNO business is great because U.S. mobile phone service is the second-most expensive in the world (second only to Canada, which is where I’m from). We have been able to build a business making north of 50% contribution margins, where our customers are paying $23 a device and they are measured (by net promoter score) as the happiest, most satisfied mobile-phone customers in the world. That’s a scrappy business from a customer acquisition standpoint, where you have essentially no industry growth; everybody who’s going to get a mobile phone already has one. That is a tough business route — taking share — but [we are] less than one-tenth of 1% of the market. We’re a termite eating a tree: there is a lot of room and the tree doesn’t notice.

Now you have these two good businesses, both of which spin off cash and require virtually no capital. We bought back our stock for as long as we could, then the telecom world presented itself again to us, and for the last 2.5-3 years we’ve been going hard fiber to the home.

We fundamentally believe that we’re at the beginning of a 15-20-year cycle, where infrastructure built for telephone or television has been retrofitted essentially to deliver the internet. It’s a simple thesis to say that at the end of a 15-20-year cycle, the vast majority of connections in the U.S. will be end-to-end fiber with a bit of Wi-Fi hanging off the edge. Two years ago I would have said that at this point there would be 50 or 100 companies copying us, but I’ve come to appreciate that there’s an intersection around operating capabilities — we’re a bunch of old ISP guys at heart — capital, and the ability to manage a construction project, which might be a bit rarer than I first thought, and so the window stays open.

Lewis: Talk about your core DNA and the strategic focus in each of your businesses in terms of customer satisfaction. Why do you feel like you have a lot of growth in the markets you’re in, and how have you been able to generate attractive returns on capital?

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Chamath Palihapitiya on Intelligent Investing in a Changing World

September 24, 2017 in Audio, Communication Services, Featured, Information Technology, Interviews, Large Cap, Latticework, Latticework New York, North America, Transcripts, Venture Capital

Noted investor and entrepreneur Chamath Palihapitiya, founder and chief executive officer of Social Capital LP, joined the MOI Global community at the Latticework 2017 summit, held at the Yale Club of New York City in September. Brad Stone, author of The Everything Store and The Upstarts, moderated the wide-ranging keynote Q&A with Chamath.

We are pleased to share a replay and transcript of the session.

The following transcript has been edited for space and clarity.

Shai Dardashti, MOI Global: Everybody has a copy of a book called The Upstarts by Brad Stone. Brad is also the author of The Everything Store, discussing Amazon, which is quite an appropriate topic at the moment and considers “Intelligent Investing in a Changing World”. I heard Chamath speak a year ago, and I was blown away by how he combines the worlds of venture and Silicon Valley with a Buffett-Munger Latticework appreciation. I am aware that Chamath respects his upbringing, has a unique story, and is quite humble. He embodies precisely what we’re trying to attain here at Latticework.

Brad Stone: We are privileged to welcome Chamath, a veteran of AOL, the Mayfield Fund, and Facebook. I was searching for the right word to describe him, and it’s one that is favored by a CEO we both admire, Jeff Bezos, which is “bold.” He started seven years ago at the Social Capital fund and has raised $2.5 billion. It is set out to change what raising and investing capital in Silicon Valley and technology companies looks like. When you started the fund, it looked like a traditional venture capital fund investing in early-stage companies. But you have set about almost relentlessly expanding the definition of the mission of the firm. What is Social Capital fund?

Chamath Palihapitiya: Well, it is not a fund. It’s meant to be, if we’re successful, what Berkshire was for so many years; this is what we would aspire to build for the 21st century. I view investing as three main arcs, and we’re starting the third arc. The first arc was where economies were relatively brittle and not that dynamic. That was probably the many thousands of years up until 1985 or so. In those periods, you had a lot of time to understand the business, to look at things bottom-up, where things like GAAP financials were a reasonable way to understand the business. Those businesses wouldn’t have changed even in the few weeks it took for a company to mail you their quarterly or yearly report. You could make decisions literally with pencil and paper and a calculator. Those decisions could withstand the test of time.

In the late ‘80s, we unleashed this weapon on finance called Microsoft Excel. Excel created this unbelievable tidal wave of false precision. Forecasting and predicting and knowing. But it happened on the heels of ushering in massive amounts of capital formation in all kinds of areas, from junk bonds to the private equity industry. All of it literally rested on teams of financial analysts running Excel models.

What has happened, particularly in the last five or six years, is the nature of companies has meaningfully changed. Every single asset is in some form of impairment. It is either fundamentally, obviously impaired, or it is being impaired unbeknownst to you, the holder of that asset, by some other technology that you do not know about.

If you believe that we venture the world of this dynamism, where the creative destruction of companies and things and technologies is so fast, then things like Excel are necessary, but they’re not sufficient to understand how the world works. A lot of what we do at Social Capital is to explore what comes after Excel. What is the next wave of investing?

Our view of the third wave is that at Facebook, a lot of what my team and I did was creating an infrastructure to collect enormous amounts of data. In the case of Facebook, it was user data. What we would do was model you—all of you—psychologically. It would allow us to get you to do what we needed you to do—click on an ad, share a story, watch another newsfeed clip. All of you have been subject to those behaviors, and you do it, and you think to yourself, “Wow, I’m in complete control.” Probably not as much as you think, it turns out, because everybody becomes predictive with enough data and information, especially if you can apply machine learning and data science to it.

We’ve asked the question; what if you apply that to the understanding of businesses? Instead of looking at lagging indicators like gap financials, start to look at the leading indicators of business quality. The only way you can get to those leading indicators is by being so joined at the hip with a company that they give you access to their operational data. That operational data could mean a transactional database, it could mean user databases, it could mean click streams, it could mean event logs. Who knows? And then you take it and you learn. What you’re trying to look for are signals that are predictive over time about how the company can and will perform. Eventually the gap financials catch up. My organization is about exploring that new frontier of decision-making. For example, Renaissance and Two Sigma would say they do some version of that, top-down. Effectively, let’s take some principles of Brownian motion, apply it to highly liquid contracts, lever it up, and trade frequently and violently. We take the opposite view, which is to partner with companies deeply, get access to their operational data, learn with them, and help them. As we understand their business, we do more with them. That’s why we’ve been relentless about adding different tiers of the capital structure to our toolkit, because with most other organizations—for example like Blackstone, a fantastic organization—every single sleeve of capital that they run is a strategy.

From our perspective, all of those are tactics. The strategy is built around data accumulation and deep knowledge. That strategy is born by hiring massive amounts of machine-learning folks and data scientists and product managers and engineers, individuals who would otherwise be at the periphery of an investment organization, or at the center of mine.

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