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Tom Russo on the Durability of Consumer Brands

September 21, 2017 in Audio, Consumer Staples, Equities, Featured, Interviews, Latticework, Latticework New York, Transcripts, Wide Moat

Highly-regarded value investor Tom Russo, managing member of Gardner Russo & Gardner, joined the MOI Global community at the Latticework 2017 summit, held at the Yale Club of New York City in September. Having Tom was a great privilege, as he is among the finest minds when it comes to understanding the evolution of brand-based businesses in a global setting. We are pleased to share an edited transcript of the keynote Q&A session.

The following transcript has been edited for space and clarity.

Q: This has been an amazing day. I’m very grateful to be here.

I feel like Mr. Russo is someone who needs no introduction, but ever wary of extrapolating my own views too broadly, I’m going to give an introduction anyway. Thomas Russo joined Gardner Russo & Gardner LLC in 1989. He serves as Managing Member of Gardner Russo & Gardner and Semper Vic Partnerships, which oversees two global value, long-only equity investment partnerships, the first of which Mr. Russo founded in 1983. He oversees more than $12 billion distributed between Semper Vic Partnerships and separately managed accounts in parallel fashion.

Mr. Russo looks for companies with strong free cash flow characteristics, who produce high rates of return on their assets and have strong balance sheets. These have typically included branded food and beverage companies, tobacco companies, and advertising-supported media. In particular, he commits capital to leading global consumer products companies whose brands enjoy growing market shares in parts of the world undergoing economic growth and enjoying increasing political stability. Mr. Russo believes managements of family-controlled companies have the capacity when investments intended to build long-term wealth are ill-received by short-term-focused Wall Street analysts. Accordingly, he often invests in public companies where the founding families still retain control or significant investment exposure to reduce management agency costs and align owner interests. On a personal note, Tom has been an inspiration and a role model for me for as long as I can remember. So many people talk about being a long-term investor and so few do it.

A: I enjoyed the chance to hear the last speaker, and I was reminded that one of the early lessons I had for value investing was through Warren Buffett’s comments about Gillette. I wrote in an investor letter that in this Amazon-oriented world you have to be careful that assets don’t become liabilities. Gillette had won the razor war at some point. There was absolutely no way anybody could have dislodged Gillette from its franchise. Wilkinson tried, Schick tried. Unilever tried in partnership with Target; they may have spent $500 million doing a frontal campaign, but none of that could budge the market share success Gillette enjoyed.

The trouble was, Gillette, because they fell prey to the standard game on Wall Street — which is quarterly-earnings-driven, short-term-results-driven — they asked too much of the brand. They charged too much for the product. Somebody reminded me the other day that the price paid for the razors was so much they had to keep them locked up behind the checkout counter. If you’re trying to sell fast-moving consumer products, the goal isn’t to lock them up behind the checkout stand. The problem is they needed to get those prices to sustain reported earnings and give themselves a chance to have the options used for a compensation vest, and to retire rich. That whole model can be undone. In that case, the asset Gillette had was that they owned the traditional route to market.

Along came these kids from a fraternity and created a business called Harry’s, and then another guy came along and did Dollar Shave Club. The core value, the essence of that business is that it’s cool. It’s cool to get your razors on a regular basis from somebody who knocks on your door and drops them off. It’s such a different approach, and Gillette couldn’t respond to that whatsoever. They were trapped in the model that had served them so well for so long; but the game had changed and they missed the memo. They were waiting for people to go out and buy the blades in the locked cabinets. The management of Gillette was following the wrong model, which was trying to extract as much from their business as possible. The world I operate in is in businesses like Gillette — I look for companies that have great franchises, but I hopefully find the ones that are a bit more sensitive to the consumer.

The other example is General Mills, which has over the years been a company that’s perfected the art of delivering steady quarterly earnings exactly to the plans Wall Street has for them. Some years back their plan was they were going to earn a certain amount per share, and one of the businesses inside the company was called Yoplait Yogurt. Yoplait had the distinction of having won the yogurt war in North America, and they were earning something like $350 million a year. If you add that to the rest of the operations and divide by X, you get $5.12 in earnings per share. That’s what they were expected to earn and, gosh darn it, that’s what they were going to earn.

During the middle of the year, they heard about a yogurt startup in upstate New York; a Turkish guy had started in an old Kraft factory. He was going to make something they hadn’t explored, it was called “Greek yogurt”, by a Turkish guy — a bit odd. They went and saw the business, a fledgling startup. For about $10 million they could have gone after the niche and they would have had a running start on the brand. If it had worked, they would have been able to immediately squelch the Turkish Greek yogurt maker. Instead, they went home and said to their superiors it was fine, “you’ll make the numbers; we won’t spend the money”. Fast-forward to today, Chobani is the Greek yogurt. General Mills never should have avoided confronting it at the start. Chobani should have been put out of business within the first year by aggressive tactics. It wasn’t, in some ways, for the same reason Gillette leaned too heavily on its core business for profits. They should have redeployed capital in ways to continue to delight the customers.

Both of those examples express the thing you have to avoid the most, which is that managements respond too much to Wall Street’s short-term quarterly earnings pressure and, increasingly, to activist pressure on public companies. By contrast, in our portfolio we celebrate businesses that tend to invest more and report less upfront than they ought to or could, but they do so in pursuit of long-term investment returns and increasing wealth over time. They’re allowed to do it largely because they have the ability to reinvest. The consumer brands we own tend to be internationally-based, they tend to have a strong presence in developing and emerging markets. The population there is vastly underserved and they have a long runway, a lot of “white space” into which to invest their mature-market cash flows. By deploying mature-market cash flows into developing markets, they guarantee upfront losses because the early return from investment spending is bad.

That’s what Chobani forced General Mills to think about. General Mills is a global partner with Nestlé around the world in cereal. They’ve adopted Nestlé’s approach for cereal, which is more long-term-minded. They blew it with Chobani because of their short-termism. We do the opposite. We look for businesses that overspend upfront to develop more competitive advantage for later on. The one difference across the portfolios is most of our companies are family-controlled, and if the families say they’re prepared to back a business for the future, three generations out, that is probably going to be consistent with our time horizon. It’s unusual, but that’s how we do it. It’s an expression that came about through early meetings with Buffett at Stanford Business School in the early 1980s when he said, “The critical thing to remember as investors is there’s only one thing the government gives you — the tax deferral of unrealized gains. You should invest your money in a way that allows you to take advantage of that.”

That means you find things that reinvest and you don’t sell. It’s become vastly harder because all of the businesses we own have had impregnable moats and all those moats are filling in and getting narrower and shallower and they face the same fights the consumer products industry generally faces, which is a lot of upstart and fast moving Dollar-Shave-Club-like assaults to their franchises. The only difference we’ve enjoyed is we’ve been more international than many investors in this room and that’s given our company’s outlets away from the mature markets in the US where the competitive activity is so strong and the businesses have adopted a longer-term mindset. I oversee mainly funds on behalf of taxable investors and so they’re aligned with us, that if we can find things to compound deferred tax — we’re better off than trading around the portfolio.

Q: Excellent. In your recent interview on the Latticework podcast, you talked specifically about three ways in which the environment is changing. Amazon is steering demand by managing availabilities and through suggestion, people are being able to find new products and brands in ways they never have before through services like YouTube and, finally, generally diminishing brand loyalties. I was hoping we could pick up where you left off in that discussion and talk about…

A: Those are bad enough.

Q: Talk about the specific ways you’re seeing your portfolio companies respond to the new environment. You broke it down in terms of product innovation and communication.

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The Most Important Moat

September 21, 2017 in Letters

This article by John Huber is excerpted from a letter of Saber Capital Management. John spoke about common sense and the most important moat and presented his investment thesis on a wide-moat business at Wide-Moat Investing Summit 2017.

[Earlier this year] I headed to Omaha to attend Berkshire Hathaway’s annual meeting. Nowadays, there is less of a reason to attend the meeting in person because it is available to watch online, but I love attending the event for all of the peripheral meetings that occur. It was a great weekend, and I got to connect with a few Saber Capital clients, as well as some good friends that I don’t see very often.

No matter how long you’ve been following Buffett and Munger, there are almost always some valuable learnings to be had at this event, and they usually touch on a topic or two that provokes me to think more deeply about a particular subject.

Here are a few main highlights from the meeting that I thought were worth mentioning:

On Learning and Getting Better

I’ve talked before about the process of continually getting better as an investor. I think investing is in some ways similar to other performance-based disciplines such as athletics or music. Top performers work on getting better each day, and while there isn’t usually a noticeable difference on any given day, stringing together a bunch of days where you are getting incrementally better by even a very small margin leads to a collectively significant improvement over time. As Buffett has pointed out many times, knowledge builds on previous foundations and grows over time, just like compound interest.

Munger has often said that your goal as an investor should be to go to bed a little bit smarter than when you woke up. Along with the idea of focusing on “the work that’s on your desk” (i.e. not looking too far ahead and just keeping focused on the task at hand), I think this goal of daily improvement is one of the most useful and practical lessons that Munger has ever taught us. I’ve tried to build Saber Capital’s business around this idea, keeping a clear schedule each morning to ensure that this objective stays at the top of my priority list.

Over the weekend, this topic of self-improvement came up, as it often does. Munger talked about his most important learning lesson, which he thought was See’s Candies.

I want to go into a brief tangent on some thoughts I have relating to this discussion. I occasionally think about what Buffett and Munger might be investing in if they were starting today. I think it would look a lot different than it did then.

First off, Munger said See’s was his most important learning lesson because it taught Munger and Buffett about the value of owning a great business, specifically one that can produce ever growing levels of cash flow with very little incremental capital requirements. See’s was a cash cow that didn’t need to be fed. And it produced more and more milk each year, still without requiring any “food” (i.e. little to no cash needed to be invested back into the business to grow).

See’s produced $4 million of pretax earnings the year they bought it. They paid $25 million, or somewhere around 12 times earnings after tax. Since that time, the company has sent around $2 billion of pretax cash flow to Berkshire, using just $40 million or so of incremental capital investments. As Buffett said in the 2014 shareholder letter:

“See’s has thus been able to distribute huge sums that have helped Berkshire buy other businesses that, in turn, have themselves produced large distributable profits. (Envision rabbits breeding.) Additionally, through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments.”

What If Buffett Knew What He Knows Now?

Everyone knows by now that See’s was a great business to buy. But the tangent I wanted to briefly take is to consider how the See’s experience likely would have impacted the decisions Buffett previously made. In other words, would it have changed some of his investments, or would it have changed his investing approach had he been able to go back in time, knowing in the 50’s and 60’s what he learned in the 70’s from the See’s investment?

I think the answer to that is undoubtedly yes. And while I’ve always thought that there is somewhat of a misunderstanding* about Buffett’s early investment strategy, it is true that he bought some cigar butts (seemingly cheap stocks of poor businesses). I think the learning experience they had with See’s would have significantly changed some of their major early investments. Buffett almost certainly wouldn’t have started buying Dempster Mill in the 1950’s—a capital intensive windmill and farm equipment company with sub-par returns on equity. Nor would he likely have purchased Hochschild Kohn (the Baltimore department store) in the 1960’s.

*(While it’s true that Buffett bought some cigar butts, even very early on he grasped the power and value of owning a good business—he bought GEICO in 1951, putting 65% of his then-small net worth into the stock as a 21-year old. Also, two of his biggest and most meaningful contributors to his results in the 1960’s, American Express and Disney, were stocks purchased while still running his partnership. Even the incredibly cheap stocks that he bought in the early years of his fund, like Commonwealth Bank or Western Insurance, were still decent businesses with stable earning power and good balance sheets. He certainly bought some laggards like Dempster Mill and even Berkshire Hathaway itself, but those were usually when he felt like he could gain control of the business eventually and reallocate the cash. Even early on, he made most of his money in the stocks of better businesses).

So the point is: I don’t think Buffett and Munger would be buying cigar butts in today’s world if they were starting from scratch, given the knowledge they gained in the 70’s and 80’s from investing in both good and bad businesses.

If they could start over with their current knowledge base, I think Buffett and Munger would be buying small and large cap stocks (and everything in between). I think they’d be turning over rocks just as they did in the early days, but I think they’d place a much greater emphasis on the earning power and longer-term viability of the business.

This Time is Different

This also gets me into a broader point on today’s markets: Things would look a lot different if Buffett and Munger were starting today. Buffett said recently that if he had started a partnership in 2004, he would have been 100% invested in South Korean stocks. Munger said at the Daily Journal Meeting that he’d be focused on looking for opportunities in China if he were starting out today.

Neither of these ideas are recommendations, it just means that they’d be approaching things differently based on the skillsets they’ve developed over the years and the knowledge they’ve accumulated. They would use that experience to capitalize on the most obvious and best available opportunities that are offered in today’s business world.

Capital-Light Businesses

Along these lines, Buffett talked about how different businesses are now. He mentioned that business moguls like Carnegie, Mellon, and Rockefeller would be absolutely shocked if they knew how quickly companies could grow today and how little capital would be required to support that growth.

He pointed out that the five largest companies in the market are:

  • Apple
  • Google
  • Microsoft
  • Amazon
  • Facebook

With the exception of maybe Amazon, those companies require virtually no capital to grow, and even Amazon, despite spending billions of dollars building out its foundation for growth, has a number of major business lines like its third party seller marketplace and its cloud business that produce extremely high returns on incremental capital investments. Facebook, which was founded just over a decade ago, did $27 billion of revenue that had 45% operating margins last year. In just the last twelve months, the company grew its pretax earnings by $6.2 billion on just $3.7 billion of additional capital investments, including acquisitions (good for a healthy 170% incremental ROIC).

In fact, the business probably would be growing even without that additional capital, and the nature of Facebook, Microsoft, and Google’s main businesses are that they produce huge returns on capital, significant cash flow, and require little to no capex.

All of these businesses got to scale much more quickly than Carnegie’s steel plants, Rockefeller’s oil refineries, or Mellon’s banks. It took decades of toil and significant sums of capital to go around the country and cobble together a network of refineries in the late 19th and early 20th century. It took Zuckerberg just eight years to build a business from scratch that reached a $100 billion valuation, and four more to reach $300 billion. In 2010, Facebook had $1.9 billion in revenue. Last year it did over $12.5 billion in pretax profits. These are businesses that Carnegie and Rockefeller could only have dreamed about.

I’d also add that the great companies of a century ago were confined primarily to their industries. Rockefeller was an oil man. He wouldn’t have even thought about getting into retail, or banking. But companies like Alibaba or Amazon start in retail, and then use their foundations and user bases to expand into businesses such as banking, payments, storage, and even investment management.

Given the value these companies provide and the size of the markets they might enter, these businesses can likely become much larger than the relative size of even the greatest monopolistic giants of last century.

I’m simply using the large-cap tech stocks as an example to illustrate my point (I’m not suggesting that buying mega-caps is solely what Buffett would be doing). I don’t pretend to know what stocks Buffett and Munger would be buying today if they were starting over, but what I do think is relevant to take home is that Buffett and Munger were both very independent-minded in the 1960’s. They did things their own way. They capitalized on the opportunities they had at that time, and I think they’d be doing the same today.

I think the foundation of value—getting more future cash flow for the price paid—will always be the philosophy that works. I also think that investors should use Buffett’s blueprint to form their own independent thoughts about opportunities—both big and small—in today’s business world. There are lots of incredible opportunities, and the one thing that will always stay the same is human nature—Mr. Market will always be moody.

Consumer Shift

Buffett also mentioned Apple, and how his main thesis was observing consumers’ perception of the brand and the stickiness of the software ecosystem. This leads to predictable demand for the iPhone, and other related Apple hardware products.

But he also said that consumer behavior is more difficult to judge than it used to be. I think that this is in part because people aren’t as beholden to consumer brands as much as they used to be. Or, put differently, I think many companies that we think had a brand really just had a distribution advantage that came from being a big incumbent with the largest market share for many years. The high gross margins led to bigger advertising budgets, which further entrenched these market leaders. Kraft used to own its place in the center of the grocery isle. This advantage is eroding, as distribution costs have plummeted. The internet and social media have lowered the cost of getting products to market and reduced the time required to get to scale. They’ve cut out the middleman in many cases, allowing small upstart companies to sell directly to consumers and avoid the typical retail markup.

Is the Product Undervalued?

As I mentioned in my 2016 year-end investor letter, one of the things I try to consider when analyzing a potential investment is whether the company’s product or service is a good deal for customers. If a business has attractive economics but is extracting value from (rather than adding value to) its customers, then I think there are some inherent risks in that model that will eventually come home to roost. This parasitic relationship might lead to above average profitability in the near term, but it also leads to customers who feel exploited, and when a competitor comes in that offers more value to customers (in the form of better products and/or lower prices), these alienated customers will be much more quick to leave.

For example, Costar owns a commercial real estate website called Loopnet, which had enormous embedded pricing power when Costar bought the site. The company understood that the site was essential to commercial real estate brokers, and began raising prices very rapidly. Some brokers I’ve talked to have seen their Loopnet subscription costs rise multiples from where they were just a couple years ago. Just about everyone in that business that I’ve talked to feels that they aren’t getting good value, but they continue to pay because of the monopoly-like position of the website (it’s basically the commercial real estate MLS, and brokers must have access to it to do business in most cases).

This type of position is often viewed as an attractive asset, a moat. But as a business owner, I’d be worried that my customers would quickly jump ship if a competitor came up with an alternative. Contrast that with the experience customers feel at Amazon Prime, which continues to provide more and more value to customers through wider selection, greater convenience, and prices that more often than not can’t be beat. This extreme customer value makes it more and more difficult for a competitor take customers away from Amazon’s platform.

The Most Important Moat

I gave a talk in Omaha called “The Most Important Moat”, which basically outlined this idea that the best way to build an enduring competitive advantage is to focus on ensuring that the customer feels like the product or service that you’re selling is a good deal.

If not, you will no longer be able to rest on the laurels of barriers to entry, high distribution costs, incumbent advantages like shelf space, bigger advertising budgets, switching costs, or just about any other advantage that you used to enjoy in years past. It’s much easier to start a business, sell directly to consumers and build a product brand using social media. This allows you (and other small like-minded upstart companies) to collectively compete against much larger brands, despite having much lower advertising or distribution resources.

I think the advantages that used to be relied on by big incumbents like Gillette, Kraft, or Kellogg are eroding. Consumers have more options to choose from, better information on products, and receive more value for the price paid.

High margins and consumer brands are still very valuable, but I think the key is determining whether a company’s perceived brand comes from its market share, distribution, or advertising budget, or whether it comes from providing customers with great value. I think the former category will see their brands lose value. The latter category will still face plenty of competition, but I think it’s much harder to dislodge a company with the best value proposition to the end customer.

Bezos said the following:

“The balance of power is shifting toward consumers and away from companies. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.”

So I think some things to keep in mind regarding Buffett’s comments about the greater difficulty in predicting consumer behavior are the following:

  • Brands are generally less powerful than they used to be
  • Distribution and advertising costs are no longer insurmountable barriers to entry (companies can sell directly to consumers on a shoestring ad budget)
  • Products can scale much faster
  • Large market share and well-known products don’t necessarily equal a moat

Key questions:

  • Does the company have a true brand that offers a valuable product?
  • Or is it a highly profitable incumbent whose high margins are due to an overpriced product and an eroding “shelf space” distribution advantage?

Is the customer getting a good deal when they buy the company’s products or services? I think spending time trying to think about and answer this question will go a long way in helping understand consumer behavior and also help value the business in question.

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Disclosures: 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 first quarter’s statement. Also note that the time weighted return (TWR) on your account specific performance summary is net of all fees.

Bias from Pavlovian Association

September 20, 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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Bias from Pavlovian association is misconstruing past correlation as a reliable bias for decision making.

“So the dog salivated when the bell rang – so what? The truth is that it is an enormously powerful force in the life of all of us. We wouldn’t have money without secondary reinforcement…Three-quarters of advertising works on pure Pavlov.” –Charlie Munger

“Coca-Cola wants to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with presidents’ funerals and so forth.”

Persian Messenger Syndrome – “The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. He didn’t hear one damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.”

In economics, we’re all taught about supply and demand, but there is also the counterintuitive result of getting more demand after raising the price, based on a Pavlovian association in the face of information inefficiency.

Bias from operant conditioning (e.g., giving the dog a reward, or Skinner’s ability to create superstitious pigeons) is also a factor.

Westinghouse lost a few billion dollars lending to hotel developers under the influence of “slick salesmen” with incentive-caused bias. It was a fiasco enabled by loose accounting standards which showed wonderful financial results in the initial phase of every transaction – an absolute sin. Joe Jett and Kidder Peabody also fell prey to this phenomenon.

Update

New examples include the association of military service and impressive music played by military bands; Napoleon and Hitler’s ill-advised extrapolation of prior military success in launching a campaign in Russia; a casino gambler on a hot streak; or an investor who “gets lucky in an odds-against venture headed by an untalented friend. So influenced, he tries again what worked before – with terrible results.”

“The proper antidotes to being made such a patsy by past success are (1) to carefully examine each past success, looking for accidental, non­causative factors associated with such success that will tend to mislead as one appraises odds implicit in a proposed new undertaking and (2) to look for dangerous aspects of the new undertaking that were not present when past success occurred.”

Persian messenger syndrome is also alive and well. There, the antidote is Berkshire’s prescription to “always tell us the bad news promptly. It is on the good news that can wait.” Dick Kovacevich of Wells Fargo offers another example. “Unlike Kovacevich, who would tell his executives, ‘The only thing I want to hear is bad news,’ Stumpf seemed to be proud that the culture was one of ‘Minnesota nice.’ He ‘was not perceived within Wells Fargo as someone who wanted to hear bad news or deal with conflict,’ noted the board report.”[18]

More prosaic problems arise when Persian messenger syndrome is a legitimate threat to someone’s career or self-interest, combining with incentive-caused bias in catastrophic fashion. Munger cites the examples of union negotiators (leading to “many tragedies in labor relations”) and lawyers who, “knowing their clients will hate them if they recommend an unwelcome but wise settlement, will carry on to disaster.”

Another “serious clump of bad thinking caused by mere association lies in the common use of classification stereotypes.” Munger cites the “sort of wrong thinking that is both natural and common” in ageism and sexism.

“It is frightening to think that you might not know something, but more frightening to think that by and large the world is run by people who have faith that they know exactly what is going on.” – Amos Tversky

Denial seems to be having a resurgence. “Truthiness” and “alternative facts” and “fake news” may be obvious tools A more vivid example comes from Daryl Morey, the psychologically astute general manager of the Houston Rockets and something of a Billy Beane Moneyball-style manager in the NBA. Morey noted, after several years of observation, that extremely tall people had an unusual capacity to charm.

“’I don’t know if it’s like the fat kid on the playground or what.’ The trouble wasn’t the charm but what the charm might mask; addictions, personality disorders, injuries, a deep disinterest in hard work. The bigs could bring you to tears with their story about their love and the game and the hardship they had overcome to play it. They all have a story.’ And it was hard not to grow attached to it. It was hard not to use it to create in your mind a clear picture of future NBA success. But Daryl Morey believed – if he believed in anything – in taking a statistically based approach to decision making. ‘Your mind needs to be in a constant state of defense against all this crap that is trying to mislead you.’ Heeding the career risk that was likely if he never interviewed a player who turned into a disaster, Morey didn’t eliminate qualitative interviews but he did move toward quantitative statistical models to evaluate players. He also abhorred certainty and suggested a “new definition of the nerd: a person who knows his own mind well enough to distrust it.”

After fits and starts in building his own framework for evaluating players, one key tweak Dorsey made was to ban nicknames. That idea came after his staff started calling a certain prospect “Man Boobs” after seeing pictures of him shirtless during their pre-draft scouting. The scouts became dismissive of him and passed on the chance to draft him. The player – Marc Gasol – went on to be quite valuable and the mistake cost the Rockets dearly.

Morey also tried to eliminate the mis-weighting of vivid evidence from in-person tryouts, from “confirmation bias” – really first-conclusion bias – and liking tendency, which was especially prevalent when scouts compared prospects to themselves. Importantly, Morey also “forbid all intraracial comparison. ‘We’ve said, ‘If you want to compare this player to another player, you can only do it if they are a different race.’ [And] a funny thing happened when you forced people to cross racial lines in the minds: They cased to see analogies. Their minds resisted the leap. ‘You just don’t see it,’ said Morey.” The development and success of Jeremy Lin – a Chinese-American player from Harvard with roughly zero comparable players in NBA history – played a big role in this thought, especially since Morey’s modeled coveted Lin but Morey “chickened out” when he had the chance to draft him.[19]

A corollary to association is the representativeness heuristic., which is often used when making judgment under uncertainty. Tversky and Kahneman defined representativeness as “the degree to which [an event] (i) is similar in essential characteristics to its parent population, and (ii) reflects the salient features of the process by which it is generated.”[20] The problem, of course, is that the representative examples are easy to access but may or may not reflect the base rate.

“Steve the librarian” sets the stage. “As you consider the next question, please assume that Steve was selected at random from a representative sample. An individual has been described by a neighbor as follows: ‘Steve is very shy and withdrawn, invariably helpful but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.’ Is Steve more likely to be a librarian or a farmer?

“The resemblance of Steve’s personality to that of a stereotypical librarian strikes everyone immediately, but equally relevant statistical considerations are almost always ignored. Did it occur to you that there are more than 20 male farmers for each male librarian in the United States? Because there are so many more farmers, it is almost certain that more ‘meek and tidy’ souls will be found on tractors than at library information desks. However, we found that participants ignored the relevant statistics and relied exclusively on resemblance…as a simplifying heuristic.”

Consider their classic example of “Tom W.” Asked to guess Tom’s field of graduate school out of nine choices, you should jump toward the base rate just as you’d want to know how many marbles of a certain color are in a jar. Participants were placed into three groups and asked to rank the likelihood of Tom as a graduate student in one of nine fields: one group was nudged toward the base rate, one was given a personality sketch, and one was given the personality sketch with the added information that the sketch was done by a trained psychologist. The results were strongly driven by how representativeness or similarity, ignoring the base rate, even among brilliant graduate students in psychology who were working on the study with Kahneman and Tversky!

Or consider their classic fictitious subject “Linda.” “Amos and I made up the Linda problem to provide conclusive evidence of the role of heuristics in judgment and of their incompatibility with logic.” Linda is adaptable to the times, but the original description said “Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Which is more probable? 1. Linda is a bank teller. 2. Linda is a bank teller and is active in the feminist movement.” Later updates offered Linda as a teacher, a bookstore clerk who takes yoga, active in the feminist movement, a bank teller, an insurance salesperson, etc. “Even in the Facebook era, it is easy to guess the almost perfect consensus of judgements: Linda is a very good fit for an active feminist, a fairly good fit for someone who works in a bookstore and take yoga classes—and a very poor fit for a bank teller or an insurance salesperson.”

On a related note, here’s a thought experiment about two new investment funds being launched at the same time. Firm A is being launched as a one-man shop with no back office in a mid-sized city. The manager is clearly very bright, but he quit an Ivy League school to finish college at a state university near home and he was rejected by Harvard Business School. He did pursue his graduate education at an excellent Ivy League business school, and after a stint as a broker went on to have a very successful two-year run at a reputable fund. He’s moderately rich but has invested only $1,000 of his own money in the fund. He doesn’t have a specialty or a focus other than general value investing. He is in his 20s and has no experience as a portfolio manager. He refuses to provide any information about his holdings, and he reports performance only once per year.

Firm B is run by a team of exceptionally brilliant people. They have a collective IQ that is probably among the highest of any group in the world. They are swimming in prestigious degrees and world-renowned awards. The strategy is cutting edge, specialized, and unique. They employ the best quantitative methods and risk systems. They have well over a decade of experience at a world-class, name-brand firm, and they are enormously rich. They are also putting ~100% of their own net worth into the fund.

Firm A, of course, is the Buffett Partnerships, and Firm B is Long Term Capital Management.[21]

Another related topic in representativeness is the “clustering illusion,” as discussed by Gilovich in How We Know What Isn’t So.[22] “Why, beyond noting that nature abhors a vacuum, do people fall prey to the clustering illusion?” Representativeness. The 2004 and 2005 hurricane seasons, the “hot hand” issue in basketball, a string of good returns by a fund manager – everything needs to be considered in this regard. And as always, our biggest problem takes from extending a good idea too far. Gilovich notes “it is the overapplication of representativeness that gets us into trouble.”

*****

Munger expanded greatly on the subject of association in a subsequent talk given at UC Santa Barbara in 2003:[23]

I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

…And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.

The investment management business still features this phenomenon in the extreme. Even though fees are in focus and under pressure, and even though passive index funds are taking share, there is a long way to go in that direction. In the meantime, investment managers that have already achieved scale and/or success – or at least the patina of success – can usually ride that wave years longer than we might otherwise think. And the most predictive indicator of investment fund-raising success remains, in my opinion, a spin-off from a name-brand firm. As a predictor of success the results might look different.

It’s also worth thinking about how Investment environments are designed. Easy access to screens, ever-cheap commissions, beautiful data and blinking lights…they all have legitimate benefits, but they’re also hugely encouraging to frequent trading. Every piece of trading software I’ve ever used literally rings a bell when a trade goes through. You can disable the sound, but you have to go to the trouble to do that. The broker isn’t just trying to notify you of a completed trade, it’s trying to encourage trading to generate more commissions.

In advertising, the world still works according to these principles, although there is some debate as to whether the world is changing in light of consumer preferences shifting away from brands toward generics. And the near-ubiquitous available of instantaneous price discovery enabled by mobile phones and Amazon must have some effect, however big, on diminishing the information inefficiencies and Pavlovian association so frequently exploited by brands. 25 years ago, it would have been hard to imagine Gillette being threatened by a start-up, or the rise of Kirkland (now with more revenue than Coca-Cola), or the slow fade of some CPG companies.

As an aside, a useful if unprovable counterfactual might be found in a hypothetical experiment: if all companies in an industry stopping advertising all together, would there be any net effect on sales? Even short of that, it follows that some or even most of the money spent on advertising is wasted. Just as I can’t prove the idea about a world without advertising, most advertising executives can provide no definite proof of success or even a quantified return on investment.

Coca-Cola, as noted by Munger, used association and availability to enormous success in the 20th century. But with hundreds of millions or even billions spent on advertising every year, what progress is being made? In any case, the vivid examples of marketing success like Coke drive plenty of mindless imitation.

Going back to Munger’s comments about accounting, Enron had a party – an actual party – when it won approval for an accounting change that enabled mark-to-market (and really, mark-to-model) accounting. It was as if this episode were written by Munger in talking about how prior accounting scandals (speaking in 1995) “would never have been possible if the accounting system hadn’t been such [that] for the initial phase of every transaction it showed wonderful financial results.” That is precisely what happened at Enron when it booked long-term energy contracts or built physical assets and immediately recognized all gains and profits up front.[24]

My opinion, which is incomplete and open to criticism, is that no one at Enron – Lay, Skilling, Fastow or anyone else – woke up one morning and decided to cook up a massive fraud. As with many such cases, there was a slippery slope and little bad behaviors snowballed into enormous bad behaviors. At Enron I think there were incentive-caused problems and cultural issues that morphed into a monster. Just as some notable people have overdosed on Ayn Rand, Jeff Skilling talked about Richard Dawkins’ book The Selfish Gene as his favorite and the foundation of his managerial philosophy. He had an extreme view of the world in which money and fear were the only possible motivators of people. He insisted on a numerical grade for all Enron employees, and it required that 15% of all people had to be given the lowest score regardless of absolute performance and forced to find another job inside or outside of Enron within two weeks (a practice known as “rank and yank”).

That is an interesting vignette about the culture, but it can’t tell the whole story. In a pattern that hopefully sounds familiar, it was a confluence of events that made the Enron situation possible. There was a load of incentive-caused bias – the entire company and culture was created as if to maximize the potential problems in that regard. There was social proof – the company was a successful, edgy, high-flying, politically connected wonderchild that was adored by the press and by Wall Street. (It was a pipeline company that quickly transformed itself and was named by Fortune as “America’s Most Innovative Company” for six consecutive years.) There was over-influence by authority as higher-ups encouraged others in the organization to engage in misconduct. There were contrast effects as the transgressions and crimes started small but grew over time, aided by commitment and consistency. The auditor was central to the villainy here too, and in this case it caused an entire firm – one of the giants of American business – to be criminally indicted and implode.

Likewise, the rise of Las Vegas is often attributed to the removal of the mafia, but the development of Las Vegas wouldn’t have been possible without some deep sources of capital to replace the mob. And the development was driven by a regulatory and accounting change. In 1969 the Nevada state legislature passed the Corporate Gaming Act, allowing corporate entities to purchase and build casinos without subjecting every shareholder to be thoroughly vetted by background checks as previously required. Expansion predictably exploded, and now you can play anywhere in Las Vegas: Strip casinos, local casinos, drug stores, car washes, supermarkets. Many of these places have not just the usual “reward” programs and perks, but they also offer childcare to enable more gambling. Likewise, legal and regulatory fights over sovereignty on Native American reservations was the driving force in spreading casino gambling to all corners of America. It didn’t take long for the politicians to sink their teeth into the juicy tax revenues casinos could offer by rewriting the laws to justify them in otherwise asinine locations. Gambling was legal on cruise boats, so all forms of water should be a safe harbor for casinos.? I’m an illegal gambler on land but as soon as I walk across some little bridge in Gary, Indiana or Joliet, Illinois onto a makeshift riverboat and suddenly I’m legitimate? It’s a Mad Hatter’s Tea Party, as Munger would say.

nextseries start series overview

[18] http://www.vanityfair.com/news/2017/05/wells-fargo-corporate-culture-fraud
[19] The Undoing Project by Michael Lewis
[20] http://datacolada.org/wp-content/uploads/2014/08/Kahneman-Tversky-1972.pdf
[21] I fudged some of the figures and details to make it less obvious, but the point hopefully stands.
[22] How We Know What Isn’t So by Thomas Gilovich
[23] As reprinted in Poor Charlie’s Almanack
[24] Bethany McLean and Peter Elkind , Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, 2003, ISBN 1-59184-008-2.

The Wisdom of Crowds

September 19, 2017 in Letters, Reading Recommendations

This article by Barry Pasikov is excerpted from a letter of Hazelton Capital Partners.

In the days leading up to the 1948 Presidential Election, all of the polls, political analyst, and media predicted that Republican Governor, Thomas Dewey, would easily defeat incumbent Democratic President, Harry S. Truman. In fact, the Chicago Tribune was so confident in the outcome, it printed its first edition (150,000 copies) with the now famous headline: “Dewey Defeats Truman.” As history has taught us, never pop the champagne bottle until the final votes have been tallied. Nearly 70 years later, Americans were treated to another “Dewey” moment when Donald Trump defeated Hillary Clinton, recording the biggest political upset in our nation’s history.

Say what you will about 2016, it was anything but boring, especially when it came to U.S. politics. Virtually no media outlet, political analyst/insider, or statistician could create a scenario in which Clinton would not become our nation’s 45th President. Even Nate Silver, the statistician who correctly predicted the presidential outcome in 49 out of 50 and 50 out of 50 states in 2008 and 2012 respectively, had the probability of a Clinton win at a conservative 72% the day of the election. This conventional wisdom was also reflected in the stock market. The final two days before the election, after Clinton’s email investigation was once again closed, the S&P 500 index rallied over 2.5%. Tuesday night, as the election results began to filter in and a Clinton Presidency began to fade, the S&P 500 index collapsed, the futures indicating a 6% decline by the open on Wednesday morning. That, too, proved inaccurate, as the S&P 500 had not only fully recovered, but even posted a 1% gain by the close of trading on Wednesday afternoon.

Now, more than ever, we live in a world where data is constantly collected and analyzed. When you get into your car, your phone, more often than not, predicts the time to your expected destination based on previous driving habits and your calendar. Open your email and Amazon has sent you a list of products you “need.” And then there is the famous story of an infuriated father screaming at the manager of his local Target store because his teenage daughter was receiving coupons for pregnancy and baby items. His daughter received these coupons because her purchasing patterns were similar to women who were or became pregnant. It turns out that Target knew the man’s daughter was pregnant before she admitted it to her father. So, how is it that Target can know that a random teenage girl is pregnant but the pollsters, political forecasters, and the media can get the election results so terribly wrong?

In James Surowiecki’s book, The Wisdom of Crowds, he explains how a group’s predictive ability can be far superior to nearly all of the collective individuals’ estimates. The power of crowdsourcing (harnessing a collective’s input) has been successfully demonstrated in marketing campaigns, beta testing, funding creative projects, and even predicting the outcome of elections. However, what Surowiecki also discovered was that as powerful and accurate a tool crowdsourcing can be, it is also very susceptible to biases. One of the biggest biases impacting collective predictions is independence. Studies have shown that when a collective’s estimates are made public, it will influence future estimates and negatively impact the group’s predictive ability. We are all familiar with peer pressure and have at some point succumbed to its influence. Our primordial brains have been hardwired to seek out the protection of the pack as a survival mechanism; distancing yourself from the collective is not only dangerous but socially alienating.

Leading up to the Presidential Election, I was part of the general consensus that believed that a Hillary Clinton Presidency was all but a certainty. I only knew of two people that would openly admit that they were voting for Trump. Of course, I live in Illinois where it has been rumored (but never proven) that the state legislature is considering reducing election costs by only listing the Democratic candidates on the ballots. But even friends and colleagues outside Illinois did not show any support for Donald Trump. Of course, my informal poll was not diverse or expansive enough to represent the zeitgeist of the nation. Polls and surveys are biased and inherently unreliable. They are dependent on a number of factors in order to be accurate: Sampling diversity, non-conformity, accurate reporting, and honesty. It is believed that the reason the 2016 election polls and results were so divergent was mostly because people would not admit to be voting for Trump because of the social stigma attached to their decision. Without accurate data, polls are worthless.

Over the past 15-20 years, business news networks have created a niche segment within the news industry by providing real-time market quotes, business news stories, and investing strategies. Unlike conventional news, which reports on the events that are occurring at the moment, business news focus on the future expectations of a company’s share price. To help in their reporting, the networks invite “experts” to share investing insights. Leading up to the election, nearly every market pundit who took to the airwaves warned of the dire market outcome if Donald Trump were to miraculously win the election. Because these “market experts” shared the same general consensus, the investing public took these insight to be highly probable.

In the short-run, markets are surveys. They are the aggregate predictions of investors. It is widely believed that markets are efficient because they distill all news and information available. But even though mathematics is involved in determining the price of a stock, investing is not a science. Just like election polling, markets are very susceptible to biases, including investor emotions of fear and greed. On election night, investors disbelief turned to terror as a Donald Trump became the presumptive winner. The market’s short-term sell-off was an emotional and Pavlovian response to an impossible outcome, and therefore, the market swoon was believed to be a self-fulfilling prophecy. But in the long-run, markets, and more importantly, a company’s share price, will ultimately reflect the fundamental strength or weakness of a company. For the long-term, patient investor who was feeling the same political distress, the market swoon was an investing opportunity.

Opportunity always comes gift wrapped in a fog of uncertainty. And given the “Trump Tweets” that we have witnessed so far, the next four years promise to be very unpredictable. There are numerous unknowns about a Donald Trump Presidency and the future of the economy. Many people believe that Trump’s desire to lower corporate taxes will be a boon to corporate profits. Or that his promise to revamp Dodd Frank will lead to less regulation and benefit the financial sector. And just as many people are fearful that a Trump Presidency will lead to tariffs, trade wars, alienating countries, and political unrest. But mostly, we have no idea what he is going to do or “Tweet” about next. Just as the market got it wrong on election night, the year end rally could easily have been an overreaction leading to a “Trump Dump,” or the beginning of another extension to the ongoing bull market leading to a “Trump Bump.” Those who pretend to know are either very lucky or trying to sell you something.

Hazelton Capital Partners is not in the prediction business. We are not trying to outsmart the investing collective. We focus on our competitive advantage: Ignoring the “sound and fury, signifying nothing,” and instead, continuously search for our next investment opportunity where the price paid for an asset is significantly lower than its expected future value, ultimately leading to long-term success.

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The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Why Purpose Matters

September 19, 2017 in Commentary, Letters

This article by Michael Shearn is excerpted from a letter of Time Value of Money, LP.

We have spent over 20 years researching the best-performing companies in the world across multiple industries in order to identify the common elements of their success. When we started investing, we thought competitive advantage was the most important element, but saw these advantages quickly erode in companies with poor leadership. We later saw leadership as more important, but made the mistake of investing in leaders who were laser-focused on shareholder value. Their strategies worked well in the short term but in most cases resulted in serious negative consequences for their companies (e.g., witness the decline of Sears Holdings). Although there obviously isn’t a single factor that guarantees success, we believe we have uncovered a few traits found in those businesses that have consistently produced the best results for our fund.

In order to find these traits it was necessary for us to look beyond the numbers and look at what we dare consider the “heart” of a company. In our experience, many of the strongest, healthiest, and most enduring companies have leaders with a purpose beyond just maximizing profits. These leaders focus on maximizing value for all stakeholders, including customers, employees, shareholders and suppliers. Ultimately, we have found that these companies also create greater and more sustainable profits.

At the simplest level, a business exists because it provides value to customers and the people who work there. If the business doesn’t create value then it will fail to exist over the long term. We think the best way for a business to create value for its customers is to have a vibrant and engaging workplace where employees feel valued and are motivated to deliver their best work.

Although many business leaders see employee engagement and workplace culture as important, they don’t always implement practices that develop such cultures in their workplaces. Recent Gallup research in the US shows that a staggering 68 percent of employees are not engaged at work, which means they aren’t putting energy or passion into their work. Included in this number, around 20 percent of all employees are actively disengaged, creating multiple problems for their companies. Professor Raj Sisodia at Babson College provides a vivid picture of what this looks like: “It is like a rowing crew where 3 are rowing, five are not rowing and two are hitting everyone else on the head!” Think about those businesses you interact with on a day to day basis where you feel the employees actually care about you and then think about those businesses where you know the employees do not care about you. Which is more likely to survive and grow? Purpose matters.

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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.

Cooks in the Kitchen

September 19, 2017 in Letters

This post by Matthew Miller and Joseph Koster is excerpted from a letter of Boyles Asset Management.

We are often asked about the impact of operating an investment program with multiple decision makers. Even Mr. Buffett and Mr. Munger have questioned the efficacy of investment committees in the management of portfolios. We’d hesitate to put co-managers in the same category as a committee, but it is an important topic.

We are the first to admit that there are frictions in addition to the benefits of the model we have at Boyles. Boyles operates with two managers, each equally responsible for finding ideas, conducting diligence, and making decisions. We do not apportion pieces of the portfolio to either manager. Each is expected to be fully conversant about ideas under examination or in the portfolio. We’ve been operating in this manner for 10 years now. That longevity tends to help.

The biggest difficulty when it comes to such a model is that not every person similarly interprets a given set of facts or places the same weight on particular facts when analyzing an investment. This is perhaps no different from any other situation in life, and it remains true even when co-managers share an investment philosophy. It is true at Boyles. While it is rare that facts themselves are in dispute, this friction can either be a source of destructive and counterproductive strain; or what Linda Hill, a professor at Harvard University, has described positively as “creative abrasion.” After studying Pixar’s success with team-based creative development, which has led to a number of blockbuster animated movie productions, she identified three cores to the success: creative abrasion, creative agility, and creative resolution. In a 2015 TED presentation, she stated:

“Creative abrasion is about being able to create a marketplace of ideas through debate and discourse. In innovative organizations, they amplify differences, they don’t minimize them. Creative abrasion is not about brainstorming, where people suspend their judgement. No, they know how to have very heated but constructive arguments to create a portfolio of alternatives. Individuals in innovative organizations learn how to inquire, they learn how to actively listen, but guess what? They also learn how to advocate for their point of view. They understand that innovation rarely happens unless you have both diversity and conflict.

“Creative agility is about being able to test and refine that portfolio of ideas through quick pursuit, reflection, and adjustment. It’s about discovery-driven learning where you act, as opposed to plan, your way to the future. It’s about design thinking where you have that interesting combination of the scientific method and the artistic process. It’s about running a series of experiments, and not a series of pilots. Experiments are usually about learning. When you get a negative outcome, you’re still really learning something that you need to know. Pilots are often about being right. When they don’t work, someone or something is to blame.

“The final capability is creative resolution. This is about doing decision making in a way that you can actually combine even opposing ideas to reconfigure them in new combinations to produce a solution that is new and useful. When you look at innovative organizations, they never go along to get along. They don’t compromise. They don’t let one group or one individual dominate, even if it’s the boss, even if it’s the expert. Instead, they have developed a rather patient and more inclusive decision making process that allows for ‘both/and’ solutions to arise and not simply ‘either/or’ solutions.”

We believe that Professor Hill’s thoughts on creative abrasion, agility (if you substitute ideas and investments for experiments and pilots), and resolution are particularly useful when thinking about how we operate a co-manager model. When each of the three are calibrated correctly, the team-based model can beat the single-manager model. However, for each of Hill’s concepts to work in the investment business, we believe there are a few necessary ingredients, including:

  • Cohesion of investment style
  • Open conversation about evolution of investment philosophy
  • Willingness to accept critique on ideas and diligence process
  • Trust that the other party is living up to their responsibilities
  • Open communication about interpretation of facts
  • Sufficient time operating under these conditions
  • Genuine acceptance that outcomes are joint outcomes

It is a constant process, and the relationship requires work, but in the end we believe it can lead to superior outcomes.

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The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Exclusive Conversation with Alex Rubalcava of Stage Venture Partners

September 19, 2017 in Featured, Information Technology, Interviews, Transcripts, Venture Capital

“Warren Buffett says he’s a better businessman because he’s an investor, and he’s a better investor because he’s a businessman. I feel the same way about venture capital and value investing.” –Alex Rubalcava

We were delighted to have an opportunity to speak with Alex Rubalcava, a founding member of Stage Venture Partners, based in Los Angeles. Prior to launching Stage Venture Partners, Alex managed a long-biased, value-oriented investment partnership focused on public market securities.

Before launching his eponymous fund, Alex was an analyst at Anthem Venture Partners, a venture capital fund in Santa Monica, CA. While at Anthem, Alex worked on early stage investments including Myspace, TrueCar, and Android. Alex has also been an active angel investor and is active in Los Angeles nonprofits; he has served on the board of Los Angeles Animal Services, KIPP LA Schools, and South Central Scholars. Alex is a 2002 graduate of Harvard University and we’ve known each other for a decade. Alex, thank you for the opportunity to learn from your experience and share your cumulative wisdom with our community.

Shai Dardashti, MOI Global: We’ve enjoyed many great conversations together over the past decade at Berkshire Hathaway shareholder weekends and Wesco annual meetings. Please help our community understand your professional journey.

Alex Rubalcava: I have always had one foot in the public markets with a value approach, and one foot in the early stage markets with a venture capital approach. I started my career as an analyst at Anthem Venture Partners, an early stage VC fund in Santa Monica. That was my first job out of college, and I was the only analyst supporting a team of four partners. Anthem I was a vintage year 2000 fund, which was a terrible year to raise a venture fund. Even though most vintage 2000 venture funds struggled, Anthem did very well, because the partners backed some really transformative and important companies. I was part of the team that did the Series A in companies like MySpace, TrueCar, and Android. It is amazing to see an idea go from a guy with a PowerPoint deck in your office like Andy Rubin in 2004, to Android with nearly 2 billion active devices globally today. That’s a kind of experience you just don’t get in the public equity business, and it is something I wanted to get back to in the venture business.

Warren Buffett says that he’s a better businessman because he’s an investor, and he’s a better investor because he’s a businessman. I feel the same way about VC and value investing. Being good at value investing can make you good at venture capital, and vice versa. At heart, VCs and value investors are fundamental investors. Both strategies emphasize longterm perseverance over short-term gratification. Both strategies reward independent thinking and contrarian perspectives. And both value investors and VCs benefit from mental models like circle of competence, opportunity cost, and the power of incentive.

Long-Term Investing Amid an Uncertain Future

September 18, 2017 in Commentary, European Investing Summit

This article has been authored by Richard Simmons, MOI Global instructor and senior portfolio manager with Credo Group. Richard is based in London.

When I was a teenager a family connection lead me to spend a good deal of time in the courts. Eventually I came to work there in the school holidays, working as a solicitor’s clerk, sitting behind the barristers, supposedly to “take a note” but none of my notes were ever consulted. The barrister was not supposed to talk to the client without a solicitor’s clerk present and I was the cheapest form of chaperone. So I spent many days sitting through criminal trials with nothing else to do but pay attention to the evidence, the process and the many interesting parties – the police, judges, juries and criminals – brought to that place. Trials would last for days or weeks but they were always fascinating. As the case neared its conclusion, with prosecuting and defence barristers making their closing arguments, the judge summing up and the jury sent into cloister there was a rising tension in the room. Everyone would hang around until the usher hurried in to announce that the jury had reached their verdict. Then, like in the last scene of an Agatha Christie novel, everyone reassembled to hear if the defendant had dunnit.

The tension is all in that moment. What would it be, freedom or ten years in jail? My mind would race through the evidence and the arguments, trying to guess what the jury would decide. Both barristers had made good cases. There was always some doubt. So the verdict, when it came, always seemed arbitrary. Worse, if it was guilty, the judge always sounded so certain in the homily that accompanied the sentence. You are a bad man, you have done a wicked thing. How could they be so sure when a moment ago no one knew anything? That was the whole point of the proceedings, of course, to sound certain, to give finality. We were there precisely to decide guilt and any uncertainty that remained undermined the system.

The law, sports, and history itself, are all lived forward and only understood backwards, at the end. Stocks, too. Every thesis, every analysis rendered redundant by the facts. But this is a perfectly useless philosophy in practice and it deserves to be reversed: life may be reviewed as a whole backwards but can only be experienced forward. Stocks will ultimately be accounted on sale but can only be assessed on purchase.

It is what it is: we shall be judged by our fruits but we cannot know them until it is too late. So we reach for what is available, heuristics, rules of thumb, annual reports, broker research, ratios. This stock is trading at a multiple of 15 but the sector is at 20, so maybe it will catch up. This stock has insider sales so we sell. All of these techniques are, in our opinion, ways to avoid the most difficult task an investor must undertake: to predict the future.

We make estimates, provisions, calculate intrinsic value and design elaborate models; but what you most need to know is whether you are moving in the right direction. How? Here is a good exercise: For a given company you follow, close your eyes and imagine what it will look like in ten years’ time. If the answer is “no idea” you probably don’t know the company well enough to invest in it. If the answer is “much the same as today”, all of the value will be in the price. You might pay a P/E of five because you believe the right number is ten, so gains will be on revaluation and any growth in the company itself is incidental. And if the answer is “I don’t know but it will be certainly be a lot more profitable”, then the math may be trickier but your price will not be geared to what other people think but to that profitable future. This is where most gains are made in stock investing.

A neurologist will tell you that the brain is a machine for making predictions. All sensory data is compared not just to memories but to our working model of what we believe will happen next.
Investing, if it is to be done well, does not depend on only looking backwards but harnesses that brain power and develops our gift for looking into the unknown and making it knowable.

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Important information note: The content of this promotion has been approved by Credo Capital Plc which is authorised and regulated by the Financial Conduct Authority in the United Kingdom and is a member of the London Stock Exchange. Investors are warned that past performance is not necessarily a guide to future performance, income is not guaranteed, share prices may go up or down and you may not get back the original capital invested. The value of your investment may rise or fall due to changes in tax and rates of exchange if different to the currency in which you measure your wealth. Investment in the fund is not available in the US or to US persons. It is only suitable for professional, high net worth and sophisticated clients as set out in COBS 4.12 of the FCA handbook. If you do not meet these criteria you must not place reliance on this document and will not be eligible to invest in the fund. This document has been created for information purposes only and has been compiled from sources believed to be reliable. None of Credo, Derby street or their directors, officers or employees accepts liability or for any loss arising from the use here of or reliance hereon or for any act or omission by such person, or makes any representations as to its accuracy and completeness. No part of this report may be reproduced or distributed in any manner without the written permission of Credo. No investment in the Fund should be considered without reading the prospectus in relation thereto and in particular the risk warnings contained therein.

Tom Gayner on the Indispensable Drivers of Long-Term Compounding

September 17, 2017 in Audio, Equities, Featured, Financials, Interviews, Latticework, Latticework New York, Transcripts

Renowned value investor Tom Gayner, co-chief executive officer of Markel Corporation, joined the MOI Global community at the Latticework 2017 summit held at the Yale Club of New York City in September. We are pleased to share an edited transcript of Tom’s remarks and Q&A.

Here is acclaimed author William Green’s introduction of Tom Gayner:

I’ve spent the last few years interviewing extraordinary investors and trying to figure out what makes them special and what we can learn from them, both about investing and how to think better and how to live. I first met Tom three years ago in the Yale Club where we had lunch and I ended up writing a profile of him in a book called The Great Minds of Investing.

I’m working on another book and so I was trying to think, “Who do I want to go long on? Who do I want to spend a lot of time with?”

Recently, I went to Virginia and spent about a day-and-a-half quizzing Tom, which is a measure of how much I admire him and how much there is to learn from him. Tom graduated from the University of Virginia in 1983, spent a bit of time working as an accountant, then became a stock analyst. One of the companies he covered as an analyst was Markel. He ended up getting invited by Steve Markel to join the company and manage the investment portfolio, which at the time was tiny. He joined the company in 1990. The first stock he bought was Berkshire Hathaway; he has owned it for 27 years, which gives you a sense of his good judgment and his patience.

Markel has been an extraordinary success story of our time. When it went public in December 1986, the stock was around $8.33 [per share]. Today it’s about $1,020. [The company] has about 11,000 employees, and it’s in twenty countries. Tom has played a key role as both initially being in charge of the investment portfolio and now also as a manager of the company. I’ll leave you with a quote I got from Tom the first time we met three years ago, which says a great deal about him. Tom said,

“Sometimes people can build great careers and enjoy great successes for a period of time through bluster and bullying and intimidation and slipperiness, but that always comes unraveled. Always. Sometimes it takes a while, but it does. The people you find who keep being successful year after year after year, you find these are people of deep integrity.”

What struck me about Tom, which is one of the reasons I wanted to spend time interviewing him for my next book, is he not only represents really good judgment in terms of investing, but he has done the right thing over many years with deep integrity. There’s this question as to how successful you can be while also doing the right thing — Tom, inspired by Buffett and Munger, represents that mentality.

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Software Feedback Loops Enable Winner-Take-All Markets

September 17, 2017 in Equities, Ideas, Industry Primers, Information Technology, Large Cap, Letters, Wide Moat

This article by Jake Rosser has been excerpted from a letter of Coho Capital.

“In normal markets you can have Pepsi and Coke. In technology markets in the long run you tend to only have one…. The big companies, though, in technology tend to have 90 percent market share. So we think that generally these are winner-take-all markets. Generally, number one is going to get like 90 percent of the profits. Number two is going to get like 10 percent of the profits, and numbers three through 10 are going to get nothing.” –Venture Capitalist Marc Andreessen

The dominance of Facebook and Google is astonishing. Together, the two companies have 64% share of the digital ad market with Facebook at 33% and Google at 31%. Despite their dominance, both companies are growing their reach, with Google capturing 60% of all digital advertising growth and Facebook the remainder of 40%. All other digital online marketers and ad tech platforms are losing share. Such dominance could be reason for caution if the digital ad market were mature. However, we expect growth to remain explosive as advertising share of old media remains well above its proportion in digital media.

Google and Facebook’s stranglehold on the digital economy extends to apps as well with the two companies combining for eight of the top ten mobile apps.

We think both companies possess durable moats and are underpriced.

Facebook

“Man is by nature a social animal.” –Aristotle

The world has never seen a company with the reach of Facebook. The company’s social network has 1.8 billion users with 1.2 billion of those users, or a sixth of humanity, using the service daily. Over a billion people use its messaging platform WhatsApp, which is the second most popular app in the world, after Facebook at number one. Facebook’s other messaging platform, Facebook Messenger, also surpassed one billion users last year. For those counting, that is three apps with over a billion users each. Facebook’s fourth platform, Instagram, may become the fourth, having grown to 600 million users last year and still experiencing rapid growth.

With incremental margins of 70% and revenue of over $3 million per employee, Facebook possesses a monopoly-like profit engine. We think Facebook is still early in its monetization opportunity with inherent operating leverage and multiple pathways to drive profits through software enhancements and enhanced data utilization.

Facebook is akin to a multi-level marketing company, yet it does not have to peddle product. There is nothing untoward about what Facebook does, but like a multi-level marketing company it leverages its users’ social networks. Instead of product, however, Facebook sells advertising and media feeds. Users freely turn over their data every time they use the site, creating a rich stream of data to mine for profits. It is no wonder Facebook enjoys such lush margins, considering the company is the world’s largest media distribution platform—and does not pay for any of its content.

Despite the company’s global reach, its monetization efforts are nascent. In a worldwide advertising market of $700 billion, Facebook has less than a 4% share. We expect to see a dramatic acceleration in advertising market share as Facebook gets more adept utilizing data. Recent market data confirm our thesis with social network ads accounting for 3.6% of Internet traffic to retailer sites over the holidays, approximately 10 times the 0.25% share they garnered last year.

Facebook is the perfect example of network effects in action. The greater the number of users on Facebook, the greater its utility for all users. Like Google, there is a virtuous aspect to its operations. The more we use Facebook, the more data we provide its software algorithms, which in turn become smarter in tailoring news and advertising toward us. This data creates a rich vein for Facebook to mine for optional services.

With many of its users engaged across its multiple platforms, Facebook becomes in effect a mobile operating system (OS), offering a menu of choices to remove friction from users’ lives. Why open separate apps, when you can order an Uber, play games, exchange photos, stream videos, and make payments all through the same software interface? China’s most popular messaging platform, WeChat, has executed on messaging as a mobile OS brilliantly. Recent updates to Facebook Messenger capabilities, along with the hiring of WeChat executives, suggests Facebook seeks to execute the WeChat playbook on a global scale.

Facebook properties dominate the mobile economy. Its scale and user base extend across geographies and nearly every conceivable demographic. We think the company is just scratching the surface on utilizing its treasure trove of data to grow profits. [The Street has focused on slowing ad loads as well as bungled advertising metrics, but this is a wonderful business.]

Alphabet (Google)

“Google has a huge new moat. In fact, I’ve probably never seen such a wide moat.” –Charlie Munger

It should be clear from our discussion of Facebook and Alibaba that technology is a platform driven world. Those with the most used platform win due to exponentially lower costs as platform users scale. This is again a core differentiation between a hardware-centric technology marketplace and a software-centric technology marketplace. While there are hardware standards, there are rarely hardware platforms. A platform requires scalability and a transaction nexus for users, something much more difficult to pull off via hardware.

Google is one of the most relied upon utilities in the world, with over three billion searches a day. According to NetMarketShare.com, Google has a 78% share of global desktop search and over 90% share in mobile search. Every search refines Google’s search results, improving search optimization. Perhaps this is why competitors have not been able to make a dent in Google’s market share. After years of effort and billions of dollars spent by Microsoft, Amazon and others, there remains no acceptable substitute for Google. Further, Google has sealed off potential breaches to its moat by establishing dominance in browsers (Chrome has over 50% share in desktop browsers) and mobile operating systems (Android has a 78% share of the mobile phone market operating system).

As with Facebook and Alibaba, Google aggregates data across its ecosystem of services to serve up more precise advertising and create additional opportunities for monetization. If data is the oil of the 21st century, then Google is John. D. Rockefeller. Apart from search, Google has six separate products with over a billion users including YouTube, Gmail, Google Maps, Google Play Store, Android and Chrome. Google’s ability to mine data across its properties, as well as to quantify results, makes it the most effective advertising channel in the world. Emarketer, a market research company, expects digital advertising to grow at a 40% annual clip over the next five years, suggesting Google can continue to grow earnings at a heady clip.

Google has been competitively entrenched for so long that the company acquired a high-class problem – it was making so much money that financial discipline was an afterthought.

Businessweek detailed the company’s efforts to instill more financial discipline under new CFO Ruth Porat in a recent cover story.

“Adwords meant advertisers only paid for ads that worked. The result revolutionized media and advertising, and gave Google a revenue stream that almost seemed limitless. Googlers have a name for its ad business: the ‘cash machine.’” –Businessweek, Budgeting Google’s Moonshot Factory

Google’s Other Bets, or non-alpha bets (there can be only one ALPHAbet and it is search) lost $3.6 billion last year. Ms. Porat has been culling speculative bets and insisting upon a realistic path to profitability, while removing redundancies. We think a bit more financial supervision was needed and should provide a nice tailwind to earnings.

As for Google’s core search business, it recently completed its 20th straight quarter of 20% growth. Put another way, Google has doubled its search business in less than a year, for five straight years!

Apart from its search business, Google has attractive future monetization opportunities in its cloud business, maps and YouTube.

Google CEO Sundar Pichai has called YouTube the “primetime of the mobile era.” He is right. The site is an advertisers’ dream reaching ten times more 18-49-year-olds during primetime than the top ten shows combined. More than a billion people watch YouTube videos each month with 80% of those users outside the U.S.

The future is mobile and YouTube is tailor-made for mobile with more than half of its video clips watched on mobile devices. It reaches more Millennials than any cable network. Generation Z, those born during 1995 or after, consume 2-4 hours of YouTube a day, compared to less than an hour of traditional television. Eight hundred twenty million people use YouTube for music streaming, seven times more than its next largest competitor, Spotify. As advertising dollars continue to shift from linear television to digital, YouTube should be a prime beneficiary.

Google’s cloud business (Google Cloud Platform or GCP) is currently a distant third to Amazon and Microsoft. Nonetheless, the company has a few arrows in its quiver to capture market share. Most importantly, technology infrastructure is not an impediment with Google controlling 30% of the world’s web traffic. The company’s global collection of data centers with homegrown servers, extensive fiber network, and world-class security ensures the company can deploy its infrastructure in an economically sensible manner despite its late start.

Google has spent two decades organizing massive amounts of data and knows better than anyone how to utilize data to unearth insights. We expect Google’s data analytics expertise will enable the company to make competitive inroads in cloud computing. As the world moves toward unlimited computing power and storage, it is hard to think of a company better positioned than Google.

Recent GCP product introductions suggest such a road map, with Google’s expertise in data analytics and machine learning being applied to language translation, image sorting and text contextualization.

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