Phronesis Fund: First Principles Reasoning

Ben Thompson / Stratechery

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Defined as “how we know what we know.”

The Price of Attention

John Candeto — Mon, 13 Jan 2025 15:01:33 GMT

Fellow Partners,

In a world of infinite content the price of attention ought to go up, and up, and up.

Why?

Let’s go back 10,000 years. Marketing — to the extent it existed — was simply a way of learning where to find what one needed i.e. “Where is the baker?”

Over subsequent years the growth of trade saw the creation of and access to more and more goods and services. Marketing evolved into “What is available?”

Today there are more goods and services available than species on the earth — tens of billions of things to choose from.1 Marketing has evolved into “What do I want?”

The only absolutely scarce item in this kind of economy is attention.2

More and different things will be created. And the world’s population is growing a bit. But at this very moment in time there are about eight billion people alive, and therefore about eight billion minutes of attention currently in progress.

That’s it.

No amount of better/faster/cheaper can create more attention. Attention is the only truly scarce asset.

Attention is the one thing sellers of goods and services must have in sufficient supply in order to survive. Without it, they’re dead in the water.

So, is the price of attention going up?

Attention is a moral act. Attention changes the world. If you attend to it in a certain way you see certain things. If you attend to it in another way you see quite different things. Attention helps to bring into existence the experiential world, which is the only world that we can ever know.
Iain McGilchrist

Waste

One way to answer this question is to assess the proportion of advertising spend as a percentage of total GDP. A rising figure would suggest the world in aggregate is spending more buying attention.

Over the past three decades we’ve actually seen a slight decline in this figure. This may be surprising at first glance.

Cue John Wanamaker:

Half the money I spend on advertising is wasted; the trouble is I don’t know which half.

Think of the endless TV commercials for cars you’ll never buy. What a waste.

Value accrues where attention pools, and the attention well for generic commercials is shallow.

What do you really pay attention to? Content you seek out, and content personalized for you.

So, is the price of attention declining, or are we just getting more efficient at finding it?

Here’s the same chart of global ad spend as a percentage of GDP, overlaid with the proportion of ad spend allocated to three dominant digital advertisers.

A reasonable interpretation is that advertising got better faster than it got more expensive.

Unsurprisingly, the global advertising market is expected to grow in excess of global GDP over the next decade.

Number go up

The dramatic shift to digital-native advertising suggests attention is increasingly being priced by digital advertisers.

So, is the price of attention going up?

Search still comprises the majority of digital advertising, so one way we could answer this question is to ask if the value per point of search market share has gone up?

Over the past five years it has roughly tripled.

Another way we could assess the price of attention is to ask whether the price-per-user of those who monetize attention is going up?

We can do so by using a traditional metric such as price / earnings, and swapping “earnings” with a proxy for attention.

Meta (Facebook) has the largest single pool of daily active users (over three billion), and we can see that the price per user has roughly doubled over the past five years.

There are numerous other ways we could poke at this.

In a world of agents and bots, the value of “known humans” ought to rise. Reddit’s dramatic rise in valuation during the age of A.I. is some evidence of this. The rise in value per active platform user at Uber is more evidence.

The specific price of attention will jump around. But the trend is clear, and passes our first-principles reasoning at the start of this essay as well as a priori reasoning from e.g. aggregation theory.

We have enough to act on.

What do we do about it?

First, we should expect the price of attention to continue to rise. In a world of rising noise — with far more products, services, bots, and content than humans to consume them — we should expect the price of attention to continue to rise, and only be limited by the lowest sustainable margins of those that need to purchase it. To rephrase Bezos:

Your lack of attention is my opportunity.

Second, we should mark up the value of the attention we already have. It is obvious that one’s existing customers are their most valuable customers. But have you increased the value you ascribe to them? The data above suggests one’s cost to re-acquire them has gone up 2-3x over the past five years.

Third, we should expect the value of curation to rise. In a world of infinite options, sometimes the only way to find a good solution is to search in a limited field. Using the internet to find a good restaurant in a city is much harder than asking a trusted friend who lives there. So, too, with just about everything. Curators will increasingly direct attention.

Fourth, we should expect content quality to go up. That is counter intuitive. But think about the search function for enduring content. Out of billions of paintings, books, songs, and movies we have found a precious few pieces of enduring content. The rate-limiter to these works — training, materials, assistance, and so forth — are plummeting in cost. This means the cost of creating “noise” is going down, but more noise also increases the odds that some of it contains real signal. We used to say, given enough time, that a monkey with a typewriter would eventually produce Shakespeare. Since we can compress creation, this is now possible in a reasonable amount of time. More noise gives more potential for signal. The challenge, of course, remains finding it.

Finally, the value of enduring content will rise. As the cost to create “noise” approaches zero — think Generative A.I. publishing infinite content — the value of enduring content ought to rise. This is a version of the curation point, but for the content itself. It will become even more useful to directly seek out and consume enduring content because finding new enduring content will become increasingly difficult. This is the Lindy effect at work.

In closing

It is an honor to serve you. As always, please reach out any time.

Thank you to CB, Lucy, Drex, Brian, and Ahmed for feedback on early drafts!

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

See Eric Beinhocker The Origin of Wealth.

We define attention as the direction of time and energy.

The Importance of Survival, Power Laws, and the Study of Complexity in Investing

John Candeto — Thu, 26 Sep 2024 16:12:31 GMT

Fellow Partners,

The rate of change of the rate of change is accelerating. The world is evolving faster than ever.

In a world that's changing so quickly, the biggest risk you can take is not taking any risk.
Peter Thiel

It is increasingly likely that our species will create more value in the next decade than all the rest of human history combined. If we fail we are still likely to be close. That is astounding.

Our efforts within the partnership have been focused on some simple but difficult questions that are downstream from this reality:

Has the value of human attention increased? (If so, it is not priced in.)
Where are the largest sustainable improvements in economy of time?
As AI’s impact grows, where can we invest in things that don’t change?
Where are we using the wrong denominators to measure progress? What are better ones?

Talking Billions

My friend Bogumil Baranowski recently hosted me on his show to discuss these and other topics.

I think you will enjoy the conversation.

Here are the relevant links:

As always, thank you for the continued opportunity to compound trust with you.

Please reach out any time.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

The Price of Everything

John Candeto — Tue, 19 Jul 2022 14:00:18 GMT

This is a companion piece to our recent essay Rational Price.

Fellow Partners,

Nowadays people know the price of everything and the value of nothing.
Oscar Wilde

Imagine you were going to purchase 100% of an asset you admire — say, all the shares of a wonderful business, all the homes in your favorite seaside town, or all the gold in the world. How much would you have to pay? The answer would be much more than was implied by the most recent market price.

In calm markets most transactions take place near the middle of a range of potential prices for the given asset. The price boundaries are not tested.

Euphoric markets test upside price bounds.

Pessimistic markets test downside price bounds.

But rarely do markets reveal absolute price — the price one would have to pay to own 100% of a given asset.

This is irrelevant for traders. Their focus is on price.

This is essential for owners. Their focus is on value.

The Anatomy of Value

Consider a pursuit to buy 100% of a desirable asset.

Phase 1: buy before the market finds out.

When one starts buying an asset, they encounter sellers willing to part with their position at recent market prices. Some will sell at a slight discount. A few may sell at a substantial discount. Collectively these sellers allow current market prices to determine the value they ascribe to their positions.

This is the easiest buying phase.

Phase 2: the market knows…now up your offer.

One’s buying difficulties increase with one’s ownership stake. Sellers will begin to exploit the presence of a large buyer, requiring the buyer to increase their offers. Some will accept offers slightly above recent prices. Some will want larger premiums.

This buying phase requires more haggling. But it is still anchored to recent market prices.

Phase 3: the wall.1

Our most profitable insights have come from recognizing the deep reality of some businesses.
Nick Sleep

Eventually one will encounter sellers who believe their positions are worth far more than recent market prices. Some will be delusionary. Some will be emotionally attached. But if it is a high-quality asset, some will simply be better attuned to the long-term value of the asset than the market writ large.2 Markets rarely surface these values. When they do, they can become key pivot points.

Conflation

As recently discussed, Rational Price can vary substantially depending on one’s time horizon.

The last and most reluctant sellers — typically hidden because they rarely transact — are a critical group.

The total value of an asset is typically estimated by multiplying the asset’s last traded price by its total quantity, giving us market capitalization. It’s a reasonable calculation, but conflates the price of a recent transaction with the potential price of all transactions.

Conflating “any” and “all” with respect to price is a recipe for poor thinking.

For example, the current market cap of all above-ground (mined) platinum is about $225 billion. Now imagine buying all of it — including all those wedding rings — with a $225 billion budget. You wouldn’t even come close. Belief in what the asset is, or could become, gets in the way. Even without the additional value applied to the raw material (e.g., raw platinum smithed into jewelry), there is a wide range of opinions on the value of the asset.

The same is true of many businesses whose publicly traded shares are a fraction of total outstanding shares (ask Jeff Bezos for the price at which he would sell all of his Amazon shares), or any asset held for properties beyond their current market prices (gold for gold bugs, bitcoin for bitcoiners, founder’s shares for founders, hedging instruments for hedge funds, etc.)

Options

This creates two basic options.

Option 1: Focus on price. Buy and sell assets frequently. This is a zero-sum game — the best win at the expense of the rest — that incurs relatively higher fees and taxes.

Option 2: Focus on value. Buy and sell assets rarely. This is a positive-sum game that focuses on allocating capital to quality.

Good investment analysis helps companies raise the world’s standard of living. Enterprises work best when they have access to capital priced to reflect the value they can create. Index funds, by the way, do not price capital; they only mimic the actions of those who do.
Abdiel Capital

Option 2 is the most rational for this partnership’s disposition and capital duration. We believe in keeping our focus on the business, knowing why, and building better businesses.

We are watching our businesses’ progress, confident that their long-term rational value will eventually be reflected in their prices.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

There are nuances to this anatomy across different types of assets — e.g., Boards are generally required to consider all purchase offers. But the basic principles are the same.

This is where insider buying and selling can provide some wonderful tells. Large inside owners selling substantial portions of their position do not inspire confidence; conversely insiders aggressively buying common stock in their company can be a great signal.

Seasons Pt. 3: Direction of Travel

John Candeto — Fri, 24 Jun 2022 16:00:59 GMT

This is the third entry in a 3-part series. Part 1 defines a useful mental model. Part 2 covers the seasons leading up to our current economic realities. Part 3 describes where we may be headed.

Fellow Partners,

As you read this note, I encourage you to keep in mind our mantra of having “the longest view in the market” and our singular focus on the intrinsic value of our businesses years into the future. This means our partnership will only be impacted by any persistent effects of the seasons we are currently experiencing. Anything in the category of “this, too, shall pass” is not of lasting concern to our calculus.

As discussed in Seasons Pt. 2: How We Got Here, an excess of excesses including easy money, maximum globalization, and geopolitical stability led to asset booms. These seasons have turned.

Consumer sentiment is the lowest it has been since 2011, inflation is at levels last seen in the early 1980s, and expectations of economic conditions are at their lowest since we started measuring them in the 1950s. Capital markets are in recession territory. Some areas of the market have pulled back violently. One can feel the glee from news outlets. Fear sells.

Perspective

We must note that this is not the whole story. There are upsides to chaos. And we’ve been here before. Consider Earl Zukerman’s take on the 20th century:

Imagine you were born in the United States in 1900.
On your 14th birthday, World War I starts, and ends on your 18th birthday. 22 million people perish in that war.
Later in the year, a Spanish Flu epidemic hits the planet and runs until your 20th birthday. 50 million people die from it in those two years. Yes, 50 million.
On your 29th birthday, the Great Depression begins. Unemployment hits 25%. World GDP drops 27%. That runs until you are 33. The country nearly collapses along with the world economy.
When you turn 39, World War II starts. You aren’t even over the hill yet. And don’t try to catch your breath.
On your 41st birthday, the United States is fully pulled into World War II. Between your 39th and 45th birthday, 75 million people perish in the war.
At 50, the Korean War starts. 5 million perish.
At 55, the Vietnam War begins and doesn’t end for 20 years. 4 million people perish.
On your 62nd birthday you have the Cuban Missile Crisis, a tipping point in the Cold War. Life on our planet, as we know it, should have ended. Great leaders prevented that from happening.
When you turn 75, the Vietnam War finally ends.

All that, and the lifestyle of the average American by the end of the century was far better than that of the wealthiest American at the start of the century.

Zukerman continues:

Think of everyone on the planet born in 1900. How do you survive all of that?
Perspective is an amazing art, refined as time goes on, and enlightening like you wouldn’t believe. Let’s try to keep things in perspective.

Forthcoming Seasons

If people could predict the timing of economic seasons with certainty they would rapidly become the richest people in the world. That the world’s richest people generally build or inherit their wealth tells us that perfect prediction of seasonal paths is not possible.

However, we can assess present incentives to understand the likely direction of travel of future economic seasons. We cannot know when they will arrive, but we can understand the attributes of their vectors vs. present realities.

Every storm runs out of rain.
Gary Allan

From their current points of monetary contraction, deglobalization, and geopolitical instability, future seasons may hold the following:

The long-term price of money (interest rates) remains low, supporting reasonable valuations for businesses such as those we invest in. Major rich world governments are so indebted that they cannot afford the debt payments that would accrue under programs of sustained high interest rates. While the world’s major central banks are generally raising rates and reducing stimulus to fight inflation, they cannot sustain policies much beyond their modest targets. In the US, the Fed believes the neutral rate is 2-3% (the average 10-year Treasury rate over the past five years was 2.3%). This means the likely long-term price of money is low, which is supportive of longer-term reasonable valuations for businesses like ours that aggressively invest in future profits, provided they can produce healthy free cash flow that limits their short-term dependence on capital markets.
Economic resilience increases, which reduces the uncertainty that reduces asset valuations. The long-run effects of some amount of deglobalization will prove beneficial. We desire economic ties with other nations as these offer the benefits of geopolitical stability and competitive advantages. We also desire a reduction in systemic fragility — nations must have some independence in production factors critical to their success so they can avoid economic dependence that leads to bad policy (e.g., about half of Germany's natural gas coming from Russia) and economic fragility that leads to critical failures (ask Ford about the trucks they couldn’t sell due to semiconductor shortages). We want systemic economic resilience, and some amount deglobalization will support this. This won’t happen overnight, but there’s plenty of evidence of the trend (e.g., the world’s largest semiconductor fab is scheduled to open in 2025 in Columbus, Ohio).
Geopolitical uncertainty declines, which reduces the uncertainty that reduces asset valuations. This variable has the greatest degree of uncertainty as it is controlled by forces far beyond economic incentives. That said, witnessing what can happen — which we are seeing in the war in Ukraine — is an antidote to it happening again soon. We want long-term geopolitical stability, and geopolitical events larger than our day-to-day partisanship are galvanizing forces in that direction.

Inflation

What about inflation?

Core inflation is likely near its peak (core inflation excludes typically volatile food and energy prices). Rising interest rates reduce demand, extremely low consumer sentiment is a leading indicator of people purchasing less in the future, base rate effects are now making inflation growth more difficult, and purchasing habits are reverting to trend making declines easier and easier.

To understand this last point, it helps to appreciate how significantly off-trend consumer habits became during Covid-19 (see chart below). A year ago consumer spending on goods was $500 billion above trend, while services spending was nearly $1 trillion below trend — unsurprising as few were taking holidays but many were upgrading their dwellings.

Link to source

This contributed to inflation (too much money chasing too few goods) but is now reverting back to trend. Target recently reported a 48% reduction in earnings vs. a year ago, and warned of additional weakness this year because they bought too many goods.

We [expected] the consumer to continue refocusing their spending away from goods and into services…we didn’t anticipate the magnitude of that shift.
Brian Cornell, Target CEO, May 18, 2022

Consumers binged on goods during the pandemic. They are now binging on services. Eventually their behavior will normalize, which will enhance the value of price signals, which will enable supply chains to better match supply with demand. In short, the core inflation game will get easier.

Contrasting with likely core inflation reductions will be continued volatility in overall inflation due to volatility of food and energy prices, which together make up just over 20% of the current inflation calculus.

About 50% of the world’s caloric intake comes from grains. The enormity of global grain output is due to modern fertilizers:

Between 1800 and 2020, we reduced the labor needed to produce a kilogram of grain by more than 98%—and we reduced the share of the country’s population engaged in agriculture by the same large margin.
…
In 2020, nearly 4 billion people would not have been alive without synthetic ammonia…. the Haber-Bosch synthesis of ammonia [is] perhaps the most momentous technical advance in history.
Vaclav Smil, How the World Really Works

There are various forms of fertilizer and fertilizer inputs. The present picture is bleak. China, the world’s largest exporter of phosphate, stopped exports last year. Russia, a major producer of potash, has been unable to export it because the government turned Black Sea ports into a war zone and ships won’t go there. Russia was also the largest exporter of components for nitrogen-based fertilizer, and Europe has stopped producing nitrogen fertilizer due to the high cost of natural gas, which is about seven times higher vs. US prices (more here if interested).

Grain production relies on timing and effectiveness of planting and harvest seasons, and there are not rapid ways to bring new fertilizer production online. Altogether this means we will have a global food shortage starting later this year, likely at the cost of human lives in the global south and continued inflation in food prices.

There is a somewhat similar story for global energy needs.

We should also expect continued dramatic swings in the prices of food and energy. As 20%+ of the inflation calculus, these swings will continue to impact overall inflation for the foreseeable future.

A Return to Quality

What do these seasons mean for our investments?

We own some wonderful businesses. As they weather these seasons they’ll get even better.

Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.
Andy Grove, former CEO of Intel

Difficult economic circumstances create some predictable realities.

A notable trend in the past decade was the absence of bankruptcies — cheap money delayed the inevitable culling of unsustainable businesses and business practices. We will now see much more focus on free cash flow and unit-level profitability (e.g., the chart below). Bad businesses will go bust, to the long-term benefit of better businesses that can take their market share.

An important component of this reality will be a more reasonable landscape in the war for talent. Data continues to suggest there are about two job openings for every person seeking employment. A strong job market is a wonderful thing, but in extremis it can force businesses to overpay for talent which increases operational risk. A difficult economic environment will result in improved job price discovery — that is, a more balanced equation between employee willingness to work and employer willingness to pay. This will reduce employment fragility for the best businesses and the best employees, to the benefit of both.

Deflation

As we recently discussed the inflation debate can be framed as demographics and technology vs. money for nothing. These variables are more important than ever:

The shrinking rich world. Declining populations reduce aggregate demand which is a deflationary force. This will happen slowly, though it is also a compelling reason to be invested in areas that will benefit as demographic weight and household wealth shifts to younger generations. As younger generations grow wealthier and more influential, their preferences become more pronounced in the market, creating a natural secular tailwind for businesses that serve their preferences (examples include expansion of e-commerce, digitization of financial services, and the growth of gaming).
The relentless march of technology. The rate of change of the rate of change (say that five times fast…) is accelerating — the “game” has sped up. Digital bits move faster and more freely than physical atoms. As digital bits become larger and larger components of overall economy, we should expect larger and faster degrees of change in competitive landscape, solutions, and transitions — especially those that serve things that never change (e.g., the desire for better/faster/cheaper products and services).

The secular curve of technology solving big problems has never been steeper, and the cycles that overlay that secular curve are not suspended. It is happening in record pace.
Brad Gerstner, Founder & CEO, Altimeter Capital

I recently rode my favorite attraction: Walt Disney’s Carousel of Progress. Originally opened at the 1964 World’s Fair, it has been through a number of upgrades, most recently in 1993. Here’s what 1993 Disney thought a futuristic home would contain in the year 2000: programmable voice controls, simple VR gaming, car phones, laser discs, and hi-def TV.

1993 Disney’s take on a futuristic home in the year 2000

Every single one of those items is not only widely available today, but also widely affordable, and several orders of magnitude better than imagined not too long ago (e.g., smartphones vs. car phones, self-programming voice assistants, and streaming media).

Playing the Longest Game

Cycles are neither good nor bad; they are natural. Peak euphoria provides the opportunity for the world to dream about the future. Rock-bottom despair forces practicality and clarity. When things are good, they're never as good as they seem; when things are bad, they're never as bad as they seem…. Zooming out, cycles can be reframed as volatile periods around a relatively consistent adoption curve.
Fred Ehrsam

Thinking in seasons helps us to look ahead, especially in times of stress. Our investments will fare better in some seasons and worse in others. What will matter through those seasons is whether we are correct in our assessment of the quality and durability of our investments, whether we buy our investments well, whether we use seasonality to our advantage (e.g., buying when there’s blood in the streets), and holding our investments to the realization of their long-term intrinsic value.

To these ends we often ask ourselves these questions:

Do our investments offer wonderful value propositions and have substantial barriers to those propositions being competed away by others?
Are we buying our investments at reasonable discounts to their long-term intrinsic values given reasonable levels of interest rates, globalization, and geopolitical stability?
Will our investments benefit from things that will never change (e.g., the desire for better/faster/cheaper products and services) — as opposed to things that do change (e.g., tastes and fashions)?
Will our investments benefit from major secular tailwinds including shifting demographic weight and household wealth?

When we can answer “yes” to these questions, we accept that the ride to the finish can be bumpy, but the finish is what we care about.

From there, we are cognizant of our present seasons and how they can advantage our multi-season ownership of wonderful businesses.

And then, we ignore the noise.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

Seasons Pt. 2: How We Got Here

John Candeto — Wed, 08 Jun 2022 14:00:21 GMT

This is the second entry in a 3-part series. Part 1 defines a useful mental model. Part 2 covers the seasons leading up to our current economic realities. Part 3 describes where we may be headed.

Fellow Partners,

As discussed in Seasons Pt. 1: A Better Mental Model, individuals, groups, markets and businesses are best understood through the lens of seasons as opposed to artificial increments of time such as months and quarters.

Pre-Pandemic Seasons

Prior to the Covid-19 pandemic we had seasons dominated by cheap money, monetary debasement, and global economic stability. This created an enormous amount of capital with opposing timelines. Some used cheap money to pursue projects that would require 10+ years of low-cost financing (e.g., e-commerce, the sharing economy, and space exploration). Others used the enormous amount of capital to play increasingly short-term games in public markets leading to capital markets dominated by momentum trading and short time horizons. Rapidly expanding globalization including hyper-global supply chains and just-in-time production flourished as well, all undergirded by:

Monetary expansion. Money was cheap and plentiful thanks to the world’s major central banks providing low interest rates and injections of capital into monetary systems through vehicles such as quantitative easing. This created a tide that lifted all boats through availability of capital. Home buyers could afford ever-pricier homes through ever-lower mortgage rates. Companies could choose to be unprofitable for years and still retain high valuations because the discount factor was low.
Maximum globalization. Geopolitical stability thanks to growing global wealth and some unsung heroes such as the US Navy which secured global shipping lanes meant that the relentless pursuit of lower prices and higher profits reached many corners of the earth. As an example, an iPhone contains components from suppliers in 43 countries across six continents, Apple tends to carry just a few weeks or months of iPhone stock, and yet they rarely run out. That is a modern-day miracle and not a natural state of economic order. But it persisted for so long that we got used to it.
Geopolitical stability. While far from perfect, peace reigned in most of the world, and the perception of peace was dominant. This allowed the expansion of globalization, including investors willing to make substantial capital investments throughout the world confident that their assets would remain safe (BP's stake in Russia’s state-controlled oil company Rosneft — acquired in 2012 and recently written down from $25.5 billion to $0 — is a prime example.)

These seasons were the predominant context in which assets were evaluated and prices set for most of the 2009 - 2019 decade. One proxy for valuations: the 2014-2019 median revenue multiple for software-as-a-service businesses was 8x. Remember that figure.

Pandemic Seasons

The Covid-19 pandemic induced rapid changes to these powerful seasons, accelerating the momentum of monetary policy whilst destabilizing the global economic order:

Monetary expansion accelerated at a stunning pace. Money got even cheaper as the world's major central banks injected enormous amounts of capital into their monetary systems and interest rates were taken to 0% (quite literally, free money). Here's a stark illustration: home prices in the US have grown 8% year on year for the past decade; the US-dollar money supply has also grown 8% year on year for the past decade, much of which occurred in 2020 and 2021. This aggressive monetary expansion accelerated the growth of asset prices. Are we actually wealthier, or have the numbers just gotten bigger? Millionaires aren't what they used to be.
Globalization began reversing. The enormous uncertainty created by the Covid-19 virus and subsequent government, business and social responses created a rapid "me first" ethos that played out about as one would expect. The rich world developed vaccines and received them first. Vaccines were utilized for political and diplomatic ends, which is why we presently have a glut of available vaccines in the world but still have large populations unvaccinated or vaccinated with less effective vaccines (e.g., China's population and others that used the Sinovac vaccine remain much more vulnerable to Covid-19). These realities woke us up to other vulnerabilities. Semi-conductors are critical to everyone, but disruption in Taiwan could set the world back years due to the immense volume of silicon produced on that single small island and the immense cost and time required to build alternative sources.
Geopolitical stability began wobbling. Global policy responses to Covid-19 woke us up to just how different the world can be. I remain surprised and deeply saddened that the world proved largely unable to look at scientific data and draw reasonable conclusions. Covid-19 was horrible. But it is not the only factor in the world, though much of the world still acts as though it is and are making unsophisticated or politically motivated trade-offs that severely lag our understanding of the virus and how we can live with its reality. This bled into other areas as we learned just how authoritarian some governments can be and how much nations will serve themselves before serving others. The underlying growth of post-modernism accelerated these factors and created the conditions for people to look at the same set of facts and draw wildly different conclusions. This eroded trust, which eroded stability.

In the context of history these were rapid seasons that persisted for most of 2020 and 2021. The effects of unprecedented monetary expansion quickly wound their way into markets. Inflation — defined as too much money chasing too few goods — arrived. The average price of a used car in the US, which hovered around $20,000 for years, quickly shot up to $29,000. The cost of homes, airline tickets, and many other assets grew as well. The median revenue multiple for software-as-a-service businesses doubled from 8x to 16x.

Post-Pandemic Seasons

We are now in a period in which the longer-term effects of these prior seasons are working through global economies, markets, businesses, and households. An excess of cheap money, Covid-induced changes to consumer demand, and supply chain issues have collided to produce inflation, which is being fought by some of the world’s central banks and has created substantial price uncertainty.

A great example: single-serve coffee creamer has been difficult to stock for months because the metal foil for the lid is manufactured in China, which has had frequent factory shutdowns and shipping disruptions as it enforces its Zero Covid policy. This is part of why IHOP and other heavy users of the stuff have had to raise prices.

Our seasons have rapidly shifted again as the world has begun accepting that Covid-19 is a reality we must learn to live with, globalization is not a de-facto reality, and peace is something we must not take for granted. These seasons are marked by:

Monetary contraction. When money remains too cheap and too plentiful for too long its value erodes and with that, trust. The world’s major central banks know this, of course, and some have set the stage to pull money out of their systems and raise interest rates (i.e., move away from free money). The anticipation of these movements has sent the price of financial assets plummeting as risk has been re-priced under new assumptions that money will have a cost (what a novel idea...) and the proverbial central bank printing presses may stop. Higher interest rates decrease the present value of future cash flows — a reasonable rule of thumb: every 1% rise in 10-year government debt reduces revenue multiples for long duration equities by 15-20% — and thus decrease the value of businesses, especially those that expect to earn relatively more profits in the future vs. the present. Higher interest rates also increase the cost of borrowing, which reduces appetite for investment and expansion.
Deglobalization. The stark realization of our global dependencies has refocused the world on securing their own supplies, including re-shoring manufacturing capabilities and reducing dependencies for critical infrastructure (the massive recent support for US-based semi-conductor manufacturing is a good example). A decade of purchasing manager behavior that had reduced working capital down to just-in-time inventory has realized the vulnerability and pain from running out of stock (e.g., Apple has estimated they will lose $4 - $8 billion in sales this coming year due to shortages in their supply chain). This has changed behavior from an elegant snow globe to stockpiling of inventory, larger-than-needed orders for future inventory, and efforts to secure multiple and alternative means of supply. In aggregate this has reduced the effectiveness of price signals, reduced the economic efficiency of globalization, and reduced trust within its systems.
Geopolitical instability. Russia's invasion of Ukraine made most matters worse. The pile of lies leading up to the invasion and the sheer and swift brutality of the Russian army's invasion helped us realize that peace is not a natural state, and war is hell. NATO nations' support to Ukraine and Russia's saber-rattling of their nuclear stockpile helped us realize the immense stakes at play. Europe's unwise dependence on Russian hydrocarbons and the world's dependence on Ukraine and Russian breadbaskets and fertilizers revealed painful vulnerabilities of massive globalization. The West's rapid and unprecedented decisions to freeze Russian global reserves and stop doing business in Russia made nations realize how globally vulnerable they are to the decisions of a few key players. This conflict catalyzed action, and highlighted deep geopolitical and economic fragilities.

These seasons emerged in 2021 and early 2022 and are now the predominant context in which financial assets are evaluated and prices set. At present, median revenue multiples for software-as-a-service businesses have fallen by 70% from 16x to 5x.

Inflation, monetary contraction, erosion of trust, impairment of price signals, deglobalization, and geopolitical instability mean substantial uncertainty in the price and supply of money, the economic tailwinds of globalization, and geopolitical backdrop supportive of economic prosperity. For investors with short time horizons, rational business prices have imploded. “Sell, sell, sell" has been an unsurprising conclusion.

Part 3

This causes us to question the future direction of travel and forthcoming seasons that will impact the prices of our investments. This is the subject of the third and final entry in this series.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

Seasons Pt. 1: A Better Mental Model

John Candeto — Sat, 04 Jun 2022 14:00:21 GMT

This is the first entry in a 3-part series. Part 1 defines a useful mental model. Part 2 covers the seasons leading up to our current economic realities. Part 3 describes where we may be headed.

Fellow Partners,

There is nothing inherently advantageous about the many ways we have sub-divided time — e.g., minutes, hours, months, quarters and decades. The earth’s daily rotation and yearly orbit provide natural measurements, though even these are not universally useful. An intuitive but non-obvious example: one’s feeling of age can be a better predictor of longevity than their actual age.

Order

When we are very young, say, ages 0 to 5, we operate with immense freedom of time. Few days look or feel identical. Meals and family create some structure, but beyond this there is little regularity in what one is required to think or do. If something proves interesting it can be explored for minutes, hours, days or longer. The uninteresting can be ignored. For those with willing minds, curiosity, exploration, and creativity can consume the better part of most days.

When schooling starts, we begin to cut this off in favor of time structures that serve our broader society. Our modern school schedule was architected to raise laborers for the industrial era and from a desire to create a tolerant, civilized society. It has the added benefits of keeping children occupied while parents work and providing all participants at least a partial set of skills with which to engage the world.

The order of each day, the notion of class subjects as distinct from each other, the timing of breaks and meals, and regular switching between tasks are all methods we have implemented within the system. Even summer breaks are a derivative of societies that lacked climate control and sought respite from hot summers in cooler locations, returning to local schools when the weather improved.

Training

These structures train us to think certain ways. Regularly changing subjects. Anticipating lunch. Looking forward to Christmas and summer breaks. Lots of shallow endeavors.

This training in regimentation — based around the needs of social orders decades or centuries ago — is reinforced from the start of school through the end of most careers. What begins with regular task switching in school between subjects, centers, sessions and sustenance continues into college with courses and semesters and into the working world with product release cycles, monthly meetings, sales quarters, fiscal years, and annual performance cycles.

With this persistent training from our early years onwards, it is almost impossible to see how deeply this crafts how we engage with and understand the world.

We learn to task switch regularly, and that success is often measured by relatively shallow performance across a relatively large range of items. We learn to judge success in artificial increments of time such as semesters and quarters.

We learn to cope with incongruities between our interests and these structures through escapism. I only recently realized how much of my 20 years of schooling I spent anticipating lunch. What a waste. Surely we can do better.

Obsession

There is nothing inherently wrong with artificial time increments, but many systems do not work to such increments and are difficult to correctly understand in these terms.

What happens when we step back from this structure? What happens if we require motivation, hard work and intelligence as inputs, but leave time free for its own best purposes, defined as some combination of curiosity, interest, and specific purpose?

I spent decades struggling to feel maximally productive when structure was measured in hours and weeks and success was measured in quarters and years. Against this backdrop I have regularly seen my best work produced within the context of unstructured time — those times when I choose to shut out the noise of what is around me and go deep on a topic. Sometimes this takes days or weeks. On my deathbed I doubt I'll be proud of anything that didn't take at least a few years to create.

We seem to produce some of our best work when we are freed to obsess about a thing almost as long as it takes to get it right (provided, of course, that the thing is worth doing). We need to create — in fact we must create — more of this in the future. We don't need lots of things for ourselves, our families, our businesses or our societies. We need the best of what we are capable.

Human Impact

This has always been true. But its impact has grown exponentially as we have created an exponential age with unlimited access to knowledge and tooling that provides immense cognitive leverage:

For any innovator, business, or problem solver, the sum of all human knowledge is only a smartphone away. The implication of this level of connectivity to this depth of knowledge is only just beginning to be realized.
...
Cloud computing infrastructure is akin to giving every tinkerer in past technological revolutions access to immediately scalable and inexpensive textile mills, steam engines, steel furnaces, moving assembly lines, and microprocessors. Providing the masses the freedom to experiment unlocks the potential of technological breakthroughs in ways that was simply not possible in past technological revolutions.
Thatcher Martin

This reality means that it is more critical than ever to have the time and space to capture our thoughts and breakthroughs and work with them until they are taken to their logical ends.

Seasons

This all points to the imperative of having the freedom and intention to operate in seasons. This is true for individuals. It is also true for collections of individuals, including markets and businesses.

Most of our training from school years onwards and the granularity of most of the data we encounter incentivizes us against understanding and aligning ourselves to the seasons of the social and economic structures we are in and, for this investment partnership, the businesses we choose to own.

Information doesn't enter the mind intact like a puzzle-piece slotted into a jigsaw. Instead, it becomes distorted to fit the shape of its container, like water poured into a vessel.
Gurwinder Bhogal

We aspire to own wonderful businesses for years, so we must resist the incentives to understand these businesses in months and quarters. Seasons are a much better model.

Think of the required progressions of any successful company. There are seasons of formation and experimentation until product-market fit is found. This is followed by seasons of scaling and refinement. There may be seasons of expanding partnerships (e.g., distribution) and/or expanding ownership (e.g., financing rounds or public listing). In all cases, durable success in these seasons depends far more on completing them well than on completing them quickly. No great business was built in a few quarters. (This is why analyzing businesses from the perspective of the persistent incentives within them is critical.)

Part 2

This brings me to the present state of capital markets which, too, are best understood as seasons — not the years, quarters, and months that corporate reporting has trained us to expect. This will be the subject of the second entry in this three-part series.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

Rational Price

John Candeto — Tue, 24 May 2022 13:59:05 GMT

Fellow Partners,

Imagine you were going to buy a business today that you were required to sell next month, next quarter, or next year. How much would you pay? Given the substantial uncertainty currently dominating capital markets, your answer would be much less than you thought the business was actually worth. This thought experiment describes much of what we are currently seeing in the stock market.

I would love to find a dataset that splits publicly traded capital by its duration — that is, the period over which performance is assessed and rewarded or punished. I expect it would look something like this:

This level of precision is not available (though please send any proxies my way!). However, there is good evidence to suggest that the majority of capital now trades on very short time horizons — well less than a year. This includes strategies that trade securities for their volatility regardless of their business attributes.

Rational Price

Over the past few weeks our partnership has been building a position in a business whose long-term intrinsic value we estimate at around $70 billion. It is currently offered for sale around $7 billion.

We could be wrong in our estimates, but $7 billion vs. $70 billion is such a large gap that, unless the business is permanently damaged, it is starting to drift into territory some may call "irrationally cheap".

Or is it?

We are currently in a season of substantial short-term uncertainty: inflation is high, interest rates are rising, growth is slowing, supply chains are still a mess, Covid-19 is still present, and the war in Ukraine rages on.

Our $70 billion estimate is based on evidence of past business performance, analysis of business incentives, estimates of business performance we expect in the coming five to ten years, and a reasonable valuation of that performance. On a five to ten year time horizon a move from a $7 billion valuation to a $20 billion or $40 billion valuation would be a healthy return, and one we would be pleased to endure, even if it meant our $70 billion estimate was far too rosy.

But what if we were required to sell this business next month, next quarter, or next year? I doubt we'd buy it. While we are confident in the five to ten year prospects of the business, we have no idea when the market will reward its performance.

It may be a while. We're fine with that. But any short-term capital — which is the majority of capital currently traded — can't be. For capital trading with a time horizon under, say, one year, the substantial uncertainty of our present reality means that the rational price may be $7 billion.

Anatomy of the Disconnect

How does this happen? Let's work it through:

Price is set by the most recent share transaction, which itself is the aggregation of buyers and sellers of the stock.
If the majority of capital is trading the stock for its prospective performance in the coming days, weeks, or months, substantial sell pressure is created by any news or analysis that suggests the company’s prospects are unknown or negative.
Furthermore, a substantial amount of capital trades based on variables entirely unrelated to business performance e.g. momentum and volatility. This can become reflexive, i.e., the stock goes down and volatility goes up, attracting strategies that trade momentum and volatility which can further reduce price.
These effects are present even if the business’s long-term prospects are highly favorable.
The only forces to counteract sell pressure is capital like ours that has a longer-term business perspective and investment time horizon.
If long-term capital is a minority of capital active in the position, over the coming days, weeks, or months, it will be insufficient to counteract the sell pressure from more voluminous shorter-term capital.
This dynamic is exacerbated by long-term capital already invested in the stock and committed to riding out the volatility in pursuit of long-term business and stock performance. This capital is not selling, but nor is it buying.

Due to these dynamics, the short-term rational price for the business may well be $7 billion or lower, even if we are correct that the longer-term value of the business proves to be much closer to $70 billion.

Options

This creates two basic options.

Option 1: Become short-term capital. This places one in an enormously competitive arena that has a very mixed track record of success, is a de-facto attempt to time the market, and with a strategy that elevates fees and taxes.

Option 2: Be grateful for the opportunity and take advantage of it. This places one in a far less competitive arena with a good track record of success that does not require one to time the market, and with a strategy that generally has lower fees and taxes.

Option 2 is the most rational for this partnership's disposition and capital duration. We are doing something psychologically hard — acting against our human nature to fight volatility or flee from it. However, this also allows us to build the position while the discount exists and exposes us to long-term rewards if we are correct about the long-term intrinsic value of the business.

Perspective

In the long run, staying our course through substantial volatility will make the market our servant, not our master.

Jeff Bezos shared similar thoughts when reflecting on the dot com crash:

The stock is not the company, and the company is not the stock. So, as I watched [Amazon] stock fall from $113 to $6 I was also watching all of our internal business metrics: number of customers, profit per unit, defects, everything you can imagine. Every single thing about the business was getting better, and fast. So as the stock price was going the wrong way, everything inside the company was going the right way. We didn’t need to go back to the capital markets because we didn’t need more money. The only reason a financial bust makes it really hard is to raise money. So, we just needed to progress.

The current market is creating opportunities to purchase businesses that have made substantial progress vs. the last time they were available at their current prices. We have recently been buying at 2016, 2017, and 2018 prices, purchasing businesses that are multiples larger than their 2016, 2017, and 2018 selves, with improved business models and traction, and much lower valuations vs. prior years.

While we’re not deploying our capital all at once, we are thoughtfully taking advantage of our ability to be patient and have the longest perspective in the market.

We are watching our businesses’ progress, confident that we will be pleased by the long-term rational business prices.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

The Upside of Chaos

John Candeto — Sun, 06 Mar 2022 15:00:29 GMT

Fellow Partners,

There are decades where nothing happens, and there are weeks where decades happen.
Vladimir Lenin

Uncertainty is at its highest in a decade or more. The largest war in Europe since 1945 is raging. The world’s 35th largest nation is under siege. The world’s 11th largest economy has been quickly cut off from most of the world. Inflation is at its highest in four decades and war will exacerbate this. Global supply chains are still a mess. Global shipping, too. Covid-19 is far from over.

We should decry the horrors we are witnessing.

We should also be mindful of some less-discussed externalities.

Emergence

Institutions, markets and businesses are best understood as complex adaptive systems.

Complex, in that they are dynamic networks of interactions, whose collective behavior may not be predictable from the behavior of individual components.

Adaptive, in that individual and collective behaviors mutate and self-organize in reaction to their environments.

These properties mean that institutions, markets and businesses exhibit emergent behavior — observable novelty, coherence, wholeness, and dynamism as they interact and adapt.

That sounds much like the description of a business we would admire.

Fragility

In the past few years, we have become victims of much that we knew but did not act upon.

Be prepared for rare-but-possible epidemics (we know they’re coming).

Don’t depend on resources from adversarial governments and be cautious about their motives (e.g., Russian government investments in NGO’s against shale gas to maintain dependence on Russian hydrocarbons).

If your supply chain is complex, don’t rely on just-in-time inventory. Keep a buffer of spare capacity and avoid single points of failure (businesses, but also central banks, and governments).

We’ve had many failures on many fronts. That’s a lot of bad news.

Adaptation

Here’s some good news: these failures will be the source of future strength.

More research firepower has been thrown at Covid-19 than any other disease in history. It’s not even close, and happened fast.

The degree and speed with which much of the world has decided to stop dealing with Putin’s government is stunning.

An economic war has begun. The West has imposed unprecedented sanctions. Investors are dumping Russian assets as fast as they can. So far this year the ruble has lost one-third of its value. The government may soon default.
The Economist

Energy independence and national defense are now back in vogue, the combination of which may lead to more democracies less reliant on the actions of global superpowers and less beholden to economic interaction with adversarial governments.

On the business front, substantial investments have been made to improve shipping logistics, increase and diversify semiconductor supply, and reduce single points of failure in supply chains. Energy, too, may see some needed rationalization as we consider exploiting cleaner resources such as natural gas (which burns cleaner than oil, which in turn burns cleaner than coal) to increase energy independence and total energy output as we continue the transition to renewable energy sources.

Time

As it relates to our partnership, how long will all this take?

We don’t know, but we don’t need to. The direction and speed of adaptation is more important than the dates.

This quote is a great example of how we are filtering the information bombardment:

If you’re making ten-year investments…a good investment isn’t really complicated. You want a compelling value proposition to consumers, and you want real reasons why other people won’t be able to duplicate this or erode your economics via competition.
Take the information you get and ask yourself: we’re sitting here ten years from now, are we going to look back on this as the seminal moment where it all fell apart? In ten years, are we going to be talking about this? If that answer is no, don’t worry too much about it. But on the other hand, think about the things that will matter in ten years and take those seriously.
Cliff Sosin

Closing thoughts

The concept and dynamics of complex adaptive systems paired with long time horizons are clarifying, and calming.

Covid-19 has been terrible. But it also helped galvanize the best of what humanity is capable of: global mass-coordination between governments, public, and private organizations to face a complex, common enemy at lightning speed.

More broadly, we are witnessing a reinvigoration of the liberal democratic order in the face of its greatest kinetic challenge in decades.1 I wasn’t around for the space race but suspect it felt a bit like the galvanization we’ve seen recently against pandemic and war.

One lesson of history is the many benefits that arise from challenges far bigger than our day-to-day partisanship. We now have several, and likely long-term externalities include less stagnation and more robustness in the world’s major institutions, markets, and businesses.

The costs will be great, and we should decry the horrors we are witnessing. But don’t lose sight of the emergent behavior in institutions, markets, and businesses that are the result of adaptation to these trials. It is likely much of the world will emerge from them far more resilient.

All the best,

John

Founder and Managing Partner

Thank you for reading. Feel free to share.

Written with thanks to Blake Allen’s insights and optimism, showcased here.

Thing 1 and Thing 2

John Candeto — Wed, 06 Oct 2021 14:01:07 GMT

Fellow Partners,

We invest in two things and only two things: cash flows and insurance.

The overwhelming majority of the investment industry has divided and sub-divided investing into a thousand tiny pieces called asset classes, sub-classes, attributes and factors, mined mountains of historical data, suggested that this creates a roadmap for the future, and claimed a need for master mathematicians to put the pieces back together for your benefit.

Because we choose to play a long-term game and only a long-term game, we get to ignore nearly all of the history-predicts-the-future complexities that have sold well for the past few decades.

Because we choose to play a long-term game and only a long-term game, we can seek to maximize long-term returns and only seek to maximize long-term returns. This isn't a popularity contest. This isn't asset squatting. This isn't pursuit of short-term bragging rights.

We invest in two things and only two things: cash flows and insurance.

Cash flows

We primarily seek to invest in something of value. In the long-run we always end up back at Economics 101: goods and services people are willing to pay for. In the long-run everything is a discounted cash flow model — which merely means we must estimate how much cash a potential investment is likely to produce, discount future cash flows back to the present, and seek to buy substantially more cash in the future with the cash we have today.

Because we choose to play a long-term game and only a long-term game, we focus our efforts on understanding probabilities of gain times magnitude of gain, less probabilities of loss times magnitude of loss. What we deem as the best opportunities end up in our portfolio.

Because we choose to play a long-term game and only a long-term game, we do not focus on a thousand tiny pieces, getting exposure to everything, or using history to predict the future. We invest in the areas we do because they are areas likely to produce the best opportunities that we are able to understand.

This is why we discuss the philosophies and behaviors we seek to apply in this partnership: long-biased; applied practical wisdom; first principles reasoning; patience. That's it.

You will not hear us discuss style boxes or find us painting ourselves into corners. We are looking to catch the best fish that we know how to catch. And fish swim around.

Insurance

Maximized returns are worthless if one blows up in their pursuit. This is regrettably common and often an argument against portfolio concentration. It's a good one, too, if applied thoughtfully.

Because we choose to play a long-term game and only a long-term game, we get to ignore nearly all of the insure-against-short-term-losses complexities that have sold well for the past few decades. When we think about insurance, we think about our ability to cross a hypothetical finish line decades from now despite substantial changes and challenges that we know we will face.

We don't seek to time the market. We do seek to figure out more substantive barriers to crossing the finish line decades from now. Our patience is the bedrock of this ability, as it allows us to ignore market prices at all times unless buying or selling is to our advantage.

We also think about deep structural factors: substantial inflation or deflation (both poorly understood and difficult to control); a decline in the global role of the U.S. dollar (seigniorage is a powerful advantage; those without it root against it); structural impairments to global reserve currencies such as excessive debasement.

Finally, we think not just about change but rates of change. Change is accelerating, but the rate of change is also accelerating. Thanks primarily to the deep currents of digitization, globalization and inexpensive capital, the speed with which ideas can move from concept to execution to scale to dominance is fast and getting faster — firms are reaching billion-dollar figures faster than ever.

CB Insights

Now consider that the data above is from 2015 and the driving trends behind it have all accelerated — substantially in some cases.

We are firmly in a world of "megas and minnows" (thanks to Josh Wolfe for this concept) — where success comes via extreme scale (winner-takes-most) or defensible niche (winner-takes-community). In this context, having the humility, hardiness and wherewithal to invest not just in what is working well today but what could compete it away tomorrow is important. To borrow from Hemingway, these disruptions are likely to happen "gradually, then suddenly." We position ourselves accordingly.

The lessons of history

None of the above is to suggest that history is irrelevant. We must learn its lessons — and realize that its lessons are largely about the immutability of human behavior.

The biggest takeaway from history is that the characters change but their behaviors don’t. Markets change, but greed and fear never do. Industries change, but ambition and complacency don’t. Laws change, but the tribal instincts of politics don’t.
Morgan Housel

The Onion

However, we must also be careful to avoid the seductive belief that businesses’ past equations are a roadmap to the future. It is supreme irony that human behavior desperately seeks certainty, does so through studying history, and misses the point that history is predominantly the study of change.

All history is the study of what’s changed, but it’s often used as a guide to the future. The irony is overlooked because the idea that if we gather enough data and read enough books we’ll acquire a map of the future is so seductive – it’s so simple, and makes you feel great.
That will never change.
Morgan Housel

Closing thoughts

Cash flows and insurance interplay. While most forms of insurance typically have a net-cost, some forms can be positive carry hedges or yield profits over longer time horizons. While we can't know with certainty which forms of insurance will have these long-term attributes, we can focus our efforts positioning within good trade-offs.

For example, in banking near-term cash flows are dominated by the world's major banks that have regulatory capture. These are attractive cash flows, and so they are being eroded by newer players who are un-bundling banking into more specialized services, and in some cases re-bundling them back into more modern institutions.

Further out still, some forms of competition are emerging that enable decentralized, automated borrowing and lending capabilities that may erode cash flows from even the newer players nipping at the heels of today's major banks.

We don’t have a crystal ball about businesses, we don’t expect history to give us one, and we're not blindly guessing. But we are positioning ourselves such that we'll be just fine however much change does (or does not) occur, at whatever the pace may be.

All the best,

John

Founder and Managing Partner

Know Why

John Candeto — Tue, 13 Jul 2021 14:00:52 GMT

Fellow Partners,

As we’ve noted before, history can’t tell you what to do, and, whatever you do, don't compete with robots.

The pitch

A few years ago a firm pitched me an investment as follows:

Look at the chart below. What do you notice? No sector has consistently been the best performer year after year. Our investment product takes this into account and buys all sectors in equal amounts because we don’t know what will perform best over the next few years. Our research has shown that this strategy outperforms the market.
Pitch guy

Interesting thought. And a common philosophy: we don’t know what the market will do, so let’s assume we can’t know much and invest accordingly.

Different philosophies

I raised some initial questions as I evaluated the strategy:

Why did this strategy outperform the market? Do we know? Can we know?
Are there good reasons for outperformance of this strategy to continue?
Would it have made sense to invest this way without the aid of hindsight?

As we talked it over, his answers to my questions came back to the same themes:

We don’t know the future
Historical data tells us this strategy outperforms the market
The strategy works because the data tells us it works

On his first point: we indeed do not know the future. Anyone who does need only be right twice, and with the right financial instruments they’ll become very wealthy and likely stay off the radar. Therefore, we either (a) don’t have perfect prognosticators or (b) they’re hiding from us. Either way, we can’t benefit.

On his second two points: the logic is viciously circuitous. Does the strategy work? It worked in the past. How would we have known in the past that it would work in the future? It worked in the past.

To me this was an obvious non sequitur. To him this was simple logic.

The strong differences in our philosophies stuck with me. Even if we disagreed, why couldn’t we understand the others’ perspectives?

I eventually concluded that we were approaching the question of “how should we invest?” from polar-opposite angles. To him, we couldn’t know anything, so we shouldn’t even try (not even to know why a strategy worked). Rather, we must assume that the future will behave similarly to the past (a big assumption), mine data about the past to tell us what worked then, and invest accordingly for the future.

Durability

My approach was the opposite: one must know why something worked and why we should have conviction that it will continue to work in order to follow it. This requires understanding markets and businesses as complex adaptive systems and understanding that some things never change, and others do. It requires application of practical wisdom to discern timeless principles from time-sensitive context, and systems thinking and first principles reasoning to understand how a business may behave in the midst of a changing and uncertain future.

This is likely a more difficult path, but also a more durable one. The challenge with seeking patterns and assuming they never change is that they do. As I’ve said before perhaps the biggest dogma of the past 5-10 years has been simply buying the market (e.g., an S&P 500 index fund) and leaving it alone. This has absolutely been one of the best performing strategies of the past decade, and a great option for people who would otherwise treat capital markets like casinos. But some forget that the strategy returned exactly 0% in the prior decade. Or that the significant majority of stocks within the index have actually performed poorly, but a few monster performers have more than compensated for the poor performance of the majority.

Closing thoughts

Will this continue? We don’t know — but we do know that if there is enough outperformance in a repeatable strategy, then over time it will be competed away. I prefer the company of uncertainty and first principles reasoning. The road may be less certain, but we will know why we are acting, and have the opportunity to build durable strategies in the midst of a changing and uncertain future.

All the best,

John

Founder and Managing Partner

Notes and references

[1] https://novelinvestor.com/sector-performance/

[2] https://awealthofcommonsense.com/2014/07/equal-weighted-sector-sp-500/

Seek Simplicity on the Far Side of Complexity

John Candeto — Mon, 05 Jul 2021 12:00:20 GMT

Fellow Partners,

This short essay highlights a piece of wisdom hiding in plain sight. It is an enormous advantage that few grab.

Simplicity and simple mindedness (listening)

A theory that you can't explain to a bartender is probably no damn good.
Ernest Rutherford

I recently finished listening to a podcast on an esoteric topic. Again. This was the fourth listen. It is an important topic, so I was trying to get to simplicity on the far side of complexity.

I’ll explain.

During the first listen I was on a walk. I was interested in the subject matter, but as is often the case I had several “wow” moments where the interviewee connected high-value items in a clear manner that helped me glimpse how the world works just a bit more.

At this stage of understanding I knew enough to think that I understood the topic. Laziness tempts one to stop at this point. Ego tempts one to boast in their new-found knowledge.

My goal was understanding, so upon returning from my walk I sat down to write out what I had learned.

The words didn’t flow.

So, I listed to the podcast again.

Struggling with complexity (explaining)

Any intelligent fool can make things bigger and more complex. It takes a touch of genius — and a lot of courage — to move in the opposite direction.
Albert Einstein

During the second listen I was at my desk taking notes. I tried to outline the structure of the topic and connect it to its broader social and economic context. I was primarily trying to understand the incentive structures within the ideas, and how these will naturally elicit action. I wrote a lot.

I often test my understanding of a topic by trying to explain it to someone else. By the end of the second listen and note taking I thought I was ready. That evening over a glass of wine I explained the topic to my wife.

Once again, the words didn’t flow (though she was gracious about it).

So, the next day I listened to the podcast again.

Crossing the complexity chasm (ordering)

If you can’t explain it to a six-year-old, you don’t understand it yourself.
Richard Feynman

This is not to suggest that anything can be made simple, but rather to insist that the right level of explanation should be widely understandable. Here’s how I try to structure such explanations:

The key takeaway is the part that should be explainable to a six-year-old. Those interested or immersed in the details will want to delve further down the tree — which is the appropriate place for underlying complexities and subtleties.

Seeking to put more structure around a topic is a forcing function to separate the important from the minutiae, and the logically consistent from the erroneous.

Having done this, I realized there were substantial gaps in my understanding of certain aspects of the topic.

So, the next day I listened to the podcast again.

Sidebar: it is critical to note that a structure such as the tree above is useful for ordering and understanding specific arguments or subjects, but perilous for trying to understand connections across arguments or subjects. It is far too rigid. Information is connected in complex and often non-intuitive ways that require open, flexible structures to explore, such Chris Harrison’s cluster ball graph of Wikipedia entries on mathematics, shown here:

Simplicity on the far side of complexity (continuing)

The most powerful force that could be potentially harnessed is dogged incremental constant progress over a very long time frame. This is above genius. It’s absolutely above genius because you can understand it.
Peter Kaufman

At this point getting to understanding becomes a matter of humility and stubbornness. Complementary explanations can be helpful. Getting real world experience with the topic can be useful. But the toolkit — pursuing simplicity on the far side of complexity, forcing logical sorting and structure, and testing on an audience — doesn’t change much.

I am still working on the explanation.

(You will hear it eventually.)

Closing thoughts

Why the obsession? Each of us will likely only have a handful of really outstanding insights and associated investment opportunities in our lifetimes. Wisdom dictates making the most of them, and the price of admission is — as Nick Sleep would suggest — understanding the deep reality of businesses and their broader contexts.

The rewards for arriving at simplicity on the far side of complexity are immense — and compound — yet most people stop somewhere along the journey between knowledge and understanding. Those that nurture the habit of getting to simplicity on the far side of complexity over time will find themselves with substantial advantages.

All the best,

John

Founder and Managing Partner

The Fabric Pattern of Reality

John Candeto — Thu, 27 May 2021 14:33:25 GMT

Fellow Partners,

This partnership began with two simple questions:

What is the most effective way to invest money we do not need for years?
Are there better alternatives to the dozens of options I had tried for my family?

Thus, the years-long experiment in assessing the effectiveness of practical wisdom applied to investing was born and culminated in the creation of this partnership.

The fabric pattern of reality

Wisdom is becoming competent with regard to the realities of life.
Gerhard von Rad

Pause for a moment and think about the implications of this definition of wisdom. It is astounding. It implies an order and truth in our reality, and that the ability to comprehend it and act accordingly will result in competence — the sort of competence that will make us better in the roles we fill (investors, parents, children, etc.) Thus, wisdom is understanding our reality and composing ourselves in such a manner as to act effectively within it.

The most impactive learning on the journey leading up to this partnership was the continual realization that there is indeed a fabric pattern to reality, that we can know some of it, and that acting in accordance with it will result in effectiveness.

That is motivating.

Rich or right

The second most impactive learning on this journey has been the continual realization of the many ways humans are constantly hindering their ability to understand reality as it really is and act in accordance with it.

I suspect most people would rather believe they are right (about anything) than submit themselves to truth and wisdom. I hope I am wrong. I fear I am not. Hence this motif in my writing.

Open mindedness / mental flexibility is an underrated trait in our business.
Dennis Hong, ShawSpring Partners

This is true from the opposite angle as well: humility is an enormous asset. There is something innate in humans that deeply desires approval in others — not just to be right, but to be seen as being right. This roadblock to learning continually truncates an enormous amount of humanity’s potential.

Willingness to pursue truth over ego is a competitive advantage in any context in which acting in accordance with truth wins in the long run. Investing is certainly such a pursuit. (Another way to measure this: what is one seeking to compound? If ego is prioritized over wisdom…we know how that usually ends.)

Changes

Believing there is a fabric pattern to reality does not imply that life and investing becomes entirely formulaic.

As discussed in previous essays, we believe businesses and capital markets are best understood as complex adaptive systems. They behave as organisms, with some more predictable traits (e.g., oscillation between greed and fear) and some less predictable traits (e.g., value creation departing from the concept of book value).

We often cannot predict changes within complex adaptive systems, but we can observe their complexity and their adaptation and adjust how we deal with them accordingly.

This drives at the importance of reasoning from first principles. For example, the past couple of months have seen a cacophony of bad headlines under the theme of “record results”, such as a Latin America ETF that is up 100% in the trailing 12 months. What happened? The terrible month of March 2020 was dropped from the data set (by the way, including March 2020 in the data set results in a 37% loss in the trailing 12 months.)

Year to date vs. inception to date

These concepts connect many places — including how we assess performance.

Many fund managers are primarily compensated on their annual performance. The (good) need for accounting and auditing requires running the numbers, assessing performance, and paying fees on a periodic basis.

An unfortunately common externality of this structure is year-to-date thinking — that is, management of the portfolio in such a way as to increase returns or protect gains to maximize the annual paycheck, often at the expense of longer-term performance.

We avoid this by staying closely aligned — in philosophy and capital. 100% of the performance fees I earned in 2020 were invested back in this partnership, and in addition to my role as general partner my family and I are and will remain substantial limited partners — continuing to grow our family’s wealth alongside yours.

This creates a better set of incentives and promotes longer-term thinking. We improve our chances of outperforming by focusing on inception-to-date performance — that is, total growth in our capital since the foundation of the partnership. This calm, patient incentive lets us ignore an enormous amount of noise which we would otherwise pay an emotional and financial toll to manage. It also helps us remain humble as we grow as it reduces temptations to assess or focus on shorter-term outcomes.

Closing thoughts

I recently finished one of Jack Schwager’s collections of interviews with traders. The interviewees had many different styles, and while they collectively focused on much shorter timeframes than this partnership, what they had learned in their careers about truth vs. ego was strikingly common. A few excerpts:

Winning streaks lead to complacency, and complacency leads to sloppy trading…if everything is going great, watch out.
The flexibility to change your opinion is an attribute, not a flaw. The flexibility to change your market view is essential to succeeding as a trader. If you are rigid in your market stance you only need to be wrong once to decimate your account.
When it comes to markets, strong opinions weakly held is a right approach.
Ego, and the need to be right, are detrimental to effective trading. Many traders are more invested in their market theories and prognostications being right than they are in being profitable, which is all that matters…it’s not about being right, it’s about making money.

The knowledge that there is a fabric pattern to reality, the understanding that we can know some of it, the desire to pursue wisdom, and the humility to act in accordance with it are all enormous competitive advantages.

All the best,

John

Founder and Managing Partner

Building Better Businesses

John Candeto — Tue, 04 May 2021 14:01:00 GMT

Fellow Partners,

We learn through experiment.

At the start of this year based on your feedback I committed to publish shorter updates on a more frequent basis.

A weekly cadence seemed reasonable, and while you have heard from me more regularly this year, this forced cadence has proven to be at odds with my insistence on publishing only what I deem worth your valuable time.

Adapting a popular quote: in some months nothing happens, and in some weeks months happen. I seem to have learned what Howard Marks has been proving for decades: write constantly; publish when ready.

Going forward you can expect to hear from me as often as needed. Sometimes this will be multiple times in a week. Other times it will be monthly. As always you can expect me to be available to speak at any point.

On to the update.

Building businesses

Good investment analysis helps companies raise the world’s standard of living. Enterprises work best when they have access to capital priced to reflect the value they can create. Index funds, by the way, do not price capital; they only mimic the actions of those who do.
Abdiel Capital

The actions of this partnership help build businesses. This point is often missed.

The capital markets we participate in are: (1) the aggregation of capital, (2) provided by allocators, (3) to businesses.

The actions of our partnership and other market participants create the prices at which businesses can access capital to serve their customers, invest in their businesses, and pay their employees.

Our partnership is centered on buying fractional shares of wonderful businesses. Over the long run these businesses flourish by meeting the needs of those they serve. To do so they require capital, and when we provide it at prices that approximate the value those businesses can create the collective output of the businesses themselves and the market as a whole improves.

Our desire for good returns incentivizes us to allocate our capital towards businesses that can create more value than is recognized by the market and away from businesses that can create less value than is recognized by the market.

Building better businesses

Quality is a phenomenal strategy.
Walt Disney

This is a happy reality. The means through which we seek to grow our capital over the long run also help shape the world we want to live in.

Putting this into practice requires thoughtful, patient, and humble action. Where would Amazon and its 1.3 million employees be if all investors abandoned them after their shares dropped 90% in the early 2000’s? Why did Enron flourish in accounting fraud for so long?

Wise capital allocation matters.

It is unsurprising that this partnership focuses on allocating capital to wonderful businesses, as over the long run businesses that create more value for their stakeholders than they consume will flourish in many ways — including financially.

Jeff Bezos’ recent shareholder letter (an excellent 22-minute read) illustrates this well. In 2020 Amazon:

Produced $21 billion in net income (value to shareholders)
Paid $91 billion in competitive wages and benefits to 1.3 million employees, including 500,000 new employees hired throughout the year (value to employees)
Provided a marketplace for 1.9 million small and medium businesses to sell their wares, which produced an estimated $25 billion in profits for these businesses (value to business customers)
Decreased software development costs by about 30% and increased software development speed through their AWS platform (value to business customers)
Saved 200 million Prime members an estimated 75 hours in shopping time (value to retail customers)

The point is not that Amazon is a wonderful business (though I believe the world is better for it), but rather that effective capital allocation is a necessary ingredient to enable businesses to reach the full potential of the value they can create — and the results over decades can be enormous.

Capital allocated well improves the average quality of the world’s businesses which raises the standard of living for the people those businesses serve. Capital allocated poorly lowers the average quality of the world’s businesses and reduces the standard of living for the people those businesses serve.

Closing thoughts

Index funds have created an enormous amount of value for their investors — especially for those that would otherwise treat capital markets like casinos — but they do not price capital for businesses. They simply follow the market participants (like us) that do.

Wisely priced capital is a key ingredient to effective business building, and when done well our world is better for it.

All the best,

John

Founder and Managing Partner

Focus on the Business

John Candeto — Fri, 12 Mar 2021 15:11:37 GMT

Fellow Partners,

A warm welcome to three new partners this month!

Several of you have asked how the partnership is growing. In a word, “steadily”, which is just the way we like it. We are growing the partnership based on alignment to our principles. If we didn’t get the occasional “no” or found ourselves accepting every offered check we would be violating this approach.

We are resuming our First Principles Reasoning series this week after our brief pause to discuss Bitcoin.

On to the update.

Distractions

It has been an interesting few weeks in capital markets. At the start of February I remarked to my wife that “returns aren’t supposed to be this easy”. Growth in some areas of the market was getting out of hand.

The recent pullbacks we’ve seen in those areas are, on balance, healthy. Businesses are beneath every stock price. A connection between market context, secular tailwinds, and business performance is vital to good long-term results. Risk goes up when prices move too far from underlying realities.

Our friends at Ensemble Capital nicely contextualized some of what we’re seeing for those that want to read more: Don’t Learn the Wrong Lessons from the Dot Com Crash (8 minute read).

Focus on the business

At all times — and especially in times of strong volatility — we must anchor ourselves in the realities of the businesses we invest in. Many portfolios had strong rallies from the start of the year through mid-February, only to give up those gains by the close of last week.

What happened? At the business level: not much. In our case, most of our businesses have reported their year-end 2020 financials over the past few weeks. Most of what really matters — revenue growth, healthy margins, strong returns on incrementally invested capital, and chunky moats around the business — is just fine.

In fact, recent market volatility has given us the opportunity to increase our ownership in several wonderful businesses, which we have done.

Understanding what drives long-term returns

What about underlying business value? For those with a long-term mindset, revenue growth is the primary necessary condition, along with the many factors that support the quality of that revenue (more on that in a future series).

Though by no means a sufficient condition for success, revenue and revenue growth are required for a business to have the opportunity to generate cash flow, invest in business opportunities, refine their business model and improve their products and services. Revenue is a necessary enabler; revenue growth is evidence of effectiveness.

Putting growth in context

Some have commented that multiples — that is, the amount investors are willing to pay for a given level of business performance — are at risk of contracting. This is true, and it will happen at some point. But this risk should be rightly understood.

First, one can miss an incredible amount of growth while waiting for lower valuations. This can be as damaging to long-term returns as over-paying.

Second, sufficient persistent growth can overcome headwinds from multiple contraction, and should be factored into one’s return and risk calculus. See the chart below1.

Finally, for long-term investors, periods of multiple contraction create buying opportunities just like the one we discussed above. If the intrinsic value of a business has not changed much and we liked it at, say, $10 per share, we should love it at $5 per share.

This is not advocating buying at any price, but rather suggesting that elevated multiples should be factored into one’s risk equation — not simply become a reason not to buy.

A more balanced perspective: paying relatively high prices in the short-term requires relatively higher confidence in the ability of the business to grow at elevated rates over the longer-term.

Closing thoughts

It is immensely helpful to zoom out — sometimes way out — to recognize the broader context of our investments.

We are emotionally wired to think this way2:

Reality often looks much more like this3:

We get the same place. Volatility is simply the price of admission.

Until next week —

All the best,

John

Founder and Managing Partner

Thanks to Luca Capital research for inspiration in this analysis.

Thanks to Brian Feroldi for the illustrations. His Long-Term Mindset publication is worth a read.

Ibid.

Don't Compete with Robots

John Candeto — Tue, 16 Feb 2021 20:23:27 GMT

Fellow Partners,

Thank you for your continued referrals. We are growing and look forward to welcoming several new partners in March. More on that in the annual report, due out this April or May.

On to the update, which is the third entry in our First Principles Reasoning series. Prior entries covered history can’t tell you what to do and priorities.

Knowing vs. understanding

Any fool can know. The point is to understand.
Albert Einstein

The first book I ever read on investing was David Dreman’s classic Contrarian Investment Strategies: Beat the Market by Going Against the Crowd. His insight was that investors overreact, consistently overvaluing the best stocks and undervaluing the worst stocks. His conclusion was to use this insight to bet against the crowd.

Dreman and a host of others produced research concluding that statistically cheap stocks are likely to go up and statistically expensive stocks are likely to go down. The conclusion drawn by many investors has been to buy statistically cheap stocks and wait for them to go back up.

These sorts of contrarian actions sometimes produces outstanding results. But while contrarian action may be a common ingredient in successful investments, it alone is not sufficient.

Look, all I want is to invest in some high-quality assets at low multiples. Is that so wrong?
Common complaint of value investors

Statistically cheap businesses can be wonderful businesses, or businesses on their way to bankruptcy. And it is not uncommon for wonderful businesses to never be statistically cheap (for example: Costco’s P/E and other ratios have been high for decades, but it is such an effective business that is has been a wonderful investment).

The key is to buy businesses for less than their intrinsic value, which requires combining historical measures of value (e.g., statistical cheapness) with a reasonable quantitative perspective on future growth and evolution (e.g., product and margin changes) and qualitative factors (e.g., competitive advantages, optionality).

This is all to say: successful contrarian actions are the result of good analysis. Contrarianism is not the process itself. (Surprisingly, this statement will be controversial to many.)

Deep reality

Nick Sleep put this well a few decades ago. Nick is best known as a value investor in the mold of Buffett, and known for understanding Amazon’s potential early on and holding as well as growing the position to enormous gains (when Nick closed his fund in 2014, his Amazon position was 66% of the portfolio).1

One of the things we have learnt over the last few years is that our most profitable insights have come from recognizing the deep reality of some businesses, not from being more contrarian than everyone else.
Nick Sleep

The “deep reality” of a business is a powerful concept.

The value of a business is simply the discounted value of the cash that can be taken out of it during its remaining life. The key questions are, “how much cash?”, “when will we get it?”, and “how much certainty do we have that we’ll get it?”

A surface treatment might reference historic earnings, company multiples, peer multiples, and estimates from management and analysts. These are all useful. But businesses with certain futures will be priced to match. Greater opportunity exists in thinking differently.

Amazon has never had a reasonable P/E multiple because it has always (very publicly) invested its free cash flow back into improving its business and building new businesses.

Costco typically has a high P/E multiple because it excels at growing same-store sales and developing new warehouses. Price grows with earnings; growth fuels returns.

Netflix had negative cash flow and growing debt for years as it invested in building an enormous subscriber base; now it generates more cash than it needs, and no longer anticipates having to borrow money to fuel its growth.

What these examples have in common is that the businesses are playing a different game — a longer game — than that of many who wish to understand them. Their deep reality is that they are shifting money over time: spending now to earn more later. When this clicks it becomes possible to answer valuation questions from the perspective of the deep reality that each business has created — not from the perspective of shortcuts such as P/E ratios.

Not everything that counts can be counted, and not everything that can be counted counts.
Albert Einstein

Don’t compete with robots

The tough part about understanding the deep reality of businesses is that it requires curiosity, work, an open mind, and an open investment mandate.

The great part about understanding the deep reality of businesses is that one is far less likely to be competing with robots which, as a rule, is wise to avoid.

Think back to valuation ratios: any investment strategy (contrarian or otherwise) that relies solely on historical measures of, say, statistical cheapness, can be — and has been — programmed into robots, which execute these strategies with far more consistency and discipline than any human could hope to match.

This creates two problems. First, robots are infinitely scalable, such that any successful robo-strategies with eventually attract enough capital to minimize their profitability. Second, even while the strategy is profitable, the robots will always out-execute the humans.

So how do we compete? First and foremost, we aim to play the longest game of any market participant. Uncommon patience is a unique advantage. It enables us to let our winners run. It lets us focus 100% of our efforts in allocating capital to the right places and businesses and lose no time worrying about when markets reward wise capital allocation. Most importantly, it lets us time-shift seeking profits in businesses, focusing instead on cash flow and capital allocation within the businesses we hold — to the benefit of long-term returns.

The intelligent investor is a realist who sells to optimists and buys from pessimists.
Benjamin Graham

For the purposes of this partnership, we will never have more information, process information faster, or get information sooner than other market participants we compete with. If our edge were in these factors, we should be worried. Good news: we’re not trying to compete with robots.

Until next week —

All the best,

John

Founder and Managing Partner

Nick’s partnership letters are an excellent read.

Priorities

John Candeto — Thu, 04 Feb 2021 15:10:32 GMT

Fellow Partners,

What a past couple of weeks it has been in capital markets. The GameStop / Robinhood / WallStreetBets et al. saga is far from over. Despite a popular narrative, there was institutional money on both sides of the trade, and market structure and regulatory requirements were substantive components of the drama.

This will have important implications when the dust settles, and we may cover it in more detail at a later date. Those looking to read more (and chuckle a bit) will enjoy Matt Levine’s recent coverage.

Turmoil demands clear principles and clear thinking, which makes this continuing series on First Principles Reasoning particularly timely. Here is the second entry in the series. Previous entries can be found in our archive.

Alignment

I recently got into a debate over the merits of a popular consumer product. The details are unimportant. What I realized halfway through the debate was that major points and minor points were being treated on equal footing. That is a recipe for poor thinking, and reminded me of a framework I use often:

But living a just and holy life requires one to be capable of an objective and impartial evaluation of things: to love things, that is to say, in the right order, so that you do not love what is not to be loved, or fail to love what is to be loved, or have a greater love for what should be loved less, or an equal love for things that should be loved less or more, or a lesser or greater love for things that should be loved equally.
Augustine of Hippo

I can’t recall seeing Augustine show up in an investment memo before, but good thinking is good thinking, and this one is a gem. Begin applying it and one will quickly realize how poorly we allocate our resources — especially our time. (A common example: spending time on returns/refunds for inexpensive items while simultaneously lamenting not having enough time to spend with family.)

Time is our scarcest resource. Our ability to do anything well requires adequate time to spend doing it. We must make it count.

Sizing

This framework is universally applicable. In investing, the size of our effort should approximate the size of the prize. When researching a company, have we allocated more time to research companies with greater long-term potential? When managing our portfolio, are positions larger when they have more favorable attributes, or smaller when they have greater opportunity of loss (on a probability-adjusted basis)?

We should comport ourselves thinking through, as a friend says, “is the juice worth the squeeze?” and, to add to the sentiment, “squeeze harder when there may be more juice.”

Sizing positions in our portfolio is one of the most powerful application areas for this philosophy and in the world of investing it is one of the most under-discussed topics. We enjoy gains when we’re right and suffer losses when we’re wrong — but the primary way we manage risk and reward is position sizing. Swinging big at fat pitches, being cautious with difficult (but potentially rewarding) pitches and choosing not to swing at many, many pitches.

Perspective

On this point it may surprise some to know the following:

Charlie Munger, at 97 years old, has said he’s made almost all of his money from 3-4 investments.
Ben Graham, the father of value investing, admitted late in his life that he made more money on his GEICO investment than all his other investments combined.
Berkshire Hathaway has made over $90 billion on its investment in Apple.

Those tempted towards a philosophy of “buy a bit of everything” (e.g. indexing) would do well to think through how that may play out, as this philosophy makes it impossible to swing big at fat pitches. Equally, those tempted to try to pick only a handful of businesses and swing big would do well to think through the implications if they are unable to end up with a few big winners.

Challenge

This brings us back to aligning size of effort with size of prize:

It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong.
George Soros

The only way to do this is to ruthlessly align our use of time — our priorities — to be spent on that which has the greatest probability of the greatest profitability.

This is hard. But it is wise. I’m smiling just thinking about the challenge.

Closing items

We will delve deeper into the details of position sizing including diversification and concentration later in this series.

Until next week —

All the best,

John

Founder and Managing Partner

History Can't Tell You What To Do

John Candeto — Wed, 27 Jan 2021 15:00:45 GMT

Fellow Partners,

A number of you have asked if you could increase your positions in the fund. Yes, we are still accepting subscriptions. Please reach out to me if you would like to do so.

Thank you for your referrals over the past few weeks. We look forward to welcoming several new partners shortly. If you know others who align with our philosophy and strategy and may be interested in this partnership please connect us.

We also recently launched phronesisfund.com. Feedback, as always, is welcome.

On to the update, which is the first entry in a series on first principles reasoning. Additional entries will be published over the coming weeks.

A company should be viewed as an unfolding movie, not a still photo. Those who focus on the past see only the snapshot and sometimes reach wrong conclusions. If just looking up past financials would tell you what the future holds, the Forbes 400 would be full of librarians.
Warren Buffett

Had enough

I spent the morning reading an investment journal. One well-known author (unnamed here due to my practice of praising publicly and criticizing privately) declared that his ultimate buy-and-hold strategy, previously consisting of 10 equity asset classes, had been refined down to four. “Simplicity itself” was claimed.

Based on asset class returns between 1928 and 2019 [1,2] it was revealed that one could create a portfolio combining four strategies — an S&P 500 fund, a large-cap value fund, a small-cap blend fund, and a small-cap value fund — which never had a loss over any 15-year period [3]. With these four asset classes, one would be set up to “capture a piece of the action” regardless of which individual strategy was leading in any given period. They would also experience the “true peace of mind” that came from reduced volatility throughout the journey.

Much of the rest of the journal followed a similar theme: look backwards, see what happened, and construct a portfolio for the future based on what happened in the past [3]. I’d had enough by the time I reached the end of the journal and sat down to write this piece.

The lessons of history

There is an immense amount we can learn from history. Within capital markets we learn valuable fundamental and behavioral truths and get a sense for how markets and businesses behave and evolve over time.

We see that companies are valued for their fundamental performance in the long run and that markets can behave irrationally for extended periods of time. We also see that markets and businesses behave as complex adaptive systems, such that profitable strategies often lose their profitability over time.

These lessons are immensely useful when we sit down with our portfolio and decide how to invest. Historical data can help us know where to look and what to watch. But it cannot tell us what to do.

Don’t outsource your thinking

All this is to say: we cannot outsource our thinking to historical data. Principles matter enormously. Profit matters; margin matters; free cash flow matters; growth matters; competitive moats matter; management matters. But no one is studying the operations of businesses a century ago to figure out how to operate businesses today. Businesses have evolved. So have markets.

To take a common example: metrics that were immensely useful a few decades ago, such as price-to-book value, are ill suited to our current environment where most of the business value for many businesses is derived from intangible items such as talent, brand, IP, code, and patents, which is not well represented by our current accounting standards and poorly accounted for in the price-to-book calculus. Those waiting around for the market to reach a low price/book valuation before investing may be waiting a long time. This metric – while still useful for certain types of businesses – is ill suited to describe the reality of a market that has evolved through the information age.

This underscores the importance of understanding how investment strategies are defined. For example, a small cap value strategy will use metrics such as price/book and price/earnings to classify companies as “value” stocks. But this is within a present reality where businesses have invested as much or more in intangible assets (vs. tangible assets that show up in price/book calculations) for the past two decades. Price/book has become a less useful (or in some cases irrelevant) metric on which to segment because it fails to account for how business value is created in much of the market. A resulting strategy that uses this metric will be flawed from the start — not because the idea or past performance of such a strategy was poor, but because this approach no longer adequately assesses the way many businesses have evolved to create value.

A similar chain of logic can be used for metrics such as price/earnings. While earnings are essential over time, investments in intangible assets are often long games, absorbing cash in early years resulting in low or negative earnings with the benefit of requiring minimal cash in later years resulting in enormous earnings. Realizing that 90% of assets in the S&P 500 are now intangibles (see chart below for how this has evolved) should prompt careful consideration on the nature of how and when firms are wisest to realize free cash flow as earnings as opposed to investing free cash flow in product, marketing, or other areas that could raise future earnings.

Source (excellent 2-minute read)

There are plenty of ways to deal with these realities, of course. They require a deeper level of consideration and — importantly — would generally undermine a financial academic’s desire to write a short pithy article about “simplicity itself” and “true peace of mind”. As is always the case: buyer beware.

A better way

The cure? Reasoning from first principles.

These principles are the gold dust of history. We know certain things always matter in the long run (long-term free cash flow chief among them). One of the greatest lessons of history is that markets and businesses are complex adaptive systems. Knowing this, we can study the systems and adapt accordingly.

We should use history as a guide to understand how markets and businesses have evolved — not as a prediction engine to outsource our thinking.

Closing items

As this series unfolds we will cover first principles reasoning in a number of areas: market context, business value, secular tailwinds, portfolio construction, risk management and a number of behavioral traits.

Until next time —

All the best,

John

Founder and Managing Partner