I started to realize, wow, it was really only 20 stocks over 50 years that drove the performance. Walmart was one of them, but unfortunately it was sold. Had the stake in Walmart not been sold, it would have become greater than the sum total of everything else over the past 50 years. The math of that one decision to sell actually wiped out decades of other good decisions.

Henry Ellenbogen, in this exceptional pod

Approximately 50% of investment partnerships fail within their first five years — by far the riskiest period for any partnership (or business) that eventually lives for decades.

In 2025 our partnership turned “5”.

Thank you for the continuing opportunity to compound trust and capital with you.

2025

We began 2025 with 21 positions and 85% of the portfolio concentrated in the largest five. We ended 2025 with 17 positions and 87% of the portfolio concentrated in the largest five.

Throughout the year we considered about 1,000 potential positions, removed nine positions and added five positions. Two of our largest positions were added to major indices — one to the S&P 500, another to the TSX 60. Portfolio turnover was about 46% — higher than the past few years, as we took some opportunities to “green” the portfolio (more on that below). We were active in the market on 64 days of the year — about 25% of the days the market was open. Much of that was distributing similar orders over multiple weeks.

The intrinsic value of our portfolio compounded well this past year and our mark-to-market returns were adequate, if not the large figures of the past couple of years. As you know, we do little to manage in-year returns, preferring instead to buy power laws when they are underpriced and let them play out. We are playing a much longer game.

I often tell those who ask that traders should be terrified of the entities they trade against. (I recently read a profile of a little-known firm that spends $1 billion each year on its trading algorithms. If you’re trading, that’s what you’re up against.) We are not traders. In the short run traders set market prices; in the long-run intrinsic value dictates valuation.

For taxable accounts, we have concluded a third straight year without realizing taxable gains. This will not always be the case, but it is a nice tailwind when we can get it. Please check your statements for specifics. As in prior years, they will vary only based on when you invested in the partnership.

Portfolio construction

We continue to run a barbell portfolio wherein an asset’s primary purpose is [1] maximizing our resilience to many different potential versions of the future, or [2] maximizing power law potential (more on that below).

At present about 60% of the portfolio is in [1] and 40% is in [2], though we are in the unique position wherein about a third of the portfolio happens to fit both camps. These are our favorite assets — ones which can be resilient to many possible future states and have the potential for substantial growth. They are rare, and we have some.

In addition to balancing resilience and power law potential, we maintain substantial optionality. We always want to be in a position to take advantage of non-fundamental dislocations (read: market freak-outs that have little to do with long-term asset value) and be able to lean into long duration assets with power law potential.

To do so, we keep a mix of assets that have both low and high correlation to the broader market, as each can present opportunities at different times. Some assets with high market correlation briefly got cheap during the Liberation Day selloff this past April. Some assets with low market correlation were cheap at other times throughout the year. Holding both gives us a much broader surface area of optionality for what we can buy, when we can buy it, and what can fund the purchases.

We also view portfolio assets in a number of other buckets:

• Cash on hand.

• Cash proxies: Positions with low market correlation that could fund substantially better opportunities, if found.

• The proportion of each position we consider tradeable: We leave room in each position to take our basis off the table to help us play an even-longer game, and the opportunity to own more of each position by selling at upper valuation deciles and buying at lower valuation deciles.

• Open orders: We maintain a limited number of offers with our brokers to buy assets at absurdly low prices. Case in point: one asset we like got absurdly cheap for 3 minutes during the Liberation Day selloff. We missed it. We won’t miss it again.

All of the above is subject to our criteria for what we are willing to hold — we only consider holding assets that we would be comfortable holding for many years. This includes a belief that the assets “need to exist” (i.e. that they are likely to do more good than harm in the world), that they have substantial resilience and/or power law potential, and we feel we understand the power law drivers, iteration rates, adoption journey, and how much of that journey is already priced in.

Greening the portfolio

As mentioned above, we are always seeking to “green” the portfolio, and we took some opportunities to do so this past year.

What does that mean?

Each asset we invest in must pass a series of tests: resilience, power law potential, is it needed in the portfolio, is it likely to do more good than harm, where is it in an adoption process, how much of that is priced in, have we used the product or service, how much conviction do we have in it, and so forth.

We score each of these attributes, with top marks getting a “green”. If you add up all that green, ideally in a given year the portfolio is greener at the end. I am pleased to report the portfolio became greener in 2025.

If it were 100% green our standards wouldn’t be high enough. But a vector of “rising green” — showing we are continuing to improve our standards and our ability to evaluate each position against those standards — is essential.

Success is iterative, and so the essential thing is to iterate. And we are.

On that point:

Experiments

Bill Gates says that if I had been born three million years ago, I would have been some animal’s lunch. He says, “You can’t run very fast, you can’t climb trees, you can’t do anything. You would just be chewed up the first day. You are lucky; you were born today.” And I am.

Warren Buffett

We are fortunate to live in the time that we do. Technologies of ambition are widespread, cognitive leverage is at an all-time high, and the potential returns on high-quality thought and execution are enormous. I am rather excited about this.

The rate of change of the rate of change has never been higher. That’s a big deal.

For most of human history success mostly meant being lucky at birth (nobility / nepotism) or just plain lucky. Hard work always mattered, but it was very easy to work very hard and not get very far.

We can never remove luck or providence from the equation entirely, but the whole point of pursuing phronesis (def.: practical wisdom) in investing is to minimize our dependence on luck. (Another way I define this is to conduct ourselves in such a way that, if we were to run this partnership 1000 times over, we would be successful as many times as possible).

To that end, one of many modern miracles is the availability and quality of cognitive leverage. For modest costs we can amplify just about anything in the digital world, which supports improving our understanding of the world (Truth) and opportunities to align our actions to it (Wisdom).

Truth is a correct understanding of how the world really works.
Wisdom is aligning one’s actions to truth.

Our partnership has access to fundamental data that would have taken hundreds of analysts to acquire and update just a few years ago.

Our partnership has access to the brains of tens of thousands of experts through networks and digital libraries.

And our partnership has access to an unlimited number of smart, tireless robots — we call them our helpful sycophants — that help us search for and understand resilience and power law potential, confirm or reject our hypotheses, surface information of importance to our investments, and improve how we implement our investment philosophies and processes.

Though we remain a small partnership, the resources we deploy are enormous.

Others have these, too. Which is why we are highly specific on who we compete with and how we compete.

95%+ of capital in public markets is rewarded or punished on time horizons well under a year (often quarterly or monthly). Because we play a longer game, we are not competing against most capital.

As I always mention in our weekly calibration notes, those best calibrated on their present reality have the greatest opportunity to accurately understand what is going on around them and act with wisdom. Our success vs. the minority of public market capital we compete against will be determined mostly by the degree to which we can utilize our enormous resources marginally better.

Over time, these small advantages — should we get them — can compound into enormous ones.

Finally, because we are playing a long-duration game tied to the compounding of intrinsic value, we are playing a positive sum game. Our partnership and the many others that we have strong relationships with have the potential to be successful together, and not at the expense of each other. As I see it, this is the only way to go through life.

Back to the point: in a world of immense cognitive leverage, the best way to learn is to experiment. In the past few weeks alone we have trained a digital investment analyst, a digital process analyst, a digital statistician, and a digital strategist. Will these be helpful? We’ll see. I’m rather bullish.

Since we began creating tools, effective delivery of all work has meant getting humans to do what humans do best, and machines to do what machines do best. This has not changed in the Age of AI (machines are not the final form factor), but the value of getting this equation right is being amplified immensely. Our partnership now has robots, great information to feed them, and practical wisdom to direct them.

The net target is this: our rate of learning and improvement is higher than it has ever been, and likely to increase. If we can become better-and-better calibrated on how the world really works (Truth) and more-and-more align our actions to Truth (Wisdom), we can continue to raise the odds that the eventual outcomes of our partnership will be highly desirable.

That is exciting.

Cost-to-decent-answer

Here’s another way to frame the evolution we are living through:

1. Pre-modernity (c. 1700s and before): The cost to get decent answers to complex questions was extremely high. There were very few accessible, knowledgeable people and even fewer who were fluent across multiple disciplines. Charlie Munger suggested that Ben Franklin may have been the last human with this capability. Ben Franklin died in 1790.

2. Modernity: The cost to get decent answers to complex questions started declining due to the spread of libraries, universities, and so forth, but remained high because searching through wide ranges of knowledge and combining them was still hard.

3. The Past Few Decades: The internet was a major inflection point in reducing the cost to get decent answers to complex questions. For the first time in history, it was possible to rapidly search immense libraries and directly access people all over the world. But combining disparate knowledge still required finding the right “combiner” (i.e. multidisciplinarian) fluent across relevant fields, and their having a desire to do so. Even when this happened, there were still many gaps between the combination of knowledge and the application of said knowledge.

4. The Past Few Years: We are now living through a dramatic collapse in the cost to get decent answers to complex questions. Large language models — wielded with wisdom — can combine knowledge, suggest applications of knowledge, and aid in the application of said knowledge in ways that would have appeared as magic just a few years ago.

All this means we have the opportunity to expand our knowledge at increasing rates, apply said knowledge at increasing rates, and reduce the odds that we mistake something we think is a good idea for something that has low odds of actually being one. I am most excited about that last one.

And that brings us to:

Power Law Potential

From day one of our partnership we have talked about viewing assets as complex adaptive systems, focusing on quality, chasing excellence (not the scoreboard), playing the long game, compounding trust within our partnership, surviving, and evolving.

Power laws in public markets — our primary focus over the past three years — has been a direct outcome of the application of our principles.

Power laws are an intuitive reality wherein a few things become very large while many things remain very small. They are a product of the process of change: try things, keep what works, delete the rest. Those that do this best create power laws, and come to dominate reality.

Power laws are widespread in the world. For example:

• Sports: Roger Federer won 82% of the 1,526 singles matches he played, but he won just 54% of the points he played. 4% made all the difference.

• Investing: 4% of firms created 100% of U.S. equity outperformance vs. T-bills over the past century. 4% made all the difference.

• Businesses: c. 2-4% of sales, clients, employees, product features, and so forth make most of the difference.1

• Time: “There are decades where nothing happens, and weeks where decades happen.” (Vladimir Lenin)

• Investment Partnerships: In his 2022 shareholder letter Warren Buffett observed that “Our satisfactory results have been the product of about a dozen truly good decisions – that’s about one every five years.” Charlie Munger observed that Berkshire Hathaway made most of its money from just ten insights. According to some accounts of Berkshire’s history, that’s roughly 4% of the investments the firm has made.

Because power laws are a natural outcome of change, we find it less risky and more profitable to invest in congruence with change than to push against it, especially in a world that is changing faster than ever.

We use three tools to find power laws:

1. Intuition. Built over years of business building and investing.

2. First Principles. Finding known power law drivers in investable structures.

3. Statistics. Finding evidence of power law behavior within business metrics.

In the long run, price is volatility around much more stable adoption curves. Power laws provide insight into the adoption curves of products and services, which we use as an input to estimate the intrinsic value of potential investments.

This is why we spill so many words on power law potential. Borrowing a concept from the world of physics, potential energy is to an object what power law potential is to an asset. We find, price, and invest in power law potential where we believe it is wise to do so.

Potential energy is to an object what power law potential is to an asset.

Those wishing to dive deeper may enjoy this recent Art of Quality episode: Finding Quality Through Power Laws.

In closing

When our partnership turned “1” I noted that I woke up many days surprised and delighted that I got to serve you, our partners, through the craft of investing. That is even more true today.

I also made a few other commitments. We will not take misaligned capital and do not make macroeconomic bets. Check and check. We do not trade hyperactively in response to the news, dabble in exotic financial instruments, or seek to manage volatility. Check, check, check.

Expect big down years, and a bias to size up during these times. Check. Expect big up years, too. Check. Volatility is the price of portfolio concentration, and the price of the opportunity for substantial outperformance.

We remain resolutely focused on compounding trust within our partnership, believing that if we do this well the rest is likely to take care of itself. Our family’s capital remains invested alongside yours, and we remain structured for only two possible outcomes: we’re all happy, or we’re all unhappy. That is how it should be.

It is an honor to serve you, and I look forward to serving you for decades to come.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

This past weekend a few Phronesis Partners and I watched from the audience as Warren Buffett did something he never does: get emotional. At the end of 4.5 hours of Q&A he noted "I have one more thing to cover" and shared his intent to step down as Berkshire Hathaway's CEO at the end of 2025.

As usual he did it his own way. “This is the first time the Board of Directors and Greg [the future CEO] are hearing about this.” A standing ovation followed, broken up by Buffett's usual sense of humor: “And I will not sell a single share of our stock!”

At The Art of Quality we seek to understand that most difficult and essential thing: capital-Q Quality. We ask all our guests the same closing question: “What is your most memorable encounter with Quality?” It is notable how many mention Warren Buffett in their answer.

Few have shared more wisdom or been more quotable. As the sun sets on sixty years of Buffett the CEO, here are some of his final gems.1

(It's worth remembering that all of these were offered in answer to spontaneous questions from shareholders about business and life.)

On Posture

The world is not going to adapt to you; you need to adapt to the world.

If every time you swung you hit a homerun the game wouldn’t be very interesting.

Your brain would turn to mush if you didn't have a few problems.

Turn every page...you'll find things that no one else does.

On Partners

You get a few breaks in life in the people who you will meet. You need a handful of them. And when you have them, you treasure them.

Make the most of the people you meet who are going to make you a better person and forget about the rest.

I never wanted institutions. I wanted people.

The great pleasure in this business is having people trust you.

On Opportunities

Prices get extraordinarily attractive very occasionally.

We will make our best deals when people are most pessimistic.

Every now and again you get an extraordinary opportunity. Most of the time you don’t have much of an edge.

Don't be patient about acting on deals that make sense...and don't be patient in talking to people about things they'll never do.

On Risk

The biggest thing we have to worry about is that we've learned to destroy the world. We have changed the world enormously, but we have not changed human beings very much.

Make sure the cathedral is not taken over by the casino.

It's easier for an organization to see its quality move downward than upward.

I spend more time looking at balance sheets than income statements...over a 5-10 year period things are harder to hide there.

Government

On spending:

It's easier to do stupid things with other peoples' money than it is with your own.

On deficits:

If you picked a way to mess up the U.S., it would involve the currency.

On currency inflation:

Those who trust their government get screwed.

On healthcare regulation:

The tapeworm won.

On America

We don't want a world where 330 million Americans are crowing about 'winning' while the rest of the world is upset about it.

I was born in 1930 and stocks got much more attractive over the next two years and I didn’t do anything about it. That was the opportunity of a lifetime and I blew it by worrying about the kid in the next crib.

In Closing

Buffett will remain Chairman of the Board.

The highlight reels never get old.

It is an honor to serve you.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

The most important organ in investing is the stomach, not the brain.

Peter Lynch

In broad strokes I know three types of investors:

1. Those who focus on future value: What could go right? They buy potential for growth.

2. Those who focus on present value: What could go wrong? They buy reversion to the mean.

3. Those who focus on relative value: What assets are cheap vs. other assets? They buy and sell a lot.

Some common phrases from these groups are 100 baggers…margin of safety…macro for context and micro for conviction…bulls and bears make money while pigs get slaughtered.

We all have our own proclivities, but I have learned a great deal from all three types. There is practical wisdom within each group, and part of our job is to find and apply it.

What is the zeitgeist of each group today?

1. Those who focus on future value: “How can such great assets be so cheap?”

2. Those who focus on present value: “We’re finally starting to see a few bargains.”

3. Those who focus on relative value: “All that matters is to survive. The rest is just words.”1

Which brings us to today’s markets.

What is going on?

Doubt is an uncomfortable condition, but certainty is a ridiculous one.

Voltaire

Broadly speaking, economic warfare is causing substantial uncertainty. How can businesses plan when they don’t know how input costs will change? How can countries plan when they’re questioning who their friends are?

This creates substantial volatility in asset prices, which turns those using too much leverage into forced sellers at any price. And this creates reflexivity in the market: selling begets selling. Time is compressing.

What are we up to?

Drawdowns are only bad if you can’t take advantage of them.

Ian Cassel

First, I would like to remind you of what we were up to last time asset prices were this volatile (link HERE, from January 2022). We were zigging when others zagged. Not all at once. But through the uncertainty. What we did then formed the basis of our substantial returns since then.

Before our present turmoil we raised some dry powder, today we are holding on to quality, and over time I expect us to get some great deals.

We understand the territory we are in. We know what we are after. And we have the ability to get it.

Our goal through this season is to exit it owning more of the wonderful assets we held before it.

Most importantly: we are set up to survive forever. Read that again. All clouds eventually run out of rain. And when the present ones do, we will still be here.

Compounding Trust

Patience is a product of confidence and trust.

Peter Kaufman

Moments like these accelerate the rate at which we are compounding trust within our partnership. As you have heard me say over and over: if we compound trust at high rates, the other things we want to compound are likely to follow.

As Peter Lynch noted above, I know volatility is hard to stomach. As always, please reach out if you would like to talk.

It is an honor to serve you.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

Ouch. 2022 was a brutal year for many in capital markets and certainly for our partnership.

Your Q4 2022 statements and our annual audit will be released shortly. Check these for specifics — they vary only by the timing of your joining the partnership.

Business performance

The most important question we ask and answer each year is: how did our businesses perform?

Most of our businesses had a good year:

• Revenue grew an average of 17%. 11 businesses had double-digit growth, three had single-digit growth, and two had single-digit declines.

• All but three businesses were free cash flow positive, had years of cash on their balance sheet, or had positive adjusted margins (with reasonable adjustments), indicating that these businesses will not be reliant on capital markets for continued funding. Most had several of these attributes.

• Four businesses bought back their own shares, and eight businesses had directors using personal funds to buy shares in the open market.

• In general, we own businesses with secular tailwinds, operating leverage, low churn, and strong balance sheets.

For our digital assets, despite a year of horrendous events in the space:

• Demand continues to grow. The number of holders, active participants, active developers, and decentralized infrastructure all grew through 2022.

• Supply continues to decline. Fewer tokens are being issued and less of the circulating supply is being traded than at any point in these assets’ brief history.

Overall, market conditions have incentivized better behavior and many bad actors, bad businesses, and bad ideas are being washed out of the market. This pulling of the weeds will benefit those growing real plants.

Our actions

How did we respond to this business performance?

We started and ended the year with 18 investments. We added one new position, exited one position, and made few other changes aside from increasing the size of several of our positions as they became more affordable relative to our estimates of their long-term intrinsic value.

As I have said in prior writings, a highlight of the year was the majority of partners increasing their investments in the fund. That allowed us to increase the size of our positions at favorable prices. That also enabled a type of efficiency I love — no one paid this partnership to sit on cash. This "storing cash with LPs" reduces my fee income (and hence is less common), but it is a fairer way to operate.

Events of the year also helped validate the software-style alpha, beta, full-release approach we have taken to growing our partnership. 2020 was our alpha release. The evolutions we made in 2021 were our beta release. We will have a “version 1” launch shortly. We’ve done this for two reasons:

1. As often discussed, signaling to and selecting only the right partners is both the biggest risk and biggest opportunity for us to build an enduring, high-trust partnership. We continue to improve our ability to do so, and this is in part due to the fact that we have chosen to do it slowly.

2. We expect continued improvement of our process, including our ability to identify the best opportunities, scale into them, and manage the positions. A "raise and go" approach is antithetical to the time and experience required for positive evolution. Again, slow, intentional growth is the best path.

Fund performance

If our businesses had a relatively good year and our partnership was stable and growing, why did our fund have such a bad year?

Ben Graham noted that the market is a voting machine in the short-term and a weighing machine in the long-term. There was a lot of voting going on in 2021 and 2022 and much less weighing. We are a partnership that wants to be weighed, and over the long-term, we will be.

The reality of 2022 proved to be one of “nowhere to hide”. Bonds had their worst year on record. Stocks, too, had a rough year. The lack of dispersion in outcomes was surprising. Defense and commodities firms (generally outside our circle of competence) had good years driven by war and energy shortages. Some traders and market makers (not our strategy) had great years driven by market volatility. Beyond this, high-or-low multiple growth, high-or-low quality value…just about everything got hammered. Macro factors overwhelmed business-level factors.

Let’s examine the major factors and consider whether they are likely to permanently impair our capital.

In Seasons Pt. 1: A Better Mental Model we noted that markets and businesses are best understood through the lens of seasons as opposed to artificial increments of time such as months and quarters. In Seasons Pt. 2: How We Got Here we noted that an excess of excesses including easy money, maximum globalization, and geopolitical stability led to asset booms, and that this season has turned. Here’s the summary:

In Seasons Pt. 3: Direction of Travel we noted that we are likely to normalize back to longer-term trends. Money will have a modest cost (that is, risk will be priced), and globalization and geopolitical stability will retreat from their zeniths but remain beneficial. These normalizations, which negatively impact prices, will eventually be balanced by increased resilience and reduced risk, which positively impact prices.

This will take time.

I recently spoke with a 20-year veteran of the world’s largest appliance manufacturer (Bosch). Pre-pandemic they manufactured 160,000 dishwashers per month. Today — still — that number is just 90,000 per month, a 44% decline. The culprit? A Wi-Fi chip used in many of their appliances that is only manufactured in a single location in Shanghai. Rolling lockdowns in China dramatically slowed chip production, limiting their ability to finish appliances.

Similarly, a major furniture manufacturer who supplies Wayfair, Restoration Hardware and other brands recently noted the difference in their sales vs. shipping cost over the past few years:

How does one optimize their businesses amidst these realities? They don’t. But they can and will as more predictability returns.

We already see evidence of improvement.

The world’s largest car manufacturer is once again producing a record number of vehicles.

Shipping has also improved dramatically:

And Bosch? China opening up is helping in the short-term. Longer-term they’ve learned a bigger lesson on supply chain resilience, are in-sourcing their chip production, and building a second chip manufacturing plant in Malaysia.

These types of adaptation are upsides of chaos that lead to increased resilience and reduced risk.

On jobs — the biggest component of the current economic equation — evidence suggests the labor market may be less tight than we think. If true, this will flow through over the coming months and support normalization of price inflation.

Zooming out, the long-term trends of progress are powerful. Despite the present headwinds, far more value will be created in the next decade than in the last, and this partnership will be part of it.

Equally, the long-term cost of capital has been on a relentless decline for centuries, and while “free” is absolutely the wrong interest rate, we do not have good reasons to believe that the normalized cost of capital will be enormously high — that would counteract most of the data we have on the subject, and the efficiencies that led to its multi-century decline.

The takeaway for long-term, patient capital such as ours is that our investments in progress remain reasonable ones, provided one underwrites assuming a reasonable cost of capital (as we do).

Our concentrated portfolio paired with our minimal trading activity guarantees substantial price volatility throughout our journey, but the major factor of permanent relevance remain business performance throughout our period of investment. This remains our focus.

Lessons learned

Mistakes often come from overweighting apparent short-term wins, without fully recognizing the consequent, long-term costs. Not investing for the future is a form of this.

The Berkshire Hathaway annual meetings always open with video clips from the firm's history. In one, Warren Buffett is asked how he differs from other investors. "Patience" is his one-word answer. Our patience has been tested this year (and possibly for a number of future years; we'll see). But our focus is unchanged.

However, if we could play 2022 over, I would make two changes.

The first would be more patience in deploying additional capital. We are never trying to bottom-tick the market, but when the balance of price-accretive vs. price-destructive variables is clearly tilted one way, more patience is warranted. While I remain convinced that we will be envious of the prices at which we purchased assets in 2022, no rush was needed. I am generally optimistic, but a slower pace of capital deployment amidst the sea of bad news (and there has been plenty) would have benefitted us.

The second would be increased caution around businesses that may be dependent on capital markets for further funding. We have three holdings today that have less runway than I would like and difficult paths to operating profitability. While they’re far from dead, I generally dislike any variable that could require a company to raise capital — the worst time to raise money is when you need it — and the perception of these three positions is that they will. The game is far from over; we’ll see.

Zooming out, the world is ruled by power laws. Our purpose is to catch them and hang on to them when we do. Our work continues.

In closing

If you read nothing else in this letter, know that we do not rely on ultra-low interest rates for successful outcomes. Our focus and patience permits an investment strategy that is likely to out-perform as the market rises, and under-perform as the market declines, as we’ve already seen in the short 30 months of this partnership. In the long-run we care little about short-term performance vs. the market. If we’ve found good investments and hold onto them, their value when we sell will be all that matters.

The majority of my family’s net worth is in this partnership. I feel every percentage point and, since inception, have constructed our partnership such that I will feel the worst financial pain should our capital be permanently impaired. That’s only fair (though rather uncommon in this business).

Thank you for the continued opportunity to compound trust with you.

As always, please reach out any time.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

We have been enduring a bevy of bad headlines about capital markets. CNBC has run their famous "Markets In Turmoil" special which, historically, has meant better times were ahead.

There is much to decry — war, inflation, and slowing growth among them — and these variables are impacting our investments. But relatively little of what we are witnessing today will matter to the businesses we own years from now.

Capital markets act as a pendulum that swings between maximum optimism and maximum pessimism. We are certainly closer to maximum pessimism today.

This 1981 New Yorker cartoon nails it:

At all times — and especially times of strong volatility — we should be focused on our businesses. You will be pleased to know that, on average, our businesses have grown 22% over the past year. That type of performance will matter for a long time. Today's market sentiment will not. The pendulum will eventually reverse its course.

As we have discussed we continue to zig while others zag. We are not selling in this market — we are buying — at prices we are likely to envy years from now. Buying when there's blood in the streets is easy to say in up markets; it is psychologically nearly impossible to do in strong down markets. But we're doing it. That is the power of what I have long said is our greatest competitive advantage: patience.

You will receive notes from me shortly that go into greater detail on today's market structure and the current seasons the market is enduring. This thought experiment is a good summary:

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.

We can capitalize on times like these because we seek to have the longest view in the market and our partnership is structured to act on it. We do not have to sell our wonderful businesses next month, quarter, or year, and will continue as proud and supportive owners as long as they continue their business performance. Rest well in the confidence that we are likely to be rewarded for this behavior.

This is a trying period. I am available to speak with you any time, and always enjoy hearing from you. Please don’t hesitate to reach out.

All the best,

John

Founder and Managing Partner

Phronesis Fund

john@phronesisfund.com

Disclaimer

The Phronesis Fund ended 2021 slightly down for the year. Per our agreement, no performance fees were paid in 2021. That’s how it should be.

A down year is never easy. How we face it is imperative to our long-term success. That is the focus of much of this letter.

My family and I remain the largest partners in the fund, and we continue to grow our position in the fund by investing additional capital alongside yours. We’re all on the same path.

You received statements on your individual positions in mid-January and our fund’s annual audit will be published to your accounts in the next few weeks.

We remain focused on long-term compounding in community with a wonderful group of partners. Over a 30-year time horizon an extra 2.5% annualized return doubles one’s total return; an extra 5% annualized return quadruples one’s total return. Compounding is an amazing force:

I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? Penny. So that’s the question. Compounding our capital is what we’re after, that’s what makes it a great investment for us. What’s the value of compounding? Well the answer, in this case, is simply astounding. Doubling a penny a day for 30 days gets you, who knows, $10,737,000 and change.1

Chuck Akre2

Our businesses

The partnership is currently invested in 17 positions which, I am pleased to say, is more focused than the 33 positions we held at the end of 2020. We have long believed in concentrating only in our best opportunities, and 2021 gave us openings to do so. This frees time to study our positions more closely and raises the bar for other positions to join this group.

These 17 positions include 15 traditional businesses and two unique forms of insurance. They are based in four countries throughout North America and Asia Pacific, though most compete globally. Only one of these businesses is in the S&P 500.

Despite substantial market volatility we have never sold a single share of 16 of these positions. For the 17th, we reduced the size of our position in 2021 as it enabled us to increase the size of other positions that were selling at much higher discounts to intrinsic value.

Our top five positions account for 55% of the fund. Our top 10 positions — which were 62% of portfolio assets at end-2020 — now account for 77% of the fund.

We currently have a modest cash balance and have been deploying capital into the declining market. We all like a good sale, and we’re in the midst of one.

While I pay minimal attention to sector-specific diversification (most things can be valuable at the right price), some of you will want to know that the fund has substantial holdings in the technology, industrials, and consumer cyclicals sectors, though I prefer to put it this way: we are invested in phenomenal business models. All of them include zero-marginal-cost dynamics (payment from new customers has extremely high margins) and sit within strong secular tailwinds, and most have elements of what I think of as “operating systems of the future” — underlying platforms that enable speed, scale, cost-reduction and revenue growth for their customers in areas such as financial transactions, restaurant management, digital commerce, entertainment and search.

We view our positions as fractional shares of businesses; as with 2020, those businesses had good years. Revenue grew an average of 50%. All but three of our businesses were free cash flow positive. Earnings were modest as most of our businesses are continuously re-investing in themselves. Some of our businesses raised more capital throughout the year, generally at very favorable terms. Only two businesses have net debt. In aggregate, we own healthy, growing businesses that could weather dry spells while pursuing their paths to long-term high structural margins.

In short: our businesses are harder-better-faster-stronger (couldn’t resist) than they were a year ago. We should be pleased by that.

As mentioned a few weeks ago, I would again encourage partners to increase their positions in the partnership to take advantage of present buying opportunities, and encourage potential partners to reach out.

Thank you to those of you who have already contributed additional capital — I believe we will be envious of some of the prices we are seeing today when we look back in five years’ time.

Macro

Why did we have a down year? In November the Federal Reserve shifted their perspective on inflation from “transitory” to “something more than transitory”.

The market rapidly began pricing in increases to the cost of capital and discounting business prices, roughly in the following order:

1. First, businesses that have never made money

2. Next, businesses that make a little bit today and might make much more in the future

3. Next, businesses that make a lot today but invest most of it in their own growth

4. Finally, businesses that make a lot today and distribute most of it to their shareholders

Our portfolio is weighted in groups #2 and #3 above and thus has felt the pain of the drawdown relatively early in the market pullback (I expect we’ll bounce back earlier as well but we’ll see — our strategy doesn’t rely on timing these sorts of things).

The carnage has been somewhat masked by the major indices which had pullbacks but have been supported by some of their largest (and thus most heavily weighted) companies. Here’s one way of looking at it: As of writing the NASDAQ composite index, comprised of roughly 3,000 stocks, is about 15% off its all-time high, yet the majority of stocks within the index have had much larger drawdowns (see chart below).

This pullback happened fast and is still ongoing. The speed was clarifying — in many cases our businesses had pullbacks without reporting any new information on business performance. That’s helpful. We had little-to-no new information to update our long-term perspective on these businesses. Sentiment, fear, and a healthy reduction in excessive optimism were the primary drivers.

Those who value businesses based on market sentiment, hopes of ever-higher prices (the “greater fool” theory), ever-expanding multiples or endless support from the Fed should be worried. We don’t. And we’re not.

What have we done? We bought larger stakes in wonderful businesses when valuations fell back into reasonable long-term ranges. We are continuing to zig while others zag.

More macro

If you spend 15 minutes a year worrying about the market, you’ve wasted 14 minutes.

Peter Lynch

An older and wiser friend recently reminded me that focus on the Fed’s actions was far lower in preceding decades — generally the territory of economists, bond and macro traders. That is no longer the case (somewhat regrettably) for good reason.

Over the past 40 years money has gotten cheaper, we’ve not seen sustained inflation, and the world’s major central banks have loaded up on assets — especially over the past 15 years (see chart below). The central bank controlled liquidity and behavior has become a substantive factor in assessing — at a minimum — a reasonable long-term purchase price for a business, as one must factor central bank movements, including the enormity of their assets and willingness to intervene in markets, into their valuation and risk calculus.

I have under-appreciated this dynamic in the past. One of its derivatives — inflation (especially wage inflation) — is the current primary factor as it relates to longer-term valuation impact on our businesses. We’re watching it closely — not for the headline news and numbers, but for shifts, if any, in longer-term structural dynamics.

What we paid

For two years the market was valuing narrative more than numbers. Now the market is valuing numbers more than narrative.

Paul Enright

The above dynamics are where purchase price matters substantially. The cost of money will go up (it cannot and should not be free forever). This reduces the present value of expected future cash flows. It creates some short-term pain.

But here’s what’s important: our valuation for our businesses does not assume anything close to 0% interest rates. Capital markets are currently pricing in a 1.75% Fed Funds rate by year-end. That would be just fine. Higher, too, would be just fine. There’s a limit, but we’re not riding the line.

We have never been interested in paying extremely high multiples, even for the best businesses. Consequently, we did very little net purchasing in 2021 until late in the year.

When did we start buying? When valuations came down substantially.

Have they come down further? In most cases, yes. But our focus is and remains paying fair prices for wonderful businesses. We don’t predict short-term prices or sentiment, nor do we believe we can time the bottom.

While the pain of drawdowns may continue in the short run, where our business hypotheses prove to be correct over time, our purchase discipline will be the bedrock of our long-term returns.

Timing

We typically hold our investments for years, and thus it can often take years to know whether we were right in our assessment of said investments.

I would encourage you to re-read our 2020 Fund Performance note. Our plans haven’t changed; what has changed as of late is the pendulum of the market, which constantly swings between maximum optimism (where we were in late 2020) and maximum pessimism (we’re closer to this end of the pendulum at present, especially in the longer-duration assets we tend to own).

From mid-2020 through mid-2021 the market loved companies with robust growth prospects and was willing to pay high prices to own them. In late 2021 many of these companies fell out of favor with the market, which is now unwilling to pay modest prices to own them. Where is ownership risk higher? As noted above, we like a good sale.

Enormous errors are made by managers and investors through implicitly playing to an annual clock. It is hard not to when nearly all business performance, investment performance, and remuneration report to this clock. That is one of the many reasons it is critical that I, as your general partner, am also a substantial limited partner. It aligns our interests as well as our time horizons.

But here’s the main problem with the annual clock: none of our investments know or care when December 31st rolls around. Acting as though they do will almost certainly hinder our performance. We focus on the long-term rate at which our capital compounds. We couldn’t care less how that overlaps with our planet’s orbit.

What won’t change

We seek to invest where the future is obvious.

Consumers shifting purchasing habits from offline to online. Media shifting from analog to digital formats. Ads served only to those most likely to buy. Automation subsuming repetitive tasks. Creators empowered to monetize their craft. Removal of non-value adding middlemen. Expansion of the digital asset ecosystem. Better, faster, cheaper.

Our success over the next decade will be primarily dependent on the speed and persistence of these trends and our ability to correctly identify and invest in those pulling them forward. It won’t make much difference whether interest rates are 0% or 3%.

Closing thoughts

This image of our partners has been the background on my computer since we launched the partnership (blurred to protect privacy, and updated only when we add new partners). It is the first and last image I see when I start and end work each day. That’s how it should be.

You’ll also notice the text at the top of the image. I recently made that addition amidst the substantial market volatility. It is amazingly hard to play a long game and only a long game. But that’s our aim. Seeing these words many times each hour of each day is my own form of encouraging myself in this direction. I hope it encourages all of us in the direction of calm, patient, long-term application of practical wisdom and first principles reasoning.

As always, please reach out any time. I enjoy hearing from you. Thank you for the continued opportunity to compound trust with you.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

1

Perhaps as amazing as the results of doubling a penny a day for 30 days is where the real money is made. By day 5 the penny has grown to 32 cents. By day 15 it is worth a modest $328. Even at day 25 it is “only” worth $335,544. Those last 5 days are astounding.

The present investing environment is an interesting one. Large indices are near all-time highs whilst there is a bloodbath in smaller stocks and especially growth stocks. No one can quite agree whether digital assets are dramatically undervalued or overvalued, or how closely they will move with other risk assets over the longer term. Inflation predictions are in vogue, and the Fed keeps playing with the punchbowl. Volatility is high and markets are moving quickly.

The present investing environment is wonderful for long-term investors applying practical wisdom and first principles reasoning to patiently compound capital, such as this partnership. Opportunities abound. I encourage partners to increase their positions in the partnership to take advantage of them, and potential partners to reach out.

This letter provides context to this environment and how we are navigating through it.

In summary:

1. In our present environment first principles reasoning is critical (as always). I have included a summary of our writing series on topic, with links to all the essays published thus far.

2. Inflation is a battle of demographics and technology vs. money for nothing1. While inflation remains impossible to predict in the short-term (so we should stop trying), it is possible to understand the longer-term forces that will influence it.

3. Our global supply chain can be visualized as a snow globe. Pre-Covid the snow was gently oscillating about. It now receives regular, violent shakes. This exacerbates the challenges inherent in managing inflation and understanding asset prices.

4. There have been many signs of froth in the market over the past 12 months. This has led to high volatility, particularly in smaller stocks and growth stocks.

5. Indices are not companies — there are both overvalued indices and undervalued companies in the present market. The aggregate of the above factors has created buying opportunities we are taking advantage of.

[1] First principles reasoning

Our writing focus in 2021 was our First Principles Reasoning Series.

Our present investing environment is a superb example of the importance of those focal points (all links go to the essays in the series):

• History can’t tell you what to do

• Priorities are critical — ours must be focusing on the business and building better businesses

• To do so we must seek to understand the fabric pattern of reality and pursue simplicity on the far side of complexity

• We must know why we own what we own and know what we’re looking for

• And, whatever we do, we must not compete with robots

[2] Demographics and technology vs. money for nothing

This has been called the chart of the century. Spend a few minutes thinking it through:

It sheds light on many current debates, e.g.:

• Have real (inflation-adjusted) prices really risen?

• Are younger generations better-off or worse-off financially than older ones?

• Have home prices risen faster than inflation?

In general, this data highlights the difference in price changes of goods (e.g., TVs, cars) vs. services (e.g., healthcare, education).

As with all data, what is happening underneath the surface is critical. Segment. Always segment. Quality often has a premium and can rise in cost far faster than inflation (e.g., home price growth in highly desirable areas vs. the overall market).

I may publish a longer piece on inflation and deflation in the coming months, but here’s the short version:

• The lower birthrate of younger generations vs. older generations means that there will be relatively fewer consumers over the coming decades to consume goods and services. This is a longer-term deflationary force.

• By contrast, elderly populations that are larger than working age populations will require more from each worker for support. This is a shorter-term inflationary force.

• As seen in the chart above, areas that have embraced technological disruption (cars, phones, computers, TVs, etc.) have seen declines in relative cost. This is a deflationary force.

• Areas that have been slow to embrace technological disruption are in a doom loop. For example, rising costs of healthcare and education have led to additional government intervention and subsidies which in turn have allowed even higher costs. This is an inflationary force.

• Consuming digital bits — such as digital software and entertainment — are deflationary. If you are reading this essay on a phone, tablet or computer, your present actions are deflationary as you are consuming bits, and bits are infinitely replicable with zero marginal cost.

• Consuming atoms (physical items) is inflationary. We all require a certain amount of physical goods and services such as housing and food. Too many people chasing too few items is the definition of inflation. Massive amounts of government stimulus since the start of Covid have exacerbated this.

In the short-run the effects of these largely demand-side considerations have been exacerbated by supply chain disruptions.

[3] Supply chain disruptions

We have been experiencing a somewhat perfect storm of rising demand amidst severely disrupted supply for well over a year.

Demand for goods and services is high due largely to massive government stimulus since the start of Covid, which led to high levels of household savings and sharply rising wages against a backdrop of pent-up consumer demand seeking outlets. Shifts in consumption mix (e.g., buying a big TV instead of going to the movies, or upgrading one’s home instead of going on vacation) make this even tougher.

Supply of goods and services is severely disrupted due to massively global supply chains and a myriad of changing variables (e.g., China’s zero Covid policy creating rapid, regular, and unpredictable shutdowns of major ports and factories that are linchpins in global manufacturing and distribution).

Pre-Covid global supply chains were so optimized that purchasing managers were carrying what we would now consider to be surprisingly low stocks.

A capable purchasing manager’s role is to [a] minimize stock (thereby minimizing working capital) while [b] ensuring stock never runs out. The relatively calm decade leading up to Covid meant that stock-minimization was, well, maximized. It was not uncommon to carry only a few weeks of inventory even if replenishing such inventory relied on global sourcing, assembly, and distribution (for example, iPhones contain components from 43 countries across six continents).

Pre-Covid the developed world had a very, very refined global supply chain and little reason to carry extra stock to handle supply shocks. Initial reactions to Covid exacerbated the low-stock problem. For example, at the start of Covid auto manufacturers cancelled orders for semiconductors in anticipation of a prolonged demand slump. Due to long manufacturing lead times, when demand returned faster than expected auto manufacturers found themselves with insufficient stock of semiconductors and months-long wait times to restock them. The effects of these decisions are still being felt in the market for new and used autos 18+ months later.

Of course, much of the above has been in the news for months. But the degree and duration of these factors remains under-appreciated.

Imagine our global supply chain as a snow globe. Pre-Covid snow generally fell gently and predictably. Now it blusters randomly and chaotically, and when the environment starts to calm down it gets another violent shake. That’s a decent metaphor for what we are currently experiencing, and why we should expect continued oddities in the availability and prices of goods and services well into 2022.

All that said, demand for and supply of goods and services is massively complex, behaving as a complex adaptive system with emergent, unpredictable behavior. It is useless to try to guess where this all goes in the short run, including whether it permits continued inflation. Forecasting is hard (see image below).

What we do know is that in the short-term supply/demand imbalances lead to volatile prices.

This has led to signs of froth.

[4] Signs of froth

In the past twelve months we’ve seen2:

The biggest IPO of 2021 — with a trading debut valuation over $100 billion — was a company with a wonderful product but no revenue.

After years of vocally criticizing himself for missing the rise of wonderful internet-native companies, Charlie Munger invested heavily in Alibaba.

Howard Marks, a famed skeptic of new-new things, was finally willing to discuss blockchain technology, and ultimately accepted it as an innovation platform.

An ETF was launched to invest in a theme we are yet to clearly define.

Facebook changed their name to Meta Platforms to signal their seriousness about said theme, and committed to spending $10 billion annually to develop it.

Very high levels of insider selling.

Shopify, the company “arming the rebels” to compete with Amazon, started working on Non-Fungible Tokens.

Visa bought a cryptopunk.

Elon Musk pumped cryptocurrency on SNL.

My barber recommended investing in digital assets (yes, this happened).

Matt Damon in those endless crypto.com commercials.

Stuff like this:

And this:

And this:

The aftermath of froth creates buying opportunities.

[5] Buying opportunities

Over the past few months we’ve had a tale of two markets.

Major indices are at or near all-time highs, including those with modest value and growth tilts (see below blue, teal, and orange lines).

This is not true in two areas: smaller stocks (yellow line) and especially smaller growth stocks (purple line).

In aggregate, smaller stocks and smaller growth stocks were volatile but overall about flat in 2021 until mid-November, when fears of rising interest rates as a response to heightened inflation began to take hold. In December the Fed signaled tightening and rate increases in 2022, and recently released minutes from their December meeting suggested even more stringent moves than previously suspected. Higher interest rates mean profits years into the future are less valuable in the present. Selloffs ensued and as of the time of this writing are still taking place.

Why do indices remain near their all-time highs? The prospect of rising interest rates means that bond prices will inevitably decrease, making bonds a poor option for a flight to safety. Instead, investors are rotating within equities — buying financials, commodities, cyclicals and other sectors — while selling positions more reliant on profits years into the future. This in essence is shifting funds from one pocket of an index to another, whilst maintaining the overall level of the index.

How is this impacting our portfolio?

We are zigging while others zag.

We have begun buying or increasing our positions in high quality companies that are currently well out of favor, often able to purchase shares at 30-60% discounts to recent prices — prices last seen months or years ago — for businesses whose performance is much better today vs. the time these prices were last offered.

We have funded these activities through selling positions that have held up well but done so at the cost of future growth prospects (relatively higher prices now results in relatively lower price appreciation down the road).

Our intention is to hold these companies for years. Short-term volatility doesn’t matter much in the long run, but purchase price directly impacts our future profits. We hold through periods of volatility and use drawdowns as opportunities to increase our holdings. This is our main focus: owning quality businesses and not overpaying. If we do both, we should be happy with the long-term results.

Another zig: our current portfolio consists of 17 positions, only one of which is in the S&P 500.

I remain very optimistic about the long-term future of our portfolio and encourage partners who are considering investing additional capital to reach out (as well as potential partners interested in joining).

Thank you to those of you who have already contributed capital. I believe we will be envious of some of the prices we are seeing today when we look back in five years’ time.

Closing thoughts

I was grateful to see most partners in-person in 2021 and hope the same again in 2022. As always, I enjoy hearing from you. Please reach out any time.

All the best for a strong start to 2022!

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

A primary goal of these essays is to provide transparency on the thinking that steers our capital.

To this end, I was recently interviewed by the wonderful folks at DealTeam who asked a very thoughtful set of questions and were kindly willing to share the output.

The conversation is a good summary of some of the philosophies that guide our investment activity and broader manners in which I think about the world.

I have provided the transcript below, though I would encourage you to listen to the audio via the player above. It flows much more naturally.

Blunt, honest feedback is always welcome! I am certain this content provides plenty of opportunities for it….

How would you describe your investing strategy?

It's a global all-cap strategy. Scott Wilson at the Washington University endowment has this great line, which is, "All ideas compete for the same capital.” That's really how I think about things we're willing to invest in: large caps and micro caps, internationally, domestically, etc. Over time the concept of asset classes, if you have a long enough time horizon, starts to become irrelevant. When one's goal is to compound capital at high rates over decades, you mentally end up in the space of looking for what sorts of things are investable and inevitable and that requires having a very long view of how the world works and how it's evolving. I think it really puts you in a space where believing in the quality of the business model, of management, of product, of service, of execution, et cetera, is the only thing that matters. One of my favorite Walt Disney lines is, "Quality is a phenomenal strategy." I view myself as someone who's on a hunt for the highest of high quality wherever that can be found.

What experience(s) most shaped your strategy?

Launching a fund is actually career number three for me. Career one was strategy consulting where our goal was to advise a handful of businesses on how to grow faster and serve their customers better. Career two was building an enterprise software-as-a-service business for the better part of a decade. Behind all that I was investing, and my hobby became an obsession which went fairly well, so it has now become a business. Those prior experiences really impacted how I look at public markets. I studied the efficient markets hypothesis at the London School of Economics, where some of the guys who wrote it taught, and it never made any sense to me. This notion that the past is the only thing that can inform the future and on top of that, the notion of, “we don't know what a good and bad business is, so let's try to buy some version of all businesses,” really makes very little sense when one's career has been advising a handful of businesses on how to get better and then spending a decade trying to build one really good business.

What I often relate to partners or people interested in the partnership is this notion that prior to doing this, I spent about 3,000 days building one really wonderful business. That was a privately funded company. We only had a market value for that business on 3 of those 3,000 days. Those were the 3 days that we raised capital. The other 2,997 days, we woke up and thought about our customers, thought about building a better product, thought about selling, and thought about serving our customers better. Those were really the things that mattered. We knew if we did those things well, then when it came time to raise more money, we'd get a healthy valuation. I take that mindset into the public markets. Although we get quoted every microsecond, price only really matters if you want to buy or if you want to sell. You can ignore it the rest of the time. That's what I do.

What is the most challenging part of executing your strategy?

It's definitely patience. I forget who said this, but there's this notion that an advantage that private equity or venture capital has is that you actually can't sell and you don't get quoted every microsecond. I find that to be absolutely true. Jim O'Shaughnessy said to me a few weeks ago, "What you're really trying to do is act against human nature", which is entirely true. That's what makes it hard; you do have to look at valuations every so often and you have to keep up with markets and it's really against our nature to ignore some of the fight or flight instincts and believe that most things are noise but know the few things that matter and take those seriously and nothing else. That's all a long way of saying patience is both the hardest part of executing the strategy and also, conversely, it's certainly the biggest competitive advantage of the strategy.

What has been your most painful investing mistake? What did you learn from it?

I would give two which tie together. I spent my first career helping grow a handful of good businesses, and a second career building one really good business. It took me too long to port that thinking over into what I was doing at the time investing my own money. I bought the Kool-Aid of diversification almost to an extreme for far too long. Tied to that was this notion of understanding GAAP accounting (and the shortfalls of GAAP accounting). Early in my software career, I was building a business that, if it had been publicly traded, would have been extremely volatile but it wasn't public and so we didn't know the market value. We were just trying to build a really good business, but within that, were things like: the firm had no assets - it was just software and people. The way those things show up on financial statements is somewhere between not very well and not at all.

So, I was having this lived experience of knowing what a good intangibles-based business looked like while simultaneously working through the traditional value-investing literature, and focusing fairly heavily on things like book value and price to earnings. It's not that any of those things are wrong, but the point is that it took me far too long to realize that the only way to invest well in the beautifully complex world we live in is just to start from first principles and understand things like price to sales and price to earnings are all shortcuts and they can be really useful shortcuts if you know exactly what they're good for and exactly what they're not good for.

Flipping it around and saying, how would I think about the worth of this business forgetting our shortcuts? It took far too long for that to resonate. The reason that was painful is because there were many potential home runs that I watched go by because I thought they were pricey for the wrong reasons while simultaneously, I was building a business that was that same thing. Fortunately, I hope I stopped doing that by now, but that was a lesson learned by many misses.

What are the top 1-3 things you want to build in the next decade?

I strongly believe anything that's worth doing is worth doing well. As I thought about launching a fund — in a lot of ways I don't think the world needs yet another hedge fund — but I learned through my other careers that the world absolutely needs people who serve their clients very well. The Munger notion of, if you want more business, the place to find it is within the work that's in front of you. That resonated. So I got into my head this idea of, what would the world's most LP-friendly hedge fund look like? I'm still figuring that out and an easy way to start was a fee model. I had the lived experience of working with some other managers who, let's just say, were not architected as the world's most friendly folks. So I have the lived experience when I wasn't focused on my own investments of investing in ways where managers grew wealthy off of me, but I didn't grow any wealthier.

I think it's hard to look around the world and find a lot of other places where it's possible to not serve your client well and not get fired for years and years and years. For some reason, that’s possible in asset management. It's just viscerally repellent to me, so I've really tried to determine, “what would the world's most LP-friendly hedge fund look like?” That's things like a win-win partnership model, a win-win fee model, a generous (hopefully extreme) amount of transparency, frequent communication, all kinds of obvious things. I'm excited to learn. I'm only a year into this journey. I'm excited to find more ways to become a more LP-friendly hedge fund.

The other big one, which is a related point, is I don't know anyone who doesn't get frustrated by this idea of accredited versus non-accredited investors. That’s not to say what I do is right for everyone but one's accreditation status is probably not a great screen for that. With technology, there are now ways to have vehicles where non-accredited investors could pretty much invest in the same way as accredited investors, at least for what I do. I look forward to building a model where that becomes possible as well.

What are you most compulsive about? What do you like doing when there’s nothing to do?

I very much can be a dog with a bone on things. Part of this really relates back to the investment strategy in the same way that I like to invest in what I deem to be inevitable and then just have the patience to let it play out. When I'm sitting quietly with my mind (which I try to do for much of each day) usually I'm trying to figure out what the end state is in a system of incentives.

I studied economics in undergrad and the most useful thing I learned there was economics in three words: people follow incentives — the Munger notion of, “Show me the incentives and I'll show you the outcomes.” There are things I think about where I'm basically trying to figure out, what is the end state of the incentives that are in front of us? An obvious one was when COVID hit, the world had to go remote, but once everyone, including senior managers and so on, could no longer force everybody into the office, the world started to collectively realize that actually, maybe we don't need an endless stream of cities where everyone's piled together. We just need good internet connections and airports. So you're starting to see migrations out of the Northeast and the West and to more desirable places to live, depending on people's preferences.

But I think it actually could go further than that. I'm in the middle of an experiment right now where my family and I are just living from the road. We've been to 23 states in four months and I'm not saying we'll permanently do that, but my point is, I'm not sure the end-state of the incentives is just, everybody moves to Florida and Texas. I actually think it's that the world opens up and everybody moves around quite a bit. We're experimenting with that. I could give you similar examples for things that I think are just inevitable. For example, YouTube being an extremely dominant form of media that is starting to compete against all different forms of media that aren't video, is another one. The attributes of video make it the most information-dense media we have. It doesn't make it perfect for everything but generally makes it more compelling than most other things that compete with it. I can imagine a world where the concept of a book starts to go away and starts to get replaced by content which is video in nature when that's useful and text in nature when that's useful and audio in nature when that's useful, and all of those things together when that's useful. The platforms that control distribution amongst that I think, are already compelling but become even more compelling.

This notion of just working hard to figure out, if you layout incentives, where do they terminate? Where's their end-state? That’s generally what I'm obsessing about.

What are you optimizing for?

That's one I've thought a lot about. I got this notion of a regret minimization framework from Jeff Bezos and the more I've thought about it, the more it's boiled down for me to be the only thing worth maximizing for which is minimizing regrets. I think there's an important aspect of that, which is across what time horizon? Minimizing regrets by the end of the week is very different from minimizing regrets at the end of your life. For me, a lot of my logic starts from when I'm hopefully quite old and looking backwards, I hope to have very little that I actually regret. So, I start a lot of my logic from thinking about the end of my life and working all the way backwards to saying, “What do I need to be doing now?” So hopefully, the list of regrets by that point is fairly minimal.

What have you subtracted from your life over the last year that has had the most additive effect to your joy and well-being?

Most meetings, which is an obvious one. Prior to launching the fund I, like many people, was on Zoom for 10 or 12 hours a day. When I was back in the office, I was in meetings all the time too. There’s nothing wrong with that, and some people really thrive in those environments. There's this notion, I want to say it was Pascal, that had this idea that most of man’s problems stem from his or her inability to sit quietly in a room with their thoughts. I've always connected with that notion, and I'm one of those folks that actually really craves sitting quietly in the room with their thoughts.

This connects with the first principles reasoning and investing in the inevitable and understanding incentives and how they play out. The ability to have enormous swaths of unstructured time to read and think and write are really where I get energy and engagement and excitement, at least from an investing standpoint. Cutting out most meetings and largely sitting quietly in a room and thinking and reading and writing has been by far the most additive thing I've done in the last year or so.

You've got to take ownership of your schedule. It's either you control your schedule, or it gets controlled for you. For me, I was in a setup where my ability to add value was heavily dependent on a lot of meetings. There’s nothing wrong with that, but it took me too long to realize that's one of the reasons it wasn't the right role for me. I could do it well, but that didn't mean it was the thing I should be doing. I hope the way the world is evolving and some of the incentives we've got in play — where we're really being forced to rethink how we structure work — I hope some of that leads to more efficiency on the meeting side. I hope this is true. I'm not necessarily optimistic about it, but I hope that efficiency gets translated into more coffees and more chats, where you actually get to develop real relationships.

What consistently surprises you?

Almost every week, I say to my wife or my friends or my partners, some version of being surprised at the degree to which people prefer their version of the truth over what is absolutely true. I suppose that means I'm in the camp that believes in absolute truth, and I do. But it's so easy for me to look at the world — and this relates to investing as well — we can want the world to work a certain way and we can invest behind the stock that we really want to do well or a change that we really want to see or whatever — and that's fine. Sometimes it works, but sometimes it’s really painful and when it's really painful, it usually has something to do with the fact that you were just wrong about how the world works.

So, I try to cultivate as much humility as I can. I think humility is an enormous asset that's not often talked about. I try to really just force myself to say, this isn't about how I want things to work, to be effective as an investor, and I would even argue as a person. It really goes back to understanding what is really true. How do humans really work? How do markets really work? How do businesses really work? Then, aligning yourself behind that and acting accordingly. In our modern/postmodern world, we're just deluged with people who, I'm not even sure how aware some people are of this, but they just insist that what their preferences are is the truth. It seems like a really hard way to live. It's full of disappointment and frustration and there's impacts on education, there's impacts on public health, there's impacts on just our general ability to get along with each other. Every week, there's something else where I'm like, man, I don't know why people can't just say, let's forget what we want to be true and just figure out what's actually true. That seems a better way to live.

What class could you teach? Bonus points if it’s not investing related.

I would say value-based thinking. I publish my family values on my website, (johncandeto.com if anyone's interested). But the backstory to all of that is my wife and I got married fairly young. In our first few years of marriage — and in any relationship, especially marriage, it’s something that's built, not intrinsic to itself — we were thinking about how do you build a good marriage? One that's built to last a long time and is high quality and wonderful in all the ways that a good marriage can be. We kept coming back to this notion of, what are our family values? That was something that my father used to do — he wrote down our family values and published them every so often. So, I took that idea from him, and we sat down and said, “What do we believe is true that can be a bedrock for how we act in the world?” That cuts across all sorts of things.

Our first stab at it was probably five pages long. Over the years, it went down to four then three and then two, and we finally got it down to a page. What that means is we're now able to make enormous decisions (or at least enormous decisions for us) very fast and often without even needing to talk to each other or needing to talk for two minutes and then off we go. And that really came back to the notion of trying to root our thinking in our values.

I often get asked the question, “So what the heck is values-based thinking?” The best example I've come across is the notion of, if you're hungry, an options-based thinker or somebody who just accepts reality walks over to the fridge, they open the fridge and they say, “All right, well, what's in here? These are my options. I'll pick my most preferred option.” But that's really letting the constraints of the fridge and whenever you last bought groceries and whatever dictate how you satiate your hunger. A values-based approach to that is to say, “Okay, what do I value and how does that get translated into what I eat?” So you might be someone who every now and then needs a really good Ben and Jerry's, and if it's not in the freezer, then maybe you go out and get it. Or you might be somebody who really wants to eat healthy so you feel better later and if that's not in the fridge you go out and get it or you order it from Uber Eats or whatever. It's a subtle but really important distinction because your thinking doesn't start from what the world gives you. Your thinking starts from, “How do I intend to live?”

The more that one attempts to figure out their values and then live from that, the more one aligns themselves to: “Here's how I think the world works, and here's how I want to act as a result.” It's constant practice. It's iterative practice. You start to slowly but surely over years end up in spaces where actions start to align back to intention in a much tighter way. I don't know that I ever will teach a course on that, but I think I probably could.

One of the things that got me onto this was the notion of deliberate practice, which I still think is under-talked about and under-reported. When you study people like high-performing athletes — when you study Alex Rodriguez and how he learned to hit a baseball — unlike me, he didn't just go out with his buddies and knock the ball around for hours and hours. He actually would go hit two or three balls with a coach. Then, his coach would correct some minor thing he wasn't doing well. Then he hit two or three more and was corrected again.

It's a much harder, probably more boring, probably more painful way to learn to hit. But you see 10 or 20 years later, these guys are just machines. It's because they rarely learned very bad things. They just obsessed about only learning to swing the bat as well as they possibly can. In a sense, I think the decision architecture and value-based thinking is all a version of the same thing. It all just starts with, “How do you want to live? And then how do you put that into practice?”

What are you seeking to understand more deeply?

As a dad of a four-year-old and one-year-old, one that my wife and I talk a lot about is how to educate our kids really well. We're applying the same values-based reasoning and first principles thinking to this as I do to investing and other parts of life.

I imagine most listeners will have some notion of the idea that our current education paradigms were crafted for the industrial age, not the knowledge age or the information age.

I think learning happens when you can hang out on the cusp between what you know, and what you don't know. If you're just in the realms of stuff that you know really well, you get bored. If you're in the realms of stuff that's just way beyond you, you get bored and frustrated and lost. So, there's something special about being right on the cusp between what you know and what you don't know.

When I think about my years of education in college and master's degree and all that, I think at best less than 10% of the 10,000 or whatever hours I spent in formal education was spent on the cusp between what I knew and what I didn’t know. I cannot get out of my head this question of, “Why can't we bump that up? Like way up?” Why can't that be 50% or 60%? It's never going to be 100%. But imagine the product of a kid who spent 50 plus percent of their learning time right on that cusp of what they know and what they don't know. You alluded to this earlier, but imagine a kid that was taught to confront how the world really works, rather than being taught the theory of how it might work.

A joke that I say to my wife all the time, that she's not a big fan of, and I'm not entirely serious, but it's an interesting thought experiment: I read about a guy one time who took his high school, I think it was a son, and gave him $10,000 and shipped him off to rural China and said, "All right, you're a venture capitalist. Go." And you imagine the kid probably lost all the money. I'm sure it didn't end well but imagine what they learned, right? You really have to think about people and human nature and who you can trust and how you create win-win opportunities and how you know what a good investment opportunity is. How do you even know what an investment opportunity is? How do you craft one? All that stuff. There's just a million things one could learn. That seems like it could be a really good use of $10,000. That's an experiment worth running.

On the flip side of this, and I'm excited for some folks that I'm close with who are working on companies in this space. What if you optimized for your kids meeting and hanging out with the best people on the planet who share their obsessions? There's no reason we can't do that now. You and I were limited to the neighborhoods we grew up in and we had good friends and it was fine and we rode bikes together. But man, imagine if my four-year-old starts to meet people who have the same obsessions that he does and spends a lot of time with them. Learning wouldn't even feel like learning, it would just feel like playing. And these things compound, so imagine compounding, optimizing for that learning instead of eight hours a day, seven classes a day, rote homework, et cetera. It just seems to me like this isn’t just an opportunity to double the output or the quality of education, this is an opportunity to exponentially change it and produce a future by way of the people who populate the future that are just an order of magnitude beyond what we're capable of. Hence, my interest and obsession and excitement around it.

On Twitter, I probably post too little and read a little too much, but like you, I've really enjoyed the community. James Clear has this idea of making everyone's best ideas your base ideas. I try hard to do that in investing and in life in general. I just think about the people I've quoted in these last 30 minutes, that's intentional. On an education point, I've been saying to people for a little while, why shouldn’t my son learn physics from Richard Feynman? Nobody disputes he was one of the best, not just the best physicists ever, but one of the best, most gifted teachers. And it’s possible, right? You can go to YouTube and get it now. And that's probably not sufficient. There are other things that need a physical person, and that's fine, but why should my son’s lectures on basic physics ever come from somebody who's not Richard Feynman? I've not found a good answer to that, and Twitter and the web make this possible. So yeah, I agree. I obviously share your excitement. I think there's some really exciting stuff that is going to come out of people taking seriously this idea that education is one of the most important things we have, and we need to radically change it.

Tell us something about your space that outsiders would find surprising.

A common one, especially for folks who don't know me, is that my office just looks like a library. A trading screen that flashes red and green at you all the time is just so obviously not a great way to cultivate good thinking. But maybe a more interesting one is that I do believe over a long enough time horizon that this whole concept that the industry obsesses about called asset classes is nonsense. Over shorter time horizons it absolutely matters. But if you really are trying to think in decades and your goal is really to take money that you're blessed not to need now (and not to need for a little while) and grow it at reasonable rates of return, having style boxes and assuming that a bunch of market studies that tell us about how the market behaved in the past is the only way to construct portfolios for the future just makes less and less sense.

Basically, human behavior doesn't change. There will always be manias and panics and so on in markets. But businesses change a lot. It wasn't possible until the last few decades to have businesses that had zero marginal costs. I built one for 10 years. It's a real miracle. Why would you say, “All right, we need to allocate some money to small-cap value and some money to large-cap growth and some whatever, and we need all of this coverage?” Buffett’s got this idea that that kind of thing lets people use math that they already know. I think that's a lot of why it’s become so popular is there's just a critical mass of people who know how to think that way. Then of course, there are very important investment problems that are solved on shorter time horizons and things like endowments I think have incredibly hard challenges because they've got to provide real cash flow to their universities today but also need to grow the endowment for tomorrow. But for purely long-term capital, asset class based reasoning doesn’t make much sense.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

One year ago we embarked on the journey of forming an investment partnership of applied practical wisdom.

We started with five partners and have grown to fourteen.

We were pleased to deliver strong performance in 2020, though even more pleasing was the response from the partnership, which could be summed up by what may have been my favorite email of the year:

Hell of a return! But wanted to call out that I'll be here to support and continue to invest with you even when the macro gets harder.

I have thoroughly enjoyed serving this partnership. Many days I wake up surprised and delighted that I get to do this full time.

In the past twelve months I cannot recall a single discussion with any partner asking about daily, weekly, monthly, or quarterly returns. That says a lot — this partnership “gets it”.

I have declined many services in the past year that have offered to introduce us to new capital. We would welcome that — but it absolutely must be the right capital. Business-focused, long-term oriented, and patient. I am continually surprised at the degree to which much of this industry is geared towards raising any capital and treating partners any way they can. We will never stoop to those behaviors.

The long game

You can hold a ballet and that can be successful. You can hold a rock concert and that can be successful. Just don't hold a ballet and advertise it as a rock concert.

Warren Buffett

Over the past year we’ve had interested parties join the partnership, decline to join the partnership, and in a few cases we’ve declined to offer them partnership. Our ability to be painfully clear on what we are — and are not — is crucial to our ability to leverage our key advantages.

We never set out to be “yet another fund” and could never do so if this partnership was built to serve any interested party with capital. We are tackling the investment problem in a unique manner, and that demands unique philosophy and application.

We focus first and foremost on quality: of thinking, of businesses, of business models, of management, of portfolio construction, of communications and relationship, and of the company we keep. 

Like many funds we have the right to use leverage, short stocks, and use options and futures as there may be periods where these are useful — but we focus most of our time and efforts on finding and investing in high-quality businesses.

We do not make macroeconomic bets.

We do not trade hyperactively in response to the latest news.

We do not dabble in exotic financial instruments.

We do not seek to manage volatility (and unlike much of this industry we do not believe volatility is a good proxy for risk).

We seek to maximize returns, not assets.

We play a long, simple game which primarily involves buying a few intensively researched businesses, holding them for years, and doing so in a portfolio structure designed for long-term durability.

We report and audit annual performance — but this is not the objective (and why I regularly remind partners not to invest money they may need for another purpose within the next five years).

Expect big down years. Those who are a good fit will be biased to add to their positions at these times.

(We expect big up years as well — but know that volatility is the price of portfolio concentration.)

The above will repel most. Those that are not will find us engaged in these philosophies and optimistic about the long-term potential of these behaviors.

3,000 days

Many of you know that prior founding this partnership I spent nearly a decade with a team building an enterprise software firm in Europe and North America.

My tenure at the firm was just over 3,000 days.

In that time the firm’s valuation grew more than tenfold.

But we only knew the market value of the firm on three of those 3,000 days. Three days. The three days we raised capital.

Years went by with no market valuation. I never lost an ounce of sleep over the inability to grab my phone look up our stock price.

The other 2,997 days we woke up and got to work thinking about how to serve our clients well, build an exceptional product and team, and grow the business.

The valuation growth was a result of what we were doing on those 2,997 days. It was an outcome, not the target.

Quality is a phenomenal strategy, and over a long enough time horizon a quality business will receive a healthy valuation. In the long-run quality is all that matters.

Contrast this with how many market operators act. I am writing this sentence from a hotel lobby whilst the gentleman behind me is loudly engaged in a phone call predicting the price of stocks in the next 48 hours.

It’s a different mindset.

Real world businesses

We view our investments as fractional shares of businesses. Taking the proportion of each business we owned in 2020, our ownership stake in those businesses served thousands of customers — including about 1,000 new customers — through digital and social content, games, and on-demand work.

In 2020 our ownership stakes were responsible for selling thousands of semiconductors, 5,000 software units, and 600 gaming consoles.

Our ownership stakes were responsible for processing over $1m in transactions and connecting dozens of workers to remotely delivered on-demand jobs.

In aggregate our ownership stakes delivered $1.1m in revenue and $160k in profit.

Most did so with admirable efficiency and scale.

That’s a small sample of the many things our fractional ownership of several wonderful businesses accomplished, and a good example of how we analyze them.

Finishing first

To finish first, you first must finish.

Old Racing Quote

We’re not racing, but I think often of this quote. In a time that continues to call for the word “unprecedented” it is always worth stepping back and seeking to understand our present context and what could limit our ability to compound our capital at high rates over many decades.

In that respect, our patience is an enormous competitive advantage. Focus on short-term valuations eliminate one’s ability to benefit from the strengthening effect that crises can have on wonderful businesses.

Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.

Andy Grove, former CEO of Intel

Our concentration in only the highest quality businesses is another enormous competitive advantage. This positioning guarantees higher volatility, but makes rational sense when one’s objective is to hold businesses able to survive and thrive through most crises. Holding everything (i.e., indexing) is a very different strategy.

Having the ability to “fish where the fish are” — acknowledging that fish swim around — is a third competitive advantage. Many funds were stuck last year with a narrow mandate that required them to invest only in areas that the pandemic would obviously decimate (think small businesses with limited access to capital, or many aspects of the energy or corporate real estate sectors). The opportunity landscape shifted quickly and dramatically in 2020, and our ability to play across it benefited us greatly.

Finally, positioning our portfolio to weather certain types of low-probability but high-damage events (e.g., hyperinflation, and certain kinds of business disruption) is a fourth competitive advantage. We value the durability this positioning provides against certain scenarios that could impede our ability to cross the finish line decades from now.

Closing thoughts

Show me the incentives and I’ll show you the outcome.

Charlie Munger

I am often asked what potential partners should know about our partnership. The first thing I say is always the same: my family’s capital is invested alongside yours, and I am continuing to reinvest in the partnership (e.g., 100% of the performance fees earned in 2020 were reinvested into the partnership).

There is always room for disagreement of opinion, process, etc. But the structure of this partnership guarantees there are only two possible outcomes: we’re all happy, or all unhappy. It simply isn’t possible for me to succeed while the partnership does not. That’s how it should be.

I would like to extend my thanks to the broader Phronesis Fund Team for their pivotal roles in launching and growing the partnership through its first year.

In case anyone missed our latest audit, it was published alongside your quarterly statements in the investor portal earlier this year (in summary: clean bill of health).

I look forward to serving you in the coming year, and for many years to come.

As always, please reach out at any time.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

We are taking a break this week from our First Principles Reasoning series and will resume that series next week.

A number of you have asked for my thoughts on Bitcoin. I am happy to share, but will approach this from the perspective of how I am thinking about Bitcoin. My intent is not to endorse or renounce. Also, please note that I am intentionally using the words “Bitcoin” (the protocol and payment network) and “bitcoin” (the currency of the network), not “crypto” or the names of other crypto assets.

I offer my usual disclaimer that I refuse to join fanatical “pro” or “con” sides of the debate. Zealots on both sides are unhelpful in helping us think calmly and rationally about how this invention may impact our world. The immense volume of uniformed opinions are equally unhelpful. A useful screen for this is to watch a person’s behavior when interviewed on the topic. If they are excessively excited, zealous, angry, or spiteful, tread carefully. There’s too much emotion in all directions.

Whether bitcoin’s price goes up, down, or sideways, it is an important invention and this is a fascinating time in monetary history.

Framing

Be curious. Read widely. Try new things. I think a lot of what people call intelligence boils down to curiosity.

Aaron Swartz

I find it most helpful to frame any discussion on Bitcoin in the context of the currently predominant valuation frameworks. It must be acknowledged that very thoughtful, successful, and well credentialed people fall in all camps, from “it’s a scam” to “Bitcoin will rule the world”. It must also be acknowledged that no one alive today has ever witnessed the invention of a genuinely new asset class, and no one has ever witnessed the invention of a digital asset class. We are watching history, however things turn out. This should give us curiosity — and humility — in our assessments.

Valuation frameworks

There are four predominant valuation frameworks (my thanks to Vijay Boyapati for this articulation). They are:

1. Bitcoin is not useful for anything. It’s a bubble. A scam. Tulip mania. Rat poison. Rat poison squared. If this is true, the long-term value of one bitcoin is $0.

2. Bitcoin is a new technology with a limited audience of interested participants e.g. the tech savvy, libertarians, and citizens of countries that can’t effectively govern their currencies. Collectively this group has a large amount of savings, but globally it is still a relatively small group. If this is true, bitcoin’s price will likely remain very volatile, and the long-term value of one bitcoin is likely in the $10k to $100k range.

3. Bitcoin is a direct competitor to gold, with the same monetary properties (store of value, medium of exchange, and unit of account) but better execution (e.g., more portable, more divisible, more durable, more limited supply). That is, the same properties that make gold good for savings over long periods of time make bitcoin great for savings over long periods of time. If this is true, the long-term value of one bitcoin is likely in the $300k (just below gold) to $1M (3-4x gold) range.

4. Bitcoin will eventually become the world’s reserve currency, assuming the role that gold had in the 19th century as the dominant means of savings used by nation states and large savers around the world and the final means of settlement between large banks and financial institutions. Everything will eventually be priced in bitcoin. If this is true, the long-term value of one bitcoin is likely in the $10M to $100M range.

It is a useful thought experiment to assess where we may be within these frameworks, and why. To this end, observing adoption (and lack thereof) is helpful.

Adoption

As I grow older, I pay less attention to what people say. I just watch what they do.

Andrew Carnegie

In the context of history, adoption is moving fairly quickly. Bitcoin is just over 12 years old, yet even a year ago most of the below had not yet happened. As of the time of writing:

• America’s oldest bank, BNY Mellon, will soon hold and transfer bitcoin on behalf of its asset management clients

• America’s largest bank, JP Morgan Chase, has accepted major bitcoin exchanges Coinbase and Gemini as banking clients, who themselves are licensed by financial regulators (e.g., the New York State Department of Financial Services )

• The world’s largest asset manager, Blackrock, has enabled its funds to engage in futures contracts based on bitcoin

• The world’s third-largest asset manager, Fidelity, provides custody and trade execution services for digital assets such as bitcoin through Fidelity Digital Assets

• Mastercard is bringing crypto onto its network in 2021, driven by demand from customers, merchants, and businesses

• Some large corporations are starting to hold bitcoin in their corporate treasuries in lieu of cash e.g. Square and S&P 500 index member Tesla1

• Asset management heavyweights including Stan Druckenmiller, Paul Tudor Jones, and Bill Miller now hold bitcoin in some of their funds

None of these are reasons to buy or sell bitcoin. But if one were to sit alone in a quiet room and answer, from first principles, “What would be required for adoption of a new asset class?”, I believe these items would be on the list. They are not sufficient in and of themselves, but should cause one to think about the forces driving these decisions and why such people and institutions have been willing to take such actions. I suspect we are about to see many more similar actions.

Positioning

How might one deal with this reality?

First, it is worth considering that if anything except valuation framework #1 above turns out to be true, today’s value of one bitcoin (about $50k at the time of writing) is somewhere between very cheap and fully valued. It is a compelling risk/reward profile for those with long-term, patient behavior.

From this perspective, an investment in bitcoin can be viewed as a position designed to benefit from the invention and adoption of a new digital asset class. Its age (more than twice as old as the next-oldest crypto asset — see the Lindy effect) and decentralized nature (the only crypto asset with both wide adoption and true decentralization) are favorable properties in this thesis.

Related to this positioning is a perspective of bitcoin as a call option on the future of digital money. Fiat money (that is, all money issued by major central banks) has not evolved in any substantive way for decades. Bitcoin’s decentralized, internet-native properties make it a favorable component in the broader context of innovation and re-architecture of financial technology and services.

Second, bitcoin’s low correlation with other asset classes is attractive in the context of portfolio construction. This is not suggesting that bitcoin is a hedge against a market downturn (it wasn’t in 2020), but it is to suggest that bitcoin’s largely uncorrelated returns over shorter timeframes are beneficial in the operation of a portfolio that may have inflows and outflows.

Finally, Bitcoin’s property of absolute scarcity (Bitcoin is limited to 21 million bitcoins) is attractive in the context of a rapidly expanding money supply. The U.S. Dollar money supply has expanded 5 - 15% each year for decades. In 2020, 25% of all U.S. Dollars ever in existence were created. Bitcoin — along with other absolutely scarce assets (e.g., fine art) — will benefit should this dramatic expansion in the money supply convert into excessive inflation.

On the point of inflation, I encourage the reader to think through price changes in goods and services they wish to consume. While technological forces have driven down the cost of many items (e.g., the laptop I recently purchased is far superior to and also less expensive than the one I had in college), the value of scarce assets unaffected by technology (e.g., high quality real estate) are rising at rates far above official measures of inflation. It is possible for reported inflation (e.g., the Consumer Price Index) to remain low while our individual realities are that of high price inflation in some of the assets we actually want to own (e.g., high quality homes and high quality businesses).

We are in virgin territory, with new and old monetary theories battling new and old deflationary forces (e.g. technology) and inflationary forces (e.g. money printing). Rapid inflation of our monetary base will have consequences. No one knows how severe they will or will not be. Likewise, financial technology is starting to radically evolve (finally), and there is growing evidence of the adoption of Bitcoin as part of a new, digital asset class.

I’ll say it again: these realities call for curiosity — and humility — in our assessments.

Closing thoughts

To reiterate: my intent is not to endorse a specific point of view. Rather, with a rapidly evolving landscape and with a potentially valuable asset, I hope to provide some simple, hopefully helpful ways to think about this time in monetary history.

We’ll return to our First Principles Reasoning series next week.

Until then —

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

I am pleased to report strong performance in our first five months of operation.

For me, the highlight of 2020 — in addition to welcoming my daughter Isabella to the world — was closing the year knowing we have been wise stewards of our capital. This includes our strong returns, but also the manner in which these returns were achieved.

You received statements on your individual positions in the fund earlier today. The only reason your returns may vary will be the timing of when you joined the fund.

Thinking about performance

We continue to believe our results should be measured over a rolling 5-year time horizon. We typically hold our investments for years, and thus it can often take years to know whether we were right in our assessment of said investments.

As usual, Warren provides great context for thinking about performance:

If the next four years are going to involve, say, a +40%, -30%, +10%, -6%, the order in which they fall is completely unimportant for our purposes as long as we all are around at the end of the four years.

The course of the market will determine, to a great degree, when we will be right, but the accuracy of our analysis…will largely determine whether we will be right.

Warren Buffett, from an early Buffett Partnership letter

We have no idea when we will be right. Instead, we focus our efforts on applying practical wisdom and playing the long game. These actions combined with patience, discipline and humility give us confidence that we will be pleased with our results over the long-run.

All that said, it is nice to have a strong start to our partnership and encouraging to see our investment philosophies bearing fruit in the salad days of the fund.

What performed

That we performed well is important; as important is knowing why. Risk comes from not knowing what you’re doing — anyone can have a good year every now and then. To that end I am also pleased with the quality of the portfolio's performance.

Most importantly: we had very few misses, and none of substantial size (the primary way we manage risk is by position sizing). We took a loss on only a handful of positions, and in aggregate all losses reduced portfolio performance by less than 1% across the period.

The majority of our positions each contributed more than 1% to portfolio performance, and while we did have a few big winners, even without them we would have performed well.

The partnership is currently invested in 33 positions based in six countries throughout North America, South America and Asia Pacific. Our cash levels averaged 11% in 2020.

We remain concentrated in high quality assets. Our top ten positions account for 62% of portfolio assets. Our top twenty positions account for 83% of portfolio assets.

While I pay minimal attention to sector-specific diversification (most things can be valuable at the right price), some of you will want to know that the fund has substantial holdings in the technology, consumer cyclicals, financials, industrials, and telecom sectors.

I will go into greater detail in our annual report, which will be issued this Spring once the annual fund audit is completed. A major focus of that report will be what our investments enabled. We view our securities as fractional shares of businesses; those businesses, in aggregate, had fairly good years.

Closing items

As always if you know others who would value partnering with us please connect us.

Thank you for the continued opportunity to compound trust with you. Here’s Isabella and I wishing you all a strong start to 2021!

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

Based on your feedback I am going to experiment with changing from monthly to weekly updates from the start of 2021. These will cover similar ground as the monthly updates but will be 2-4 minute reads vs. the 8-12 minute reads typical of the monthly updates.

As always I continue to value your candid, direct feedback.

Here is the December 2020 update.

Summary

• Putting oil back in the ground

• The importance of intangible assets

• Value hiding in plain sight

• Compounding trust over long periods of time

Putting oil back in the ground

We bought 5% of the Walt Disney Company in 1966. It cost us $4 million dollars. $80 million bucks was the valuation of the whole thing. 300 and some acres in Anaheim. The Pirates ride had just been put in. It cost $17 million bucks. The whole company was selling for $80 million. Mary Poppins had just come out. Mary Poppins made about $30 million that year, and seven years later you’re going to show it to kids the same age. It’s like having an oil well where all the oil seeps back in...

In 1966 they had 220 pictures of one sort or another. They wrote them all down to zero – there were no residual values placed on the value of any Disney picture up through the 60s. So [you got all of this] for $80 million bucks, and you got Walt Disney to work for you. It was incredible.

You didn’t have to be a genius to know that the Walt Disney company was worth more than $80 million. $17 million for the Pirates ride. It’s unbelievable. But there it was. And the reason was, in 1966 people said, “Well, Mary Poppins is terrific this year, but they’re not going to have another Mary Poppins next year, so the earnings will be down.” I don’t care if the earnings are down like that. You know you’ve still got Mary Poppins to throw out in seven more years... I mean there’s no better system than to have something where, essentially, you get a new crop every seven years and you get to charge more each time...

I went out to see Walt Disney (he’d never heard of me; I was 35 years old). We sat down and he told me the whole plan for the company – he couldn’t have been a nicer guy. It was a joke. If he’d privately gone to some huge venture capitalist, or some major American corporation, if he’d been a private company, and said “I want you to buy into this...” they would have bought in based on a valuation of $300 or $400 million dollars. The very fact that it was just sitting there in the market every day convinced [people that $80 million was an appropriate valuation]. Essentially, they ignored it because it was so familiar. But that happens periodically on Wall Street.”

Warren Buffett

In September 2020 Nintendo released a number of products and games to celebrate the 35th anniversary of the 1985 launch of the original Nintendo console. This included a package of the first three 3D Mario games:

I bought it to re-experience the fun I first had playing Mario 64 when it was released in 1996, and to share the experience with my son:

I happily forked over $60 to buy the game when it was released. Five million other people did as well. That’s a fast $300 million in revenue — much of it profit due to digital distribution (no middle men) and the fact that Nintendo didn’t have to build anything new. They’re just re-selling what they already own. And they can do this again and again and again. (Case-in-point: this is the third time I’ve bought Mario 64 — first in 1996, again in 2012, and now in 2020).

What a business.

Thanks to my friend Ryan O’Connor at Crossroads Capital for first bringing this gem to my attention. His deep dive on Nintendo is a great read for those interested in the company.

Intangibles matter

The Nintendo story is a great example of the value and importance of intangible assets, which account for over a third of all American business investment (see table below for examples). For accounting purposes these investments are often treated as an expense, though when they are the product or means of production — such as the Super Mario game catalog and brand — they are clearly an asset.

Business investment in intangible assets has grown faster than investment in tangible assets (e.g. buildings and equipment) since the late 1970’s. Today $1.4 is invested in intangible assets for every $1 invested in tangible assets — a complete reversal of investment ratios in a mere four decades.

Yet seeing this trend in company financial statements is a challenge. Take Microsoft: in fiscal 2020 reported capital spending was $15 billion. Yet this figure is likely closer to $35 billion if portions of R&D, Sales & Marketing, and General & Administrative expenses are re-allocated as investment in intangible assets, not business expenses.

This makes intuitive sense. Microsoft reports revenue split by their main product lines: Windows, Office, and Azure (cloud services) — all of which are software products in nature. These products are the products of the firm. But they are not represented in Microsoft’s financial statements in any format that comes close to approximating their true value to the firm.

In service-led economies the value of a business is increasingly in intangibles — assets you cannot touch, see or count easily. It might be software; think of Google’s search algorithm or Microsoft’s Windows operating system. It might be a consumer brand like Coca-Cola. It might be a drug patent or a publishing copyright. A lot of intangible wealth is even more nebulous than that. Complex supply chains or a set of distribution channels, neither of which is easily explicable, are intangible assets. So are the skills of a company’s workforce. In some cases the most valuable asset of all is a company’s culture: a set of routines, priorities and commitments that have been internalized by the workforce. It can’t always be written down. You cannot easily enter a number for it into a spreadsheet. But it can be of huge value all the same.

The Economist

Why does this matter?

Intangible assets have unique characteristics which are hugely advantageous to the firms that possess them — most importantly the fact that intangible assets can be used by lots of people at the same time (they are “non-rival” goods). Microsoft only needs one primary code base for Office and Nintendo only needs one game catalog for the Mario brand — regardless of how many people use these products. This allows for infinite scalability from a relatively fixed cost base which can be highly profitable in the short-run and produce increasing returns to scale in the long-run. This economic attribute is also a major reason some enormous firms keep getting bigger.

Hiding in plain sight

Why is it difficult to see an accurate representation of intangible assets in company financial statements?

Intangibles’ treatment in company accounts is a bit of a mess. By their nature, they have unclear boundaries. They make accountants queasy. The more leeway a company has to turn day-to-day costs into capital assets, the more scope there is to fiddle with reported earnings. And not every dollar of R&D or advertising spending can be ascribed to a patent or a brand. This is why, with a few exceptions, such spending is treated in company accounts as a running cost, like rent or electricity.

The Economist

For one, estimating their value is itself difficult, though the deeper challenge is posed by the strain we have put on accounting rules. We ask corporate accounting to serve many masters: tax authorities (profit), business operators (company performance), creditors (debt repayment), and business owners (long-term cash flows).

There are too many complexities in business to serve all these stakeholders well with a single set of accounting rules. This combined with the relatively rapid growth of investment in intangible assets (software is eating the world…) has created opacity in the means by which businesses with substantial intangible assets create value.

A more detailed accounting discussion would be helpful here, but I’ll save that for another day. Suffice it to say a substantial remedy to seeing the value of intangible assets comes from one of my favorite adages:

It is better to be approximately right than precisely wrong.

Warren Buffett

In valuing intangible assets the ability to make reasonable estimations of value trumps the attempt to nail them down to a precise figure. This will frustrate those who try to use spreadsheets for everything (I’m sure a few of you are chuckling at me right now), but is a critical skill in a world where enormous — and rapidly growing — business value is derived from asset-light businesses with outstanding intangible assets.

Closing items

The best conversation I listened to recently had (almost) nothing to do with investing. Former 76ers General Manager Sam Hinkie made a rare appearance on ESPN. (Sam’s resignation letter is a master class in application of liberal arts thinking). I highly recommend listening to it at some point over the holidays (link here). It is worth the time.

In the interview he discusses The Process (again, worth investigating), but the primary concept he returns to over and over is the idea of “compounding trust with people over long periods of time”. This struck me as a fantastic way to describe what this partnership is about.

We hold a set principles, we focus on quality, and we invest accordingly. The core of our behavior comes down to compounding trust with each other as we compound capital over long periods of time.

Thank you for the continued opportunity to compound trust with you. I wish everyone a wonderful holiday season and look forward to serving you in the year ahead.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

A warm welcome to four new partners!

Thank you for the connections you have been making to other parties who share our long-term, patient, focused values.

If this letter has been forwarded to you and you would like to discuss further, please reach out to info@phronesisfund.com.

Here is the November update.

Summary

• Learn the building blocks (in rock and roll and investing)

• Forward-looking market returns are not mouth watering…

• …but we only need to invest in a few great businesses for satisfactory returns in the long-run

• Leading companies will dominate via extreme scale or defending a niche

• We figure out what a business is worth and pay a lot less

• The real money is made in the waiting

Learn the building blocks

Investor letters need more wisdom from the world of music (and more rock and roll). Here’s a great example:

For everything you learn, learn the thing that is the building block for the thing you just learned…trace back why you like the thing, and learn the thing that made the thing you like, and you will be five times better every time you do that.

John Mayer

This is how to learn to think from first principles and a route we regularly follow when applying practical wisdom to crafting the Phronesis Fund. It is the reason I expect this partnership to be good and to get better. We think from first principles — and much of that is intentionally standing on the shoulders of many others that came before us.

A corollary that is not celebrated nearly enough: in the past decade the sum of human knowledge has been put on the internet. What amazing opportunities this creates. We’re still in the early innings of seeing what this enables.

Here is the full the clip and some good riffs (4 minutes):

Where is the market now?

We are in a very low interest rate environment which has the following properties:

• Anything involving financing has become more attractive since money is less expensive (e.g. record bond issuance and record home buying and refinancing)

• The future earnings power of companies has become more valuable because the discount rate is lower (e.g. today’s value of $100 of earnings in 2030 is $39 with a 10% discount rate, $61 with a 5% discount rate, or $100 with a 0% discount rate)

• Returns demanded by investors for all asset classes are reduced, leading to higher valuations for companies (e.g. on many metrics such as price/sales Apple stock is now more expensive than at any other point in its history). The Fed’s asset buying also juices valuations.

• All these factors encourage risky behavior and “reaching” for return

Ramifications of fiscal and monetary policy are summarized nicely in this chart, and in great detail in Jesse Livermore’s epic piece on upside-down markets (60+ min read).

Howard Mark’s latest memo (30 min read) summarizes the market implications:

…the odds aren’t on the investor’s side, and the market is vulnerable to negative surprises. This is how I described the prior years, and I’m back to saying it again. The case isn’t extreme — prices aren’t grievously high (assuming interest rates stay low, which they’re likely to do for several years). But it’s hard in this context to find anything mouth-watering.

Howard Marks, October 2020

In short, prospective returns across asset classes are lower.

We only need a few great companies

But take heart. This is a major reason we don’t believe in blindly buying the market and hoping it goes up.

We only need to invest in a few great companies to produce good (and potentially great) results.

The great personal fortunes in the country weren't built on a portfolio of fifty companies. They were built by someone who identified one wonderful business.

Warren Buffett

I frequently return to this sentiment. At every point in the years I have followed the market I could find strongly negative, scary sentiment, alongside businesses that knocked the cover off the ball. Of course the real challenge is finding those businesses and holding on.

But this is worth pondering, particularly as the market climbs its classic wall of worry.

We are not trying to buy the market (if you are, please go buy our benchmark or something similar). We are trying to buy a few great companies and let them be great for years on end.

I recently came across one of the most interesting questions I’ve seen in years: who is more likely to default, Amazon or the US Government?

Ignoring the bit about the government being able to print unlimited money to stave off default, the sentiment is fascinating: some businesses are so good they have become (or are becoming) something truly outstanding, to the benefit of many including us, their shareholders.

That’s where we plan to be.

And on another bright note, check out the recent spike in applications to open businesses:

Who will survive? Who will thrive?

Thinking at the level of individual businesses requires a framework for understanding the sorting and shifting that we are observing day to day. I encountered one of the most useful through Josh Wolfe (Lux Capital) and Daniel Ek (Spotify):

Businesses will trend towards dominance via extreme scale or a defensible niche.

These 12 words explain an enormous amount of the change we are seeing around us. As we’ve dealt with the realities of Covid-19, Amazon, Target, Costco and other mega-scale players have dominated retail. Netflix, Disney, Nintendo and other mega-scale players have dominated entertainment. The Visa / Mastercard electronic payment duopoly has accelerated.

By contrast, in the long-term the local barber, great chefs, high quality local clubs and communities are in no danger (though I feel for them in the short-term). Geography and other scale-limiting factors create defensible niches that can be won with quality.

We should be cautious about investing in businesses that do not fit either of these categories. They are likely to struggle.

When do we buy?

When we find great businesses able to dominate via extreme scale or defensible niche, when should we buy? Doubtless you’ve seen comparisons of when-to-buy-what across investing styles. A recent interview with Joel Greenblatt (45 min read) phrased our thinking nicely:

I gave a speech last year called “Is Value Investing Dead?” and my answer was “yes, no, maybe, and I don’t care.” And the reason for that is it really depends on how you define value. If you define it like Russell or Morningstar as low price/book or low price/sales its had a tough time. [By these definitions] in the last five years growth has outperformed value by 11 percent per year. In the last 12 months it’s about 43 percent….

…If you define value like we do, which is to figure out what a business is worth and pay a lot less — that’s what I define as value investing (Ben Graham would say leave a large margin of safety) — then that’s never really going to go out of style. We look at companies like we’re a private equity firm. No private equity firm buys a business because it’s a low price/book or low price/sales. They’re really looking at cash flows.

Joel Greenblatt, October 2020

Here’s the idea as a visual:

Closely connected to buying businesses with a margin of safety is buying businesses that can produce exceptional returns on incrementally invested capital — a key component of intrinsic value.

I’m going be long…CEOs that can invest all the money they make today for the future simply because I can now lazily let that person work on my behalf.

Chamath Palihapitiya

A great example: Amazon has invested the money made in web services and e-commerce to build another Fortune 50 company within itself: Amazon Logistics.

While generating a relatively small amount of press, Amazon Logistics was launched in 2014, delivered about 20% of Amazon packages in 2018, and grew that to nearly 50% in 2019, for a 2019 total of 3.5 billion packages delivered (vs. 3.9 billion for FedEx, 5.5 billion for UPS, and 6.2 billion for the USPS). The scale and speed of that growth is mind boggling. Within 10 years of its launch Amazon logistics will likely eclipse its primary competitors in package volume.

How did they do it? Check out their latest earnings release (screenshot below). While revenue and earnings (net income) are always the focus of headlines, Amazon lists these last. The first half of the information they report is about cash flow. Why? Amazon obsessively uses their cash flow from existing businesses to reinvest in those businesses and build out new businesses. Their target is not profit — it is using cash flow from things they built to build even more.

The long-term advantages of Amazon Logistics are substantial. Their focus on cash flow as opposed to net income is the type of thinking that enables such massive scale investments that ultimately create long-term advantages.

Another favorite example is Costco who provide a textbook model of wise capital allocation. When they can put capital to use at high rates of return they build more warehouse stores and invest to grow these stores. When they can’t, they pay a dividend, and occasionally a special dividend to return larger amounts of cash to shareholders.

Costco’s sales per warehouse report (below, and in each annual report) provides a good high-level lens on this, and an impressive degree of transparency to shareholders. This is an easy way to see Costco’s track record of building and investing in stores when, on average, those stores can grow over time. When opportunities aren’t sufficiently attractive, Costco returns capital to shareholders that can be invested in more attractive opportunities.

If all this all sounds like common sense — it is. But very, very few companies behave this way. The incentives for executives to build empires are often too great. However, you will find many of the happy few mature capital allocators in our portfolio.

When do we sell?

There are always reasons to sell.

The astute observer notes the general trend, and takes heart that our strategy net of fees has outperformed the trend since its inception five years ago.

This isn’t to say there are never reasons to sell. We do sell — we just have a very high bar for doing so. The reason must be extremely compelling. The overall calculus is fairly simple:

• Business quality or performance has substantially deteriorated

• Substantially higher-quality opportunities exist — but these must be so much better that we can afford to take the transaction costs and tax hit that comes with selling and still believe we will outperform over the long-run by trading up

Here’s an example.

Portfolio company Costco is a wonderful business. Portfolio company Booking Holdings is also a wonderful business.

During the depths of market despair over coronavirus Costco was very well positioned — a fiercely loyal customer base, warehouse-style stores for buying en masse, substantial price advantages, and growing online distribution to name a few. Booking Holdings, at first glance, was poorly positioned — its major sources of revenue are from the travel industry. But, due to good positioning, Costco’s stock price was about even on the year. Booking Holdings was down about 40%. Some basic logic told us that (1) Booking Holdings was well positioned to weather the storm and potentially emerge stronger, and (2) even if the travel industry took 2-4 years to recover to pre-Covid levels, Booking Holdings’ intrinsic value should only be down 10-15%, not the 40% reduction it was trading at.

So what did we do? We sold some Costco and bought some Booking Holdings. We remain proud owners of both companies. But over the next 2-4 years I suspect Booking Holdings will outperform Costco simply because both are wonderful businesses but Booking Holding’s setup was substantially better.

Statements, focus, and patience

The stock market is a device to transfer money from the impatient to the patient.

Warren Buffett

Quarterly statements arrived in your inboxes early last month. You will also shortly receive an email from the Fund’s administrator with signup details to a portal that allows you to see the performance of your positions in the fund on-demand.

I encourage you to review your positions in the fund any time you wish. I also encourage you to be thoughtful about how often you review them. There is a mountain of research that tells us excessive information leads to excessive action, and this is especially true in long-term investing.

In the long-run investors get the returns they deserve, and an enormous component of successful long-term investing is the ability to be patient and focus on owning wonderful businesses while ignoring what the crowd thinks. Market values will jump around. We solely focus on the value of our positions over a period of years.

The big money is made not in the buying and selling, but in the waiting.

Unknown

If we own wonderful businesses over the long-term we will be very pleased with the resulting performance.

Here’s some inspiration.

Closing items

I have begun aggregating partner resources on this page for ease of access. Think of this as a one-stop-shop with links to all the resources available to you.

As always, please feel free to reach out to discuss the above or anything else.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

A number of you have kindly asked if you could forward these updates to interested parties who share our long-term, patient, focused values. Yes! Please do.

If this letter has been forwarded to you and you would like to discuss further, please reach out to info@phronesisfund.com.

Here is the October update.

Summary

• The market is expensive or cheap depending on how you measure. But what really matters is the value we get for what we buy.

• Risk is hoping for too much in the future

• Patience is our biggest competitive advantage

• Investing is the greatest game on earth

• Several resources have been added to the partnership portal

Expensive or cheap?

We continue to believe that equities are cheap.

Bill Ackman, Pershing Square Capital, May 2020

This is the second-most overvalued market I have ever seen.

David Tepper, Appaloosa Management, May 2020

A lot has happened since May, but these divergent opinions from two investing legends still adequately summarize the current debate on market valuation.

Who is right?

That depends on your starting point.

The “market is overvalued” camp tends to compare current market valuations vs. historical valuations and conclude that the market is overvalued vs. history. The Shiller PE ratio is one such metric and clearly we’re on the high-end vs. history [1].

The “market is cheap” camp tends to look at the market in a way that allows us to compare all types of assets — not just stocks. I touched on this briefly in our September Partner Update. Chamath Palihapitiya of Social Capital recently summarized this well here (thanks Andrew for pointing this out!):

If one has money to invest (and the Fed has supplied plenty of it) then they make a risk/reward decision on where to invest it. The option historically considered to be “risk free” is US government bonds. But their returns have been declining for the past 30 years and are now below 1%.

This creates an incentive to look elsewhere. One can compare assets via yields — for example, a market PE ratio of 31 (shown above) is a yield of about 3%. Not great, but well above government bond yields.

This is even more appealing when one considers that bond yields are fixed — one knows upon purchase exactly what they will get paid, and when. By contrast, stocks have the potential to grow in value and/or produce future cash flow. A guaranteed sub-1% return is unappealing vs. a potential 3%+ return, especially for capital that can be patient.

Betting on too much future performance

This partnership does not exist to seek 3% returns (as you know, I am not paid an incentive fee unless I clear a 6% hurdle each year).

What is the risk vs. bonds? Primarily in buying poor businesses, and in overpaying for wonderful businesses.

Poor businesses — as defined by poor business models — can be identified and avoided. One way to look at this is businesses that need a lot to go right to make good money. The example du jour is airlines. Yes, they can be highly profitable, but to do so they need to keep most of their planes mostly full of passengers most of the time. They must pay enormous operating costs (and given their use of debt, large financing costs as well) to keep their planes in flying condition and their operations running. If they can keep their planes mostly full, they make bank. If for any number of reasons they can’t do this, they are highly leveraged with operating and financing costs that can only be partially reduced to offset lower demand.

I clearly remember hearing American Airlines CEO Doug Parker say “I don’t think we’re ever going to lose money again.” in 2017 [2]. I have never owned American Airlines stock, but if I did I would have sold it that day.

By contrast, wonderful businesses (again, as defined by wonderful business models) can be identified and pursued — e.g. Google’s immensely profitable AdWords business — but they are often priced to match.

In our current market, with lots of money seeking yield and investors willing to “pay up” for it, investors are reaching further and further to justify what they buy. This includes evolving the set of valuation metrics used [3], and looking for potential earnings further and further into the future to justify current valuations.

This can be logical. Only a few percent of a firm’s intrinsic value comes from any single year’s earnings. But when stocks purchased today require many years of strong performance into the future to justify their current price, risk adds up.

Paying too much for future performance (or, what are we doing about all this?)

Price is what you pay. Value is what you get.

Warren Buffett, Berkshire Hathaway

Our focus on wonderful businesses has led us to a portfolio of firms with excellent economics and enormous tailwinds — digital payments, gaming, essential infrastructure, top-shelf media, and digital adverting to name a few.

The primary long-term risk to our ability to compound capital over the long-term is in over-paying for these wonderful businesses.

With interest rates near 0%, the valuation of assets returning above 0% can be quite high. But if inflation goes up (and it will, eventually), these forces work in reverse and valuations of the same businesses come down. So our first risk-mitigation step: avoid buying businesses at prices that require the interest rate to stay near 0% to sustain a reasonable valuation. For our evaluations it is useful to assume that the long-term sustainable interest rate is well above its current level and act accordingly.

A related risk is paying a price for businesses that requires perfect execution well into the future. It can be logical and very profitable to pay for businesses that will not make substantial profits for years into the future — especially when they are using returns from current business operations to fund the growth of their business or development of new businesses.

Bezos lays this out very well here (9 minute clip):

But what happens if a business stumbles in its execution? We want to buy businesses at prices that — even if the business stumbles — would still produce good returns on our investment.

So where do we focus?

Wonderful businesses that can experience execution challenges and/or rising inflation while still providing good returns on capital.

Focus on the controllable inputs to your business instead of the outputs; in the long-term you get better results.

Jeff Bezos, Amazon

Imagine a business required to meet every current growth expectation for the next five years and the interest rate must remain near 0% to reasonably justify its current price. Now imagine a business that can miss expectations and handle the inflation rate rising several percentage points and still be valued above its current price.

The first business is Zoom ($ZM) and any number of other businesses in today’s market (wonderful, but expensive). The second business is Berkshire Hathaway ($BRK), Nintendo ($NTDOY) and a few other businesses in today’s market. All are wonderful businesses — but we prefer the company of the later.

Patience is our main competitive advantage

When will the interest rate rise? When will the price of our portfolio companies rise to meet or exceed their intrinsic value?

No one knows.

But that’s the point of our strategy.

Patience is our main competitive advantage.

Those of you whom I worked with during March and April of this year — what turned out to be the bottom of the market (though of course we didn’t know it then) — know how well our ability to deploy calm, patient, focused capital amidst that market environment of panicked and short-term thinking worked out. We quite literally bought dollars for fifty cents. We were only able to do that because we were deploying capital that did not require short-term rationalization by the market. (The market bounced back quickly but no one knew that it would at the time; if they had, those opportunities would not have existed.)

Investing is the greatest game on earth

I am often asked what I pay attention to in the markets. Which data, signals, trends, investors, etc.?

One way of thinking about investing is as one of the world’s most complex, enigmatic problems with infinite and highly variable solutions.

So my answer: everything matters. But not everything matters equally.

Those of you that I’ve discussed process with know that I view capital markets as a complex adaptive system wherein competitive advantages evolve over time.

In the 1940’s one could make a fortune by simply buying companies trading for less than the combined value of their cash and liquidated assets. But others got wise. In the 1980’s one could make a fortune by levering up businesses with debt to juice their equity returns. Then others got wise. In the 1990’s one could make a fortune using complex business valuation variables to determine what was cheap and buying or selling accordingly. Then others got wise. This pattern has repeated over and over, and it will continue.

An unpopular but strongly-held belief: avoid investors that have a dogmatic, highly repeatable process. If their process is repeatable enough and profitable enough, it will be copied, to the detriment of future returns [4].

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, as I’ve said before, a good 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.

What’s next? It’s anyone’s guess. But this is why there is no substitute for applying practical wisdom, reasoning from first principles, seeking wonderful businesses at reasonable prices, and playing the long game.

Some are maddened by the complex and enigmatic nature of investing in capital markets.

I think it’s the greatest game on earth.

Updates and reminders

All partner updates and resources are available on our portal. These include the full team that serves the fund, our investment philosophy, and will shortly include a link to on-demand statements. I will provide further details in next month’s update.

As always please feel free to reach out to discuss the above or anything else (details below).

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

Notes and references

[1] https://www.multpl.com/shiller-pe

[2] https://www.cnbc.com/2017/09/28/american-airlines-i-dont-think-were-ever-going-to-lose-money-again.html

[3]

[4] There are exceptions, of course. A major exception is patient capital willing to ignore the short-term vicissitudes of the market. Most investors aren’t very patient, so patient strategies can repeatedly perform well.

We now have one month under our belt. I have shifted the partner updates and associated resources to Substack, which means this information is now sent to your inboxes and hosted here for on-demand access.

As always I welcome your candid, direct feedback.

Here is the September update.

Summary

• Welcome to two new partners — Andrew and Brian!

• Major components of the economy that we experience — restaurants, airlines, hotels — have minimal impact on market performance.

• The US economy did not shrink in Q2 2020 by the 32.9% that was reported. The real figure was about 9.5%.

• The Fed flooding the market with money, prices being set at the margin, and the popularity of passive investing have created strange, uncommon dynamics in the current market.

• We are still buying stocks, being cautious not to overpay, and positioning ourselves in the midst of powerful tail winds.

What is happening

The market is rallying. The economy is tanking. Does this make sense?

This is the most common question and discussion I’ve had in the past month, and I did a fair bit of digging and reflecting before it all “clicked”.

In short, there is a substantial incongruity between how we experience the economy — moving through cities, seeing businesses closed, spending far less on restaurants, planes, hotels, in stores, etc. than normal — and how those businesses contribute to the stock market. “The economy is not the market” is the phrase du jour, though the degree to which this is true is under-appreciated.

A few examples from the S&P 500, the most widely followed proxy for US market performance (all data from late August 2020):

• All airline stocks in the S&P 500 — Southwest, Delta, United, American and Alaska — account for just 0.21% of the index. The index’s largest business, Apple, is 33 times larger. So while the airlines are down 46% year to date, they have barely impacted market returns.

• Resorts and casinos — Sands, MGM, and Wynn — are just 0.13% of the S&P 500 index.

• The only department store still in the S&P 500 — Kohls — is a mere 0.01% of the index.

The story is similar for restaurants, hotels, cruise lines, travel services, and other industries that are very obviously struggling. While we see them often, they are a minuscule component of the overall market.

By contrast the S&P 500’s five largest members — Apple, Microsoft, Amazon, Facebook and Google — are nearly 24% of the entire index. These five firms have contributed 94% of the market return year to date. The big are getting bigger.

What about the economy?

The economy is shrinking. But by how much? A recent notification on my phone read:

U.S. Economy Shrinks at Record 32.9% Pace in Second Quarter [1]

There’s no substitute for first-principles thinking. As I mulled this over it didn’t pass a basic logic test — especially in light of the market composition discussion above. Did the U.S. economy really shrink by 1/3 in three months?

No. Not even close.

That 32.9% figure is the percentage by which 1Q 2021 GDP would be below 1Q 2020 GDP if GDP were to decline in the next three quarters at the same rate as it did in 2Q 2020 [2].

If that seems like a useless number — it is.

Reality check: no one expects this to happen (e.g. Morgan Stanley currently expects full-year GDP to be down c. 5.3% year-over-year).

A clearer perspective would be to ask: how much did Q2 2020 GDP shrink vs. Q2 2019 GDP? The answer: 9.5% (real GDP) or 9.1% (nominal GDP).

Not great — but nowhere close to the 32.9% that news outlets had a field day with.

Strange, uncommon dynamics

Did Apple really double in value in 2020?

No.

In the past five years Apple’s revenue growth has slowed to a crawl and margins have declined. Free cash flow — the life blood of any business — is flat.

But some powerful forces have combined to more than double Apple’s stock price (and many others) since the US market bottomed on March 23rd this year.

First, the US Federal Reserve has flooded the market with money at a speed and scale unseen in US history. Recipients seek to put this money to productive use.

Second, stocks are priced by the most recent transaction between a buyer and seller (prices are set at the margin). A minority of exuberant traders can take prices into silly territory.

Third, more than half of stock investments are via passive vehicles which trade according to their formula. For example, $7 out of every $100 put into an S&P 500 index fund is invested in Apple since it is so large. And the higher the price of Apple stock rises (relative to other S&P 500 index components), the more the indexes must buy. It is a flywheel that can go on for some time.

Finally, our short- to mid-term reality has shifted in light of the Fed’s extreme commitment to keep capital markets flush with cash. The Fed moved the price of money (the interest rate) close to 0%., which drove down government bond yields, which led investors to accept lower prospective returns for stocks.

Historically investors have demanded about a 3-5% premium to hold stocks over government bonds. A 4% yield is equivalent to a price/earnings ratio of 25, which is about where the S&P 500 is now. This is a level not seen since the early 2000’s, but to be expected in an environment with such low interest rates.

Should we sell?

If we bought well, no. Here’s a gem from Peter Lynch that I often return to (2 minute clip):

So what are we doing about all this?

We are buying stocks, with our philosophy of buying wonderful businesses at fair prices. This environment turns up the volume on both of those factors.

There are many wonderful businesses in the today’s market that we would love to own, but are just too rich at these price points. “Priced for perfection” is a good line. Basic reasoning tells us that these firms must get everything right — for years and years into the future — to justify their current prices. Buying at these prices would create substantial risk to our ability to compound capital even if the businesses remain wonderful. Hoping for even-greater enthusiasts to come along and pay even-higher prices is not investing.

By the same logic, quality is always important, but especially so in this market which is and will continue to weed out poor businesses and poor business models. Off balance sheet leverage (high fixed cost) has rightly been discussed in huge volumes over the past few months, as has its opposite (zero marginal cost).

The forces outlined above will continue to play out in the short- to medium term. This makes positioning within strong tailwinds critical. We want to benefit from the Fed fund induced flywheel and associated market re-valuations, without risking our ability to compound capital over the very long-term. Our ability to be patient and play the long-game is critical and a major strategic advantage.

Bezos is one of the best in this philosophy. When he was congratulated in 2017 on closing a strong quarter, this was his response (1 minute clip):

Combining patience and playing the long game with powerful tail winds is another major strategic advantage.

The emergence of and shift to SaaS (Software as a Service) is one such tail wind. The shift is happening en masse. SaaS poster child Salesforce.com grew to overtake on-premise software poster child Oracle in late July 2020.

But for all the headlines, SaaS software is still tiny. SaaS revenue only crossed $100Bn in late 2018. That’s 0.01% of the $85Tn global economy, and a business model in which marginal cost is zero. (Side bar: It is ironic that I studied at the London School of Economics, then joined a SaaS firm in which the economics I was taught were useless. Academics still need to adapt their theories to zero marginal cost business models.)

Combine this with the fact that Enterprise SaaS adoption is still relatively low — about 20%. This could easily expand to 60-80% as cost, speed, and services are generally superior in SaaS (vs. Non-SaaS) engagements. ARK recently published a nice succinct piece of research on the trend (see graphic below, from the same piece). [3]

There is much more to come in future Partner Updates on these dynamics and how we are executing on them.

Updates and reminders

We can now invest IRA assets. Please reach out if you would like to discuss.

A web portal for on-demand statements will be launched in the coming weeks.

If you know potential partners who would benefit this community and who share our long-term, patient, focused values, please connect us.

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer

Notes and references

[1] https://finance.yahoo.com/news/u-economy-shrinks-record-32-123047521.html

[2] https://www.oaktreecapital.com/docs/default-source/memos/timeforthinking.pdf

[3] https://ark-invest.com/white-papers/saas-white-paper/

The Phronesis Fund formally launches today — 1 Aug 2020. I am thrilled to be on this journey with you! Thank you for joining.

This is the first in a regular series of partner updates.

Summary

We've launched!

The Partnership

There is a strong team behind the launch of the fund. Legal, brokerage, administration, custody, banking, tax and audit teams all work together behind the scenes so we can focus on the purposes of this partnership: building a wonderful community that invests in wonderful businesses through application of practical wisdom.

What you can expect

• Regular communications from me on the businesses we own, why we own them, how the businesses are doing, and the practical wisdom we apply as owners.

• Community discussion. We will run a Slack community for ongoing discussion and debate. Look out for an invitation shortly.

• Quarterly statements on your positions in the partnership as well as on-demand access to a web portal with the same information (details forthcoming).

Incentives

We are all in the same position as partners. My family and I are substantial owners alongside each of you. We will succeed together.

Asks

My first priority is ensuring this newly-started engine runs smoothly. To that end my focus will be internal: the portfolio and you. We will grow this community, but only as it benefits this community. If you know potential partners who would benefit this community and who share our long-term, patient, focused values, please connect us.

Finally, a reminder on how we apply practical wisdom. This guides operations and keeps us focused, and will be the subject of substantial discussion in future communications. As always, I welcome feedback and discussion (contact details are below).

All the best,

John

Founder and Managing Partner

Phronesis Fund | Disclaimer