A Dozen Things I’ve Learned From Larry Ellison About Business

1. “The only way to get ahead is to find errors in conventional wisdom.” “Because conventional wisdom was in error, this gave us tremendous advantage: we were the only ones trying to do it.” “When you innovate, you’ve got to be prepared for everyone telling you you’re nuts.”  “When you’re the first person whose beliefs are different from what everyone else believes, you’re basically saying, ‘I’m right, and everyone else is wrong.’ That’s a very unpleasant position to be in. It’s at once exhilarating and at the same time an invitation to be attacked.” If you have been reading the profiles of successful investors and entrepreneurs on this blog there is probably no other point made so consistently than this: to outperform the market, you must sometimes be contrarian. Of course, you must also be right when being contrarian in enough of those cases that you outperform the market. It is a mathematically provable fact that you can’t beat the crowd if you are the crowd. Breaking at least one aspect of conventional wisdom is the only way to achieve something truly great. Breaking conventional rules or rejecting conventional assumptions for its own sake is unwise (and as an aside, even though being a someone being contrarian and someone being counterintuitive are different concepts, some people recently have improperly treated them as interchangeable).

Reid Hoffman has pointed out that if you are contrarian you ideally want being correct about that to cause a daisy chain of success. You also want the outcome of your contrarian view coming true to have positive optionality (small downside and a big upside).  You also don’t want to be in a situation where multiple contrarian predictions must happen for your business to become very profitable. Finally, the contrarian bet should be substantially mispriced in your favor (e.g., because you have superior domain expertise or others have lost control of their emotions).

Bill Gurley puts it perfectly here: “a lot of the [bets] that become the breakouts, break any rule set that you have created…” The question is: “Which of these rules am I going to break. What is the new truth going to be?” In other words, make your rule-breaking contrarian prediction count by only making it against an outcome that has huge positive optionality.  Don’t compound your odds of failure by requiring that you “bowl multiple strikes” in a row on contrarian bets to win.

 

2. “Software is not a capital‑intensive business. You can do it with on a shoestring. And all the great software companies started that way.” “The larger you are, the more profitable you are. If we sell twice as much software, it doesn’t cost us twice as much to build that software. So the more customers you have, the more scale you have.” Many people today have either (1) lost track of key aspects of how beautiful the traditional software business model that developed in the 1980s and 1990s can be or (2) are too young to know that this golden era of gushing up front free cash flow even exists. In the traditional software business model, you write software and people buy it. They pay in cash up front. After the software developer pays back its development expenses, incremental revenue is almost pure profit.  Fees are often based on peak usage not actual usage.

Some people advocating software as a service (SaaS) today like to say: “recurring revenue is the greatest thing since sliced bread.” Recurring revenue can indeed be nifty, but there is this thing called customer churn in a “lifetime customer value” based business model which means that what may seem to be recurring revenue, does not always recur. Someone can pretend that customer churn does not exist, just like someone can believe in Santa Claus. Recurring revenue does help avoid a situation where a customer licenses version X of the software and upgrades only after many years and in that way SaaS shares elements with yearly maintenance fees so beloved by Oracle. But the tradeoff with SaaS is that customers can churn more easily and buy only what they need instead of paying for peak capacity.

A dollar of almost pure profit paid up front is better for a provider than a dollar of revenue coming in later that may or may not generate any profit margins. Do customers love a business model where the provider supplies all the capex and supplies the services as SaaS? Yes! That’s new consumer surplus (i.e., what the customer gets).  That’s the future!  I’m “all in” on the cloud and SaaS because it is better for many consumers.

Is SaaS also a great way to compete against incumbents in established markets since the means of competition is asymmetric and harder to defend against? Yes!  If I started a new business today it would de SaaS? Yes. But in terms of producer surplus (what the software company gets), SaaS is neither good or bad in and of itself.  Larry Ellison is a billionaire who owns things like nearly all of the island of Lanai for a reason, and that reason isn’t that SaaS revenue is more predictable than Oracle’s traditional business model which includes things like cash paid up front by the customer, the customer being responsible for capex, and a yearly 20 percent plus maintenance fee payable to Oracle.

Again, I want to be perfectly clear that SaaS is great for consumers. It is the future. But is not an easy model to execute on (e.g., has less attractive cash low, can have high customer acquisition costs (CAC), has higher customer churn to manage, etc.) as compared to the traditional model. As an analogy, I liked it when I had no joint pain after exercise too, but I can’t go back, just like you can’t go back from offering pay-as-you-go SaaS to the traditional licensed business model for software.

 

3. “From the day we started the company, over the 17 years, we have had only one quarter [in which we lost money]. And, boy, even that was one too many.” Creating and selling software in the pre-SaaS days was magical if you established the right sort of business driven by network effects.  People paid up front in the software business and cash flowed like water at Niagara falls if you got it right. Is a SaaS market potentially vastly bigger today in terms of revenue? Yes! Is revenue the same things as profit? No. Is it fantastic that everyone has a connected super computer in their pocket? Yes!  Is the rise of SaaS inevitable? Yes! Is the shift to the new SaaS business model an unmitigated blessing for software producers? No.

 

4. “It’s like Woody’s Allen’s great line about relationships. A relationship is like a shark, it either has to move forward or it dies. And that’s true about your company.” Businesses that can adapt to change can thrive. Businesses that don’t adapt, die. The average lifespan of a business on the S&P 500 in 1960s was 60 years. Today, that average age is 10 years.  As I said in my comments on the past three quotations, SaaS based business models are part of the future. If you don’t accept that change, you are toast.

 

5. “The computer industry is the only industry that is more fashion-driven than women’s fashion.”  When you have been in the technology business as long as I have you have seen many concepts come and go. Information highway, e-business, clipper chip, Dodgeball, Clippy, Lively, etc. The list is endless. Both software and venture capital firms and investors love to chase a trend. As Bill Gurley said once: “Venture capital is a cyclical business.” The great venture capitalists are mostly done with new investments in a sector before the mob moves in and makes it a trend. The great venture capitalists also have money to invest in startups when the cycle is at its bottom (when it is out of fashion).

 

6. “To model yourself after Steve Jobs is like saying, ‘I’d like to paint like Picasso, what should I do? Should I use more red?” You are not going to be Steve Jobs, Larry Ellison or Bill Gates. Get over it, if that’s your goal. But you can look at qualities they have and chose some you would like to try to emulate, as you would in looking at a menu on a Chinese restaurant. I knew someone once who thought he needed to treat people like Steve Jobs treated people early in his career to be successful in a startup. That is a full load of rubbish.

 

7. “When I started Oracle, what I wanted to do was to create an environment where I would enjoy working. That was my primary goal.” “We used to have a rule at Oracle to never hire anybody you wouldn’t enjoy having lunch with three times a week. Actually, we are getting back to some of our original ideals these days.” Working with people you enjoy is highly underrated. Working with people you don’t enjoy is, well, odious. The great news is that working with people you enjoy is more likely to lead to success. You will end up with less loss from friction since you can benefit from a seamless web of deserved trust. Will you enjoy everyone you work with? No. But with a little work can you find a way to work with most people? Yes.

 

8. “I think I was interested in math and science because I was good at it. And people tend to like what they’re good at and not like very much what they’re not good at.” “I’ve never really run operations. I’ve never had the endurance to run sales. The whole idea of selling to the customer just isn’t my personality. I’m an engineer– tell me why something isn’t working or is, and I’m curious.” Larry Ellison is probably capable of doing what Mark Hurd does or even Safra Katz does.  But he is saying he does not enjoy doing those things. Doing what you enjoy is underrated.

 

9. “Great achievers are driven, not so much by the pursuit of success, but by the fear of failure.” I am not a fan of using failure as a motivational tool. But there is a little of this in everyone and a lot in others. Larry Ellison is obviously competitive. Going up against him in any competitive activity is an adrenaline rush.

 

10. “I think about the business all the time. Well, I shouldn’t say all the time. I don’t think about it when I’m wakeboarding. But even when I’m on vacation, or on my boat, I’m on e-mail every day. I’m always prowling around the Internet looking at what our competitors are doing.”  I have heard this joke for many years: The difference between God and Larry Ellison is that God Doesn’t Think He’s Larry Ellison. This joke widely misses the mark. If Larry Ellison really thought this way he would not be “always prowling around the Internet looking at what our competitors are doing.” He would not be driven by a “fear of failure.”

 

11. “All you can do is every day, try to solve a problem and make your company better. You can’t worry about it, you can’t panic when you look at the stock market’s decline.” If you execute well and focus on great strategy, the stock price will take care of itself.  The price of a stock is not the same thing as the value of a proportional share in a business. This point is fundamentally important to investing which is fundamentally about understanding business. A share of stock in a proportional ownership interest in a business and is not a piece of paper to be traded on popularity like a baseball card.  Ignore short term noise and shorty term price fluctuations cause by the bi-polar Mr. Market and you will be a better businessperson and investor. Only occasionally will the price and value of a business be the same. Knowing the difference between price and value is a critical part of successful investing.

 

12. “In some ways, getting away from headquarters and having a little time to reflect allows you to find errors in your strategy. You get to rethink things. Often, that helps me correct a mistake that I made or someone else is about to make. I’d rather be wrong than do something wrong.” Waking up before you make a mistake is a very good thing. The experience of actually peeing on the electric fence can sometimes be avoided if you think things through before you pee. Taking a break with something as simple as a walk or as complex as an America’s cup race is wise. Admitting you are wrong, especially before you are wrong in actually doing something, is a very good thing.

 

*p.s., There is a great related post from Nick Mehta that includes this sentence:  “So have a stiff drink, open your eyes and accept that [the new world of SaaS] is harder. This is the new world, and as long as we live in it, we need to embrace it. And, as Lorde would say, we can keep driving Larry Ellison’s yacht in our dreams.”

 

Notes:

Academy of Achievement – Interview: Larry Ellison

Smithsonian Institution – Oral History: Lawrence Ellison

Forbes – Lunching With Larry

SFGate – Larry Ellison, On the Record

CNet – Ellison Nails Cloud Computing

 

A Dozen Things I’ve Learned From Henry Singleton About Value Investing & Venture Capital

William Thorndike (author of The Outsiders) said in an interview that Henry Singleton: “was a MIT trained mathematician and engineer, he got a Ph.D. In electrical engineering from MIT. While he was there he programed the first computer on the MIT campus, and he proceeded to have a very successful career in science. He developed an inertial guidance system for Litton Industries that’s still in use in commercial and military aircraft. He did a whole range of things. And then later in his career– in his mid-40s, he became the CEO of a ’60s era conglomerate called Teledyne.” Henry Singleton was also a limited partner in the pioneering venture capital firm Davis and Rock, and invested $100,000 in Apple in 1978.

Understanding Henry Singleton is worthwhile no matter your investing style, but that is especially true if you are a value investor or a venture investor. As an example of the esteem in which he is held by value investors, Warren Buffett once said: “Henry Singleton of Teledyne has the best operating and capital deployment record in American business.” In his book the Money Masters, John Train writes that Buffett once said this about Singleton: “According to Buffett, if one took the top 100 business school graduates and made a composite of their triumphs, their record would not be as good as that of Singleton, who incidentally was trained as a scientist, not an MBA. The failure of business schools to study men like Singleton is a crime. Instead, they insist on holding up as models executives cut from a McKinsey & Company cookie cutter.

On the venture investing side, Arthur Rock once said: “Henry Singleton was this very brilliant, intellectual type who could foresee all these problems that no one else could see, and he saw opportunities. Henry was as intellectual as anyone I had come across.

Coming up with 12 quotations in this case was not easy since Henry Singleton was a very private individual. If you go looking for quotations from Henry Singleton, you will not find much more than is set out below.

1. “I don’t believe all this nonsense about market timing.” Singleton was not someone who thought he could profit from timing the market in the short term. Because of his aversion to market timing, Singleton believed that making precise predictions about the short-term direction of markets was neither possible nor necessary, if you understand value and have the discipline to invest aggressively when the time is right. Following this approach, Henry Singleton was able to accumulate one of the best capital allocation records of any investor ever. He generated a 20.4% compound annual return for shareholders over 27 years. Charlie Munger has said Singleton’s financial returns as an investor were a “mile higher than anyone else …utterly ridiculous.”

 

2.“My only plan is to keep coming to work every day. I like to steer the boat each day rather than plan ahead way into the future.” “I know a lot of people have very strong and definite plans that they’ve worked out on all kinds of things, but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible.” Henry Singleton was also someone who understood the value of optionality. Singleton was able to put himself in a position to opportunistically capture profits when assets were mispriced. They key to optionality is simple: bet big when you have a big upside and a small downside. When you have a big downside and a small upside, don’t bet. If you have a big upside and a big downside, why bet if other bets have more valuable optionality?

3. “It’s good to buy a large company with fine businesses when the price is beaten down over worry..” Buying shares in a business with a moat at a price that is beaten down is the value investor’s mantra. Prices get beaten down when there is a lot of uncertainty caused by worry. Be greedy when others are fearful. John Train points out that Singleton bought over 130 business “when his stock was riding high, then when the market, and his stock fell, he reversed field.”

Singleton used big stock price drops to aggressively buy back Teledyne shares. Mike Milken describes one of Singleton’s business decisions here: “In the 1970s two businessmen I greatly admired were doing what Drexel and its clients and its imitators were doing ten years later: using debt–junk, if you will–to acquire equity. I’m talking about Dr. Henry Singleton of Teledyne and [the late] Charles Tandy of Tandy Corp. These were both great operational managers and great financial managers. They recognized that their common stock was selling at ridiculously low levels, so they offered to swap high-coupon bonds for common stock. Tandy used $35 million in 10% 20-year bonds to acquire 11% of its own common. In less than ten years that repurchased stock was worth more than $1 billion. Singleton bought in 26% of Teledyne’s equity for $100 million in 10% bonds–a very high coupon in those days. By the early 1980s that repurchased stock was worth more than $1.5 billion.”

 

4. “There are tremendous values in the stock market, but in buying stocks, not entire companies. Buying companies tends to raise the purchase price too high.” “Tendering at the premiums required today would hurt, not help, our return on equity, so we won’t do it.” Henry Singleton did not like paying a control premium. If you are paying a control premium, you are counting on the fact that you will be able to change the operations or strategy of that business AND realize that value, in addition to the right return on investment on that premium. With control you do have the ability to change strategy, benefit from supply or demand side economies of scale or scope, lower the cost structure of the business, sell unattractive assets or obtain tax benefits.

 

5. “After we acquired a number of businesses we reflected on aspects of business. Our conclusion was that the key was cash flow.” This approach is not dissimilar to Jeff Bezos, John Malone and others who focus on absolute dollar free cash flow rather than reported earnings. Growth of revenue and size of the company were never key financial goals. Singleton liked businesses which generated cash that could either be taken out of the business or reinvested when it makes sense. Reinvesting only make sense when you can generate substantially more than a dollar in value for every dollar reinvested. Some executives like Henry Singleton, John Malone and Warren Buffet know how to redeploy cash, but some don’t.

 

6. “Our attitude toward cash generation and asset management came out of our own thought process. It is not copied.” You don’t outperform a market if you are not occasionally contrarian and right about what you believe on enough occasions. Charlie Munger has said about Henry Singleton: “He was 100% rational, and there are very few CEOs that we can say that about.” Arthur Rock once said about Singleton: ”He really didn’t care what other people thought.” Independence of thought and emotional self-control are the keys to making successful contrarian bets. The other point made here by Singleton is about doing your own thinking and not outsourcing it to consultants and bankers.

 

7. “To sell something to lift the price of the stock is not thinking correctly.” In this quote he was referring to a potential spin off or sale, but he also had strong views on stock buy backs and new stock issuance. Henry Singleton believed that the time to sell a stock is if it is overvalued and the time to buy shares is when they are undervalued. What could be simpler? The purpose of a stock buyback should not be to lift the price of the stock. Thorndike puts it well here: ‘[CEOs] can tap their existing profitability– their existing profits– they can raise equity, or they can sell debt. And there are only five things they can do with it. They can invest in their existing operations, they can make acquisitions, they can pay a dividend, they can pay down debt, and they can repurchase stock. That’s it, those are all the choices. And over long periods of time, those decisions have a significant impact for shareholders.”

 

8. “We build for the long term.” Appeasing analysts who cry out for accounting earnings or other concocted metrics in the short term is folly. When his stock went down, Henry Singleton bought more back. That’s an example of long-term thinking. Being fearful simply because others are fearful is a big mistake. The greatest investing opportunity arises when people are fearful.

 

9. “All new projects should return at least 20% on total assets.” Free cash flow was not the only driving metric for Henry Singleton. He believed that businesses with sustained returns on assets (lasting for years, not months) produce superior investment returns. This sustained high return is what investors Warren Buffett and Charlie Munger mean by the “quality” of a stock. This rate of return must be maintained over a period of years to be considered a positive investment criteria, since otherwise you can’t tell whether there is a genuine moat versus merely high points in a business cycle.

 

10. “Our quarterly earnings will jiggle.” Henry Singleton was not someone who managed earnings. Singleton would much rather have had a long term average financial return of 14% that was lumpy than a 12% return that was smooth. Sergey Brin and Larry Page of Google (executives and co-founders) once wrote: “In Warren Buffett’s words, ‘We won’t ‘smooth’ quarterly or annual results.’ If earnings figures are lumpy when they reach headquarters, they will be lumpy when they reach you.”

 

11. “Teledyne is like a living plant with our companies as the different branches and each one is putting out new branches and growing, so no one is too significant.” If Singleton is criticized it is because he operated “a conglomerate.” Warren Buffett disagreed with this criticism: “Breaking up Teledyne was a poor result, certainly now and in the future.” Singleton was able to ignore the criticism since he has the discipline to think and act independently.  It is one thing to talk about being a contrarian and quite another thing to actually do it.  Singleton once said in an interview with Forbes: “being a conglomerate is neither a plus nor a minus.”

“There was no general theme,” Rock has said. “This was a conglomerate of scientific companies, and most of these were allowed to operate with very little direction from corporate.”

While Singleton diversified the businesses of his conglomerate, in terms of his outside investments, Singleton was a “focus” investor who did not believe indexing made any sense for an investor like him. Charlie Munger said Singleton “bought only a few things he understood well” - an approach he shared with famous investor Phil Fisher. Singleton said in his Forbes interview: “the idea of indexing isn’t something I believe in or follow.”

Of course, Singleton was not an ordinary investor.  Singleton was one of the few investors who, as Warren Buffett says, fits into the “know something” category.  Most people are better off with an index-based approach to investing since they do to have the temperament nor the inclination to work as hard as Singleton did to understand the businesses that he was investing in.

 

12. “A steel company might think it is competing with other steel companies. But we are competing with all other companies.” Henry Singleton knew that any moat is subject to attack and that that attack does not need to come from a competitor that is engaged in the same activities. The most successful attacks on a business tend to be asymmetric. Businesses tend to fail not from a frontal attack, but when they are eclipsed or enveloped.

p.s., This interview with Will Thorndike is an outstanding way to understand Singleton.  Thorndike points out in the interview: “Throughout that decade, his stock traded at an average P/E north of 20, and he was buying businesses at a typical P/E of 12. So it was a highly accretive activity for his shareholders. That was Phase One. Then he abruptly stops acquiring when the P/E on his stock falls at the very end of the decade, 1969, and focuses on optimizing operations.

He pokes his head up in the early ‘70s and all of a sudden his stock is trading in the mid single digits on a P/E basis, and he begins a series of significant stock repurchases. Starting in ‘72, going to ’84, across eight significant tender offers, he buys in 90% of his shares. So he’s sort of the unparalleled repurchase champion.”

 

Notes:

If you read anything in the notes below, read the Forbes interview with Singleton.

Forbes – The Singular Henry Singleton 
Amazon – The Outsiders (William Thorndike)Ideas for Intelligent Investing – ‘The Master of Capital

Allocation, Henry Singleton’
Investor’s Business Daily – How Singleton Built An Empire
Manual of Ideas – Teledyne’s Takeoff
NY Times – Henry Singleton Obituary
Berkshire Hathaway Chairman’s Letter - 1981
NY Times – Wall St. Eyes Are On Teledyne
Manual of Ideas – Strategy vs. tactics from a venture capitalist 
Harvard Business Review – How Unusual CEOs Drive Value
Forbes – Mike Milken Interview

A Dozen Things I’ve Learned from John Malone

 1. “The question is: Is the cable business going be a great business; who is going to make the money? It may well be that the Disneys of the world make the money and cable and video continue to get squeezed. But I think at least for now they’ve got enough pricing power in broadband to make up for that.” “They key to future profitability and success in the cable business will be the ability to control programming costs through the leverage of size.” No one has taught me more about transfer pricing than John Malone and the people who work for him. I was lucky enough to work for Craig McCaw who started in the cable TV business before he became a pioneer in cellular communications and interacted with John Malone, TCI and Liberty over the years.

The takeaway from this quote is simple: every business has a value chain and profit pools. How profit is allocated between the layers in the value chain is determined by the relative transfer pricing power of the layers. Lots of businesses create value, but no profit. This fact is poorly understood. The profitability of an industry not the same issues as its importance. As an example, airlines create huge value for society (consumer surplus) but generate very little profit (producer surplus).

 

2. “[Don’t] expose yourself to one financial source.. diversification of every kind.. isolation of financial risk..” The best way to combat the wholesale pricing power of a supplier or customer is to have alternatives. As an example, the cable industry would never rely on a single supplier of a hardware component for that reason. The second point John Malone makes is that creating watertight compartments in a ship (and in a business) to isolate risk is just good engineering.

 

3. “[The sort of ] business that investors want today [is] predictable. It’s got glue, sustainable revenue streams, …meaningful growth and pricing power in parts of the business.” John Malone likes a strong economic moat. The test for whether a moat exists is whether the business has “pricing power.” Warren Buffett puts it this way: If you must hold a prayer meeting to raise prices, you don’t have much of a moat. What happens when you don’t have a moat? Here’s John Malone with an example: “The fiber business is a good business—for one or two providers—but for thirty? All funded with borrowed money? …(I’ll repeat,) great business for one or two providers. Questionable business for six, especially when it’s financed with a bunch of bonds.” I lived this one up close and personal with a portfolio company known as NextLink/XO and know all too well that huge increases in supply when there are many providers is not good for profits. Some people during the bubble thought the Internet had suspended the laws of supply and demand, but they were proven wrong.

 

4. The concept that cable television looked more like real estate than it did manufacturing was always obvious, … to me, anyway. And I think the financial markets really didn’t have a model for cable, because the industry was a small, startup industry with no real following. Coming out of that period of the ’70s, the industry needed some model, some metric how the market could value us. We decided out …to go on a cash flow metric very much like real estate. Levered cash flow growth became the mantra out here. A number of our eastern competitors early on were still large industrial companies — Westinghouse, GE, — and they were on an earnings metric.”

“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings..” “The first thing you do is make sure you have enough juice to survive and you don’t have any credit issues that are going to bite you in the near term, and that you’ve thought about how you manage your way through those issues.”

“I used to go to shareholder meetings and someone would ask about earnings, and I’d say, ‘I think you’re in the wrong meeting.’ That’s the wrong metric. In fact, in the cable industry, if you start generating earnings that means you’ve stopped growing and the government is now participating in what otherwise should be your growth metric.” Among the many lessons I have learned about finance are as follows: (1) accounting earnings are an opinion; (2) free cash flow is a fact and (3) the only unforgivable sin in business is to run out of cash.  A key figure for John Malone in terms of raising the necessary cash was Michael Milken, who was also a key figure for many other people in this business world like Bill McGowan (MCI Communications), Bob Toll (Toll Brothers), Steve Wynn (Wynn Resorts), Steve Ross (Time Warner), Rupert Murdoch (News Corporation), Craig McCaw (McCaw Cellular, Nextel), and Ted Turner (CNN).

 

5. “Our skills here, internally, are very much in financial engineering.” “Entrepreneurs will always be able to take an asset, leverage it up, operate it tightly and make it worth money to them and get good equity returns.” “You can borrow money against a growing cash-flow stream, and as long as your growth rate’s faster than your cost of money it’s a wonderful business.” 

“The cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money.” “Inflation lets you raise your rates and devalue your liabilities.” How can I say this better than John Malone? I can’t. So I will leave it at that.

 

6. “[Taxes are] a leakage of economic value. And, to the degree it can be deferred, you get to continue to invest that component on behalf of the government. You know, there’s an old saying that the government is your partner from birth, but they don’t get to come to all the meetings.” “Better to pay interest than taxes.” John Malone is a master of deferring taxes. In this video lecture John Malone explains the difference between tax avoidance and tax evasion. What John Malone said he wants to do is make sure that Uncle Sam does not collected his taxes too early. Deferring taxes allows the value of the shares to compound pre-tax. In the video he also talks about how debt, which has interest that is tax deductible, creates significant tax advantages versus equity.

Warren Buffett and Jeff Bezos defer taxes too. Here’s Charlie Munger on this point: “If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%, or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.”

 

7. “Just like making movies. God help us if we think we can pick winners and losers when it comes to making movies. Even the good guys don’t know how to do that. There are certain fields, in my experience, that it’s good to stay out of. One can be a good investor in them, if one’s prudent, but one shouldn’t fool oneself into thinking one knows how it really works.” This quotation is all about staying within a circle of competence and avoiding hard problems. One excellent way to avoid problems is quite simple: understand that people who know what they are doing make fewer mistakes.  Hollywood is a particularly troublesome place to try to make money if you are not an insider. Cash travels into Hollywood from outside investors, but rarely comes out. You sometimes read about a hit movie, but rarely the failures (which causes survivor bias and investor dysfunction).

 

8. “Recently somebody said, ‘Hey, you lost weight,’ and I said, ‘Yeah, thirty-five pounds and three and a half billion dollars’.” “I’ve done lots of bad deals… Yeah, I’ve done some horrific deals.” “When I stick to my knitting I do okay. It’s – it’s when I listen to some pied piper.” John Malone is talking about the Internet bubble in this quote, when he refers to the money he lost. It was a very crazy time. The level of fear of missing out (FOMO) is hard to convey to someone who did not go through it.

Valuations were nutty. John Malone once called AOL “a big puff bag.. it didn’t have any real assets. A lot of the revenue AOL was reporting as recurring even though it was one time.” Lots of paper wealth was created, which over a very short period of time quickly evaporated. The speed at which the bubble was destroyed was stunning. One month it was possible to raise billions of dollars in cash and the next month you could not raise 5 cents.

 

9. “Don’t ever bid against Rupert Murdoch for anything Rupert wants, because if you win you lose. You will have paid way too much.” Warren Buffett’s advice about auctions is simple: Don’t go. A lollapalooza of psychological factors causes people’s minds to turn to mush at auctions. When it is a charity auction, that dynamic is all good. But in business, auctions can create huge problems – especially if you are bidding against Rupert Murdoch. I heard a famous billionaire once say that no other billionaire scares other billionaires more than Rupert Murdoch.

 

10. “You just have to be opportunistic, and try to figure out what creates value—where the bottom is, what creates incremental value, and in what combinations.” This quote is about optionality. Rather than trying to predict what is going to happen, it is a far more effective to be in a position to capitalize on something that unexpectedly happens. One reason John Malone is so successful is that he has what Greg Maffei has called a “frictionless mind.” What Greg Maffei means is John Malone’s mind can turn on a dime as opportunities change.

As an aside, many of these opportunities John Malone benefited from over the years were acquisitions. John Malone believes the nature of vertical and horizontal acquisitions are very different and that “a lot of mergers fail for cultural reasons.  Vertical acquisitions are much tougher than horizontal ones. You are essentially buying a business you don’t know and you don’t understand.”

 

11. “You’ve got to play both offense and defense.” Watching John position himself in his competition with Murdoch was fascinating. As much as John Malone wants to avoid having single a supplier or customer, he would want to be one if he could. That set off interesting bidding wars in the industries that he is involved in. His battles with people like Rupert Murdoch are fascinating to watch. Because I worked for Craig McCaw at the time, I had a ringside seat during the battle of what was known as “the death star”. John Malone described it this way: “We persisted with PrimeStar right up to the point where our license to buy a high-speed satellite – our joint venture with Rupert Murdoch to use his license – was shot down by the government. So we persisted all the way through and ultimately sold PrimeStar to DirectTV – broke my heart.”

 

12. “Broke my heart to do the AT&T deal. When you’re the controlling shareholder and somebody comes along and offers you a 40-percent premium to a record high stock price, really full valuation, and to a liquid security, you just can’t turn it down. In retrospect, I wish I hadn’t done it.” Sometimes you need to sell a business for one reason or another and its breaks your heart to do so. McCaw Cellular was such a situation.  I do still wish McCaw Cellular had not been sold to AT&T. It was a great business that accomplished great things.

 

Notes:

Mavericks Lecture (video)

Biz Journals – John Malone talks of his past and future  

 

Ken Auletta – A Conversation with John Malone

Tycoon Playbook – The Cable Cowboy

 

Broadcasting Cable – Malone Again

Multichannel.com – Unleashing Liberty

 CNBC – John Malone Interview

A Dozen Things I’ve Learned From Chris Sacca About Venture Capital

1. “Capital just isn’t that important to the early triumph of a company anymore. Much more vital in those inaugural days is collaborating side by side with a founding team that controls its own destiny. Entrepreneurs who are empowered by seasoned advisors, but free to frame achievement for themselves, are much happier.” “When you’re just getting started, I’m the guy you want in your room to help design your product, build the funnel to convert, help you recruit your first couple of employees, get that shit done.” Not all investors are created equal. The winners are persistently the same relatively small groups of investors time after time.  Success not only has positive signaling effects in attracting the factors that drive success, but also talent enhancing effects for the venture capitalists themselves.

In short, the best talent, investors and partners are attracted to each other in ways that are self-reinforcing. By getting to work more with other great talent, investors like Chris Sacca actually become more talented and attract more talented people [repeat]. This is an example of what is known as “cumulative advantage.” If you genuinely have a great idea for a business that has the necessary tape measure home run potential payoff, talent is a far greater constraining resource than money. Getting access is the best investors is not only valuable but essential. What is the biggest startup success you see out there today that was financially backed by no one you have ever heard of?

 

2. “The founder needs someone to bring their A-game to. I did the analysis across my portfolio actually, and the companies I have, those that had leaderless seed-rounds underperformed.” “I think it’s important for anybody to have to sit down, put together a deck, and bring their A game to somebody else, who’s gonna listen. A coach, somebody, you feel accountable to.” “My job is to obsolete myself by series B.” “It’s all fun and games until you raise a Series B.”  People often find a niche where they are most effective and Chris Sacca is telling you where he feels he is most effective and having the most fun. Having a lead investor in a seed round who adds value is really important. If you are raising early stage money and the money is just money, you are settling for less. If you meet a founder and he or she says that all the investors added was money, they may have had a decent financial exit but they almost never hit a tape measure home run.

 

3. “Good investors are in the service business.”  “There are angels who have 75 companies and don’t call any of them ever.” The difference between Chris Sacca and a dentist who writes seed stage checks is measured in light years. Someone like Chris Sacca hustles on behalf of the portfolio company, has judgment and a network of people who know how to get things done. That they are both called Angels by some people seems wrong to me. Great seed stage/early stage venture capital investors are not a common phenomenon.

 

4. “I was involved in a company, where Bill Gurley is an investor and the company was thinking about hiring CFO, and Bill opens up his folder, and he’s got six CFOs, ready to go.  People of public company quality. I thought, ‘I don’t know six public company CFOs in the world.’” “Bill Gurley, will never take credit for that.” When a company gets to a Series A investment round or greater, a business increasingly needs a new set of resources if it is going to scale. Trains need to run on time. Systems must be built. New types of things need to get done. New VCs with new skills often arrive after the seed and A rounds and new management and talent starts to appear. People like Bill Gurley and Chris Sacca have a symbiotic relationship. Sacca is saying that by the time the B round happens he is ready to hand over his active/lead investor role to others. Knowing your highest and best use and what makes you happy is an important life skill.

 

5. “As investors, VCs are wrong more often, than we are right.” “As a VC, I’m wrong most of the time, so whenever any of the VCs tell you about the rules etc. it’s really, because we’re wrong all the time. You should expect me to be wrong most of the time. When I’m right, I’m really really right. That’s what you should expect from a VC.” Being a VC is all about hitting tape measure home runs.  You can be wrong often. In fact you can be wrong most of the time as long as you are very very right sometimes. It is magnitude of success that matters, not frequency. This is called “the Babe Ruth effect” which I have written about before.

 

6. “Any VC will tell you where they really make their money is on following on, it’s on doubling down into the winners. The things that are growing geometrically in terms of users, revenue that kind of stuff.” As the timeline of a business moves along, phenomena start to emerge from the nest of complex adaptive systems that is an economy or a market.  Spotting the emergence of a potential unicorn causes the best venture capitalists to double, triple or more down on their best bets. They didn’t necessarily see it coming when they did their first investment but later on, they know it when they see it. What was originally optionality over time starts to look more and more like inevitability.

 

7. “I do try to focus a lot on the entrepreneur as a person, I think that has fallen out of the equation recently…. look for driven people.” Getting a company through adversity and challenges takes someone who is driven to succeed. This is why venture capitalists prefer missionary founders to mercenary founders. They also know that strong founders and strong teams are their own form of optionality since they can adapt as the environment changes and opportunities arise.

 

8. “Companies don’t succeed, when there’s a lot of chiefs and no Indians.” Someone needs to do the work. In fact, everyone needs to do the work.  Startups with poseurs don’t survive. Public relations and hype only get you so far and if the founders start believing the PR you can put a fork in the business. It is done.

 

9. “Once you have FOMO (fear of missing out) on your side, you no longer have to ask people like [me] for money. They’re lining up to give it to you.” When doubt or uncertainty exist, people tend to follow other people. For this reason, if you can get a great lead investor getting each additional investors get vastly easier. The process can become like a snowball running downhill. That can have good results and bad. In the Internet bubble, Pets.com was the poster child for FOMO. Today Clinkle would be an example of FOMO creating big problems for investors.

 

10. “Create value before you ask for value back.” This is a fundamental principle of networking.  Chris Sacca shares this view with Heidi Roizen, who I wrote about here.

 

11. “Simplicity is hard to build, easy to use, and hard to charge for.  Complexity is easy to build, hard to use, and easy to charge for.” What Chris Sacca talks about here is why there is such a premium on design these days in venture capital. This, in no small part, helps explain the mass migration of companies up into San Francisco from the peninsula (designers are often allergic to suburbs).  As the great Startup L. Jackson once said: “Y’all talk about UX like it’s just another feature. For a user, it literally is the product. Full stop. Everything else is inside baseball.”

 

12. “It’s people with these broader life experiences who have balanced relationships who come up with the cool shit.” “College done right, particularly like a liberal arts school, is a lot less about the individual facts. You learn more about how to think, how to communicate, experimenting with personal boundaries, drinking too much, taking the time to go abroad.” This is straight up consistent with the Charlie Munger view that you need to have a latticework of different models to make good decisions. People who only know one or even a few models have “person with a hammer syndrome.” They have their one model and everything to them looks like nail for that model. A broad liberal arts education helps you become wise. Wisdom is a highly underrated skill.

A Dozen Things I’ve Learned From Steve Blank About Startups

1. “A startup is a temporary organization designed to search for a repeatable and scalable business model.” Any analysis of this statement should start with a definition of “business model.” I like the Mike Maples, Jr. definition: “The way that a business converts innovation into economic value.” Steve Blank has his own definition: “A business model describes how your company creates, delivers and captures value.”  One very effective way to find a business model is to apply a trial and error process in which the optimal result is discovered via experimentation rather than a grand plan generated at once from whole cloth. As I pointed out in my Eric Ries/Lean Startup post, others believe the truly big and important business models can’t be discovered incrementally.  Applying the scientific method to the business model discovery process can be very valuable. It is not the only useful model for creating a business model, but it is an important one.

 

2. “A company is a permanent organization designed to execute a repeatable and scalable business model.” “Large companies are large because they found a repeatable business model and they spend most of their energy executing – meaning doing the same thing over and over again. They figured out what the secret is to growing their business.”  An established business that has existing systems and procedures developed to execute on a known business model can, if it is not careful, generate antibodies which stifle the development of new products and services as well as new business models. There is an inherent tension between creating a new repeatable and scalable business model and optimal execution, since great execution often involves eliminating anything that is not core to that mission.

 

3. “Business plans are the tools existing companies use for execution. They are the wrong tool to search for a business model.” “Startups are not smaller versions of larger companies. There are something very different. So, I asked ‘Why are you teaching us to write business plans? Business plans are operating plans. and we don’t even know what it is we are supposed to be operating.’ A business plan is the last thing you want a startup to write, yet we’re still not only requiring it for small businesses, we won’t fund you without one.

“A business plan is exactly like telling you to go boil water when someone’s having a baby: it’s to keep you busy, but there’s no correlation between success and your activity.”  “The unique people who need a 5-year business plan are VCs and Soviet Union.”

“In a startup, no business plan survives first contact with customers.” The operative word in this series of Steve Blank quotes on business plans is “search.” You can describe your ‘planned search process’ when you are creating a startup, but trying to describe the result of your search before it happens is a useless exercise. The world is changing so quickly and there is so much uncertainty that writing out a long-term business plan is essentially a work of fiction and a waste of precious time and resources.

 

4. “A startup is not about executing a series of knowns. Most startups are facing a series of unknowns—unknown customer segments, unknown customer needs, unknown product feature set, etc.” “A pessimist sees danger in every opportunity but an optimist sees opportunity in every danger.”  The biggest financial returns are harvested when uncertainty is the greatest, since that is when assets have a much more significant tendency to be mispriced. I have written a post on optionality and venture capital which directly addresses what Steve Blank is talking about.  Making decisions in life and in business is a probabilistic activity.  We all face:

  1. Risk: future states of the world known, and probabilities of those future states known (e.g., roulette).
  2. Uncertainty: future states of the world known, but probabilities of those future states are not known (i.e., most things in life).
  3. Ignorance:  future states of the world unknown, probabilities therefore not computable (i.e., black swans).

The best way to deal with this reality is to apply the following four-step process like Howard Marks:

  1. “The future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability  distribution;”
  2. “Risk means more things can happen than will happen;”
  3. “Knowing the probabilities doesn’t mean you know what’s going to happen;” and,
  4. “Even though many things can happen, only one will.”

Howard Marks goes on to say: “since future events can’t be predicted, risk can’t be qualified with precision.” One can deal with this by having a probabilistic approach to life, focusing on having sound processes and thinking long-term.

For a founder or investor who can remain rational this uncertainty is a huge opportunity, since this is what causes assets and opportunities to be mispriced. It was precisely when the economy was at its low point after the recent financial crisis that the times of greatest opportunity existing for an investor or founder.  In other words, the best time to found a company is in a downturn. Employees are easier to recruit, resources less expensive, and competition less intense. It takes courage to do this, but that courage can pay big dividends. Optimists and people who have been through previous business cycles are much more likely to realize that things inevitably get better.

 

5. “Products developed with senior management out in front of customers early and often – win. Products handed off to a sales and marketing organization that has only been tangentially involved in the new product development process lose. It’s that simple.”

“The reality for most companies today is that existing product introduction methodologies are focused on activities that go on inside a company['s] own building. While customer input may be a checkpoint or ‘gate’ in the process it doesn’t drive it.” “There are no facts inside the building so get the hell outside.”  Nothing drives the customer development process forward more than time spent with actual customers. The best founders, CEOs and senior managers spend huge amounts of time with customers. It is not an activity they delegate. This inevitably happens because they love the product and services and want to share this love with others.  This is a large part of why missionary founders do better than mercenary founders. Passion of founders and employees pays dividends that compound for the startup.

 

6. “This whole lean stuff actually works best if you’ve failed once. If you’ve failed once, you’d really appreciate the value of not just following your passion, but maybe devoting 10 percent to testing your passion before you commit three to four years of your life to it.” Good judgment tends to come from experiencing bad judgment either on a first party or third party basis. Nothing is more precious than time, and time spent early in the process figuring out whether the dogs will eat the dog food is priceless. There is no sense following your passion right off a cliff if a relatively small effort devoted to testing can keep you from that fate.  Better yet, that experimentation may allow you to discover a vastly better way forward that does not involve a journey off that cliff.

 

7. “’Build it and they will come,’ is not a strategy; it’s a prayer.” “Using the Product Development Waterfall diagram for Customer Development activities is like using a clock to tell the temperature. They both measure something, but not the thing you wanted.” The traditional product development process is described as a “waterfall” since the intent is to have progress flow down from step by step over time.

 

Waterfall Model

Source: Wikipedia

 

The syllabus of Eric Ries’s Udemy class on Lean Startup contrasts the approaches:

“Waterfall – the linear path of product build-out – is best used when the problem and its solutions are well-understood. However, its hazard is that it can also lead to tremendous investment without guarantee of its success. Agile development, on the other hand, is a less-risky model of what can happen when the product changes with frequent user feedback and minimal waste. Without an authoritative solution clearly in sight, which is often the case of the startup, agile programming allows the growing enterprise to build-out quickly and correct itself often.”

 

8. “The company that consistently makes and implements decisions rapidly gains a tremendous, often decisive, competitive advantage.” “What matters is having forward momentum and a tight fact-based data/metrics feedback loop to help you quickly recognize and reverse any incorrect decisions. That’s why startups are agile. By the time a big company gets the committee to organize the subcommittee to pick a meeting date, your startup could have made 20 decisions, reversed five of them and implemented the fifteen that worked.” The companies that survive in a rapidly evolving environment are those that are most agile. The Lean movement and agile development generally reference using a process of continuous experimentation and feedback from the results of those experiments to stay on top of changes.

Nassim Taleb describes this approach in this passage from Antifragile:  “Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it…” and “Someone who, unlike a tourist, makes a decision opportunistically at every step to revise his schedule (or his destination) so he can imbibe things based on new information obtained. In research and entrepreneurship, being a flaneur is called “looking for optionality.”

 

9. “Founders see a vision but then they manage to attract of a set of world-class employees to help them create that vision.” A founder who will succeed at creating a startup must be able to sell, and a very early test of that skill is his or her ability to recruit a team. Convincing world class people to join something with as much uncertainty attached to it as a startup is a genuinely valuable skill.  The best venture capitalists know that the first hires are critical so they will often help with recruiting especially at that stage. It is not uncommon for a founder to spend 25% or more of the their time recruiting the team that will ultimately drive the startup forward.

 

10. “You don’t have to be the smartest person, but showing up is 80% of the game. My career has been all about just showing up and people saying, ‘Who’s here? Blank is here. Let’s pick him.’ Volunteering and showing up has been a great thing for me. But all along the way, I’ve always been very good at pattern recognition. Picking signal out of noise. Not smarter than everyone else, but more competent perhaps at seeing patterns.” Things like being on time, being there when leaders and teams are chosen, and developing sound judgment, are the blocking and tackling of the startup/business world. Woody Allen once wrote in a letter: “My observation was that once a person actually completed a play or a novel, he was well on his way to getting it produced or published, as opposed to a vast majority of people who tell me their ambition is to write, but who strike out on the very first level and indeed never write the play or book. In the midst of the conversation, as I’m now trying to recall, I did say that 80 percent of success is showing up.” To create a startup or a new line of business you must first start. As an example, the way I wrote my first book was that I started writing. I didn’t know anything about book proposals, agents or the sometimes strange ways of the publishing world.  I just wrote a book and sent it to a publisher and they published it. What I did is not a process I would recommend now that I know more about the industry, but at least I started. By writing the book I “showed up.” Each weekend when a 25IQ “12 things” blog post appears, I “show up.”

 

11. “Upper management needs to understand that a new division pursuing disruptive innovation is not the same as a division adding a new version of an established product. Rather, it is an organization searching for a business model (inside a company that’s executing an existing one.)  When you’re doing disruptive innovation in a multi-billion dollar company, a $10 million/year new product line doesn’t even move the needle. So to get new divisions launched, large optimistic forecasts are the norm.

Ironically, one of the greatest risks in large companies is high pressure expectations to make these first pass forecasts that subvert an honest Customer Development process. The temptation is to transform the vision of a large market into a solid corporate revenue forecast – before Customer Development even begins.” People spend a lot of time at large companies coming up with optimistic market forecasts. They are often created using methods pioneered by Professor “Rosy Scenario.” Market research firms make a nice living supplying these forecasts. Lots of forecasts about the future have zero tie to reality. They are little more than imaginative story telling trying to convince people that an area with some optionality has promise. I like stories. Stories are very useful and can be fun to tell.  I have published two books of stories that you can buy on Amazon http://www.amazon.com/Ah-Mo-Indian-Legends-Northwest/dp/0888392443/ref=sr_1_1?ie=UTF8&qid=1413604348&sr=8-1&keywords=ah+mo+griffin and http://www.amazon.com/More-Indian-Legends-From-Northwest/dp/0888393032/ref=pd_sim_sbs_b_1?ie=UTF8&refRID=139GKX2N9KC8WDFG2E50 but they are just stories.

 

12. “I said ‘There are 500 people in this room. The good news is, in ten years, there’s two of you who are going to make $100 million dollars. The rest of you, you might as well have been working at Wal-Mart for how much you’re going to make.’ And everybody laughs. And I said, ‘No, no, that’s not the joke. The joke is all of you are looking at the other guys feeling sorry for those poor son-of-a-bitches.’” Financial success in creating and funding startups follows a power law.  This means that a very small number of startup founders, employees and investors will reap most all of the financial rewards.  The overconfidence heuristic will make most everyone overconfident that the winners will include them. The inevitable failures are hard for individuals, but the right thing for society as a whole.

 

Notes:

Entrepreneur in London – Steve Blank

Inc, Entrepreneurship – Six Types of Startups

Reuters – Q&A with Silicon Valley “Godfather” Steve Blank

Philadelphia University – Steve Blanks Commencement Speech

Francisco Palao – Best Quotes from the Lean Start up Conference

Stanford – Four Steps

LogoMaker – Thirteen Inspiring Quotes for Small Business from Steve Blank

A Dozen Things I’ve Learned From Guy Spier About Value Investing

1.“The entire pursuit of value investing requires you to see where the crowd is wrong so that you can profit from their misperceptions.”  A value investor seeks to find a significant gap between the expectations of the market (price) and what is likely to occur (value). To find that gap the value investor must find instances where the crowd is wrong. Michael Mauboussin writes: “the ability to properly read market expectations and anticipate expectations revisions is the springboard for superior returns – long-term returns above an appropriate benchmark. Stock prices express the collective expectations of investors, and changes in these expectations determine your investment success.”

Value investing is buying assets for substantially less than they are worth and, says Seth Klarman “holding them until more of their value is realized.” Klarman describes the value investing process as “buy at a bargain and wait.”  It is critical that the value investor not try to time the market but rather make the market their servant. The market will inevitably give the gift of profit to the value investor, but the specific timing is unknowable in advance. If there is a single reason people do not “get” value investing it is this point. The idea of giving up on trying to time the market is just too hard for some people to conceive. For these people, timing markets is a hammer and everything looks like a nail. That you can determine an asset is mispriced now relative to intrinsic value does not mean you can time when the asset will rise to a price that is at or above its intrinsic value. So value investors wait, rather than try to time markets.

 

2. “When we apply Ben Graham’s maxim that we should treat every equity security as part ownership in a business and think like business owners, we have the right perspective. Most of the answers flow from having that perspective. …thinking like that is not easy…”  When you treat shares of a company as an interest in a business (rather than a piece of paper to be traded based on mob psychology) you naturally think about private market value. Value investors have developed a valuation process for determining private market value that is very rational. The lynchpin of this valuation process is intrinsic value. While the process of determining intrinsic value is fuzzy (since methods slightly vary) that is ok, since the margin of safety can cover up small amounts of fuzziness if the margin of safety is sufficiently large (e.g., 25-30%). Investment firm Euclidean Technologies has articulated some of Buffett’s views on this valuation process:

“Buffett talks about book value as a measure of limited worth when estimating the intrinsic value of a business. After all, book value reveals very little about the operations of a company; it makes no distinction between a pile of cash and a company with productive assets, great products, and loyal customers. Instead, when evaluating intrinsic value, Buffett focuses on understanding the amount of cash that a business can generate and distribute to its owners.  He calls this concept owner-earnings…”  

In calculating a valuation of a business, many people fail to understand that value investing and growth are “joined at the hip.” Value and growth investing are not alternatives, but rather inextricably linked. Here’s Buffett:

“Growth is simply a component–usually a plus, sometimes a minus–in the value equation. Indeed growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.”

Some of the misunderstanding arises because some (but not all) value investors consider quality as a factor in valuation. Many people assume that looking at quality means a focus on growth, when this is definitely not the case. Quality relates to the ability of the business to generate higher return on invested capital.  In his new book Tobias Carlisle explains the difference:

“Earnings—central to [John Burr] William’s net present value theory—were only useful in context with invested capital. Despite his obvious regard for William’s theory, Buffett could show that two businesses with identical earnings could possess wildly different intrinsic values if different sums of invested capital generated those earnings…. All else being equal, the higher the return on invested capital, the more valuable the business.”  

Here’s Buffett on what drives the quality of a business:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”

Note that the way Buffett measures quality does not refer to reliance on a new growth input and most certainly not any macroeconomic factor. Quality is about relative return on invested capital!

Euclidean Technologies writes on return on capital:

“Buffett cares deeply about the magnitude and resiliency of a company’s long-term return on capital.  Return on capital is simply the relationship between the earnings a company generates and the amount of capital tied up in its business.  For example, a company that can consistently deliver $0.20 for every $1 in capital employed would show a robust 20% return on capital.  To Buffett, this would be a higher quality business than another that delivered a lesser yield or showed deteriorating, or inconsistent, returns on capital.  Moreover, this yield relationship between earnings and invested capital allows Buffett to view a prospective investment in relation to all other potential uses for capital…” 

What determines long-term return on capital? The strength of any barriers to entry (a moat) possessed by the business.  Unless you have a moat your profitability will inevitably suffer as competitors copy your success. If there is no impediment to new supply of what you sell, competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital. (Econ 101)

 

3. “All-too-often, we feel like we are forced to take a decision. Warren Buffett has often said that, unlike baseball, there are no ‘called strikes’ in investing. That is a truism, but the point is that too many of us act like it is not true. Amateur investors, investing their own money, have a huge advantage in this over the professionals. When you are a professional, there is a whole system of oversight that is constantly saying, “What have you done for me lately!” or in baseball terminology, ‘Swing you fool!’”

“Most of the time the answers are not to invest and to do nothing.” 

To profit as a value investor you must:

  1. find an instance where the crowd is wrong,
  2. that gap must be within your circle of competence, and
  3. the value of the asset purchased must substantially exceed the price paid (e.g., 25%), so you have a margin of safety which can allow you to profit even if you make a mistake or suffer from bad luck.

Since these three things happen at the same time only occasionally, most of the time you should do nothing. Since inactivity tends to be contrary to human nature, learning to be patient and yet aggressive when the time is right is a trained response.  This is part of the reason why value investing is simple, but not easy.

 

4. “I’m trying to manage myself, not just my portfolio.” Most mistakes made by investors are psychological or emotional. The task of managing yourself is all about avoiding those mistakes.  The work required to overcome emotional and psychological mistakes never ends.  You will never stop making some mistakes. But hopefully you can at least learn to mostly make new mistakes and to learn from the mistakes of others.  Paying attention and being a learning machine are essential. People who don’t pay attention are surprisingly common. As Seth Klarman writes in his book, Margin of Safety: “The greatest challenge for value investors is maintaining the required discipline.”  As an example, to be a contrarian you must be willing to sometimes be called wrong by the crowd. That will be uncomfortable for most all people.

 

5. “Leverage can prevent you from playing out your hand, because exactly the time when markets go into crisis is when your credit gets called.” Leverage magnifies your mistakes in addition to your successes.  Guy Spier is also saying that it can interfere with your ability to continue investing, since a called loan can take you out of the game. James Montier writes:  “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad. When you are leveraged, you can run into volatility that impairs your ability to stay in an investment – which can result in a permanent loss of capital.”

 

6. “Going forward, a 5% position will be a full position. An idea will have to be something absolutely extraordinary to become a 10% position and many positions in the portfolio are currently 2-4%.” It seems like Guy Spier has moved away from a Phil Fisher/Charlie Munger view on diversification, to something that is closer to what Graham himself believed. At these ownership levels, Spier is not at risk of being a closet indexer and yet he still has a comfortable level of diversification.  His new view on diversification seems consistent with views of Ed Thorp as internalized by Bill Gross and Jeffrey Gundlach.

 

7. “Value investors probably pay far too little attention to the credit cycle. In my case, I think that I was utterly convinced that my stocks were sufficiently cheap, such that I could invest without regard to financial cycles. But I learned my lesson big time in 2008 when I was down a lot. I now subscribe to Grant’s Interest Rate Observer so as to help me track the credit cycle.” Howard Marks has said he watches the business cycle but he has never actually said what he does with what he sees in the cycle. Marks seems to use his view on where the business cycle may be as a signal to raise more cash or send it back to his limited partners. Guy Spier seems to be saying he treats the credit cycle as a factor, in some unquantified way. I find myself increasing cash gradually as markets reach prices that are on “the high side of fair,” but I doubt this is based on some rational process and I don’t see any magic formula. Warren Buffett says he never pays attention to macro factors. But he is Warren Buffett and you and I are not. Not everyone has his discipline.

 

8. “I do not use short selling. The fund has not shorted a stock since the 2002 to 2003 time frame. At that time I did short three stocks, on which I broke even on two and made money on one of them. The experience taught me that I was not going to be using short selling going forward for a slew of reasons. The first is the straightforward logic of the matter. The trend of the market is up, not down. Shorting stocks puts you against that trend and thus makes it more difficult to make money. … Second, the mathematics of shorting – when you short something and it goes [against you], it becomes a bigger and bigger part of your portfolio, thus creating increasing risk as things go against you, making it an unbalanced and unstable thing to manage. By contrast, when you go long something and it goes against you, it becomes a smaller and smaller proportion of the portfolio, thus reducing its impact on the portfolio. So there is a tendency for long positions to self-stabilize in a certain way – they have a stabilizing effect on the portfolio, whereas short positions have a destabilizing effect on the portfolio.” Ordinary investors are significantly at risk when they short stocks. When I say something like this, people tend to extrapolate and say that I must favor banning shorting stocks. No, I don’t favor a legal ban. That something is unwise for an ordinary investor does not necessarily mean it should be made illegal. That people like Jim Chanos can (1) profit and (2) perform a socially useful function does not mean an orthodontist or a bricklayer should be shorting stocks.  If Guy Spier, Berkowitz, Pabrai, Buffett and Munger don’t short stocks (since it is “too difficult”) what chance of success does the ordinary investor have?

 

9. “If I’d not fallen under the sway of Warren Buffett, who knows, maybe I’d still be working at some skeezy place and if not committing financial fraud, then at least not serving society very well.” Guy Spier graduated from Harvard Business School and found out too late that he had gone to work for a business with questionable ethics.  Guy Spier credits Buffett and Munger with leading him away from the dark side of Wall Street. This is a good thing. Guy Spier’s publisher describes his book as revealing “his transformation from a Gordon Gekko wannabe, driven by greed, to a sophisticated investor who enjoys success without selling his soul to the highest bidder.”

Spier himself writes: “I think it’s important to discuss just how easy it is for any of us to get caught up in things that might seem unthinkable—to get sucked into the wrong environment and make moral compromises that can tarnish us terribly. We like to think that we change our environment, but the truth is that it changes us. So we have to be extraordinarily careful to choose the right environment—to work with, and even socialize with, the right people. Ideally, we should stick close to people who are better than us so that we can become more like them.”

 

10. “We know in particular that there is a class of investors who get excited about stock splits – even though they do not change the value of the business or achieve anything else substantive. By not catering to that group, Berkshire already makes significant strides in that direction of having a higher quality shareholder base.” “Decentralized organisms are more resilient to having their legs cut off and Berkshire Hathaway is the same way… as opposed to a command and control organization.” Regarding the first point, having better investors is a competitive advantage for a business.  It allows the business to invest for the long term and to be contrarian when it makes sense to be contrarian. Regarding the second point, Nassim Taleb points out:  “In decentralized systems, problems can be solved early and when they are small.” Decentralized systems are more robust to failure. If you ask Buffett how Berkshire ended up this way, he will say that it is just his nature. And of course it has worked very well. Charlie Munger points out that for this approach to work you must have a seamless web of deserved trust in which the decentralized managers are given the freedom to manage what they do and sufficient skin in the game to be properly motivated/aligned.

 

11. “The idea that we are managing some finely tuned machine is just not the case. I’m just trying to get it right. 55% of the time or get it slightly better 55% of the time.”  Guy Spier is pointing out that over time even a modest level of outperformance compounds in a beautiful way, if expenses and costs are kept low. Everyone will make mistakes but if you have a sound investment process you can be way ahead in the game. Mauboussin is the master of this area in my view: “While satisfactory long-term outcomes ultimately define success in probabilistic fields, the best in their class focus on establishing a superior process with the understanding that outcomes take care of themselves.”

 

12. “Mohnish Pabrai taught me to be a cloner. In the academic world, plagiarism is a sin. In business, copying other people’s best ideas is a virtue, and it is no different in investing. I would go further. In the same way that if I wanted to improve my chess, I would study the moves of the grandmasters. If I want to improve my investing, I need to study the moves of the great investors. 13F’s are a great way to do that.” As Charlie Munger likes to say, trying to learn everything yourself on your own from first principles is just too hard and takes too long. Learning from others and then working to extend that is the superior approach. Stand on the shoulders of giants whenever you can, but strive for more.  The other key point about cloning relates to business strategy and the business strategies of businesses that one may choose to invest in. Anything you do in business and investing will be copied and cloned. Continued innovation and adaptation are essential to success.

 

Notes:

The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, and Enlightenment

The Manual of Ideas – Interview with Guy Spier

Morningstar – “Don’t Be Your Own Worst Enemy” (video)

Seeking Alpha – The Art of Value Investing

Columbia GSB – Guy Spier: Build your Life in a Way that Suits You

Seeking Alpha – Q&A With Guy Spier Of Aquamarine Capital

Value Walk – Decision-Making for Investors, Michael Mauboussin

A Dozen Things I’ve Learned From Jeffrey Gundlach About Investing

Jeffrey Gundlach is always an interesting investor to watch, but recently he has become even more interesting given the news about Bill Gross leaving PIMCO.

It is useful to contrast his style with that of Bill Gross in an attempt to understand how the wheels came off the bus from Gross at PIMCO. Few things result from a single cause, but it Gundlach has been managing far less money than Bill Gross and the bigger a fund gets, the harder it is to outperform a benchmark index.

A bond manager must deal with many types of risk in addition to interest rate risk. For example, there are credit risks and duration risks. Gundlach is focused, as he should be, on mispriced risk. Where that risk may be at any given time will vary. So he or she is an opportunist. And in being an opportunist it is easier to outperform if your fund is not too large.  If your funds get too big, the portfolio can suffer. One can argue that Bill Gross suffered much the same fate as Bill Miller did before him in stocks. The fund grew too big and that became a drag on performance. in other words, at some point, being dubbed the bond king can become a ball and chain. I also suspect that changes in monetary policy and in markets generally after the 1987 fiscal crisis have made it even harder for bigger bond firms to outperform smaller competitors. Jeffrey Gundlach faces these same challenges as he grows his assets under management.

Gundlach once said: “When we started the company, our stretch goal was to reach $50 billion of [assets under management] within three years. We do not have a goal of trying to reach $100 billion any time in the foreseeable future. I don’t think we can add another $50 billion to [Total Return Bond] and still manage it the way we want to manage it. What you really don’t want to do is what the young guys do, and that is take every single dollar that is dangling in front of you.” “Closing something is sort of an abstract idea. In the first quarter of 2009, I probably could have invested something close to $1 trillion.  [But] those periods like early 2009 don’t happen all that often.” It will be interesting to see if he has the discipline required to close the fund to new money.  A recent paper argues that “a doubling in ‘bond king’ assets under management has been associated with a 10-20% decline in achieved alpha. As a result, historically a ‘bond king’ with a smaller asset base has outperformed a ‘bond king’ with a larger asset base.”

 

1.“The trick is to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.” Gundlach seems to be communicating the same view that has been also expressed by Bill Gross when it comes to following the advice that Thorp developed to beat the dealer in blackjack.  “Mr. Thorp: You have to make sure that you don’t over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss — but never more. If you bet much more you can be ruined, even if you have a favorable situation.” Taking in risk for its own sake is a sucker’s bet. More risk does not necessarily mean more investment return.

What can generate more return is mispriced risk on the part of someone else. As Howard Marks has pointed out, “if riskier investments necessarily delivered higher returns they wouldn’t be risky.”

Businessweek argues that until his recent spell of underperformance Gundlach competitor Bill “Gross did better by investing in riskier bonds…. Estimates from Morningstar suggest that relative to a bond index fund, Gross’s Total Return Fund is twice as likely to move in tandem with the Standard & Poor’s 500-stock index. Since the financial crisis, that spread has only widened—from 2009 to today, Pimco’s fund returns began to more closely resemble the S&P 500. (The opposite happened to the Total Bond Fund offered by Vanguard: It now moves inversely with the broad stock market.)” Now that the “bond king” spell is broken more investors will find their way into indexed funds instead of another actively managed fund. And some will seek the next bond king, follow Gross to Janus or move to Gundlach.  It will be interesting to watch.

 

2. “Avoid investment positions that have poor asymmetrical risk/return trade-offs.” This is straight up advice about the dangers of negative optionality. Investing in situations where there is a big downside and a small upside is a very bad idea. What an investor should seek is the reverse: a big upside and a small downside. Howard Marks puts it this way: “In order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.”

 

3. “We always try to ensure that we understand the risks we are taking and to avoid the risks for which the potential return is likely to be inadequate. For example, there are times when ideas become too popular and investors don’t understand the risks of an asset.” These statements by Gundlach are consistent with the views of Warren Buffett. To pick just three similarities to Buffett: (1) “I’d be a bum on the street with a tin cup if the markets were always efficient.”; (2) risk comes from not knowing what you are doing and (3) don’t follow the crowd. Investing has universal attributes. Buffett has said, and I doubt Gundlach would disagree: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value, at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price.”

 

4. “People love junk bonds because for some weird reason they feel [junk bonds] don’t have interest rate risk.” This is another example statement of Jeffrey Gundlach’s views that markets are not always efficient.  People who do not think rationally about a risk create opportunity for the investor. There are many heuristics that as a whole have been helpful to humans in evolution but which can be very dysfunctional in investing. People are “weird” about some things and that can be arbitraged.

 

5. “We try to be liquidity providers and get paid for that. That’s one of the things that tend to support outperformance over time — buying when other people need to sell. That’s always been part of our strategy.” Having cash when others need it can be a huge source of investment out-performance.  People for some reason get easily confused about the difference between cash and wealth. The reality of life is that sometimes people with a lot of wealth are unable to get their hands on cash. Predicting when those times will happen is impossible. When it comes to ash especially, it is better to prepare than predict.

The only unforgivable sin in business is to run out of cash.  If you have cash at the right times and can be aggressive at those times in buying assets at a bargain, you can do well as an investor. This will not be easy, especially today, since these are times of great uncertainty (e.g., we are increasingly living in Extremistan).

 

6. “I want fear. I want to buy things when people are afraid of it, not when they think it’s a gift being handed down to them.” Be greedy when others are fearful and fearful when others are greedy. One of the best times to invest is when uncertainty is the greatest and fear is the highest.  Gundlach is channeling Howard Marks and other contrarians. You can’t beat the market if you are the market. Sometimes you must be contrarian if you want to outperform a market and you must be right enough of those times to succeed. This is also consistent with the Mr. Market metaphor. Make the market your servant and not your master.

 

7. “There is one thing about being an asset manager. Timing is everything. The synonym for “early” in the investment business – is ‘wrong’.” Being a contrarian is not enough if you are wrong. You must be contrarian and right enough to beat a market index. Of course, it is magnitude of correctness that matters and not frequency.

 

8. “People always want investments to go up like a line.…That’s just not reality. You make 80% of your money in 20% of the time in investing and you have to be patient.” Success in investing and in life will be lumpy. Accepting that fact is a significant part of not only financial and career success, but happiness in life.

 

9. “To hold cash you have to have a conviction that prices of something that you’d otherwise own will go down.” Cash has optionality. That optionality has a cost that may or may not be worth paying. Whether this is worth paying depends on the circumstances and the time. I would rather have cash and not need it, than need it and not have it. As always, a margin of safety is wise and that statement applies to cash.

 

10. “One way you get high yields is taking interest-rate risk, but you don’t want a lot of interest-rate risk because interest rates are low and they could rise from time to time during the course of this year or could even break out to the upside ultimately in the future. In the nonguaranteed mortgage market, there is still a market that’s plagued with defaults. And the way to think about it is if those defaults get better, that would be the sort of scenario of higher interest rates and a better economy if the defaults slow down.

So actually those securities don’t have interest-rate risk, and yet you get paid for taking the default risk. So the secret is to marry together opposite moving investments relative to interest rates while getting paid on both sides of the trade, and that’s why we’ve been so successful with the DoubleLine Total Return earning those yields.” This is an interesting statement but it only works if the two bets are mispriced. If this trade or any other trade gets “crowded” it won’t work. Are there situations where there are two risk premiums to be earned? Yes. But that depends on price.

 

11. “The fundamentals are always important but it does get trumped by policy decisions when policy decisions are so radical as has been the case in recent years.” “One thing that is absolutely undeniable about quantitative easing is, it is reducing the supply or the float to the non-central-bank world. Reducing the float of high-quality assets.” The period since the financial crisis has not been a normal time for most markets, including the bond markets. How is that for an understatement? What may have tripped up Bill Gross: the penalty for having massive assets under management (AUM) may have grown significantly due to changes in factors like liquidity and volatility. Changes caused by (1) new and extraordinary monetary policy (2) changes in the markets as a result of changes in policy, have interfered with his long held theses regarding interest rate, duration, credit and other risks. It is now “the new abnormal”.

 

12. “I don’t often know where my ideas come from. Maybe it’s the fact that I’m obsessively regimented in my analysis, borderline autistic.” It has been my experience that some people who are borderline autistic can have a gift for rationality that can be very helpful in investing. This is not always true but I have seen it happen enough that I think what Gundlach says about himself is not a one-off case.

 

 

Notes:

Barrons – “The King of Bonds”

MastersFunds – Litman Gregory Alternative Strategies Fund Call

 

Morningstar – Gundlach: Stock Market Will Have Trouble Topping Bonds (video)

Bloomberg – Gundlach Leads Bond Funds

 

Business Insider – Jeff Gundlach’s Bloomberg Interview

ZeroHedge –  Gundlach on ‘Why Own Bonds?’

 

Bloomberg – Gundlach’s DoubleLine Waits To Buy Until Everyone In Fear

Financial Advisor – ‘Melt up’ in Bond Market Possible

Investment News –  An In Depth Talk with Jeffrey Gundlach (subscriber only)

A Dozen Things I’ve Learned from Eric Ries about Lean Startups (“Lattice of Mental Models” in VC)

Preface:

Charlie Munger uses a “lattice of mental models” approach to acquiring what he calls “worldly wisdom.”  Here’s Munger:

“What are the models? Well, the first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models…”

Eric Ries has created a very important model in the startup world that has risen to the level of a movement.  I find his ideas and the model to be very useful. Whether you agree or disagree with aspects of The Lean Startup, it is beyond question that Ries’ ideas and model have been influential to many successful founders.

That some people might have issues with his ideas which should not be a surprise to anyone. As an example, Tom Tungz has a post describing Peter Thiel’s critical views on Lean Startup.  Pinterest co-founder and CEO Ben Silbermann has also expressed issues with the methodology. Silbermann said he was glad he didn’t read The Lean Startup “because it might have convinced him to give up…” Silbermann’s advice: “Don’t take too much advice… Most people generalize whatever they did, and say that was the strategy that made it work… In reality, there’s very little way of knowing how various factors contributed to success or failure.” (Mark Suster has argued that it is best to triangulate when it comes to advice, and that takes this preface full circle to a multiple models approach, as I think this is essentially what Suster advocates.)

I don’t think Eric Ries has created the only useful model for startups, but it should be part of anyone’s lattice of mental models. Actively listening to alternative or different views (like Sam Altman presented this week) helps create that lattice of mental models effect.

Here’s my take on Eric’s ideas and the Lean Startup model in my usual format.

 

1. “If learning is the essential unit of progress for start-ups, any effort that is not absolutely necessary for learning what customers want should be eliminated. So how do we do that? By building what I call a minimum viable product—or MVP.” The process of creating a minimum viable product is based more on discovery than prediction. The business creates a less than fully developed but still “viable” product or service and offers it to a small number of early adopter customers to obtain feedback. The business efficiently and quickly learns what customers want through the MVP process. Society as whole benefits from the innovation produced when new approaches are tried, even if they mostly fail.

MVP is not the only way to build a business and is not the right approach in all cases. For example, an Elon Musk style business (e.g., launching rockets; building an automobile) is not a good candidate for Lean Startup methodology. But Lean Startup is a process which enables the business to reduce failures based on faulty predictions in a very cost effective manner.  Learning what you did wrong after all the resources are gone or the market opportunity has passed is part of what a MVP process is intended to avoid. If you aren’t a very experienced entrepreneur with a big financial backer, Lean Startup is a particularly attractive process. The principles can also be beneficial to organizations which are not startups. Large businesses, governments and nonprofits can also benefit from building a MVP, in the right circumstances.

 

2. “The question is not ‘Can this product be built?’ Instead, the questions are ‘Should this product be built?’ and ‘Can we build a sustainable business around this set of products and services?’” “Products a start-up builds are really experiments…Learning about how to build a sustainable business is the outcome of those experiments [which follow] a three-step process: Build, measure, learn.” “[A startup is] … an organization dedicated to creating something new under conditions of extreme uncertainty.” The only certainty in the world is uncertainty. Various forms of ignorance are also common. This uncertainty and ignorance is a very good thing for investors since it enables them to benefit from mispriced opportunity. By using a process based around experimentation, uncertainty can be incrementally “retired” and value created.

It is important to be crisp about what uncertainty actually is: future states of the world known, probability unknown. Ignorance is: future states of the world unknown. What you want to avoid is risk when the house has the advantage: future states of the world known, probability known. The Lean Startup process is designed to give a business quick feedback so it can adapt to a changing world. As Sam Altman said in his talk this week (linked above): “The best businesses have the tightest feedback loops.”

 

3. “The nice thing about relying on human judgment and using the scientific method is (we develop) a system for training judgment to get better over time.” Eric Ries’s point is that learning to be a better entrepreneur is a trained response. People who are paying attention while engaging in the startup creation process can learn by doing. Yes, some people actually do create a startup and learn little. Ries is also saying judgment about company formation gets better when it is systematized based on the scientific method. Of course, the primary cause of good judgment is bad judgment so it is best to (1) jump into the fray and learn via making some mistakes and having some successes and (2) engage with a community of others doing the same thing so you can learn vicariously from the successes and mistakes of others. Learning from the experiences of many people has a multiplier effect on the acquisition of good judgment.

 

4. “…every action you take in product development, in marketing, every conversation you have, everything you do – is an experiment. If you can conceptualize your work not as building features, not as launching campaigns, but as running experiments, you can get radically more done with less effort.” Here Ries is expanding the Lean concept beyond the product offering. Many aspects of a business can be turned into lean experiments. Marketing, for example, can be systemized in ways that reduce inefficiency. One caveat is that the Lean process shouldn’t be used as an excuse to rely on viral adoption that you hope will suddenly appear. If your product or services does “go viral,” great. But don’t count on that happening. Learn how to SELL.

 

5. “The two most important assumptions entrepreneurs make are what I call the value hypothesis and the growth hypothesis. … The value hypothesis tests whether a product or service really delivers value to customers once they are using it. … The growth hypothesis tests how new customers will discover a product or service.” A business provides value when it solves a genuine customer problem. Growth means the offering is able to generate significant revenues as product or service sales grow. Without value you don’t have a business and without growth you don’t have a startup (as Paul Graham has defined it). Some new businesses are not startups. There is nothing wrong with that. In fact, a business like plumbing or dentistry can be very attractive for some people since it is antifragile.

Andy Rachleff had a fantastic post this past week that provides definitions of these hypotheses and the right sequencing:

“Eric (and I) believes in order to increase the likelihood of succeeding, a startup should start with a minimally viable product to test what he calls a value hypothesis. The value hypothesis should state the founder’s best guess as to what value will drive customers to adopt her product and indicate which customers the product is most relevant to, as well as what business model should be used to deliver the product. It’s highly unlikely that a founder’s initial hypothesis will prove correct, which is why an entrepreneur has to iterate on her hypothesis through a series of experiments before product/market fit is achieved. As a consumer company, you know you have proved your value hypothesis if your business grows organically at a rapid pace with no marketing spend. Only once the value hypothesis has been proven should an entrepreneur test her growth hypothesis. The growth hypothesis covers the best way to cost-effectively acquire customers. Unfortunately many founders mistakenly pursue their growth hypothesis before their value hypothesis.”

 

6. “All of our process diagrams [in major corporations] are linear, boxed diagrams that go one way. But entrepreneurship is fundamentally iterative. So our diagrams need to be in circles. We have to be willing to be wrong and to fail.” The “build, measure, learn process” is one loop in a process. An example of a model for developing a customer is set out below.

Lean Startup Customer Development

 

A decision to pivot shouldn’t be taken lightly. Some founders pivot their way right into bankruptcy. Failing is not a good thing. Instead, having the ability to fail and then possibly still recover is a good thing,

 

7. “Innovation accounting works in three steps: (1) Use a minimum viable product to establish real data on where the company is right now. (2) Startups must attempt to tune the engine from the baseline toward the ideal. This may take many attempts. After the startup has made all the micro changes and product optimizations it can to move its baseline toward the ideal, the company reaches a decision point. That is the third step: (3) Pivot or persevere.”  If “the dogs aren’t eating the dog food”, that is the outcome of the trial and error process. The business can then either pivot (try a new approach) or move on.  In one sense the tuning process is many small pivots that are improving the offering, leading to a big decision that may lead to a big pivot. Pivoting is not something that should be desired. The better outcome is to stay the course and persevere. If you are doing a big pivot, you have made a mistake. Mistakes are costly.  That one might be able to sustain a big pivot and still win is a feature of The Lean Startup process, but it is not a goal.

 

8. “The mistake isn’t releasing something bad. The mistake is to launch it and get PR people involved. You don’t want people to start amping up expectations for an early version of your product. The best entrepreneurship happens in low-stakes environments where no one is paying attention, like Mark Zuckerberg’s dorm room at Harvard.”  Some people argue that early adopters can actually be skeptical of an offering from a startup that is too polished. That’s an interesting thesis but unproven I think. I look at it this way: A business which over promises and under delivers can quickly die. My friend Craig McCaw has said to me several times: “You can spend the rest of your life recovering from a bad first impression in business.”

 

9. “Startups employ a strategy, which includes a business model…” “The Lean Start up process is a method that can be used to create or refine a business model, a business strategy and/or a business design.” This quotation requires some agreement on definitions. A business model is a concept people often misunderstand. Mike Maples Jr. puts it this way: “A business model is a way a business turns innovation into economic value.”  The business objective is simple, says Bill Gates: “Take sales, take costs, and try to get this big positive number at the bottom.” I believe that the best business models are built around mechanisms which generate barriers to entry (a moat).

A business model is very different than a business plan, which is a written document setting out what a company will do in the future. A business plan is only as good as the assumptions that underlie it. Steve Blank points out: “Unless you have tested the assumptions in your business model first, outside the building, your business plan is just creative writing.” Business strategy is yet another concept and refers to the manner in which the business strives to be unique. Business design is the totality of everything a business must do to be a success.

 

10. “You need the ability to ignore inconvenient facts and see the world as it should be and not as it is. This inspires people to take huge leaps of faith. But this blindness to facts can be a liability, too. The characteristics that help entrepreneurs succeed can also lead to their failure.”  Optionality is most often found in places where others are not looking or not seeing what is actually happening. This is why venture capitalists are looking for businesses that seem half crazy. Most things that are crazy are actually nuts, but once in a while there is a huge opportunity no one has discovered yet.  As I’ve said many times before, there is no optionality in following the crowd. The entrepreneur’s blind faith is both how new products and services are discovered and why many businesses fail. Failures vastly outnumber successes but the impact of the successes outweighs all the failures. It is magnitude of success and not frequency of success that makes the process worthwhile for society (the Babe Ruth Effect).

 

11. “New customers come from the actions of past customers.” “The speed of growth is determined by what I call the rate of compounding, which is simply the natural growth rate minus the churn rate.” “Each customer pays a certain amount of money for the product over his or her “lifetime” as a customer. Once variable costs are deducted, this usually is called the customer lifetime value (LTV).”  My favorite post on the lifetime value model is by Benchmark Capital’s Bill Gurley. I like to say that ARPU, COGS, CPGA, churn, and WAAC are the Five Horsemen of the Business Apocalypse. Each Horseman is deadly and can kill you on their own. Understanding each Horseman is worthy of a book or two, or at least an article. Tom Tunguz has a nice essay on churn here.

 

12. “Anybody can rent the means of production, which means entrepreneurship is becoming truly democratized, which means nobody is safe.” This is a fundamental opportunity and challenge in business today. Profit is generated by a barrier to entry (otherwise price drops to opportunity costs) and barriers to entry (moats) now have shorter lives than ever before.  Warren Buffett writes: “All economic moats are either widening or narrowing, even though you can’t see it.” Occasionally you will see someone say that moats don’t matter anymore. This sort of thinking is rubbish. The idea that supply of products and services from competitors does not matter to a business result is the business equivalent of insanity. When this principle is forgotten, as it was by Jonathan Schwartz while at Sun Microsystems, the result is a disaster. Moats are more important than ever, but they need to be renewed more than ever as well.

 

P.S., Nassim Taleb has described why a Lean Start Up approach works well: “it is in complex systems, ones in which we have little visibility of the chains of cause-consequences, that tinkering, bricolage, or similar variations of trial and error have been shown to vastly outperform the teleological—it is nature’s modus operandi. But tinkering needs to be convex; it is imperative…. Critically [what is desired is to] have the option, not the obligation to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.” This is what is known as positive optionality. As an example for a venture capitalist, all they can lose is 100% of what they invest and what they can gain is potentially many multiples of that investment – which gives them positive optionality. Success is found via negativa.

 

Notes:

Principles of Lean Startup Methodology

FastCompany – Eric Ries is a Lean Startup Machine

McKinsey – Interview with Eric Ries

Inc – Eric Ries on Usability, Testing, and Product Development

Reuters – Bringing Order to the Unruly World of Early Stage Entrepreneurship

A Dozen Things I’ve Learned from Bill Gross

This is a special rushed edition of my usual post given today’s news. I planned to post this in two weeks, but it is more interesting today. I had already collected the quotations last weekend, but had not written the usual commentary. Since it is a rushed edition (I read the news less than an hour ago at 6AM), there is less commentary than usual, but most of the quotes are self-explanatory.

 

1. “I picked up Ed [Thorp's] book in early 1966. I got in an automobile accident and had to go into the hospital and had time to practice the card-counting technique he discovered. And it worked! I had $200, so I headed out to Las Vegas. I turned my $200 into $10,000. I didn’t care about the money. I wanted to prove that you could beat the system. Then I thought about what I could do that takes the same skills. I realized it was investing.” “My early blackjack career taught me several things. The first is that if you apply yourself with a lot of hard work and mathematical prowess you can beat the system.” “Many of the same principles I learned from blackjack apply equally to equities as to bonds. First, spread your risk. Cards run hot and cold, so be prepared. Second, as far as possible know your risks. Quantify them, predict the consequences, and prepare how to react.” “It’s just like in blackjack. That puts the odds in your favor. If you don’t bet too much and if you stay at the table long enough, the odds are high that you are going to go home with some extra money in your pocket.”  “Dice have no memory and, it’s said, the only way to win at roulette is to steal from the table. Blackjack is not chance. It is not an independent trial process; rather the cards played affect the odds on subsequent hands. So, situations emerge that give the player the advantage, situations where the house edge can be overcome. It requires discipline, dedication and skill, but it can be achieved. You learn to predict what the next card might be, whether it is likely to be high or low. You may be frequently wrong, but if on average you come out on top, you win in the long term. And I like winning.” Investing is like gambling, but it is not gambling. Knowing the difference between gambling and investing is important. Investing is a potentially net-present value positive activity (the likelihood of the net present value of the potential benefits minus the likelihood network present value of the potential loses, is positive) whereas gambling is not. Gambling is a form of present-moment consumption and the net present long-term value of the activity is negative.

 

2. “Gambling is viewed negatively because the average gambler is emotional, undisciplined and often desperate. A card counter has a method to assess and evaluate the probability of future events. This probability theory is based on mathematics. Cards dealt are cyclical challenges. The blackjack player, like the professional investor, tries to develop the skill to predict the cyclical challenge to ensure success over the long term. Our bets don’t always succeed, but we win often enough to come out well ahead.” As stated above, at a fundamental level, investing is just one form of making a bet. It’s essential, however, that the bet be made in a way that is investing (net present value positive) rather than gambling (net present value negative).

 

3. “I am not a quant. I don’t have a 150 IQ… put an amount of suspicion in the modelling of anything. The model could get broken by animal behavior.” “I am more of a subjective, seat-of-the-pants guy, although I appreciate the need for mathematical analysis and modelling. Unlike card games, human nature changes the rules of economics with the potential to punish anyone who relies too much on any one system, no matter how consistent it has been over time.  I would say that human nature is a consistently inconsistent input into a model.” Gross does not believe that humans are perfectly informed rational agents or in the efficient market hypothesis. He believes in using multiple models.

 

4. “Big bets are crucial. You need to make them when you believe the odds are in your favor, but big bets can go spectacularly wrong. I always set aside 50 times my maximum bet to avoid significant loss through a bad streak. We apply the same principles at PIMCO with risk management being one of our highest priorities. We can and have lost bets, but we are well hedged and can stay in the game. …Ed’s basic thrust concerns the idea of gambler’s ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot. Here at Pimco, it doesn’t matter how much you have, whether it’s $200 or $1 trillion. You’ll see it throughout our portfolio. We don’t have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that’s a big part of our success.” You will see below that he has made a different statement when it comes to stocks. Part of a Wall Street Journal Interview is explanatory:

5. Mr. Thorp: You have to make sure that you don’t over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss — but never more. If you bet much more you can be ruined, even if you have a favorable situation.

WSJ: Your key risk-management strategy is known as the Kelly Criterion. What is it?

Mr. Thorp: It’s a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge.

Mr. Gross: Ed’s basic thrust concerns the idea of gambler’s ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot.

Here at Pimco, it doesn’t matter how much you have, whether it’s $200 or $1 trillion. You’ll see it throughout our portfolio. We don’t have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that’s a big part of our success.

 

6. “Do you really like a particular stock? Put 10% or so of your portfolio on it. Make the idea count … Good [investment] ideas should not be diversified away into meaningless oblivion.” This is what Charlie Munger calls “focus investing.” What Bill Gross is recommending here for a stock, is very different from how he diversifies in bonds as explained above.

 

7. I learned in 1966 with blackjack, where although odds were many times in my favor, if you took too much leverage and had too much debt, then the house of cards will come tumbling down.”  “[Minsky was] a relatively unknown economist whose work helped us save billions. His Financial Instability Hypothesis influenced PIMCO’s Paul McCulley resulting in us developing a strategic plan to avoid the subprime meltdown well ahead of time. Minsky argued that Wall Street encourages businesses and individuals to take on too much risk, creating ruinous boom-and-bust cycles. Sounds familiar, wouldn’t you say?”  As Charlie Munger has said: “Three things ruin people: Drugs, liquor and leverage.” Leverage magnifies not just the upside but the downside. If things go wrong having a loan that can be called by a lender dos snot allow you to let your hand play out.

 

8. “The longer and longer you keep at it in this business the more and more time you have to expose your Achilles heel – wherever and whatever that might be.” Black Swans happen. People stop getting lucky.  Stuff happens.

 

9. “It’s sort of like a teeter-totter; when interest rates go down, prices go up.” “All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Perhaps it was the epoch that made the man as opposed to the man that made the epoch.”  That publications like the Wall Street Journal need to repeat in virtually every article about bonds that interest rates and bond prices move in different directions is a clue that this market is less well understood.  Bond investors have been surfing a trend toward lower interest rates for some time. Load up on bonds and even leverage up as well and you can look like a genius until you don’t.

 

10. “An effective zero percent interest rate, as a price for hiding in a foxhole, is prohibitive.” “Central banks and policymakers are acting like barbers. They haircut your investments.  Negative real interest rates, inflation, currency devaluation, capital controls and outright default are the barber’s scissors.” “In a rising interest rate environment over time, a portfolio manager might rely less on maturity ‘horses’ and depend more on the ‘machine guns and flamethrowers’ associated with credit, volatility, curve and currency.” There are many types of risk and uncertainty that someone like Bill Gross manages that are not just interest rate risk.  Each is potentially a source of profit or loss.

 

11.“PIMCO’s foundation is one that attempts to analyze what we call the secular outlook, which means, for us, the next three to five years.“  “Secular analysis …examines geopolitical, social and demographic trends to anticipate what may occur. Cyclical trends affect the market over the shorter term, such as new producer price index figures or changes in the federal funds rate. Taken together they tell us where to invest our clients’ money – domestically or internationally, more interest rate risk or less, high quality or high yield. This approach improves our ability to consistently add value over the long term. “Successful money management over long periods of time rests on two, somewhat disparate, foundations. The first is “a secular outlook…. forces one to think long term and to avoid the destructive bile arising from the emotional whipsaws of fear and greed. Such emotions can convince any investor or management firm to do exactly the wrong thing during “irrational” periods in the market. The second foundation is what might be called the “structural” composition of portfolio management, and whether the reader agrees or disagrees with the secular thesis, I would argue that those who fail to recognize the structural elements of the investment equation will leave far more chips on the table for other, more astute investors to scoop up than they could ever imagine. A portfolio’s structure is akin to its genetic makeup: It is how it is constructed without regard to short-term strategic decisions. Structure incorporates principles that are longer than secular, principles that are nearly paramount and should be able to deliver alpha during years when the manager’s magic touch—to use a basketball metaphor—seems to have disappeared or when there’s simply a time-out on the court, with secular investment opportunities few and far between. Duration, curve, credit, volatility, and other less obvious tilts to a portfolio’s steady state status are what I mean when I speak of a portfolio’s inherent structure, although some tilts are more volatile than others and, therefore, produce less risk-adjusted alpha.”  “Financial structure [is] almost guaranteed to generate a positive return on capital.”  “Closer to portfolio managers is the structure of Warren Buffett’s Berkshire Hathaway, which depends on “float” (about which he frequently writes and talks). This structure, combined with his bottom-up, secular stock picks, has produced one of the world’s great fortunes and investment success stories.” “In addition to their profit-generating elements, these structures share the common element of longevity, near permanence. They span time periods beyond the secular segments of three to five years, which define typical forecasting periods, and secular stretches of inflation/disinflation that have endured for several decades. An investment’s structural magic, then, comes from its ‘Methuselahian’ ability to persist.” This immediately above is the best summary of Bill Gross’ investing thesis I can find. Cyclical, secular and structural are all key concepts for Bill Gross. He has an investing thesis/methodology that is not easy to execute on.  Cliff Asness essentially said this week in an interview that he would not want to make his living making macro economic predictions.  I agree with Asness.

 

12. “We are on the edge of uncertainty. It is almost like Columbus is sailing to the New World, all the time wondering whether the earth is flat and whether the Santa Maria would fall over the edge at any minute. That is the biggest amount of uncertainty – which is enormous – and is reflected in the violent changes in financial markets.” As Nassim Taleb likes to say, we are increasingly living in Extremistan. Be careful out there.

Notes:

 

http://online.wsj.com/articles/SB120614130030156085

 

http://www.aaii.com/investing/article/bonds-investing-faqs?adv=yes

 

http://www.ici.org/pubs/faqs/ci.faqs_bond_funds.print

 

http://www.investinginbonds.com/learnmore.asp?catid=3&id=383

 

http://www.moneymasters.com/default.aspx?page=GrossWilliam

 

 

A Dozen Things I’ve Learned from Henry Ellenbogen

The investments of Henry Ellenbogen’ s New Horizons Fund are particularly interesting since they span both public and late-state private markets. While his late-stage private investments are only about 2-3% of the total assets of the New Horizons Fund, they have disproportionate visibility.  Since he joined the fund in 2009 Ellenbogen has invested in five to seven private companies per year.

Ellenbogen’s investing results speak for themselves. Barron’s writes: “Ellenbogen, is up an average of 23% a year over the past five years, versus 14.7% for the Russell 2000.”

 

1. “I like it when the company has come up with a product, service or strategy that is unique and visionary enough to change its industry.” Ellenbogen is looking for a business with an underappreciated ability to create or extend a moat in a big market.  The asset must be available at a price which is significantly below its value. As is the case with any asset, Ellenbogen wants to find a business with “a fundamentally better business model”  (unique) which is “durable”  (sustainable). All of this is consistent with fundamentally sound investing principles and many funds do this. What makes Ellenbogen unique and attracts most of the interest people have in his fund is the late-stage private investing. Yes, other mutual funds do late-stage private investing (as do some hedge funds), but few do so as often, as consistently or with the same level of success and influence.

In the case of Ellenbogen’s late-stage private investments, there are several potential sources of mispricing that can create an investment opportunity.  First, the ability of the business to create or extend the moat can be underappreciated since the investment thesis is contrarian or not recognized since it involves optionality.  Second, Ellenbogen’s fund can be offered a discounted price since it is willing to hold assets which are not very liquid.  Third, the shares may be discounted since the business raising the funds values staying private to avoid scrutiny or delaying the compliance obligations of a public company. Fourth, the business may need to raise cash quickly and is not ready for an IPO process so Ellenbogen is given a favorable price due to his ability to act swiftly.  Fifth, Ellenbogen’s fund may be given a favorable price since they do not impose onerous governance requirements. Sixth, the fund may be allowed to buy at a favorable price since Ellenbogen is putting a seal of approval on a company prior to an IPO given his track record.  The combination of factors involved in valuation and setting deal terms (e.g., any liquidation preference) of a given late-stage private investment will vary based on the unique circumstances of the business and the current state of the markets. But it seems that private businesses often find that Ellenbogen offers a particularly attractive combination as a late-stage investor.

 

2. “The appeal of the small-cap growth firms I buy is that they reward patient buy-and-hold investors.” “The trick is identifying companies and having the patience to hold onto them. Both parts are equally hard. Sometimes one of the best things I do is resist the desire to trade.”  Ellenbogen invests in firms that are less liquid and less traded than big public companies since they are small-capitalization or private. This means the assets are more likely to be mispriced. The trade-off is that the value of the fund’s assets can be more volatile and irrational at times. This approach requires discipline and the ability to stay the course not only from Ellenbogen but the fund’s investors. Ellenbogen is saying that sometimes the best thing to do is nothing.

 

3. “I tend to have a high quality screen. I focus on free cash flow per share. Those companies tend to be able to fund their own growth. That tends to make them less volatile over time.”  Ellenbogen is focused on the ability of a business to generate free cash flow. Businesses which are not reliant on the constant kindness of the capital markets for new cash are less volatile.  People too often forget that sometimes, without warning, the ability of a business to come up with new sources of cash from third parties can completely disappear. This is potentially dangerous since the only unforgivable sin in business is to run out of cash.  If a company can generate its own cash Ellenbogen believes the business is of higher quality.

 

4. “I look for businesses that I am confident can grow their earnings at above-average rates —15–20 percent — for at least the next 10 years.  Consistency is the key. I shy away from red-hot companies with soaring growth that get all the headlines. Those stocks often crash and struggle to recover when growth slows or investors find something more exciting. Sustainable growth gives me the discipline to hang on to a stock year after year.”  These are the some of the same qualities in an investment which are sought by Warren Buffett and other value investors, the only difference is that Ellenbogen includes technology investing within his circle of competence. While Ellenbogen is sometimes labeled as a growth investor and his fund a “small-cap growth fund,” I see a fund that is run with value investing principles in mind.  While he is not a cigar butt investor, Ellenboggen appears to me to be a Phil Fisher-style investor who wants to buy good companies at good prices. One of his tests for “goodness” is consistency.  A very smart friend of mine points out: “If you are only looking at trailing twelve month numbers on earnings growth and ROIC, then you can’t distinguish from a company being truly high quality or just at a peak in its business cycle.” Looking at trends lasting for several years is what is important for an investor like Ellenbogen.

 

5. “The ability to grow revenue at a double-digit pace is really, really hard to do over an extended period of time, and to be able to compound wealth at 20% or more is very rare.”  “We own 250 stocks, and among our top 20 holdings, it’s rare to find a name that was added to the portfolio within the previous three years. There is a very long tail at the bottom with position sizes smaller than 25 basis points [one-quarter of a percentage point]. These tend to be early-stage companies – some of them privately owned – and there is a high failure risk.”  Managing a portfolio of 250 stocks is not an easy task for Ellenbogen or any fund manager, especially when it consists of small capitalization stocks and late stage private investments. You can’t do this successfully without a lot of hard work and a sound process. For example, position sizing is critical (position sizes in his portfolio will not reflect a bell curve).  It is worth pointing out that another fund holding 250 large capitalization public stocks would be closet indexing. Ellenbogen is able to avoid this problem only because his is a small capitalization and late stage private investor.

 

6. “Warren Buffett credits the compounding of interest as one of the keys to his wealth. But it’s also the compounding of earnings growth over long periods of time that pays off big. A company whose earnings growth averages 20 percent a year for 10 years will see earnings rise six fold over that time, thanks to compounding, and I expect to see its stock price rise by that much as well.” Both feedback and compounding are everywhere if you know where to look. Charlie Munger puts it simply: “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.” Buffett was once asked how someone can get smarter. Buffett then held up a stack of paper and said: “read 500 pages like this every day. That’s how knowledge builds up, like compound interest.” Lots of other things in life compound, like hiring great people or retaining happy customers. Ellenbogen is saying that earnings also compound and that this compounding will inevitably be reflected in the stock price over time.

 

7. “If we can find one or two outlier companies, and — it’s a big ‘and’ — we have the discipline to hold on to them over an extended period of time, that is the majority of the battle.” It is not frequency of success but overall magnitude of success that determines return.  Ellenbogen understands what Michael Mauboussin calls “the Babe Ruth effect.”  You can win big even if you strike out lot, if you hit a lot of home runs. Ellenbogen is also saying that being a contrarian is hard and requires significant discipline.

 

8. “Companies that do require a lot of borrowed capital have a hard time maintaining consistent growth rates. They often can’t borrow at favorable interest rates when they need money the most—during downturns in the economy.” Markets love to loan money to companies when they don’t need it. But when companies do need to borrow in a downturn or cash cunch, the price of leverage is high. Mistakes are magnified in periods like this.  Ellenbogen particularly likes companies such as Amazon, which can benefit from “negative working capital.” Bill Gurley describes the phenomenon of business with negative working capital: “They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero.”  As another example, businesses which can benefit from cash “float” like Amazon, Berkshire and large “too big to fail” banks have a structural advantage.

 

9. “One question we ask here is: Does management have the mindset to lead the company to a second act, which is what you need to become a billion-dollar company” “Every once in a while we see a business that can become much larger that’s also run by a person who has the ability to make it larger.” When someone is investing in the late-stage private market they are typically investing in a company that has substantial momentum. In such a case the question for Ellenbogen is: can it scale in a much bigger way? He is searching for a second layer of optionality that from the optionality which took the business to where it is when he invests. In other words, what he wants to find is a business which most people don’t realize has the equivalent of the second stage of a rocket that will send it even faster into space.

 

10. “We make our share of mistakes.” The most important thing to do if you find yourself in a hole as a result of making a mistake is to stop digging. What is past is past. What is sunk is sunk. Thinking you don’t make mistakes is a one-way ticket to Hubrisville. Your investment decisions won’t always succeed, but as long as you win often enough to come out well ahead, you have a sound investing process. Your frequency of success as an investor will never be perfect.  Any individual failures must always be considered in relation to magnitude of overall success.

 

11. “We have a view of what fair value is. We use ranges as opposed to absolute points.”  Any estimate of the value of a business is an estimate since future payments are not an annuity from a risk free issuer. Even the concept of intrinsic value Warren Buffett calls “fuzzy.”  Value is best thought of as a range and it is better to be approximately right than precisely wrong. Your goal should be to buy an asset at a bargain which is so big that your investment will be profitable even if the estimate is fuzzy.

 

12. “…we pay attention to the macro environment, but it’s not what drives our focus. We are looking for companies that compound wealth over extended periods of time, through economic cycles.” That the macroeconomic environment is interesting and that people love to speculate about it does not mean that the information is actionable. To If you focus on the micro (the value of the individual business) the macro (the state of the economy) takes care of itself.

 

Notes:

Bottom Line Publications – Five Companies You Haven’t Heard Of…Yet

Bloomberg – Ellenbogen Wins With Best Small-Cap Fund: Riskless Return

 

Barrons – Pick Wisely, And Wait

PEHub – One of the Most Powerful People in Silicon Valley? He Lives in Baltimore

 

Forbes – Towering Returns

NYTimes – Is Online Retailing A Victim of Its Own Success?

 

Twistity – What Home Run Stocks have in Common

Barrons – Investing in the Next Great Companies