The Future To Bet On

Investors should focus on what’s important and knowable. Yet the future, which determines everything that investors do now, is unknowable.

If the future is far from certain, how can any investor make a decision today?

I reconcile the contradiction using “endgames”. The path to the future may be unpredictable, but certain parts of the destination are clear when backed by overwhelming logic.

There are two endgames that I think would happen (these should address the most common questions from readers of my annual letter).

Don’t fight the Fed and the world

The first endgame is low to acceptable inflation. The current narrative of lasting high inflation is very likely unsustainable.

Because every central bank is formed to fight high inflation. Traders quip don’t fight the Fed, or any central bank for that matter (Soros may disagree).

Another reason is the commoditized nature of most products and services. They have trouble raising prices because of competition and lack of differentiation. Cutting prices to get more customers is also not sustainable. Competitors would respond in kind, resulting in an end state where everyone makes just enough (usually meager) profits to survive. This is the brutal reality for most businesses.

For inflation to be high, most businesses have to raise prices in concert with competitors. This means that most businesses have to risk dealing with detrimental competitive responses.

Why would any business want to take the risk? My guess is they have no other choice. Costs have increased so much that they are certain every competitor has the same issue. Hence they are certain that no competitor would cut prices when they raise prices.

The reader should find the aforementioned extraordinary. How can costs increase for every business, given diverse inputs/niches/geographies/customers, all at the same time?

History has shown that would only happen when the most fundamental inputs become expensive. One example is energy. The formation of the OPEC cartel in the 1970s increased energy prices so much that no business is spared.

Other examples are labor and transportation. Covid has reduced the supply of aggregate labor so much that, again, no business is spared. So wages have to rise in aggregate. Policies to reduce the spread of Covid have slowed supply chains to a point that transportation costs have increased in aggregate.

The whole world is united to eradicate Covid. Just as no one should fight the Fed, no one should bet against the will of the entire world to end Covid. When Covid eventually passes, costs of common inputs would stop increasing, and inflation would moderate.

Bet on value-creating machines

The second endgame is companies creating the most value would prevail. This seems redundant to say, but it is a timely and timeless reminder

My investments are lagging market indices by the widest margin since the inception of FRC. But price may not be an accurate indicator of value.

A rising stock price does not mean that the underlying business is doing better, and a declining stock price does not mean that the underlying is doing worse. This is because stock prices are nothing more than the collective behavior of many buyers and sellers, many of whom transact without any concern for underlying businesses.

Ben Graham once said that the stock market is a voting machine in the short run, and a weighing machine in the long run. While price and value may disconnect in the short run, price eventually catches up to value, for better or worse.

That is why I am invested in value-creating machines. They continuously create value, and their best years of exponential growth are still ahead. Their consistent value creation would eventually be recognized by their stock prices.

The stock prices of these companies are lagging because of expectations of rising interest rates. Fears of persistent inflation (which I hope are dispelled at this point) have led to expectations for rising interest rates. Rising rates depresses the value of future cash flows. The further out the cash flows are in the future, the less valuable they are (given standard yield curves). So companies with cash flows now seem more valuable than those with future cash flows.

This phenomenon is so pronounced now that the valuation for the S&P 500 (proxy for the former) exceeds that for the S&P 600 (proxy for the latter) by the most in 20 years.

Neither Covid nor high inflation would be persistent in my opinion. Rising interest rates, by extension, would also not persist.

Over the long-term, what truly matters is the sum of all cash flows, both current and future. Near-term volatility may make a convincing but mistaken case in valuing one over the other.

When interest rates stabilize at a level higher than they are today, there would be little impact to value-creating machines with high returns on capital and long growth runways. It won’t be the same for weak companies. The higher costs of funding means they have less capital to burn to gain traction, and would be insolvent sooner rather than later.

Rates cannot differentiate between good and bad capital investments. The market is selling every company making large capital investments, even those making good capital investments that would yield high returns

Both Sea Limited and Roku, discussed in my letter, make high returning capital investments (see table below)

5Y incremental revenue ROIC 5Y incremental gross profit ROIC
Sea Limited137%42%
Roku200%100%
ROIC=Return on Invested Capital. ROIC measures the return on capital invested in assets, excluding cash and some working capital items. Revenue and gross profit are used because they are relatively more difficult to manipulate than lower line items in the income statement. They also tend to lead GAAP net profits and cash flows. Incremental figures indicate trends more than standard point-in-time figures.

These are incredible returns. Compare them to other best-in-class companies for context:

5Y incremental revenue ROIC 5Y incremental gross profit ROIC
3M19%6%
Disney14%-3%
Microsoft97%72%

Great returns in the past may not last. That is why value-creating machines must also have long growth runways sustained by positive feedback cycles (mentioned in my letter) and grounded and inventive leaders (also mentioned in my letter).

If these companies create so much value, why are their stocks prices so volatile, and when would the market realize their potential?

Human nature, and the market by extension, prefers the certain and the now. A bird in the hand can be worth two in the bush, but most would prefer the former than the latter.

It’s uncertain that value-creating machines would continue to grow and eventually show profits. Investors can only guess at the future, and guesses can fluctuate wildly and make stocks volatile.

But value-creating machines actually have futures that are clearer than what most investors think. Their attributes underlie my confidence in their endgames.

When would the market agree with me? My best answer is to allow time for it to happen. Invest in companies that are likely to deliver growing top-notch fundamentals, monitor to make sure they’re delivering, and …

wait.

There is really no better answer.

Human nature is impatient, because waiting introduces uncertainty. That’s why quality detailed research is prized. Good research reduces uncertainty.

But the analysis for truly big gains in stocks fits poorly in a spreadsheet. No analyst would dare to model 50% growth in revenue for 5 years. A regression to mean growth rates seems more certain and likely to be accepted by peers, regardless of the company in question.

To seek certainty is to wait as little as possible. To gain acceptance is to differ as little as possible. Combine the two and you get short-term group-think, the concoction for low returns.

To get truly big returns is to do the opposite – long-term independent thinking. The truly big gains requires living with the uncertainty of waiting, independence from peers, and above all the courage to do both.

In my letter, I discussed why deep understanding is important. The point is not to simply know more, but to know what matters. And what matters, after you find a value-creating machine, is to be a true owner.

True owners know what matters in their assets. They stick to fundamentals, and are not easily shaken by non-fundamental reasons. They see their assets through temporary difficulties, as long as the key drivers are intact. They are able to manage the emotional discomfort of uncertainty and independence.

While true owners may not be right on every bet, their mentality allows a fighting chance at truly big gains.

I knew a financial advisor who always said to stick to what’s comfortable in stocks. I suspect his clients would had done better if he were a realtor or car salesman.

Behave well. It offers the best chance in dealing with the unknowable future.

How to be right (2021 letter to partners)

Topics: The beacon; thinking right; thinking the right things; our investments; the price of being right

Dear partners and friends,

YearFRC ReturnS&P 500 Total Return
201766.1%21.8%
2018-7.9%-4.4%
201919.9%31.5%
2020139.5%18.4%
2021-25.4%28.7%
   
CAGR since inception26.8%18.5%
Cumulative since inception227.8%133.3%

Farm Road Capital lost 25.4% in 2021, while the S&P 500 gained 18.5 %. From inception in 2017, FRC gained 227.8%, while the S&P 500 gained 133.3%.

The S&P is a formidable foe. Only 1 in 10 institutional investors out-performed the index over the most recent 5-year period. Fewer did so over longer time frames.

Odds are clearly stacked against your manager in out-performing the S&P. This is perhaps more obvious in the past year, during which your manager appears to deserve tomatoes for badly lagging the S&P.

High-flying stock indices mask the market’s sharp shift to caution. While the Nasdaq was only 3% from its high, the average drawdown for a constituent stock was near 35%. The fears of above-average inflation and Fed tightening are palpable.

Your manager is not in the business of anticipating macroeconomic shifts. The focus has always been on investing in the longest-duration growth companies, which provide the best defensive and offensive values regardless of macroeconomic backdrops.

FRC’s performance is best measured with 3-5 year rolling averages. The longer-term outlook is encouraged because your manager practices a unique philosophy that serves as a beacon for out-performance.

The Beacon

Everything should be made as simple as possible, but no simplier” -Albert Einstein

It comprises two pieces. The first deals with how to think. The second with what to think.

Thinking right and thinking the right things are different endeavors. To think right is to choose the appropriate road to run on, while to think the right things is to run appropriately.

One cannot live without the other. Running on the wrong road is useless. So is running wrong, even when on the right road.

In the context of FRC, to think right is to commit to investing in a sustainable way. And to think the right things is to develop deep understandings of companies that sustainably compound capital at high rates of return.

Thinking right

All investors need are quality decisions. However, the unfortunate reality of investing is filled with innumerable distractions that discourage quality decisions.

The most damaging distraction is the most common, that is the pressure of timing. Institutions, with mostly impatient capital, must out-perform benchmarks annually (sometimes even quarterly) or risk losing client assets. Picking the best companies matters little if their stock prices do not keep pace with benchmarks. Timing what to hold, buy, or sell is consequential. The challenge of picking winning companies is intensified by the stress of timing. This seems unhealthy and unsustainable.

A healthier and more sustainable solution is the practice of permanence, meaning a very long (ideally infinite) duration in companies and client assets.

A long-term outlook and patient assets remove the pressure of timing, allowing your manager to focus on dynamics rather than discrete events. This is crucial for out-performance because strong dynamics, such as sustainable competitive advantages, lead to positive events, such as strong quarterly earnings or outlooks, and rising stock prices.

But exactly when is anyone’s guess. Getting the timing consistently right is beyond the assessment of dynamics. Timing is mostly outside of your manager’s control, but the challenge of correctly parsing dynamics is not.

Without the pressure of timing, decisions are less hurried, which leads to less stress and higher quality decisions that should in turn increase returns, reinforce the entire practice, and further improve returns.

Alfred Chandler, a business historian, wrote “unless structure follows strategy, inefficiency results”. FRC is structured to sustain the practice of permanence. Much of your manager’s time is spent on developing deep and differentiated understanding of dynamics (more on this later), which avoids distractions from the ebbs and flows of events. Your manager spends little effort courting clients, and accepts only the most productive assets and relationships (the “no-brainer” types). Expenses are low without analysts or a formal office to avoid the stress of excess expenses when events lag dynamics.

Thinking the right things

Knowing more is not the same as being right.

Knowing more helps in getting to the right answer, but is not enough per se.

This is where deep understanding comes in.

As a bridge between knowledge and right answers, deep understanding connects disparate pieces of existing knowledge, and weighs some pieces more than others to arrive at right answers.

Trade-offs are necessary. Trying to weigh every piece of knowledge equally may make a detailed report, but not successful investing.

Great investing is all about discounting information that the market has not. Participants tend to discount what can be counted. Yet what cannot be counted is the real story. Past numbers ought to be used to parse qualitative growth drivers, which account for future numbers.

In the context of FRC, to be right means to be invested in companies with long-duration growth (ie sustainably compound capital at high rates of return). To have deep understanding is to put sufficient weight on information that clarify permanent growth drivers.

The most important of growth drivers is positive feedback cycles (PFCs).

PFCs continuously improve results. They are conducive for product iterations, allowing the company to innovate and adapt quickly. The best companies understand their value, and do everything to refine and accelerate them. Yet they are not even on the radar for most companies.

Why? First, PFCs are difficult to initiate. They require resources but yield little results to start. Their outcomes follow an exponential curve that fit poorly in linear forecasting models. Two, they are difficult to sustain. Many stakeholders are involved with differing needs.

To start, a culture of grounded obsession is necessary. To be sustainable, an ecosystem of overwhelming incentives is required.

As mentioned, the outcomes of PFCs are ill-fitting for a standard forecasting model. Hence, for companies to begin investing in PFCs, they need a visionary but grounded leader who can look beyond spreadsheets to see the value of PFCs. The leader must be sufficiently obsessed about the mission to have a leap of imagination about the exponential outcomes of PFCs, and also pragmatic enough to gather the team and financing for PFCs to start.

Your manager observed that company culture starts at the top. A mission-obsessed and grounded leader, preferably a large shareholder as well, would inspire the same company characteristics essential for PFCs to begin.

To sustain PFCs, the value proposition for each party involved, be it customers/vendors/partners, must be overwhelming – good to start, and great over time. This means that each party finds more reasons to stick with the company over time.

Sustaining PFCs is more difficult than it looks. Attracting new parties require different incentives than keeping existing ones. Heavy investments are necessary during early phases. Early success attracts competitors, including heavyweights with immense resources and excellent histories of building businesses.

Yet the best companies are not deterred. They understand that, when done right, PFCs accelerate innovation over time, yielding ever-improving results that place them far ahead of competitors.

A fast pace of innovation, sustained by PFCs, is the only defensible moat in your manager’s opinion. It also offers the best offence. Companies investing in PFCs now cannot begin to imagine how their best years would look in the future.

Our investments

Great leaders and sustainable PFCs are rare. Most companies do not deserve permanence. That’s why your manager prefers to invest only in the worthy few, resulting in a concentrated portfolio.

The quest to look for the worthy few is challenging. Unforced errors in the form of analytical mistakes are aplenty. Forced errors happen when competitive or managerial dynamics become unpredictable. Rest assured that your manager is hard at work in minimizing errors.[1]

Your manager is persistent because the rewards of being right far outweigh the costs of mistakes. Practicing long-duration investing (ie permanence) in the worthy few would generate notable returns from compounding, as long as mistakes are kept as short-duration as possible. Let profits run, and cut losses early.

For a worthy company, holding on to its stock for a long duration is much more consequential than timing purchases at the bottom or sales at its annual high. As said by Morgan Housel in his book (which I recommend everyone to read twice at minimum), time in the market is more important than timing the market.   

One example among the worthy few is Roku, the largest TV streaming platform globally with a 31% share (ahead of second-place Amazon’s 16% share).

Roku is headed by founder/CEO Anthony Wood, a serial media entrepreneur (Roku means six in Japanese, and is Wood’s sixth company) with a maniacal focus on building the most vendor-, user-, and partner-friendly operating system for smart TVs. The Roku OS is designed to have great performance on inexpensive hardware. Cheap hardware allows vendors (TV OEMs) to make more profit by manufacturing Roku-powered TVs than building their own. Cheap hardware and great performance have also popularized Roku-made streaming sticks among users. The Roku OS makes it easy for partners (content providers), even small ones, to launch, so users find the greatest variety of content on Roku.

Two PFCs drive Roku – hardware and content. They work together to support Roku’s leadership in streaming and advertising. User demand for Roku’s cheap and high-performing hardware drives supply, which are incentivized by higher profits to meet demand. The high variety of content on Roku attracts users, which in turn attracts more content providers. Roku is investing in original content, which is free for users in exchange for watching advertising, to accelerate the content PFC.

Competitors have trouble replicating the strengths of Roku OS, demonstrated by their lack of TV OEM partners (Roku has 15). Google has made multiple attempts in building Google/Android TV, each time failing to build traction (the latest attempt really frustrated Best Buy). Amazon just started building its own TV, which has poor resolution and low variety of content.

Another example is Sea Limited. Sea’s primary businesses are mobile game publishing and ecommerce, both in emerging markets. From its start, Sea has formidable competitors in Lazada (owned by Alibaba) and others. Thankfully, Sea has founder/CEO Forrest Li, whose obsession with customers and courage in challenging large established players define the company.

“Hyper-localization” defines Sea’s customer-centric playbook and PFCs. Its mobile games work well on low-powered devices common in its markets. Game content celebrates local cultures by involving local festivities, customs, and celebrities. Ecommerce “localizes” by offering a much larger variety of local products (driven by C2C sellers) relative to competitors and adapting to local payment habits (eg cash-on-delivery in Indonesia and Philippines).

The MMORPG (massive multi-player online role-playing games) nature of Sea’s games means users beget users. Exclusive localized content attracts users, who attract more users interested in competition. Sunk costs in customizations lock users into the game, generating recurring revenue that is invested into new content. Sea’s success in hyper-localization attracts game publishers to license content, effectively helping Sea future-proof its franchise. With a total of 725 million QAU, the gaming PFC has worked wonders.

In ecommerce, in which Sea operates as Shopee, Shopee enters a market by first having large B2C merchants to provide brand-name, recognizable products. As its reputation builds, it subsidizes small C2C merchants to significantly increase the variety of local products. Users are first attracted to Shopee by brand-name products, and they stay for the large variety of cheap local products. Increasing users attract more merchants, who provide more products that in turn attract more users. The ecommerce PFC produces excellent results. Shopee transacts near $50B GMV, and holds #1/#2 positions in most Southeast Asian markets and Taiwan, while expanding in Brazil and parts of Europe.  

Sea has plenty of potential for growth. Despite its dominant market position, Shopee hasn’t begun to monetize ecommerce. In an effort to attract more users and merchants, Shopee limited the annual increases of transaction-based fees, and only just started offering advertising services, both of which are high-margin sources of revenue. Its current fees are mostly related to logistics and payments, both of which are low-margin.

In addition, Sea only recently expanded into financial services such as mobile wallets, payments, BNPL etc 75% of the population in its target emerging markets are under-banked. Sea would build on trust gained from consumers in ecommerce and gaming to expand in financial services.

The price of being right

Your manager noted in last year’s letter about the risk of the Fed removing accommodative policies. However, FRC’s performance appear to indicate a lack of effort in preparing for the risk.

Why not be less invested going into a tightening Fed cycle? Because there are no guarantees in the market. A tightening cycle does not mean that our investments will decline. In addition, knowing that the Fed would tighten does not mean knowing the extent of discounting by the market. As mentioned, timing the market is beyond your manager’s focus.

What about the risks of inflation? Standard financial logic dictates a reduction in present values when interest rates increase to combat inflation. Your manager suggests more emphasis on companies than macroeconomic forces. Value provided by long-duration growth companies should overwhelm macroeconomic impacts.

Your manager is mostly invested as long as opportunities are available, because missing the best days of the market is consequential. A study shows that between 2005 and 2020, missing the best 10 days of the market more than halves returns. Missing the best 20 nullifies returns. To avoid missing the best days, your manager is prepared to endure volatility on the worst days.

Volatility is the price of excellent returns.

To be specific, the volatility in question relates to stock prices, not underlying business values. Business values mostly do not fluctuate as much as stock prices suggest. But businesses mostly are unable to control their stock prices, so even those with the best prospects can have volatile prices.

Warren Buffett once said that he is willing to trade the pains of short-term variance to maximize long-term performance.

That is the right road to run on.

If you have any questions, contact me at farmroadcap@gmail.com.


[1] The sharp reader may be curious about how forced errors can be minimized. Forced errors cannot be prevented by definition, but they may be avoidable. In the context of FRC, this means to invest in low-risk companies and industries. Buffett has largely avoided investing big in technology (with the exception of Apple) because of high risks of obsolescence. In a departure from Buffett (!), your manager thinks that some tech companies and others have low risks of being obsolete. Low business risk is an important nuance in investing in long-duration growth companies. But business risks are difficult to measure, and should not be measured by the volatility of stock prices. Thoughts on business risk will be included in future letters.