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.

Marcel Gozali


[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.

Tennis, Sardines, and Bitcoin (2021 mid-year letter to partners)

Topics: the practice of permanence; price is not value; sardines and Bitcoin

Dear partners and friends,

Farm Road Capital out-performed the S&P, which gained 14.4%, in the first half of 2021.

The lack of details is intentional. Your manager encourages you to avoid considering short-term returns. Industry customs dictate that short-term returns are indicators for long-term returns. Your manager cannot disagree more. The proper value investor knows what would likely happen, but could only guess at when. Short-term returns matter little in judging the skill of the value investor. In early letters, Warren Buffett preferred his returns judged on a rolling 3-year time frame at minimum.

The practice of permanence

At the center of FRC’s investment philosophy is a widely known yet commonly misunderstood concept – compounding.

Compounding is really just interest on interest. Returns on prior returns over a long duration generate true wealth. This is well-known.

What is not well-known is how compounding is achieved. The answer is within the public filings of Berkshire Hathaway. More than half of Berkshire’s net worth was generated by less than half a dozen investments. Warren Buffett has held some of these investments for decades.

Permanence is what Buffett ferrets out and treasures in a business. He searches for timeless competitive advantages that are sustainable through good times and bad. Decades of ownership of select companies made Berkshire worth $640 billion, the 6th most valuable company in the Fortune 500.

This is what FRC aims to achieve – finding companies worthy of permanent investment. Practicing permanence means that the ideal goal is to never sell. However, this is easier said than done. FRC sells when the assessment of the business is mistaken (unforced error); when unforeseen circumstances significantly alter the prospects of the business (forced error); or when valuation reach wild levels.

Your manager, first and foremost, seeks to minimize unforced errors. Dr Simon Ramo identified two different games of tennis in his insightful book Extraordinary Tennis For The Ordinary Player. The first game is the Winner’s Game played by professionals, who win by scoring excellent shots. The second game is the Loser’s Game played by amateurs, who win by making fewer mistakes than their opponents. In a Winner’s Game, 80% of points are won. In a Loser’s Game, 80% of points are lost – hitting out of bounds, double-faults. Amateurs win by avoiding mistakes.

Returns in investing can be described as the difference between intelligence and arrogance. The more intelligent and less arrogant one is, the higher the returns. One may play the Winner’s Game by guessing the future of self-driving (ie be more intelligent), or play the Loser’s Game by sticking to what one surely knows (ie be less arrogant).

Investors can win by betting on crazy ideas that work, or just by being not crazy.

Your manager has made many errors by over-estimating his intelligence. Minimizing errors is crucial yet counter-intuitive. Our minds are programmed to reach goals, not avoid mistakes. Think about driving. We drive to get from A to B. It is unnatural to explain driving to avoid accidents. Yet defensive driving has the best chance to get you to your destination in one piece. This means that avoiding errors has to be a conscious effort. Your manager is hard at work to be less arrogant in determining the limits of his knowledge.

Management of companies, which are worthy of permanent investment, tend to have similar habits. They avoid crazy M&A that peers are doing, and focus mostly on organic growth. They are humble by never going all-in on a single product. They survive by diversifying bets and avoiding large risks.

Your manager said at the start that compounding is often misunderstood. This is because of the popular belief that it is possible to time the market consistently (ie buy at the bottom, sell at the top, repeat). This belief disfavors permanence and encourages active trading (exactly what Wall Street and Robinhood want). Reuters calculated that the average holding period for US stocks was only 5.5 months. The great economist and investor, John Maynard Keynes, spoke about the futility of market timing:

As the result of these experiences I am clear that the idea of wholesale shifts [in the stock market] is for various reasons impracticable and indeed undesirable. Most of those who attempt it sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind” -Keynes’s memo to the Estates Committee at King’s College in May 1938

Despite the futility, many still believe in timing the market, likely because of inherent human instincts that are difficult to resist. Some favor action more than profits. Others trade based on social proof more than business fundamentals. Many cannot detach from the grips of greed and fear. Ed Thorp once said that you always get what you want from the markets. That many would lose and yet still believe in timing the market implies that some non-monetary concerns are probably satisfied.

Price is not value

A few readers questioned whether your manager has the correct selling discipline. An example should aid that consideration. In the first quarter of 2021, the valuation of technology stocks had risen so high that a company in the portfolio was valued at 40-50x revenue. It intuitively seems like an ideal time to sell, but your manager did not sell. The assessment of the business was correct, unforeseen circumstances were absent, and valuation was not at wild levels.

Within weeks, the stock fell 47% from its peak because of inflationary concerns (see Appendix for a more detailed explanation). Your manager again did not sell because of the same reasons applied weeks earlier.

The stock then increased 53% from bottom (still 15% below peak). Guess what your manager did not do.

The stock price fluctuated wildly while its underlying business improved. The investor must hence never rely on stock prices as an indicator of underlying business quality. 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. Using prices to inform business quality, which in turn affects prices, is a logic fallacy (circular reasoning to be precise).

Stock prices are nothing more than the collective behavior of many buyers and sellers, many of whom transact without any concern for underlying businesses. Your manager analyzes business quality to understand stock prices, instead of looking at stock prices to determine business quality. Many investors practice the latter more often than they care to admit.

The stock market is bullish in nature. Wall Street, corporations, and even countries have much to gain from rising markets. Stocks, therefore, are biased to be over-priced. You would likely get less than what you pay for. The adage “you get what you pay for” almost always does not apply in stocks.

Investors face a daunting task because they have to get more than what they pay for in a mostly over-priced market.

Price is what you pay, but value is what you get.

Sardines and Bitcoin

“There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared.

One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.” -Margin Of Safety by Seth Klarman

Speculation is built on sentiment. Prices increase for no reason other than willing buyers paying higher prices than previous buyers. Circular reasoning, while false in logic, is difficult to resist.

Anything is a candidate for speculation. There is no criteria other than willing buyers. History has shown that flowers, gold, land, property, stocks, baseball cards, tea leaves, and even uranium are worthy candidates.

The allure of speculation lies in its ounce of truth. Sardines is a source of nutrition, and should be priced as such. What speculation does is take inherently good things so far that they turn into damaging traps for the unwary.

A modern example is cryptocurrency. With roots in cryptography, Bitcoin is built on blockchain technology deemed impervious to hacking, conferring convenient proof of ownership. Its cousins want to take hack-proof technology further. They purport to make “smart-contracts” a reality, in which digital currencies can be exchanged according to a set criteria without human intervention. The truly ambitious want to build a decentralized ecosystem where applications are unhackable, untraceable, free of human government, and truly utopian.

Bitcoin and others have utility. The question is how much. Bitcoin is now worth more than Disney, American Express, and Coca-Cola combined. Its market value exceeds the GDP of Hong Kong and Sweden.

Thinking about customers often reveals hints to the potential of cash flows and valuation. Who would appreciate the unhackable, untraceable, and utopian nature of crypto assets? Your manager can think only of repressed societies, criminals, and hobbyists, all of whom have little potential to generate sustainable cash flows. Repressed societies are generally poor without functioning governments. Criminal activity would eventually be punished and their cash flows confiscated. Would crypto assets become a magnet for hobbyists like what Lego or Magic The Gathering did? It is difficult to tell.

Without real promises of cash flows, cryptocurrencies are difficult to value at best, and downright speculative at worst. Value investors should avoid them for these reasons.

Your manager may be completely mistaken about the potential of cryptocurrencies. A friend, who became a hundred-millionaire from Bitcoin, would like nothing more than insist on its world-altering potential (on a new yacht no less, to make his argument more compelling). In investing, nothing compels one to jump over seven-foot hurdles when there are one-foot bars to step over. Your manager prefers the latter, following the rules of the Loser’s Game.

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

Marcel Gozali

7/9/21

Appendix

Our portfolio declined near-40% from its peak during 1Q21, before rebounding in 2Q. During 1Q, readers questioned why the portfolio declined when the markets were at record highs. Our portfolio invests mostly in technology and media companies, which show the most promise in growing intrinsic value over the long-run. While the overwhelming majority of these companies reported improving financial results in 1Q21, their stock prices did not keep pace, mostly because of inflation concerns. Markets anticipated that the Federal Reserve had to raise interest rates to offset higher inflation. The higher interest rates are, the less valuable future cash flows are, the more valuable current cash flows are. Companies in our portfolio invest heavily in R&D to support future growth, so they are likely to generate more cash flow in the future than present, hence markets believe they are worth less in a potential high-rate environment.

Your manager spotted a gaping hole in the market narrative. It is not certain that our companies would definitely perform poorly in a high-rate environment. There is no question that high rates lower the valuation of future cash flows, ceteris paribus. The question should be would cash flows grow enough to offset the impact of high rates.

Our focus is on fundamental business performances, not on their stock prices. Many mistakenly look to market prices for guidance, thinking that prices correlate to business performance (ie higher prices mean better performance). Yet the market is nothing more than the collective result of many buyers and sellers, many of whom transact without any concern for business performance. Your manager aims to rise above the instinct to conform to the “herd” that is the market, and remain independent in assessing business value.

Clearsign of growth

Clearsign Technologies (NASDAQ: CLIR) is the first pre-revenue company that I have invested in. The company is very close to commercializing a game-changing technology in combustion systems with ExxonMobil and other customers with significant scale. Clearsign’s technology costs much less, produces far less emissions, and presents as the sole viable update to a 65-year-old combustion treatment method that is as expensive as it is antiquated. Competent leadership, proper incentives, viable commercialization roadmaps, and environmental tailwinds support a $500m valuation (~3x current valuation).

Potential customers are industrial furnaces, boilers, refineries, and any facility that employs large-scale combustion systems. These facilities constantly balance between generating revenue and pollution: how long can combustion systems operate (ie revenue generation) while keeping NOx (nitrogen oxides) emissions low enough to comply with increasingly strict environmental regulations. The most common solution is a post-combustion treatment process. Run the combustion system; pass the resulting NOx into a catalyst chamber comprising porous ceramics, precious metals, and gases; circulate the mixture to reduce NOx before release to atmosphere. This process, known as SCR (selective catalytic reduction), is expensive because of the use of precious metals, cumbersome because of the need for gas circulation, and unstable because of the constant need to replace porous ceramics clogged by pollutants.

Clearsign provides an ingenious solution. Its key IP (known as Clearsign Core) allows the combustion system to produce less NOx in the first place, eliminating the need for post-combustion treatment.

Combustion begins with an ignition of a flame. This flame initially burns at very high temperatures that produces high levels of NOx. As fuel and air mix with the flame, temperatures decline and exponentially less NOx is produced. Clearsign Core reduces the duration and intensity of peak flame temperatures. The technology allows fuel and air to mix properly before starting ignition, resulting in shorter and lower peak flame temperatures and lower NOx emissions than standard combustion.

The technology has other means to reduce peak flame temperatures. It “separates” the source of a single, large flame into numerous, shorter flames that can be more easily mix with fuel to lower peak temperatures. Its mechanism also employs radiation cooling that cools the flame quickly.

Clearsign provides the aforementioned benefits at much lower prices compared to the current SCR solution. A third-party engineering consultant found that Clearsign Core (originally named Duplex) provided 80-90% lower startup and maintenance costs compared to SCR (see tables below). Clearsign Core is currently the most cost effective solution to meet strict NOx emission standards (under 2.5 parts per million, or 2.5ppm) set by California and Texas, which set the standard for the rest of the country to eventually follow.

In spite of valuable IP, Clearsign had a difficult start as a public company. Its IPO in 2012 was build on a ground-up, complex redesign of combustion systems. Its technology today started as an offshoot to the original technology. Clearsign invented a flame management system that significantly reduced NOx emissions as a complement. Clearsign did not sell any combustion systems, but found large refineries owned by Tesoro and Delek wanting its flame management system. However, all the company had to show, after 7 years and and 5 equity raises, was less than $2 million in cumulative sales. Its stock declined from $4 at initial offering to a low of $1 in 2018.

Poor execution capped the sales potential of its technology. Management failed to account for extensive pre-installation testing, after-sales support, and customization required by complex refinery operations. The high cost of failures in combustion systems made refinery operators extremely careful in adopting new technologies. They demand multiple demonstrations and field-testings, and require a comprehensive maintenance system. Clearsign, as a startup, had limited resources that were perceived as risky. The company required collaborations with other vendors to get to market, but was unable to find partners because of its insistence on standard licensing deals. A typical deal require partners to pay Clearsign large upfront cash as a licensing fee, but partners were unwilling to pay for startup technology without proven traction. Without partners, Clearsign could not commercialize its valuable IP.

The company’s fortunes began to turn when Robert Hoffman, a veteran investment manager, bought a 20% stake and joined the board in July 2018. He repealed the attempt of a ridiculous proxy battle by a sketchy investment banker. Anthony Digiandomenico was an owner of MDB Capital, focusing on micro-caps and purporting to be “Wall Street’s only intellectual property-focused investment bank” (not kidding), albeit with history of misrepresentation (see Red Flag #3 in link). Digiandomenico owned only 112,733 shares of CLIR (less than 1% of 1% shares outstanding) when he submitted a proposal to replace the board and management on November 9, 2018. Luckily for CLIR shareholders, Hoffman stood his ground, convinced Digiandomenico to back down, and prevented the escalation of the proxy battle to an all-out war.

I did not find information concerning Hoffman’s long-term track record. However, his written responses in the proxy contest showed him to have sound business logic, focus on fundamentals, a long-term outlook, and transparent communication (see highlights below from 14A filed on December 6, 2018):

The second most important decision that Hoffman made for Clearsign, after settling the proxy battle, was the hiring of Jim Deller as CEO in January 2019. Deller spent his entire career, all 28 years, in combustion systems and had a doctorate in flame chemistry. That Deller left a comfortable job as director at Honeywell to join Clearsign validated the company’s technology and sales potential. His deep understanding of technical underpinnings and commercialization processes made him the most invaluable addition to the company after Hoffman. Hoffman described Deller as such:

While younger investors might not grasp the analogy, Jim is the Bart Starr as opposed to the Joe Namath of the combustion industry. As investors get to know Jim, they will discover that he will never be like Broadway Joe and “guarantee victory”, nor will he ever be the flashiest guy in an investor conference. Conversely, like Bart Starr, he will be the understated field general getting the most out of his team while, at the same time, being the most important cog in driving that team to victory and making the clutch decisions when it is most important.” -Q119 earnings call

Clearsign has gained significant traction under Deller. He simplified the core technology for easier “plug-and-play” installation at customer sites. He found partners by abstaining from licensing deals in favor of revenue-share collaborations without upfront investments. He recruited leaders in sales and engineering. He steered the company through Covid-19 and secured a license to sell in China amidst complex US-China relations. Notable customers and partnerships include:

  • ExxonMobil and Zeeco. The oil major will be testing Clearsign Core in calendar Q3 2021, after completing a year-long exhaustive qualification of the technology. If successful, this would be the most vital validation of Clearsign Core in company history. Equipment required for Exxon’s testing would be fabricated by Zeeco, a household name in the global refining and petrochemical industry. The collaboration with Zeeco in manufacturing, sales, and research is a transformative partnership that solidified Clearsign’s commercialization efforts.
  • An unnamed European oil major, likely Shell or Total. This company placed an order for Clearsign Core on February 2, 2021.
  • California Boiler and a North American major energy infrastructure company who purchased Clearsign Core in October 2020. The technology has been installed, and revenues would be recognized in financial Q1 2021. This project was sold by California Boiler, which is Clearsign’s channel sales partner.
  • World Oil and the California South Coast Air Quality Management District (government emissions regulator in Southern California). Clearsign Core is so promising that the emissions regulator in California had agreed to fund 1/3 of a demonstration project with World Oil, a recycler of motor oil and antifreeze. The demonstration has been delayed for a year because of Covid, and would likely be completed by early 2022.
  • Beijing heating district and Jiangsu Shuang Liang Boiler Company (simplified as JSL Boiler). Clearsign cleared government testing of its technology in China, and obtained a license to sell in China. The northern districts in China received central heating during winters from numerous industrial boilers (combustion system for heating) operated by the government, unlike individual boilers in homes in the United States. Clearsign had also signed a collaborative agreement with JSL Boiler, the top boiler manufacturer in China. Sales efforts just began in May 2021.

In thinking about valuation, I suggest readers consider Buffett’s quip: “you don’t need to know a man’s weight to know that he is fat”. Precision matters less in this thesis than directional accuracy. The most obvious markets for Clearsign are the 14,000 industrial combustion systems in refineries and petrochemical plants in Texas and California, and 350,000 heating furnaces in the northern districts of China. In the table below, assuming modest market shares and retrofit prices (about 10% cost of SCR), I estimate a near-$5-billion opportunity.

Combustion systems in CA and TX [A]14,000
Initial addressable market [B]10%
Revenue per retrofit ($m) [C]$1.0
Maintenance revenue over 10 years ($m) [D] $0.5
Revenue potential ($m) [A*B*(C+D)]$2,100.0
  
Firetube boilers in northern China350,000
Initial addressable market2.5%
Revenue per retrofit ($m)$0.2
Maintenance revenue over 10 years ($m) $0.1
Revenue potential ($m) $2,625.0
  
Total revenue potential ($m)$4,725.0

Three tailwinds may further expand the opportunity. One, pollution emission standards are expected to become more stringent over time in the US, China, and other developed countries, regardless of political affiliations. The regulatory tailwind would become stronger over time as more resources are devoted to managing climate change. Two, the slow pace of innovation and performance improvements in SCR provides a clear opportunity for Clearsign to take share. Providers of SCR are mature companies that compete largely on price. While the maturity of SCR presents a high barrier to entry, Clearsign has shown sufficient traction to be a viable substitute. Three, Clearsign is currently testing adjacent products such as flares and sensors that complement its core technology.

Clearsign is valued at about $160m today, which appears to significantly undervalue its potential. Judging from the $5-billion revenue potential over the next decade, it should be reasonable to estimate a valuation at $500m (1x annual sales). Margins are likely to be high (~30-40% EBITDA margins) given management’s plan to create an asset-light technology provider that relies on a network of partners for fabrication, sales, and customer support. In any new technology, commercialization is often the biggest risk. A successful demonstration with ExxonMobil in calendar Q3 later this year would significantly mitigate the risk and place Clearsign on the path towards realizing its true valuation.

How to generate insights

“…when it came to real-world complexities, the elegant equations and the fancy mathematics he’d spent so much time on in school were no more than tools – and limited tools at that. The crucial skill was insight, the ability to see connections.”

Taken from Complexity by Waldrop Mitchell, the quote described W. Brian Arthur, a pioneer in complexity economics.

Similar to Arthur, investors want insights. They want to know something that others do not. The most competitive institutional investors pursue insights in the form of differentiated data. Gabriel Plotkin, the owner of Melvin Capital (of GameStop short-selling fame), was an early user of credit card data when picking consumer stocks. Many investors interview vendors, employees, and product experts to uncover unique data.

If the puzzle of above-market returns is a walled castle, pursuing differentiated data is similar to a head-on attack. Accumulate armies of analysts and differentiated data, and swarm the castle’s defenses with sheer intellectual brilliance.

Yet a head-on attack is not without risk. Casualties abound (high turnover in analysts and data). The castle walls have to be re-built to prevent others from attacking (differentiated data is discounted by the market, demanding even more differentiated data sets for returns).

A better tactic would be to understand the needs of the town within the walls, and negotiate with its leaders for a surrender. No casualties. Nothing destroyed.

I label the alternative tactic as differentiated understanding.

The path to differentiated understanding begins with a hypothesis, which is tested against real-world data. Even when data is supportive, the hypothesis is never fully accepted. Statisticians use the term “cannot be rejected”. This means that other data, not yet considered or available, may reject the hypothesis. The analysis leaves room for further exploration, which, when repeated, leads to correct and deep understanding.

Compare what I just describe to the opposite. Start with differentiated data (instead of a hypothesis), determine patterns, then attempt to understand. This is what investors commonly do, and it leaves plenty of room for error instead of exploration. The patterns are likely to reflect correlation. Mistaking correlation for causation results in erroneous understanding, which is often expensive to correct in investing.

Yet data is often used as the starting point because it is relatively easier to obtain than a hypothesis. A credible hypothesis is abstract and creative, because it hasn’t been fully proven by data, isn’t known by others, and isn’t discounted by the market (hence containing the potential for profit).

More difficult than coming up with a hypothesis is refining it. The process demands more creativity and abstraction, more grounding by real-world data, and sometimes long feedback cycles. This is diametrically different from the touch-and-go nature of the typical data analysis process, in which analysts move quickly from one data set to another without proper understanding (hence creating an industry for more and more differentiated data).

Differentiated understanding is wisdom, whereas differentiated data is still data, just with unique sources. Dee Hock (founder of Visa) describes it best:

“Data, on one end of the spectrum, is separable, objective, linear, mechanistic, and abundant. Wisdom, on the other end
of the spectrum, is holistic, subjective, spiritual, conceptual, creative, and scarce.”

That statement is as profound as it is useful. The modern scientific pursuit is reductionistic. It distills the world to the few factors that mostly explains the observed phenomena. The resulting theory is thus indisputable and mechanical. Yet the theory only works in the defined environment, and can hardly be extended to the real-world containing more variables and complexity.

What wisdom attempts to achieve is results in the real-world. It discards the elegance and simplicity of reductionistic theories for utility. It sees the world not as linear cause-and-effect, but as a system comprising myriad interrelated nodes. Changes in a single node would reverberate through countless others.

Perhaps an example would aid in solidifying concepts. Say theory and experience have proven that mean reversion works in investing. Buy cyclical companies at trough valuations, sell them at peak valuations, repeat. Wisdom would require asking “and then what”. What happens when more and more investors realize and practice this strategy? Trough valuations would no longer be low when more investors buy. Peak valuations would no longer be high when more investors sell. What happens when more and more cyclical companies realize what investors are doing? They might adjust their business models to maintain stable valuations, which would aid as a currency for M&A and employee stock incentives. The entire game would evolve.

In another example, research has consistently proven that rising EPS is the key determinant of rising stock prices. Linear cause-and-effect logic would dictate one look for stocks with rising EPS and stagnant or declining prices.

This simple dynamic leads to complex behaviors. Consider that one should buy the stock before EPS rises. How early should investors be? Perhaps wait for indicators such as rising operating earnings that precedes rising EPS? If the market knows about rising operating earnings, the wise investor would have to look for earlier indicators yet to be discounted.

Here’s the kicker. What happens to the original linear cause-and-effect logic? The market has evolved such that actual rising EPS forms a weak (but not impossible) case for rising stock prices. When the market is looking for earlier and earlier indicators for rising EPS and yet ignores actual rising EPS (when it shouldn’t be), the market is strongly signalling that the rising EPS won’t last.

To achieve wisdom is to understand how the world really works. The real world evolves, but an experimental one does not. Little changes result in enormous shifts in the real-world, but are unlikely to be demonstrated as such in a controlled setting (it would make the setting uncontrollable).

This is not to say scientific inquiry is useless. If anything, wisdom recognizes both the utility and limits of scientific inquiry.

Every investor begins with a scientific mindset. There is no starting if you cannot count and theorize. But achieving great returns requires leaps beyond, and many non-scientific subjects would aid that effort. Dee Hock said it best again:

“Science has traditionally operated in the provinces of data … where measurement, particularity, specialization and rationality are most useful. It has often blithely ignored the provinces of understanding and wisdom.

Theology, philosophy, literature, and art have traditionally operated in the provinces of understanding and wisdom, where subjectivity, spirituality, and values are most useful. It has often blindly opposed the scientific way of knowing.

Data moves at the speed of light today (quite literally). Data, no matter how differentiated, is quickly discounted. Wisdom is difficult to gain but also hard for the market to discount quickly, and should henceforth be the insight upon which investors rely.

2020 letter to partners

Topics: a lesson from Napoleon; the unprecedented risk in stocks; our investments; trust as leverage; gratitude shout-outs

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%
   
CAGR since inception44.8%16.0%
Cumulative since inception339.4%81.3%

Farm Road Capital gained 139.5% in 2020, while the S&P 500 gained 18.4%. From inception in 2017, FRC gained 339.4%, while the S&P 500 gained 81.3%.

Your manager assures you that the S&P is not an unduly short yardstick. 68% of my peers under-perform benchmarks over the most recent 3-year period (2016-2019). Over 5 years, 82% under-perform. Over 10 years, a staggering 89%. The numbers suggest that excess return is rare. Your manager faces long odds, but hopes you are assured by the alignment of our interests. 99% of your manager’s net-worth is invested in the same securities in which you are invested. Your manager eats his own cooking.

Your manager is also the first to assure you that the success in 2020 is unlikely to be repeated. Unprecedented conditions created once-in-a-lifetime (maybe twice) opportunities that are unlikely to repeat in the foreseeable future. Your manager prefers to avoid throwing cold water on your returns, but would do so only to adjust your expectations to reality. There is nothing like cold water in wintry January that wakes one up to the real world. It is your manager’s goal to perform in excess of benchmarks by 10% annually over the long-run.

A lesson from Napoleon

Some pilots describe their jobs as “hours and hours of boredom punctuated by moments of sheer terror.” It is almost the same with investing (replace ‘boredom’ with ‘uneventful reading’).

What pilots do during terrifying moments determine the fates of many. The few decisions made in those moments have impacts larger than many decisions combined in routine flights. The same principle applies to investing. What investors decide during extreme market turmoil have outsized impacts on performance.

Napoleon perhaps has the best response, that is “the average thing when everyone else is losing their minds”. An experiment first conducted in 1951 showed why this is difficult. Psychologist Solomon Asch showed eight college students two diagrams:

He asked them: “Which line – A, B, or C – is similar to the line in the other diagram?” Each participant answered sequentially, such that the next participant could hear the previous answer.

The correct answer was simple. Yet when the first seven participants (who were actors with predetermined responses) gave the wrong answer, the eighth (the sole real subject) almost always gave the wrong answer as well.

The researcher viewed the results “as a striking example of people publicly endorsing the group response despite knowing full well that they were endorsing an incorrect response.” The experiment demonstrated the tendency to conform with the crowd.

When everyone else is losing their minds, the easy choice is to lose your mind as well. The difficult choice is to “do the average thing”. In investing terms, the difficult and “average thing” to do is to take action when the market goes crazy.

I wrote a short article to buy stocks on March 23 2020. With hindsight, the day coincided with the market reaching a bottom after plunging at the fastest pace since the Great Depression in 1929. On March 23, there was no way to tell whether the market would decline further, but there was a reason to buy:

“How do we know that stocks have bottomed? The truth is that there is no way to tell, despite what you hear from Goldman Sachs and CNBC. Steve Jobs said that “you can never connect the dots forward. You can only connect the dots backwards”, which means that we will only know the bottom with hindsight. Because you can’t be certain to buy at the bottom, you should only buy when you expect reasonable returns. Using 90-year averages for the S&P 500 as a benchmark, the investor can expect roughly 7% returns per year in the next 10 years (see Appendix at end of article for calculation), a reasonable return.”

Farm Road Capital on March 23 2020

Buying during turmoil entails a few overlooked yet important nuances:

  1. You must not have excessive leverage: You cannot buy when a significant downturn obliterates your equity. You can only buy if you survive the downturn. This sounds obvious, but it is difficult to expect a downturn when the going is good. Because there is no way of knowing when downturns occur, your manager operates with limited to no leverage.
  2. You know what to buy: The most opportune windows do not stay open for long. Your manager keeps a wish-list of the best businesses to own should opportunities arise.
  3. You know what to abandon: This is perhaps the most difficult yet important. Significant downturns tend to alter the economics of some businesses. The investor must be aware of the paradigm shift. The endeavor requires an unique and rather contradictory blend of skills: sound logic backed by commonsense and financial history, the foresight in imagining what hasn’t happened before (that may defy current logic), and the sturdy independence of thought when commonsense is on shaky ground.

An old saying in Chinese opera goes: every minute of performance on-stage is backed by ten years of hard work off-stage. Investors toil in the shadows for years, ready to perform at a moment’s notice when opportunity arises.

The unprecedented risk in stocks

The exuberance in some technology stocks – electric vehicles, autonomous driving, software – is hard to miss, but the mania is nowhere near the previous sector bubble. These stocks may still decline, just not because of a bubble burst.

I am old enough to remember Yahoo listing on the Nasdaq in 1996. The then-quintessential search engine was valued at $850 million, implying a massive revenue multiple of 607. China.com (a Chinese clone of Yahoo) was listed in 1999 with a $5 billion valuation and $2.4 million revenue, an astonishing 2083x revenue. Even mega-caps with slower growth rates were valued highly. AOL was valued at $200 billion at its peak, even when it generated slightly more than $4 billion revenue. These bubble conditions are absent today. There is only a handful of technology stocks (about 40) trading at 30x revenue or more, and only 4 at 100x revenues or more. Recent popular IPOs such as Snowflake and C3.ai trade at 245x and 125x respectively, which are very expensive but not bubble-expensive. Mega-cap technology companies (Facebook, Apple, Netflix, Google) trade at 8x revenues or less, a far cry from AOL’s 50x.

The general market does not seem expensive either. The S&P trades at 22 forward PE, near its 2000-tech-bubble peak of about 24, raising alarms for a probable (and painful) mean reversion. But it is likely wrong to assume that 24 applies as the ceiling for valuation today. The economy was very different in year 2000. Quantitative easing and Facebook were not invented yet. Netflix only delivered DVDs. Amazon offered mainly books. Banks were over-levered and held little equity relative to risky assets. Overnight rates were 5-6%, compared to 0-0.25% now. The American economy is stronger and better supported today. The large technology companies are delivering consistent double-digit growth in revenue and profits with no end in sight. They make up 12% of the S&P, up from nothing in year 2000. Banks now hold plenty of capital relative to risk levels, and still make record profits even with lower leverage. The Federal Reserve is much more effective in responding to crises. A stronger economy, with unprecedented supportive monetary (and now fiscal) policies, should see higher multiples.

The question is how long the support would last. This is a complex topic, because the central bank does not have complete control. The Fed has a dual mandate of maintaining stable prices and maximum employment. It currently keeps rates low to promote job growth, and affords to do so because inflation has been below the 2% target in half of the past decade.

What happens if inflation is above 2%? The Fed would raise rates to control inflation, yet higher rates reduce job growth. Fulfilling the dual mandate would be trickier. What happens if longer-term rates increase? The Fed only has control over overnight rates, which influences, but does not determine, longer-term rates. Higher longer-term rates depresses growth. What can the Fed do when overnight rates are already at 0%?

What is certain is that the Fed is determined to expand its influence. It sends the message through a relentless stream of unprecedented and timely policies during the past 12 years, whenever the outlook is dire. An influential Fed amplifies the upsides of its supportive policies, but also intensifies the downsides of policy missteps. The global economy is fortunate that the Fed has not made major policy errors since 2008. The lack of errors is actually an aberration. The Fed made numerous errors in the 94 years between its birth in 1913 and 2007. Its inclination towards novel policies means that significant errors in the future may be difficult to reverse, because history would offer little guidance.

We should count ourselves lucky for a responsive and (almost) error-free Fed for the past 12 years, but should not count our chickens before they hatch.

Our investments

Your manager is invested in the same securities as you are. Our portfolio contains 6 US-listed equities in the technology, media, and healthcare industries, with market capitalizations ranging from $100 million to $100 billion.

Your manager favors businesses in sustainable, predictable, and non-traditional niches growing at above-market rates. History has shown that sustainable above-market growth is rare, because the required ingredients tend to exist separately. Each ingredient appears ordinary in isolation. When bundled together, each ingredient reinforces others, and, in a flywheel fashion, results in a multiplier effect and a whole that is greater than the sum of its parts. The ingredients include heavy commitments to innovation and people, clear visions for market leadership, industry tailwinds, excellent unit economics, and incentivized leadership, among others.

The value of our holdings in ecommerce and digital advertising have significantly increased. Social distancing and lockdowns caused by the pandemic accelerated the shift to online retail and advertising. Consumers are unlikely to favor physical retail after experiencing the seamless nature of ecommerce. Advertisers are also less likely to commit to non-digital formats after benefiting from the greater efficiency of digital advertising over alternative formats. More importantly, the management teams of our holdings delivered. No one expected the scale of the pandemic and disruptions. Yet our management teams recovered quickly from the economic shock, took advantage of disruptions, and led their businesses to new highs.

The key risk in technology and media is the unintended consequences of regulations. Not the regulations in and of itself, not even the immediate effects, but the second, third, and subsequent order effects of regulations. Ecologist Garrett Hardin advocates asking ‘and then what?’

Regulators start with good intentions in restricting the outsized, black-box influence of Facebook and Google (black-box because many elements of ad pricing are proprietary). The results should unfold like any worthy economics textbook says so. More players in digital advertising results in more competition and innovation. Advertisers can shop for the lowest cost amidst the plethora of choices. The lower cost of advertising would benefit the ultimate end-consumer.

Reality is more complex. Human behavior, unlike physical phenomena, unfold in unpredictable ways. Facebook and Google have commanding leads because of their copious collections of data. New and smaller players do not have an edge in data. What would they do to get an edge? Would they resort to new methods of data collection that threatens consumer privacy further? Would they refuse transparent reporting on collection methods to protect their edge? Would digital advertising then become less transparent than it was?

There is no one easy answer that balances the interests of all involved. Your manager does not dream to be a regulator, but would align our investments with the way the world works.

Trust as leverage

I have been told that the logo is an abstract image of houses or mountains. It really is simply a handshake, which is a universal representation of trust.

Any self-respecting investor knows that it is impossible to know everything about a company, though it is just as important to work as hard as possible to know as much as possible.

So how is it possible to be sure of a good deal? One has to trust that the other side would hold up its end of the deal. And that is what the handshake really represents. You trust that the other side would take care of things, that you would never have known, to your benefit.

In this perspective, trust functions like leverage. In physics, leverage allows for results that are multiplies of the effort exerted. When you trust the other side, the Pareto principle works (80% of results from 20% of effort).

How is trust established for an investor in practical terms? Your manager hardly has contact with holdings. There are no boots on the ground. Your manager favors publicly available information, and it is usually sufficient to know whether management is trustworthy. How does the CEO represent the business, industry, and competitors? Does the CEO fulfill promises? What excuses does the CEO or CFO have for missing targets? How do senior executives talk about other employees? The catch is to read enough to know what makes sense.

Gratitude shout-outs

Many have provided advice and support to your manager:

  • My wife and mother-in-law, who have believed and supported me in every way possible (nothing motivates an investor more than having the mother-in-law’s savings on the line)
  • My parents, who provided the opportunity for me to pursue my education in the United States
  • Peter Kaufman, who generously showed me how the world works by teaching me its timeless and unique principles
  • Scott Hendrickson and Mike Kimpel, who taught me their research framework and provided useful feedback on my ideas at Columbia
  • Alex, Ben, James, Roger, and many others who provided useful feedback

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

Marcel Gozali

1/5/21

Unique and hidden flywheel powers growth at Elastic

Elastic NV (NYSE: ESTC) is the most interesting enterprise software company that I have encountered. Its strong and improving financials are obvious. What is hidden is its unique flywheel, which relies on open-source and powers rapid innovation and growth.

Its core competency is in Elasticsearch, an open-source and near-realtime search solution that supports many applications in analytics, monitoring, security, and likely many more in the future.

The keyword is open-source. Elastic’s steadfast commitment to open-source has fostered a large and dedicated community of developers (150,000 and counting). Users provide rapid feedback, remove bugs, and guide feature development. Elastic effectively crowd-sources innovation from its developer community, taking cues on what to expand into and what to acquire. Crowd-sourcing innovation is also faster and more cost-effective than the traditional, “closed” corporate R&D model.

Another benefit of open-source is shorter sales cycles. The large and loyal base of developers enables an effective bottom-up “grassroots” (as opposed to top-down CIO-first) approach to sales and marketing, shortening the infamously long sales cycle in enterprise software. Elastic counts about half of the Fortune 500 and a third of the Fortune 2000 as customers, which supports high recurring subscription revenue (92% FY20 revenue). Elastic is growing rapidly (57% FY20 rev growth yoy, 45-55% rev growth yoy during Covid qtrs), and is still early in its growth journey because of the innumerable innovations that its community would eventually discover in the future.

Critics often question developer loyalty. Why would a developer release self-developed improvements for free? Because the developer must use Elastic software for projects. The developer has to reports bugs and suggest improvements so that projects can be completed. Elastic has shined in strategic execution to achieve developer mind-share when there are many other open-source search and analytics solutions. There are two subtle but visionary nuances worth discussing.

The first is straightforward (but not simple to execute): a relentless focus on developers. Shay Banon, founder and CEO, discussed how Elastic differs from its open-source competitors:

“One common open source business model, is to sell support subscriptions. Sadly, support-only business models trend towards a conflict between what’s best for the user and what’s best for the company. In these situations, the company isn’t motivated to make their products easier to use, more reliable, scalable because that would eat into their support profits.”

This makes sense. Open-source providers are incentivized to make products difficult to use, so developers must pay for support, discouraging developers from improving the software.

“[Elastic] was never, and never will be, willing to bear the tension of not making our software better in order to ensure that the company stays in business. We want to continuously improve and our goal with support is to make your project successful so that you are the expert in your Elastic Stack deployment. We want you to be successful so that you choose the Elastic Stack for your next projects too.”

Elastic encourages developers to improve its software by promising it would do the same. The software would always improve, and would never be held back for commercial reasons. Wouldn’t this reduce support subscriptions? Elastic’s answer is the second nuance to its strategy. It only sells support to the most intensive users (think Fortune-ranked companies). It also sells them access to some features that are high-value to them but used little by the larger community, who mainly uses the free core software.

Elastic’s strategy serves the entire spectrum from the large corporations, from whom it charges and financially profits, right down to the individual developer, from whom it does not charge but gains technically and intellectually. The flywheel starts with Elastic relentlessly improving the software and helping the developer succeed, incentivizing the developer to turn only to Elastic and nothing else. As more developers use Elastic, they improve the core software more effectively than competing software. Increasing developer usage improves the standing of Elastic at large corporations, which pay for support subscriptions to Elastic, who in turn uses the revenue to reinforce the flywheel.

Competitors to Elastic are specialized solution providers (Datadog/Splunk in application monitoring, FireEye/Checkpoint in endpoint security), some of which are built atop Elasticsearch. The key advantage of Elastic is its large and loyal community, enabling the aforementioned flywheel and unbeatable economics. The community is also its key defense against Amazon. Amazon forked code from Elasticsearch to build AWS Elasticsearch (thought Amazon insisted it wasn’t), but was unable to build a community around it (see approximate community size for Elasticsearch and AWS Elasticsearch here), riddling the service with numerous bugs. AWS Elasticsearch should be effective in retaining unsophisticated users in the AWS ecosystem, but is unable to scale quickly without a dedicated developer community that takes years and resources to build. Because AWS Elasticsearch is only of many AWS managed services, Amazon is unlikely to dedicate sufficient resources to mount a challenge to Elastic.

Elastic’s leading competency in search, open-source distribution, unique flywheel, and shorter go-to-market cycles would sustain growth for years. A reasonable bull case can be made for 30-40% topline growth for current applications in the next 5 years, multiplying revenues by 4-5x (forward EV/sales about 5x). 50-60% growth in deferred revenue and $350 million cash provide adequate funding, further supported by expected positive FCF in FY21. Assuming 4.5x growth in revenue in 5 years, steady-state 35% EBITDA margin, and 36x terminal growth multiple (r=9%, g=6% ~ 3x global GDP), the projected EV is about $16 billion, and target price is $185/sh. (32% upside).

The projection excludes the upside optionality of additional applications which Elastic’s community has yet to discover. The community led Elastic to its current applications in monitoring and security, which were built with a three-pronged approach: community development, internal R&D, and M&A (executed brilliantly by current management). It is likely that Elastic would find future revenue growth from additional applications from its community, continue its excellent execution with improving internal funding, and launch new offerings in years to come.  

How to miss life-changing opportunities, again and again

How can anyone miss once-in-a-lifetime opportunities? Missing it once is unimaginable. Twice, ludicrous. Thrice, plain stupid.

How about missing it one thousand eight hundred times?

My dentist did exactly that.

His dental practice, built over three decades, is popular and profitable. The wait list to get an appointment is long. His success motivated his sons to be dentists as well. He makes enough for a million-dollar home, country club membership, and private schools for his kids.

These are nothing compared to what he missed.

20 years ago, he attended a farewell party. His cousin’s startup was acquired by Company X. As part of the acquisition, his cousin had to move to Nevada to work for X.

The cousin was a robotics engineer by trade. His startup owned two patents and had no revenue. He was thrilled that X appreciated the intellectual property enough to acquire it. What was better, in his mind, was that 98% of the acquisition price was paid in X’s stock, with more on the way as part of his employment agreement with X. Suffice to say, he was optimistic on X’s prospects.

X is the most amazing company. You all have to buy its stock, the cousin said at the party.

Out of 30 family members present, my dentist was the sole buyer of X’s stock. He had never owned stocks before. He had no idea what a stock is. But he trusted his cousin. X traded at $5 per share then.

As business at the dental practice picked up, my dentist almost forgot about his tiny stake in X. He checked his portfolio bi-annually, if at all.

To his surprise, X increased six-fold after two years. He was thrilled. He had never bought a stock before X, yet his first purchase was wildly profitable. He called the cousin to ask about X.

Everything is going great because of our proprietary advances in precision robotics and biomedical engineering. Do not worry about the litigation matters. You should continue to own X, the cousin said.

My dentist, perplexed by the conversation, promptly sold his stake at $30 per share.

For the next five years, my dentist had conversations about X with his cousin at least once annually, before they lost touch. At every conversation, his cousin touted the milestones at X. Every major regulatory approval, significant purchase order, and successful R&D outcome reinforced the cousin’s confidence in X (These were all public information). At their final meeting before losing touch, my dentist insisted that he was satisfied with the six-fold return, and could do without owning X’s stock.

Shortly after the final meeting, the United States faced its worst financial crisis since the Great Depression.

My dentist felt justified in not owning stocks at all, and perhaps even more justified in selling X’s stock five years earlier.

Fast-forward to 2020. It has been 12 years after the financial crisis, a little over 12 years since the final conversation my dentist had about X with his cousin, 17 years since my dentist sold X at $30 per share, and 19 years since the cousin began working for X and recommended X at $5 per share.

The cousin invited his entire family to a 4-day, all-expense-paid trip at an exclusive ranch in California. The occasion was his retirement. After 19 years of service at X, he retired as a senior executive. Adjusted for stock splits, X was trading near $700 per share.

The cousin never sold a single share of X in his 19 years of employment.

The cousin was wealthy. How wealthy? If he had sold his startup at $1.5 million (estimated, the price was never disclosed), of which 98% was paid in X’s stock, his stake in X would be worth $206 million, a staggering 140-fold return.

And $206 million is the minimum estimate of his stake. Because about 30% of his compensation was paid in stock annually.

My dentist invested $50,000 in X and sold his position for $300,000. Had he held until his cousin retired, his stake would have been worth almost $7 million.

My dentist missed the boat for a 23-fold return ($30 to $700 per share). Not once. Not twice. Arguably for five years (between selling X and losing touch with his cousin), my dentist had direct access to an executive with intimate knowledge of X and keen enthusiasm for the business. Every day in those five years was a chance to buy X again. He missed all of them.

All 1,800 days.

A few takeaways:

1 – Missing life-changing opportunities happens more often than you think.

Between 1952 and 1962, Warren Buffett taught investing at the Municipal University of Omaha (now the University of Nebraska Omaha, or UNO). It was a non-credit class because Buffett disliked giving bad grades.

A photo showed 16 students in Buffett’s class. In 10 years, Buffett perhaps taught 160 students. Guess how many invested with Buffett?

One.

Less than one percent of 160 students felt that the Oracle of Omaha was good enough for them to invest in. Every student listened to hours of insights, taught directly by the Oracle, yet almost every student thought he won’t be good enough.

You probably think that you won’t behave like those students or my dentist.

But you probably would.

We are inclined to perceive things as “normal” because that is the easy way to understand things. Perceiving things as extraordinary requires a leap of faith and more mental effort.

Ergo, the human instinct is unable to spot the outstanding early. The outstanding, by definition, is different. The human mind is inclined to dismiss the differentiating elements, and explains them as similar to everything else. The outstanding has to be prove itself, again and again and again, for the human mind to believe.

For the purposes of investing, this innate quality is not helpful. The cat is out of the bag by the time the outstanding has proven itself to be outstanding. As more investors learn about the outstanding, they would bid its price up to a point that curtails the potential for it to appreciate further.

The point is to spot the outstanding early. To buy and hold X at $5 per share before it becomes $700. To invest in a young Buffett before he becomes the Oracle.

I know one way to do so.

2 – All you need is context, a lot of it.

If you have $122 billion in a checking account, how would you look for an investment?

Most would rely on hordes of lawyers, consultants, bankers, accountants, analysts, and of course, endless meetings. This is the gold standard of corporate due diligence.

Berkshire Hathaway has exactly that in cash and equivalents. Its owners prefer this way:

We really can tell you in five minutes whether we’re interested in something.” – Warren Buffett

Five minutes is all he needs, because he has context. A lot of it.

Within 5 minutes, he analyzes the investment relative to others and knowledge accumulated over 70 years (Buffett started investing at 11 years old. He is 90 now), during which he spent 80% of his days reading.

In an average day, Buffett spends almost 13 out of 16 waking-hours reading (assuming 8 hours of sleep). How much does he read? 500 pages.

Per day.

Todd Combs did that and more. He is now the CEO of Geico, arguably Berkshire’s most valuable asset.

Knowledge provides context. You can identify the outstanding early with context.

To be clear, what you want is not just any knowledge. You want the right set of knowledge, which provides what I term the complete context.

To determine whether X is a good investment, you have to know not only about X, but also everything else that surrounds it and came before it. Knowing all three and seeing their connections provide complete context.

Think about the complete context as a three-dimensional perspective (x-y-z planes, if you recall high school geometry).

The first dimension is a single plane (x-axis). Your knowledge of X per se, no matter how much, is just one plane. It is a start, but not helpful in forming a complete picture.

The second dimension comprises two planes (x and y axes). The additional plane is akin to knowledge of X’s peers, industry, market size etc. In this dimension, you can draw lines to connect your knowledge of X to its comparable peers, industry, market size etc.. A better picture emerges.

So what else is missing? The time element.

The third dimension (x, y, and z axes) includes the historical perspective – the knowledge of X and its peers, industry, market size etc in their past.

Complete context is only possible when you combine knowledge of X (first dimension), knowledge of peers, industry, market size etc surrounding X (second dimension), and the corresponding historical knowledge (third dimension).

Combining all three creates unique knowledge when you see connections among the three. Therefore, the combination of the three is greater than the sum of its parts.

Think back to my dentist and his cousin. Who had the more complete context of X and significantly more success?

Recall that my dentist sold X after his cousin mentioned complex engineering terms and litigation matters. He feared about his lack of understanding, which, in all likelihood, is not because of the inherent complex nature of X.

It is because he did not work hard enough to attain the complete context of X.

And that is the problem with this method. To most people, it takes too much effort.

And the reason it works is because most people won’t do it.

“Read 500 pages every day. That’s how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.” – Warren Buffett

What will you do?

The investor who crashed but ended wealthy

I have a large extended family. My mother has ten siblings. My father, six. Out of eighteen people (including my parents), only two are financially well-off.

The first arrived in the United States without knowing a word of English. She was not a bright student. She struggled in a work-study program paying below-minimum wages. She eventually built a significant manufacturing operation employing near fifty.

Yet it is the second relative with the more interesting story. I’ll call him V.

V was expelled from school because he got into one too many fights. He then worked in his father’s (my grandfather’s) small hardware store, and later delivered eggs for a farm. His fortunes turned after his tiny startup capitalized on the explosive growth of jeans. He supplied the then-unique fabric to manufacturers. He even timed the sale of his controlling stake at peak valuations. By any measure, V was no longer poor.

This was when his problems began.

Armed with abundant capital for the first time, V started “investing”. He speculated in currencies, stocks, and derivatives, with a rudimentary understanding of finance. His frequent and enormous trades summed to hundreds of millions in turnover, attracting brokers of all sizes. The more shrewd and cunning suggested trades that he could never understand. They explained that the trades were exclusive to a select few, and that profits were virtually certain, but not when and how. V never stood a chance against Wall Street.

V took five years to build and sell his startup. His account took less than half that time to be down 120%.

V should have been in utter financial ruins. An otherwise tepid transaction, suggested by his wife, not only saved V from ruin, but also generated profits enough to make him a millionaire many times over.

His eldest son was born shortly before the sale of his startup. In planning for the family’s future, his wife suggested that they plant roots in the neighboring country of Singapore. This was the late 1970s, when the majority of Singapore was rural and unsewered (I urge readers to learn what unsewered is to appreciate the miracle that is the modern sewage sanitation system). V was flabbergasted. To leave the familiar for a wasteland (pun intended) was absurd. His wife was insistent, believing that the public school system in Singapore, however undeveloped, was better than what her country offered. V, with little formal education, did not understand her perspectives, but gave in out of respect. The young family eventually migrated to Singapore. V used some proceeds from the startup sale to purchase land and real estate in the new developing country, and allocated the balance to his trading account.

In 1978, Singapore’s GDP per capita was about $3,200, roughly a third of the United States’. In 2018, the same measure for Singapore had grown 20-fold and exceeded the USA by about 3% (The USA grew the measure by about 6-fold in the same period).

So how did real estate in Singapore performed? About a 22-fold increase. V’s returns are likely much higher because of leverage and favorable exchange rates. By rough calculations, his returns were at least 60-fold in USD terms, considering a 50% down-payment (interest rates exceeded 10% in the late 1970s, so buyers tend to place large down-payments to reduce interest payments) and a 70% appreciation of Singapore versus US dollars (meaning that one Singapore dollar today buys 70% more US dollars than it did).

A few takeaways:

1 – Success is not transferable. What made you successful in one game does not directly make you win in another.

V was a sharp operator before indulging in securities. He knew exactly how machines are running, and what his suppliers, customers, and employees expect. His skills did not translate directly to trading. Only his confidence and ego did.

As an operator, constant action was the norm. V was always on his feet, inspecting machinery and talking to people. He thought he had to do the same in trading. He could, but he didn’t have to. His skills may had worked if he were a tape-reader (ie the quintessential intuitive trader), but results certainly showed he wasn’t.

You have to understand your strengths at their core, in order to know what to work on and how to work in the unique way that caters to your strengths.

To work in a certain way, just because your peers do or some successful person says so, ensures disappointment.

2 – When you have capital, the right thing to do mostly is nothing.

Warren Buffett once quipped “I make mistakes when I get cash. Charlie tells me to go to a bar instead. Don’t hang around the office.”

Investing is akin to a baseball game with infinite pitches. You only have to swing at those which assure home-runs. You have to know your sweet spots. Every investor has unique backgrounds, knowledge, and by extension, sweet spots.

Home-runs are rare by definition, so the investor should behave similar to the batter who watches many pitches pass and does not swing. Yet the batter must always be prepared to swing at a moment’s notice.

Wall Street gets paid when the batter hits the baseball. Every hit on the bat is a commission, so WS throws as many pitches as possible in as many ways as possible to entice investors to swing their bats. WS does not care whether the batter hits a dud or a home-run.

WS makes it difficult to do nothing when you have capital, but nothing is exactly what you mostly have to do.

To be fair, real estate in Singapore is not V’s sweet spot. However, V is likely to understand where and how to buy a home for his family, more so than when to buy and sell complex securities. V’s home-run in real estate obscures an important but subtle point, which brings us to the next takeaway:

3 – Home-runs are not short-term large returns, but are really long-term moderate returns.

A 60-fold return is significant. Over 40 years, it equates to 10.8% per year. The annual returns do not appear significant relative to equity indices. The S&P 500 reached a bottom in March 2009, and returned 16.5% per year between then and now (with dividends reinvested).

The secret is not in the annual returns. It is in the duration.

Over a long-enough time frame, even moderate returns can achieve astonishing results. Committing to the investment, through large and small downturns, is essential but counter-intuitive. It is a characteristic that V had help on, which leads to the final takeaway.

4 – Marry the right person, and have reasonable expectations.

Investors take pride in sticking to cold, hard facts. But investing is predominantly a human activity. The cold, hard facts underpinning decisions are selected by bias, which contains an emotional element. Trading algorithms, designed to be emotionless, are designed by emotional humans.

This means that human psychology matters.

Just knowing about home-runs is insufficient. You have to know how to emotionally stick to the strategy producing the home-run.

Judging from V’s trading, I am certain that he wanted to sell the real-estate in Singapore after a certain level of appreciation. One who trades in minutes and hours does not have the patience to invest for months and years, let alone decades.

I am almost certain that every discussion V had with his wife about selling, he was persuaded otherwise. His wife loved the home that was built from scratch, the large yard, its polite neighbors, proximity to great schools and public transportation etc. On top of those, the home and land values appreciated almost every year.

In all fairness, V’s wife knew next to nothing about investing. Singapore real estate was certainly not her sweet spot. However, that she could stick to a home and its surroundings for more than 40 years is telling of her reasonable expectations (she does not want or need a bigger house) and stable sense of contentment. The average American, contrary to V’s family, moves 11.7 times in a lifetime (Singaporeans about a third as often).

Reasonable expectations allows one to stick to a strategy, through thick and thin, for the long-term. It is not the same as being ignorant. Quite the opposite. It is being aware of the facts, and the understanding of the futility of reaching for the very best returns when the present works fine.

Contentment, the act of not reaching for more, is the paradoxical key to get more, because it results in long-term duration that underpins astonishing returns.

Marrying the right person can do wonders for the psychology of contentment. After V saw his trading account wiped clean, he never traded again for short-term profit, likely at the behest of his wife. His wife constantly reminded him to appreciate the present, which offered a higher standard of living by any measure relative to their lives before moving to Singapore. V’s appreciation for the present grew gradually. As his brokers pay less attention to him, he eventually sold all his luxury jewelry and watches, and traded his Mercedes for a beat-up Honda van. The less he owned, the more contented he became.

The Oracle of Omaha said the following about reasonable expectations. It is no wonder that he achieved the rare combination of being wealthy, contented, and in all likelihood, happy.

I was going to do the same things when I had a little bit of money as when I had a lot of money. If you think of the difference between me and you, we wear the same clothes basically (SunTrust gives me mine), we eat similar food—we all go to McDonald’s or better yet, Dairy Queen, and we live in a house that is warm in winter and cool in summer. We watch the Nebraska (football) game on big screen TV. You see it the same way I see it. We do everything the same—our lives are not that different. The only thing we do is we travel differently. What can I do that you can’t do?” -Warren Buffett

Tech boom or bubble?

The strength of technology stocks in 2020 is indisputable. The five largest companies – Google, Amazon, Apple, Facebook, Microsoft – are all in technology. Their dominance is increasing. Their market values make up more of the S&P 500 than their counterparts did at the dotcom bubble peak 20 years ago.

Yet such strength often precedes bubbles that end with painful crashes. History contains many examples – conglomerates in the 70s, thrifts and semiconductors in the 80s, “tiger” economies in Southeast Asia in the 90s, TMT in early 2000s, and financials before the GFC in 2008.

All bubbles begin as booms, but not all booms become bubbles. Sometimes a boom is deflated by timely contractionary policies or gradual loss of investor interest. The boom to worry about is the one with a self-reinforcing character. It starts with good fundamentals, leading to rising valuations, high investor interest, and pressure on companies to show improving fundamentals. Companies venture into less-profitable activities that are disguised as sound decisions to support valuations. Rising stock prices discourage investors from prudent due diligence and encourage them to use impractical assumptions to justify increasing valuations, which further increases pressure on companies. The self-reinforcing frenzy results in a bubble that would inevitably end after companies meet the limits of expansion and show deteriorating fundamentals.

History shows that two factors are essential for a boom to become a bubble:

  1. Excessive valuations
  2. Abundance of overly simplistic elements as key drivers of value

Is the boom in tech stocks actually a bubble?

1. The largest tech companies do not appear to be excessively valued relative to past bubbles and long-term interest rates.

The conglomerate bubble in the 70s involved the then-largest companies, while the dotcom bubble in 2000 involved TMT companies. These bubbles are used as proxies because they relate to the current largest tech companies in size and sector respectively.

The reader should also understand the concept of equity yield and its relation to long-term interest rates. The equity yield is the underlying company’s earnings and dividends relative to its stock price. Another way to put the equity yield in context is to view a stock as a bond. Earnings and dividends of a stock are akin to coupons of a bond (except that earnings are not distributed like coupons are, but are left for management to allocate).

Compared to the yield on treasury bonds, the equity yield of a stock should be higher. This is because a stock’s risk is higher than treasuries’ (ie risk-free), so it should almost always offer higher yields than treasuries to entice investors. Higher risk, higher yields; lower risk, lower yields.

During the 1970s, the conglomerate bubble saw large-cap stocks yielding less than 2%, while 10-year treasuries yield more than 6%. This discrepancy was evident of a bubble. Equity investors accepted yields lower than treasuries!

Put in a different way, investors accepted low yields that implied excessively high valuations (PE ratios range 70-80), and could had accepted higher yields in treasuries with much lower risk.

The tech bubble in 2000 saw even lower equity yields. The 100-200x PE ratios of Nasdaq stocks implied yields of 0.5-1.0%, which were much lower than the 6.5% yield on 10-year treasuries.

Today, with the exception of Amazon, the four large tech companies trade near 32x forward PE, which translates to 3.1% yield (inverse of 32). Only Microsoft and Apple in the group pay dividends in the 0.7-1.0% range. Hence 4.0% can be used as an appropriate proxy for the equity yield of the group.

Relative to 10-year treasuries yielding 0.7%, the group isn’t expensive. Even if the 10-year yielded 1%, PE ratios of the group have to triple to match.

This method shows that only Amazon is expensive relative to long-term rates. Amazon sports 108x forward pe, which translates to 0.9% yield, just slightly above the yield on the 10-year.

2. There is little evidence of overly simplistic elements as key drivers of valuations.

During the late 1960s and early 1970s, conglomerates relied on M&A for high growth rates that were rewarded with increasing multiples. Their success attracted imitators, which went on acquisition sprees. M&A activity eventually involved the most mundane businesses with stagnant or even contracting revenues, such as metal scrapping. At the peak of the bubble, companies were rewarded with high multiples as long as they promised fervent M&A.

In the late 1990s and early 2000s, any business related to the Internet, whether it be laying fiber-optic cables or selling pet products online, had high multiples based on projected revenues. No attention was paid to earning, cash flows, and other traditional indicators of the sustainability of business models.

As shown by history, bubbles are formed by the lack of investor discrimination.

Current trends favor SaaS (software-as-a-service), IaaS (infrastructure-as-a-service), and similar business models with strong customer loyalty, platforms with network effects, and subscription components that support recurring revenues. However, investors are selective about the quality of business models. Most importantly, they discriminate to an extent that a company cannot market itself as “something-as-a-service” to achieve high multiples.

Take Grubhub as an example. The company was once a high-flyer, whose stock increased 22% in a single session after Yum Brands (the parent of Taco Bell, KFC, and Pizza Hut) bought a small stake. The stock crumbled after competition from Uber, Postmates, and Amazon intensified (Amazon has shut down its food delivery business) and revealed that high margins were unsustainable because of expensive customer acquisition cost. As with airlines and autos, consolidation to achieve scale is the solution to the problem of costs outpacing revenue growth. Uber is merging with Postmates, and Just Eat Takeaway is acquiring Grubhub.

Another example is lesser-known Alteryx. The company pioneered data analytics SaaS, increased revenue by 12x in 6 years, and oversaw near 13-fold returns from its IPO. Despite its excellent history, AYX was punished with a 53% decline in its stock when it provided earnings and an outlook that missed expectations. Investors were unforgiving despite the SaaS nature of the business and the company’s excellent track record.

Even Intel faced the wrath of the market when it failed to deliver. After announcing a delay in its next-generation chips, the stock of the technology stalwart fell 23% in 3 days.

Investors are (still) careful, so the current tech boom is not a bubble (yet).

Despite the lack of a tech bubble, technology stocks are still prone to large and small declines. It is hard to tell what the market would focus on. At one moment, it is revenue growth rates, no matter the cost. At another, it is liquidity and cash flows., no matter the business model. The investor must be ready for the market to do anything, and has to prepare accordingly. Investors, especially those in technology, would do well to heed Ben Graham’s advice:

“You can get in more trouble with a sound premise than an unsound premise because you’ll just throw out the unsound premise” -Ben Graham, father of value investing and mentor to Warren Buffett