What We’re Reading (Week Ending 31 January 2021) - 31 Jan 2021
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 31 January 2021):
1. Why It’s Usually Crazier Than You Expect – Morgan Housel
I want to try to explain why Gamestop went up 100-fold in the last year and why Sears never recovered. They have to do with the same force in opposite directions. It’s a force that can explain a lot of baffling trends lately, and it’s so easy to underestimate and overlook…
…Find a feedback loop and you will find people who underestimate how crazy prices can get, how famous a person can become, how hard it can be to change people’s minds, how irreparable a reputation can be, and how tiny events can compound into something huge.
They take small trends and turn them into big trends with unforeseen momentum. And they happen in every field.
If you become a good reader as a child, reading is fun. When reading is fun you do it more. When you do it more you become a better reader – on and on. The opposite is true: delayed reading ability can make reading feel like work, which can cause kids to read less, which delays reading comprehension even more.
When it doesn’t rain, there’s less evaporation, which makes the air drier, which reduces rainfall, on and on.
And, of course, feedback loops can do astounding things in business and investing…
…GameStop – whose stock is up 100-fold in the last year as a reddit message board coordinates a buying spree to hurt short sellers – is experiencing a similar thing.
The reddit campaign to push its stock up started two months ago. At first shares rose a little. That caught people’s attention, those people bought, which pushed prices up more, which caught more people’s attention – on and on – until this week when virtually every investor in America is paying attention to GameStop because it’s risen so high, and it’s rising high because every investor in America is paying attention to it. I have three friends who bought a few shares of GameStop this week “to see what happens.” They’re only doing that because the price went up. And they’re making the price go up.
Attention is hard to obtain. But once it’s achieved it can take on a life of its own, becoming self-sustaining and able to morph into something you never imagined.
2. Keith Gill Drove the GameStop Reddit Mania. He Talked to the Journal. – Julia-Ambra Verlaine and Gunjan Banerji
The investor who helped direct the world’s attention to GameStop, leading a horde of online followers in a bizarre market rally that made and lost fortunes from one day to the next, says he’s just a normal guy.
“I didn’t expect this,” said Keith Gill, 34 years old, known as “DeepF—ingValue” by fans on Reddit’s WallStreetBets forum and “Dada” by his 2-year-old daughter. He said he didn’t set out to draw the attention of Congress, the Federal Reserve, hedge funds, the media, trading platforms and hundreds of thousands of investors…
…Mr. Gill began investing in GameStop around June 2019, he said, when it was hovering around $5 a share. Earlier that year, the game retailer was hunting for its fifth chief executive in a little over 12 months. Mr. Gill kept buying. Although he never played much besides Super Mario or Donkey Kong, he saw potential for the struggling retailer to reinvigorate itself by attracting new customers with the latest videogame consoles.
“People were doing a quick take, saying GameStop was the next Blockbuster, ” he said, a chain caught in a retail decline. “It appeared many folks just weren’t digging in deeper. It was a gross misclassification of the opportunity.”
3. Yes, a Stock Can Have Short Interest Over 100% — Here’s How – Dan Caplinger
At first glance, it might seem like you could never have more than 100% of a company’s shares sold short. Once all the shares have been borrowed, you might think there wouldn’t be any more for short-sellers to get.
Indeed, there are U.S. Securities and Exchange Commission regulations designed to prevent what’s known as “naked” short selling. With a naked short sale, the broker allows the customer to do a short-sale transaction without actually arranging to borrow the shares beforehand. This can lead to market disruptions, and while there are some exceptions to the regulations, most brokers stop regular retail customers from selling stock short if they can’t obtain shares to borrow.
However, even without a naked short sale, it’s theoretically possible for short interest to exceed 100%. The reason has to do with the nature of the short-sale transaction itself.
As an example, take a situation involving four investors. Annie owns shares of GameStop, and Annie and her broker have an agreement that allows the broker to lend Annie’s shares to short-sellers. It lends them to Bob, who subsequently sells those borrowed shares short in hopes that GameStop’s share price will fall.
An investor named Chris ends up buying those borrowed shares from Bob. However, Chris has no way of knowing that those shares have been borrowed from Annie. To Chris, they’re just like any other shares.
More importantly, if Chris has the same kind of agreement, then Chris’s broker can lend out those shares to yet another investor. Diane, another GameStop bear, can borrow those shares and sell them short.
In this example, the same shares end up getting borrowed and sold twice. The short interest volume these transactions add to the total is twice the number of shares actually involved. You can therefore see that if this happened throughout the market, total short interest would eventually exceed the number of shares outstanding and approach 200%.
This still might seem impossible, and in a sense, it is. But part of the answer lies in the fact that there are investors that don’t currently possess actual shares of GameStop but who have the same economic interest as shareholders. They have the right to get back the shares they lent at any time. When you add together the actual shares plus these “synthetic” positions in the stock, the short interest can’t exceed 100% of that larger total.
4. A Look at Compounders through the Lens of “The Intelligent Investor” – Robert Vinall
I expect everyone has a slightly different understanding of what the term “compounder” means, but generally it describes a company that can grow or compound earnings by reinvesting capital (not by raising external capital). Compounders are likely to share some or all of the following characteristics.
1. High returns on capital;
2. Profitable (on an underlying, not necessarily reported basis);
3. Large Total Addressable Markets (“TAMs”);
4. A growing competitive advantage;
5. A strong culture characterised by humility and adaptability (essential to overcome growth pains);
6. A founder who likely embodies these values;
7. And predictable, better still, recurring revenues.
This is not a definitive list, and different companies will have these qualities in different quantities, but it gives a sense of what I am driving towards. Google most certainly is a compounder; Deutsche Bank probably is not…
…Graham did not write, to my knowledge, about compounders, but he did write about what he termed “growth stocks”. He defined growth stocks as follows:
“A growth stock may be defined as one that has done this in the past and is expected to do so in the future.”
This description falls somewhat short of my definition of a compounder above; however, many of today’s compounders have certainly done well recently and look set to continue to do so in the future. I feel fairly sure that Graham would identify today’s compounders as growth companies. For the remainder of this memo, I will use the terms “compounders” and “growth companies” interchangeably, notwithstanding the obvious definitional differences.
Graham was a well-known sceptic of growth companies. In Chapter VI of “The Intelligent Investor”, Graham asks rhetorically why not simply buy the most promising-looking growth companies and let the cash roll in? Consider his response:
There are two catches to this simple idea. The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases turns downward.
Graham’s scepticism is routed in three main objections. First, few companies can sustain their growth, i.e., genuine growth companies are rare. Second, the analyst’s judgement about a company’s long-term prospects is often flawed, i.e., there are lots of false positives. Third, growth companies have high valuations, i.e., the positive long-term prospects are already priced in.
The conclusion that generations of value investors have drawn is that investing in growth companies is a mug’s game to be avoided at all costs. This is without question Graham’s opinion too; however what people miss is that his scepticism was clearly routed in the context in which he was investing. Based on the opportunity set he saw – and extensively documented in “The Intelligent Investor” – he thought the odds of successfully investing in growth companies were poor. This being the case, is it any wonder he was sceptical about doing so?
In my view, the lesson to be derived from “The Intelligent Investor” is not that investing in growth does not work, but that every generation of investors needs to figure out for itself what the odds of it working are. Graham’s approach offers an excellent framework to figure out just what those odds are.
5. Type I and Type II Charlatans – Ben Carlson
Pockets of the market are flirting with silly territory.
SPACs, IPOs, and electric vehicle companies are all sprouting up like weeds.
I’m not intelligent enough to sort through the winners and losers in these areas but the fact that there are currently winners means there will be a flood of losers to follow. That’s how these things work. When speculative investments are in demand, the supply ramps up to meet it.
And many of those losers will be pushed relentlessly by hucksters and charlatans who flock to rising markets like me to a new Tom Cruise movie.
Charlatans tend to flourish when some or all of the following characteristics are present:
- When there’s an “expert” with a good story
- When greed is abundant
- When capital becomes blind to risk
- When individuals begin taking their cues from the crowd
- When markets are rocking
- When innovation runs rampant…
…Type I charlatans are the visionaries who are more or less sincere but wind up ruining their investors anyway because they take their ideas to the extreme or fail to account for the unintended consequences of their ideas.
These false-positive charlatans are so passionate that it becomes difficult for their victims to see any downside. When you combine intellect, passion, and people in search of money and/or power, it’s easy to become blinded to potential risks.
And once a Type I charlatan gets a taste of success, it’s tough to pull in the reins when things go wrong.
Type II charlatans are the out and out fraudsters who blatantly set out to take people for all they’re worth. These hucksters are only interested in making as much money as possible and don’t care who gets hurt in the process.
These charlatans are false negatives because they lie to persuade you to part with your money. It’s difficult to see through this type of charlatan because they know exactly how to sell you. They understand human behavior and tell you exactly what you want to hear.
They move the goalposts and shift the blame when it appears they’re wrong and understand how to massage your ego to keep you in line.
Bernie Madoff is a type II.
Elizabeth Holmes likely started out as a type I and slowly morphed into a type II once she realized Theranos was never actually going to happen.
6. Twitter thread on mental models learnt from Tobi Luetke, Shopify’s CEO – George Mack
LUTKE LEARNING 1 – OPERATE ON CROCKERS LAW
Crocker is a Wikipedia editor who asked people to NEVER apologise about editing his pages.
He just wanted them to focus on making his pages BETTER.
He took 100% responsibility for his mental state. If he was offended, it’s his fault.
“Just give me the raw feedback without all the shit sandwich around it.” – Tobi
“Feedback is a gift. It clearly is. It’s not meant to hurt. It’s meant to move things forward, to demystify something for you. I want frank feedback from everyone.” – Tobi
“If I’m insulted it’s because my brain made a decision, to implant in my memory and thoughts the idea of being insulted by that person…
I did that under my own volition. It was my own choice. My brain has assigned the power to the other person” – Tobi referencing Aurelius
LUTKE LEARNING 2 – ALWAYS BE A STUDENT TO FIRST PRINCIPLES
Tobi’s most consistent used mental model throughout his interviews is:
Global Maximum > Local Maximum
Local Maximum = Optimising a cog in the machine
Global Maximum = Optimising the machine itself
Tobi’s favorite example of FIRST PRINCIPLES is a Truck driver.
His truck was sat still for 8 HOURS on THANKSGIVING waiting for his cargo to be unloaded when he realized…
“Why not take the WHOLE trailer off the back of my ship rather than unloading + reloading each item?”
This Truck driver was called Malcolm McLean
His first principles approach created the SHIPPING CONTAINER
The results?
Global shipping costs went from $6 a tonne to $0.16 a tonne Exploding head
The most underrated entrepreneur of the last century AND the godfather of modern global trade.
7. Buried in Reddit, the Seeds of Melvin Capital’s Crisis – Michelle Celarier
For months, retail investors posting on a Reddit forum were broadcasting their intentions to take down a prominent, but reclusive, hedge fund called Melvin Capital — and doing so by buying call options on video game retailer GameStop, a stock in which Melvin had disclosed a big short bet…
…The effort to take down Melvin appears to have started late last year, and by mid-January, short sellers began noticing spikes in the price of GameStop. They suspected someone was covering — well-known short sellers Jim Chanos and Andrew Left were known to be short GameStop and had tweeted about the company.
But it wasn’t either one of those men who had earned the most ire of a popular Reddit forum, WallStreetBets, whose description reads, “like 4Chan found a Bloomberg Terminal.”
These retail investors had taken aim at Melvin, a fund headed by Gabriel Plotkin, a former portfolio manager with Steve Cohen’s SAC Capital. Cohen’s successor firm Point72 had more than $1 billion invested in Melvin’s fund, according to the Wall Street Journal.
About two months ago, a Reddit user called Stonksflyingup posted a video, with the title “GME Squeeze and the Demise of Melvin Capital” — with trial scenes from the miniseries “Chernobyl” superimposed with text asserting that “Melvin Capital got too greedy,” as well as an explanation of how a short squeeze can occur. The clip concluded with a photo of an explosion with the words “Melvin Capital” splashed across it.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. Of all the companies mentioned, we currently have a vested interest in the shares of Alphabet (parent of Google) and Shopify. Holdings are subject to change at any time.
