What We’re Reading (Week Ending 03 March 2024) - 03 Mar 2024
Reading helps us learn about the world and it is a really important aspect of investing. The late Charlie Munger even went 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 03 March 2024):
1. The Future of Ecommerce That Wasn’t: An In-depth Look into What Went Wrong with Wish – Speedwell Research
A good explanation is a story that is hard to vary. If we did a postmortem of WebVan (grocery delivery) or Pets.com (online specialty store for Pets), what would we say went wrong? If we did the postmortem in 2006, most likely we would have said it was a silly and unrealistic idea. But if we were to do a postmortem now, with the existence of Instacart (grocery delivery) and Chewy (online specialty store for pets), how would our understanding change?
This is not a trivial exercise. It is far too easy to be dismissive about a failing business and think it was the entrepreneur’s ill-thought-out idea or just incompetence, but this does not hold scrutiny.
Look at Apple. For how many years was Steve Jobs and his insistence on not licensing the Mac operating system seen as the impetus for their failure? And the same thing happened again when the iPhone was released: analysts thought their unwillingness to license the phone’s iOS would ultimately lead to their demise. Now though, Apple’s success is attributed to their close integration and their proprietary software is a key selling point, which wouldn’t be possible if they licensed it.
If you took over Lego in 2004 when it was nearing bankruptcy, what would you diagnose as the problem? Would you have thought that with digital entertainment kids just don’t want to play with toy blocks anymore? Or would you have thought the focus on “noncore” activities like theme parks, clothing, and video game development were the issues? Perhaps the product was good but was simply too expensive? You know that today there are vastly more digital entertainment options than there were in 2004, they still have theme parks and video games, and their products are still expensive, so what was it?
If you were appointed CEO of Crocs in 2008 when their stock dropped 98% and was on the verge of entering bankruptcy, tell us that you wouldn’t be tempted to lay the blame on the aesthetics of the shoes. It is the most ridiculed shoe design with “ugly” virtually synonymous with Crocs and yet they now sell over 150 million of them a year. Again, what some people would identify as the problem of the business turned out to be a virtue…
…So, if we are saying Wish was unsuccessful because of their focus on cheap items with slow shipping, we shouldn’t be able to point to another company that did something similar and was successful…
…We will do one final analysis to estimate churn before concluding. However, we want to note that this analysis is unnecessary to make the point we are about to. If you simply saw that they lost users despite spending >80% of revenues on marketing, or almost ~$1.5bn, is there any explanation you would accept that could convince you the business was healthy? Imagine your Chief Marketing Officer just told you they spent $1.5bn to lose 2mn buyers and grow revenues 2%. How would anyone possibly see that as a good thing? And yet, with a little bump in numbers from Covid in 2020, it was overlooked by investors in favor of the hope of buying the next Amazon at IPO.
In the S-1 they disclose the following LTV chart. They calculate “LTV” as cumulative gross profits over a period of time attributable to new buyers acquired in a given cohort, divided by total new buyers, which is most certainly not what an LTV really is.
For example, let’s say a cohort generated $15 of gross profit in year one and then another $10 of gross profit in year two. They would add those two numbers up and say the “LTV” of the customer in year 2 is $25. Therefore, if you wanted to calculate how much each cohort generated in gross profits in a given year, you just have to take the difference between each year. In this example, this cohort generated $10 in gross profits in the second year versus $15 in the first year, suggesting ample churn. What you would want to see is each year’s incremental figure stay steady or increase.
The chart above shows cumulative gross profit by cohort. If it was a perfectly linear line, then that would mean in each period the cohort bought the same amount of goods as the previous period.
We will focus just on the 2017 cohort for simplicity. We annotated it to show how we estimated incremental gross profits. The average buyer from the 2017 cohort earns $15 in gross profits in year 1, which drops to $10 in year 2, and then to $6 in year 3. We can already see that by year 3, each cohort is generating about 1/3rd what it did in year 1, which suggests heavy churn. Remember that Wish’s payback period is about 2 years, which means it isn’t until year 3 they make that small incremental gross profit. And remember, this is just to pay back the initial marketing investment, not other S&M they spent on promotions to reengage that buyer.
Here, we can see that that the difference between the gross profit for total buyers divided by the gross profit per average active buyer gives us a churn estimate. At the end of year 1, 100% of buyers are active (by definition) and by year three that drops to 19%. That comes out to about 44% annual churn over two years. It is also noteworthy that the churn is much worse in the first year. A full 67% of buyers do not return after buying once.
Now, remember that their average payback period is under 2 years. That is rather problematic in the context of almost no one being left after 2 years! They have a thin amount of remaining users that not only need to cover all of the reengagement marketing, but also all of their G&A and R&D cost. And that’s before they can even make a profit!
This is a fundamentally broken business. Users do not stay long enough, they have to pay to get users to return, and users are not profitable…
…Earlier we said that an explanation is a story that cannot easily vary. Well, we have trouble figuring out exactly what the story is that cannot vary. There is nothing in principle wrong with an ecommerce offering catered to the consumers in the low-end of household earnings. Some would note that the low average order value would make it hard to make enough contribution profit per order, but that is essentially what Pinduoduo did in China, what Shopee is doing in Southeast Asia and Brazil, and what Temu is doing in the US. While we don’t know exactly if all of those initiatives will end up being profitable, it is hard to claim it is the idea itself that is rotten.
Clearly, Wish had a problem with both their high cost to acquire users and their ability to retain them. We know that Pinduoduo had a better customer acquisition engine piggy backing off of Tencent’s Weixin with preferred placement and the Community Group Buy model was a novel way to spur consumer sharing, free of charge. Shein had TikTok and went viral early on with “Shein hauls”, where influencers would post everything they purchased. They would later lean into influencer marketing on TikTok to much success. Amazon has Amazon Prime which helps retain users, and their optimal customer service helps keep customers satisfied at potential churn events. Wish was lacking something in the customer acquisition and retention area, but exactly what isn’t obvious.
Perhaps it was a mix of everything that individually created customer churn events from slow shipping to “unreliable shipping”, fraud, fake listings, sub-par customer service, inadequate item selection, poor item quality, inaccurate recommendations, or perhaps even internal issues. But again, other companies have survived similar or worse issues. And the longer the list, the more it speaks to our lack of confidence in any one variable. As an investor from the outside, it isn’t apparent what the key problem was, at least not to us.
What is crystal clear though is that there were issues since at least 2019, and some red flags prior. An investor only needed the company’s IPO prospectus to see these problems brewing, and could have avoided even worrying about any potential “narrative fallacy” by just focusing on the financials.
2. Bill Ackman: Investing, Financial Battles, Harvard, DEI, X & Free Speech | Lex Fridman Podcast #413 (partial transcript here) – Lex Fridman and Bill Ackman
Bill Ackman (57:12): So this was at the time of the Financial Crisis, circa November 2008. Real estate’s always been a kind of sector that I’ve been interested in. I began my career in the real estate business working for my dad, actually arranging mortgages for real estate developers. So I have kind of deep deep ties and interest in the business. General Growth was the second largest shopping mall company in the country – Simon Properties many people have heard of – General Growth was number two. They own some of the best malls in the country…
…General Growth the company, the CFO in particular, was very aggressive in the way that he borrowed money. He borrowed money from a kind of Wall Street – not long-term mortgages – but generally relatively short-term mortgages. He was pretty aggressive. As the value went up, he would borrow more and more against the assets and that helped the short-term results of the business. The problem was during the Financial Crisis, the market for what’s called CMBS – commercial mortgage backed securities – basically shut. And the company, because its debt was relatively short-term, had a lot of big maturities coming up that they had no ability to refinance. The market said, “oh my God, the lenders are going to foreclose and the shareholders are going to get wiped. The company’s going to go bankrupt, they’re going to get wiped out.” The stock went from $63 a share to 34 cents. There was a family, the Bucksbaum family owned I think about 25% of the company and they had a $5 billion stock that was worth $25 million or something by the time we bought a stake in the business.
What interested me was, I thought the assets were worth substantially more than the liabilities. The company had $27 billion of debt and had $100 million value of the equity, down from like $20 billion. And sort of an interesting place to start with a stock down 99%. But the fundamental drivers – the mall business – are occupancy, how occupied are the malls? Occupancy was up year on-year between ‘07 and ‘08. Interestingly, net operating income, which is kind of a measure of cash flow from the malls – that was up year-on-year. So the underlying fundamentals were doing fine. The only problem they had is they had billions of dollars of debt that they had to repay – they couldn’t repay
If you examine the bankruptcy code, it’s precisely designed for a situation like this where it’s this resting place you can go to restructure your business. Now the problem was that every other company that had gone bankrupt, the shareholders got wiped out. And so the market, seeing every previous example the shareholders get wiped out, the assumption is the stock is going to go to zero. That’s not what the bankruptcy code says. What the bankruptcy code says is that the value gets apportioned based on value, and if you could prove to a judge that the assets’ worth more than the liabilities, then the shareholders actually get to keep their investment in the company. And that was the bet we made.
So we stepped into the market. We bought 25% of the company in the open market. We had to pay up. It started at 34 cents – I think there were 300 million shares – so it was at a $100 million value. By the time we were done, we paid an average of – we paid $60 million for 25% of the business, so about $240 million for the equity of the company. And then we had to get on the board to convince the directors the right thing to do. The board was in complete panic, didn’t know what to do, spending a ton of money on advisers…
…And the key moment, if you’re looking for fun moments, is there’s a woman named Maddie Bucksbaum who was from the Bucksbaum family. Her cousin John was chairman of the board, CEO of the company. And I said – as she calls me after we disclose our stake in the company, she’s like “Billy Ackman, I’m really glad to see you here.” I met her – I don’t think it was a date – but I kind of met her in a social context when I was 25 or something. And she said, “I’m really glad to see you here and is there anything I can do to help you, call me.” I said, “Sure.” We kept trying to get on the board of the company, they wouldn’t invite us on. Couldn’t really run a proxy contest, not with a company going bankrupt, and their advisers actually were Goldman Sachs and they’re like, “You don’t want the fox in the hen house” and they were listening to their advisors. So I called Maddie up and I said, “Maddie, I need to get on the board of the company to help.” And she says, “I will call my cousin and I’ll get it done.” She calls back a few hours later, “You’ll be going on to the board.” I don’t know what she said, but she was convincing.
Next thing you know, I’m invited to the board of the company and the board is talking about the old equity of General Growth. Old equity is what you talk about when the shareholders are getting wiped out. I said, “No, no, no. This board represents the current equity of the company. I’m a major shareholder, John’s a major shareholder, there’s plenty of asset value here. This company should be able to be restructured for the benefit of shareholders.” And we led a restructuring for the benefit of shareholders and it took let’s say eight months and the company emerged from Chapter 11. We made an incremental investment into the company and the shareholders kept the vast majority of their investment. All the creditors got their face amount of their investment – par plus accrued interest. And it was a great outcome. All the employees kept their jobs, the malls stayed open, there was no liquidation. The bankruptcy system worked the way it should. I was in court all the time and the first meeting with the judge, the judge is like “Look, this would never have happened were it not for a financial crisis.” And once the judge said that, I knew we were going to be fine because the company had really not done anything fundamentally wrong – maybe a little too aggressive in how they borrowed money.
Stock went from 34 cents to $31 a share…
…Lex Fridman (1:05:44): How hard is it to learn some of the legal aspects of this? You mentioned bankruptcy code – I imagine it’s very sort of dense language and dense ideas and the loopholes and all that kind of stuff. If you’re just stepping in and you’ve never done distressed investing, how hard is it to figure out?
Bill Ackman (1:06:05): It’s not that hard. I literally read a book on distressed investing. Ben Branch or something, on distressed investing.
Lex Fridman (1:06:12): So you were able to pick up the intuition from that, just all the basic skills involved, the basic facts to know, all that kind of stuff.
Bill Ackman (1:06:20): Most of the world’s knowledge has already been written somewhere. You just got to read the right books.
3. Why is Google killing cookies? – Eric Benjamin Seufert
What is Google’s underlying motivation in deprecating third-party cookies in Chrome? Suspicion is warranted. Google’s mission statement for its Privacy Sandbox initiative is to “Protect [user] privacy online,” across its Chrome browser and its Android operating system (Google intends to deprecate its GAID Android identifier at some point). Cookies, unquestionably, present severe data leakage risks to consumers: they allow anonymous services to observe the web activities of users with little preventative recourse. But as I point out in this piece, “privacy” is an abstract social concept, and firms – but especially multi-trillion dollar market leaders – don’t make dramatic, sweeping policy changes absent commercial benefit. Believing that a company would utterly reform the mechanics of digital advertising solely in service of increased user privacy is as absurd as believing that two firms would engage in a merger as an expression of friendship. To not assume a commercial motive in cookie deprecation is naive.
Apple’s App Tracking Transparency (ATT) privacy policy is an apt example of this. Apple launched an international PR campaign championing the privacy safeguards of the iPhone following its introduction of ATT in April 2021. Yet as I point out in this piece, Apple collects and utilizes consumer data in the ways that ATT was ostensibly designed to prevent. Apple positions its use of install and purchase data collected via consumer engagement in apps that it doesn’t own as “ads personalization” and not “tracking.” Apple claims first-party privileges over this consumer data because Apple exerts (and is stridently maintaining a firm grip on) control over iOS payments, giving it exclusive, proprietary access to that data. And in a court filing from December 2023, Apple had the following to say about the logical contortions of its privacy policies (all emphasis from the document):
The Allow Apps to Request to Track setting governs whether apps can ask to track users across apps or websites owned by other companies, as Apple’s descriptions of the setting consistently make clear … Plaintiffs also include a screen shot of the Tracking disclosure, which explains that Apple “requires app developers to ask for permission before they track your activity across Apps or websites they don’t own.” … Given Apple’s extensive privacy disclosures, no reasonable user would expect that their actions in Apple’s apps would be private from Apple.
This isn’t to say that Google and Apple don’t employ well-meaning, intelligent, and highly effective people whose efforts are centered on promoting their conceptions of digital privacy. But digital privacy initiatives from publicly traded, multi-trillion-dollar corporations must be viewed in a broader commercial context…
…So given that Google must have a commercial motivation in deprecating cookies, what is it? The most obvious is simply margin expansion: Google’s network business, which serves ads on third-party websites and apps, will almost certainly suffer if the Privacy Sandbox is less effective for targeting and measurement than cookies (and early indicators suggest it is). If the economics of buying third-party open web inventory through Google’s tools degrades, some of that demand may simply be routed to Google’s owned-and-operated channels. And these channels feature much higher margin for Google than its Network business: Bernstein estimated in December 2022 that Google’s margin on Network revenue is 10%, while it’s 15% for YouTube and 55% for Search. As I argue in this piece, because advertising budgets are deployed against absolute performance, Google will likely lose some degree of top-line revenue if its Network business unit declines. But Google doesn’t need to shift all of the revenue from Network to these channels to maintain its current bottom line given the margin differentials: $1BN in Network revenue produces the same margin as $181MM in Search revenue.
4. Twitter thread on life and investing lessons from climbing Mt Kinabalu – Eugene Ng
1 | Hiking is a marathon, not a sprint. It is about finishing, whether or not you finish first or last it doesn’t matter, as long as you finish. There is no gold medals for the fastest, and only rescue for those who don’t. It only matters as long as you finish, and that you remain safe when you finish. Safety first, go slow.
It is the same with investing. Never be permanently wiped out, avoid all unlimited downside trades, and then you can focus on making asymmetric bets with unlimited upside…
…3 | I was in awe out the scale of the human labour require for the entire operations. We saw numerous porters carrying up 20-40+ kg of fresh water, food, furniture, equipment for the lodge where we stayed at. There were also a number of porters who carried up luggage for some climbers as well. Without them, the support, the ecosystem, none of these would have been possible for us to experience the climb.
It is ever easier than ever to get data, but we cannot be lazy. We need to learn to appreciate the ecosystem and what we have now with the internet, versus 50 years old with libraries and faxes. Use them to your advantage. Easily available does not mean everyone will actually read them. Do not confuse it.
4 | We had a fantastic mountain guide who was one of the oldest and fittest at 52 years and he has been doing it over 32 years old since he was 20 years old. He still does this three times a week and will retire next year. He was leading us in our walk through easier path with such a controlled and comfortable pace, like he is meditating. Without him, it would have been so much more difficult. Having the right leader to help guide you really matters.
Having the right mentors, the right people around you matters. They can have the right expertise, experience to share that can help you in your journey to become better and to avoid the pitfalls…
…6 | When ascending up and descending back down, it is not an individual effort but a collective team effort. The company matters. Without the right company to support you mentally on every step of the way makes so much of a difference, everyone has a role to play.
Like in investing, there are going to be ups and downs. The right people/investors to stand by you matters, and not run away at the first sight of trouble. Choosing carefully the right team to the best of your ability matters.
7 | Sometimes a member of your team is not going to be feeling very well or can be injured, it is being prepared and bringing along extra supplies, medical or food, and continuously supporting them with what you have physically and mentally. Remember that if they can’t finish, you can’t finish.
Know that the businesses that we invest in are not going to do well all the time, it is not going to be a straight line. There are going to be ups and downs, and they will zig and zag from time to time. We need to have the patience to stand by them through difficult times, and the good times, and not sell them.
8 | Run your own race at your own pace, sometimes you will overtake and sometimes others will overtake. Don’t be stressed by someone behind you trying to push you go faster. You set your own pace. If they want to overtake, just stand to the side and let them overtake, if not just chill. Separately, if you want to overtake someone slower, then just overtake on the side.
Find your own investment strategy that suits you best, that energises you. The real race is against yourself, not against others. There will always be someone who will do better than you in any given year, so chill. It is not about being the top 10% in a year, but the top 10% after 10 or 20 years and more…
…11 | Always remember to never get complacent and choose speed, or get distracted. Do a misstep over a loose rock, and you may just end up spraining your ankle (like me), and end up not finishing the climb. But thankfully, it was serious and painful, but it was still okay enough for me to complete the last 8km. It was insanely painfully with every descend as my right ankle landed on every step.
Never think highly of yourself. Stay humble, have humility. The moment you lose that, you stop listening, you stop absorbing, you stop learning, and then with a mis-step you might just result in eventual failure. Never do that.
12 | At the end, despite how much preparation, it is really willpower at the end that gets everyone through to the end. It can be so powerful, the human mind and the will power. Despite how tough it is, we were just highly focused on taking step at a time mindfully and carefully, that’s all that mattered. I sprained my right ankle horribly with 8km left, it was really painful, but I kept persisting, and my teammates were patient with me and walked slower. “Stay hard” by David Goggins was our slogan to keep us going.
Investing too is a slog, managers get paid to endure all the emotional and psychological elements with all the ups and downs. It is knowing when to keep pursuing and staying the course even especially when the going gets tough…
…14 | Memories over medals. We did not finish first, but we finished in the end, and that’s what matters. To Team Endurance!
If you beat the index after 10 or 20 years, you will be in the top quartile. You want to keep staying and playing the game, and keeping doing okay and eventually you will do very well.
5. Things I Don’t Know About AI – Elad Gil
In most markets, the more time passes the clearer things become. In generative AI (“AI”), it has been the opposite. The more time passes, the less I think I actually understand.
For each level of the AI stack, I have open questions…
…There are in some sense two types of LLMs – frontier models – at the cutting edge of performance (think GPT-4 vs other models until recently), and everything else. In 2021 I wrote that I thought the frontier models market would collapse over time into an oligopoly market due to the scale of capital needed. In parallel, non-frontier models would more commodity / pricing driven and have a stronger opensource presence (note this was pre-Llama and pre-Mistral launches).
Things seem to be evolving towards the above:
Frontier LLMs are likely to be an oligopoly market. Current contenders include closed source models like OpenAI, Google, Anthropic, and perhaps Grok/X.ai, and Llama (Meta) and Mistral on the open source side. This list may of course change in the coming year or two. Frontier models keep getting more and more expensive to train, while commodity models drop in price each year as performance goes up (for example, it is probably ~5X cheaper to train GPT-3.5 equivalent now than 2 years ago)
As model scale has gotten larger, funding increasingly has been primarily coming from the cloud providers / big tech. For example, Microsoft invested $10B+ in OpenAI, while Anthropic raised $7B between Amazon and Google. NVIDIA is also a big investor in foundation model companies of many types. The venture funding for these companies in contrast is a tiny drop in the ocean in comparison. As frontier model training booms in cost, the emerging funders are largely concentrated amongst big tech companies (typically with strong incentives to fund the area for their own revenue – ie cloud providers or NVIDIA), or nation states wanting to back local champions (see eg UAE and Falcon). This is impacting the market and driving selection of potential winners early.
It is important to note that the scale of investments being made by these cloud providers is dwarfed by actual cloud revenue. For example, Azure from Microsoft generates $25B in revenue a quarter. The ~$10B OpenAI investment by Microsoft is roughly 6 weeks of Azure revenue. AI is having a big impact on Azure revenue revently. Indeed Azure grew 6 percentage points in Q2 2024 from AI – which would put it at an annualized increase of $5-6B (or 50% of its investment in OpenAI! Per year!). Obviously revenue is not net income but this is striking nonetheless, and suggests the big clouds have an economic reason to fund more large scale models over time.
In parallel, Meta has done outstanding work with Llama models and recently announced $20B compute budget, in part to fund massive model training. I posited 18 months ago that an open source sponsor for AI models should emerge, but assumed it would be Amazon or NVIDIA with a lower chance of it being Meta. (Zuckerberg & Yann Lecunn have been visionary here)…
...Are cloud providers king-making a handful of players at the frontier and locking in the oligopoly market via the sheer scale of compute/capital they provide? When do cloud providers stop funding new LLM foundation companies versus continuing to fund existing? Cloud providers are easily the biggest funders of foundation models, not venture capitalists. Given they are constrained in M&A due to FTC actions, and the revenue that comes from cloud usage, it is rational for them to do so. This may lead / has led to some distortion of market dynamics. How does this impact the long term economics and market structure for LLMs? Does this mean we will see the end of new frontier LLM companies soon due to a lack of enough capital and talent for new entrants? Or do they keep funding large models hoping some will convert on their clouds to revenue?…
…What happens in China? One could anticipate Chinese LLMs to be backed by Tencent, Alibaba, Xiaomi, ByteDance and others investing in big ways into local LLMs companies. China’s government has long used regulatory and literal firewalls to prevent competition from non-Chinese companies and to build local, government supported and censored champions. One interesting thing to note is the trend of Chinese OSS models. Qwen from Alibaba for example has moved higher on the broader LMSYS leaderboards…
…How much of AI cloud adoption is due to constrained GPU / GPU arb? In the absence of GPU on the main cloud providers companies are scrambling to find sufficient GPU for their needs, accelerating adoption of new startups with their own GPU clouds. One potential strategy NVIDIA could be doing is preferentially allocating GPU to these new providers to decrease bargaining power of hyperscalers and to fragment the market, as well as to accelerate the industry via startups. When does the GPU bottleneck end and how does that impact new AI cloud providers? It seems like an end to GPU shortages on the main clouds would be negative for companies whose only business is GPU cloud, while those with more tools and services should have an easier transition if this were to happen…
…ChatGPT launched ~15 months ago. If it takes 9-12 months to decide to quit your job, a few months to do it, and a few months to brainstorm an initial idea with a cofounder, we should start to see a wave of app builders showing up now / shortly.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have a vested interest in Alphabet (parent of Google), Amazon, Apple, Meta Platforms, Microsoft, and Tencent. Holdings are subject to change at any time.
