What We’re Reading (Week Ending 06 March 2022) - 06 Mar 2022
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 06 March 2022):
1. TIP 422: Frontier Market Investing w/ Maciej Wojtal – Stig Brodersen and Maciej Wojtal
Stig Brodersen (00:01:12):
So we are very excited to speak with you here today and talk about investing in frontier markets, and specifically about Iran. And here on the show, we are big followers of, Warren Buffett. I don’t necessarily think Warren Buffett would invest in Iran. That’s not so much what I’m saying, but he’s very famous of saying that there’s no difficulty bonus in investing. And I thought of this exact quote, going into this interview, because I heard you comparing investing in Iran with what happened in Poland and China, whenever the markets open up. So perhaps for our listeners, could you talk about what does a market open an up mean?
Maciej Wojtal (00:01:45):
So market opening up can mean, obviously, many different things and it will be different. But if we look at the last 20 years of history and those main markets, the main thing it meant is that there was an inflow of foreign capital and usually not enough liquidity in the stock market to absorb it, which meant that the local market was just moving rapidly higher in a very short period of time. For example, in the early 90s, China opened up, also not fully partially, and the index in dollar terms went up around 12 times in less than two years. Well, it’s interesting to know that at that time, China was actually still under sanctions after Tiananmen Square. So it wasn’t very easy and it wasn’t very straightforward still, when it opened up and there were no foreign investors involved. When they came, the market just skyrocketed. With Russia, it was similar. I mean, the index in dollar terms in, I think, it was 1994, went up around 10 times. Again, in less than two years.
Maciej Wojtal (00:02:50):
[Poland] was so even more striking because the stock market was launched around 1992, 1993. For the first two years, nothing really happened. The stocks were trading at free time earnings. No one was investing. There were no foreigners. Then foreign investors saw, okay, it’s actually a stable enough economy after transitioning from socialism to market economy. It’s stable enough. And they started investing and the market went up in dollar terms almost 25 times, 25X in less than two years. Then it crushed, obviously, then it went up again. But at the beginning, it was just moving sideways at very low valuations. And then there was this sudden inflow of foreign capital that just lifted the market big time…
…Maciej Wojtal (00:07:13):
But actually, Iran is much more than just China, Russia, and Poland in the early 90s because of the same sanctions. The other countries just opened up to the flow of foreign capital. Iran will also open up its economy. Right now when you look at Iranian companies, you have exporters. For example, petrochemical exporter, most profitable petrochemical companies in the world, just like in Saudi Arabia, highest margins. But if you are an Iranian exporter and want to sell your products abroad, it’s difficult for you to find investors because it’s Iranian, people know there are sanctions. So they don’t know whether they are allowed to buy products from you or not. So you have to entice them by offering discounts. So the selling prices that you’re realizing are much lower than global prices that other companies are realizing. Then try to get paid. If you’re Iranian company, banks don’t really work. The connections between Iranian banks and foreign banks, try to get your products insured, try to arrange logistics…
…Maciej Wojtal (00:12:43):
Iran is completely misunderstood because it’s been under sanctions because it’s been shut down, there are not too many foreigners in Iran, investing or living. So people just don’t know. And Iran, so starting with the very basic facts, is a big country of 84 million people with the median age of around 30 years with the beautiful demographic profile. And it’s located in the region between Middle East and Central Asia. So it’s very important because Iran benefits from its location because it is, for example, on the way of Chinese China’s Belt and Road Initiative, and very important country between Europe and Asia. But it’s also important because Iran plus all its neighbors, it’s more than 500 million people. It’s like second Europe. And Iranian companies have very good connections in the region. They are well placed to export in this region. So the whole market, when you look at Iran for those companies, say, okay, 80 million people, but then many regional exporters export to the market of 500 million people. That’s why they can gain enough scale. And for example, sustain through sanctions.
Maciej Wojtal (00:13:56):
But what is very important is the quality of people in Iran. So the education level, so tertiary education enrollment rates are similar to Europe. Iranians have 5,000 years of written history and there is a strong sense when you speak to Iranians that they understand this and that there is this heritage, strong culture heritage, and that education has always been important. So you get very strong quality of people that you can employ and wages are lower than in Vietnam. It’s as ratio of cost quality, probably the best country in the world. Now, when it comes to the economy, indeed, Iran has the largest combined oil and gas reserves in the world. But it is only, right now, it’s actually less than 10% of GDP. It used to be 15% then because of sanctions, now, Iran is exporting much less oils, so it’s less than 10%, for sure.
Maciej Wojtal (00:14:55):
And the rest of the economy, it’s a well diversified economy. You have a lot of manufacturing. They produce more than a million cars per year. So while the industry is related to car manufacturing and the steel industry is huge, auto parts, then petro chemicals industry is very important. So all this makes it a well diversified economy that is self-sufficient to a large extent. So they don’t import a lot of goods. They do have to import some essential goods, some food products, some pharmaceutical products. But the majority of what they consume is actually they can produce themselves. These are good things about having sanctions for a couple of decades, that you don’t have a choice. You need to develop all those different industries so that your economy can function properly.
Maciej Wojtal (00:15:39):
So yes, it is rising because when you look at Iraq or Saudi Arabia, more than 90% of GDP is coming from oil. And in Iran, those commodities, so it’s not only oil and gas, it’s also metals like iron ore, zinc, some other industrial metals deposits as well. This is an additional feature of the Iranian economy that can help to kickstart the growth and help finance infrastructure investments, for example. So this is important. But the biggest opportunity is actually in the non-oil part of the Iranian economy and in the resources, that’s the main resource of the Iranian economy. And this is also reflected in the stock market. What struck me, I mean, I was very surprised to learn that the stock market has 600 companies listed across 50 different industries and there is no oil and gas on the stock market. So it’s not a proxy on oil prices.
Maciej Wojtal (00:16:32):
You have petrochemicals, telecoms, steel companies, pharmaceuticals, lot of different manufacturing companies, software companies, consumer staples, FMCG companies. So really like a proper well diversified market. The market cap is around $250 billion. So probably one of the biggest frontier markets. If it was classified as a frontier, it would be one of the biggest frontier market with proper liquidity. So the average daily liquidity last year was around $400 million. $400 million of trading per day in Iran with no foreign investors. All of foreign investors are, as I said, less than half a percent of the market cap. So it’s all local money driven by individual retail investors. So you have one to 2 million retail investors that invest probably around $100 on average. And this makes the market very inefficient, which is very interesting as well for professional investors. It’s a bit like China A-Shares before hedge funds started investing there or Vietnam at an earlier stage before institutional investors got involved.
Maciej Wojtal (00:17:43):
So this was what struck me when I started learning about Iran. One thing is how well developed the country is. Then absolutely how I enjoyed meeting and spending time and talking with the local people. And they’re super friendly. I mean, another misconception about Iran, because of political reasons, the whole country is often portrayed as the country of, I don’t know, terrorists or some dangerous place out there. And when you go to Iran, if you travel there by yourself, you see that if you go around different cities, you meet people. If they speak English, they will approach you and have a chat with you. They don’t have too many tourists. So everyone is curious. Everyone is super friendly. So not only neutral, they’re friendly and want to have a chat, want to get to know you. It’s a very tolerant society.
Maciej Wojtal (00:18:34):
So obviously, Iran as a country is Muslim. It’s a [Shia] Muslim country. You have big minorities, Sunni minorities, Jewish minorities, Christian minorities. I was going around site seeing different churches, was going to Jewish synagogues, Zoroastrian churches, Christian churches, and everyone is doing his thing. There is no police in front of the church. It’s open and the society is tolerant. More than that, you actually have permanent seats in the Iranian parliament for the Jewish minority, Christian minority, and the Zoroastrian minority, so that they are also represented in the parliament. Again, the situation with women. So I guess that people in the West who don’t know, who don’t understand Iran, probably only notice that women in Iran have to wear hijab, right? That this is compulsory to cover your head. But when you look deeper, actually, the majority of students are women from the top universities in Iran. When you start to get to know the local families, you understand that households and household budgets and the most important decisions they are run by women. They actually control the households.
Maciej Wojtal (00:19:48):
And when I meet with women in professional jobs, working in banks and so on, they are the best educated with the best English, doing really important jobs. With countries like Iran, it’s so important, it’s so good to go there by yourself, and actually not only do your own investment research, but get to know the country, start to understand its culture, its population. So this was a very surprising, positively surprising thing to observe. And I had no bias. I mean, I had never met an Iranian in my life before my first trip to Iran. I went there for the first time in 2016, when the JCPOA was signed, so the Iran nuclear deal was signed. The UN sanctions were lifted and it became legal for non-US people to invest in Iran. So this is the first time I went there.
2. An Interview with Intel CEO Pat Gelsinger – Ben Thompson and Pat Gelsinger
Stepping back, a critical piece of making this strategy work is the secular bet that computing is going to significantly increase. TSMC has obviously made the same bet and their capital expenditures are stratospheric. Right now we see this chip shortage, it’s very acute, but at the same time, IFS isn’t going to reach scale for several years. Are you worried that we’re going to have a situation where all this TSMC capacity comes online, IFS comes online, Samsung comes online — this is classic in the semiconductor industry — that there’s suddenly way too much capacity? Are you worried about a slump in that case?
PG: I’m not really, but let’s tease it apart a little bit more, Ben, while I sit here. The first thing I’d ask you, because there is a cyclical nature to the semi industry, when was the last time we had a logic surplus, not a memory surplus?
I don’t know.
PG: The last memory surplus was about three and a half years ago. The last logic surplus was over a decade ago. So, this idea, as I asserted at the investor event, was there’s an insatiable demand for computing and high performance.
You had smartphone though over the last decade though; going forward it’s all high performance, machine learning, that’s where you see all the demand coming from.
PG: Yeah, I just could see I want my phone to be more powerful at lower power. I want my cloud to be more powerful at lower power, my car — we’ve talked about the automotive industry going from 4% of the BOM to 20% of the BOM by 2030. Where’s that bill of materials going in the auto semi? High performance connectivity, autonomous vehicle characteristics, which are hundreds of tops of performance requirement, advanced infotainment systems, and EV, the electrification of the vehicle, which is largely specialty nodes at that point. None of it’s going into mature nodes, all of it’s going into advanced computing. As we tear that apart, we’re not all that worried.
Now, let’s look at the capital expenditures. Only three companies get to go below 10 at scale. Samsung, TSMC, and Intel. Obviously, Samsung’s capital budget is clearly going to be carved up between memory, taking the majority of it, and logic. My budget is not going to be carved up between memory and logic, it’s all about logic. TSMC’s capacity is carved up between mature — they’re now having to go can reinvest the mature nodes.
3. ‘Yes, He Would’: Fiona Hill on Putin and Nukes – Maura Reynolds and Fiona Hill
Maura Reynolds: You’ve been a Putin watcher for a long time, and you’ve written one of the best biographies of Putin. When you’ve been watching him over the past week, what have you been seeing that other people might be missing?
Fiona Hill: Putin is usually more cynical and calculated than he came across in his most recent speeches. There’s evident visceral emotion in things that he said in the past few weeks justifying the war in Ukraine. The pretext is completely flimsy and almost nonsensical for anybody who’s not in the echo chamber or the bubble of propaganda in Russia itself. I mean, demanding to the Ukrainian military that they essentially overthrow their own government or lay down their arms and surrender because they are being commanded by a bunch of drug-addled Nazi fascists? There’s just no sense to that. It beggars the imagination.
Putin doesn’t even seem like he’s trying to make a convincing case. We saw the same thing in the Russian response at the United Nations. The justification has essentially been “what-about-ism”: ‘You guys have been invading Iraq, Afghanistan. Don’t tell me that I can’t do the same thing in Ukraine.”…
…Reynolds: Do you think Putin’s current goal is reconstituting the Soviet Union, the Russian Empire, or something different?
Hill: It’s reestablishing Russian dominance of what Russia sees as the Russian “Imperium.” I’m saying this very specifically because the lands of the Soviet Union didn’t cover all of the territories that were once part of the Russian Empire. So that should give us pause.
Putin has articulated an idea of there being a “Russky Mir” or a “Russian World.” The recent essay he published about Ukraine and Russia states the Ukrainian and Russian people are “one people,” a “yedinyi narod.” He’s saying Ukrainians and Russians are one and the same. This idea of a Russian World means re-gathering all the Russian-speakers in different places that belonged at some point to the Russian tsardom.
I’ve kind of quipped about this but I also worry about it in all seriousness — that Putin’s been down in the archives of the Kremlin during Covid looking through old maps and treaties and all the different borders that Russia has had over the centuries. He’s said, repeatedly, that Russian and European borders have changed many times. And in his speeches, he’s gone after various former Russian and Soviet leaders, he’s gone after Lenin and he’s gone after the communists, because in his view they ruptured the Russian empire, they lost Russian lands in the revolution, and yes, Stalin brought some of them back into the fold again like the Baltic States and some of the lands of Ukraine that had been divided up during World War II, but they were lost again with the dissolution of the USSR. Putin’s view is that borders change, and so the borders of the old Russian imperium are still in play for Moscow to dominate now.
Reynolds: Dominance in what way?
Hill: It doesn’t mean that he’s going to annex all of them and make them part of the Russian Federation like they’ve done with Crimea. You can establish dominance by marginalizing regional countries, by making sure that their leaders are completely dependent on Moscow, either by Moscow practically appointing them through rigged elections or ensuring they are tethered to Russian economic and political and security networks. You can see this now across the former Soviet space.
We’ve seen pressure being put on Kazakhstan to reorient itself back toward Russia, instead of balancing between Russia and China, and the West. And just a couple of days before the invasion of Ukraine in a little-noticed act, Azerbaijan signed a bilateral military agreement with Russia. This is significant because Azerbaijan’s leader has been resisting this for decades. And we can also see that Russia has made itself the final arbiter of the future relationship between Armenia and Azerbaijan. Georgia has also been marginalized after being a thorn in Russia’s side for decades. And Belarus is now completely subjugated by Moscow.
But amid all this, Ukraine was the country that got away. And what Putin is saying now is that Ukraine doesn’t belong to Ukrainians. It belongs to him and the past. He is going to wipe Ukraine off the map, literally, because it doesn’t belong on his map of the “Russian world.” He’s basically told us that. He might leave behind some rump statelets. When we look at old maps of Europe — probably the maps he’s been looking at — you find all kinds of strange entities, like the Sanjak of Novi Pazar in the Balkans. I used to think, what the hell is that? These are all little places that have dependency on a bigger power and were created to prevent the formation of larger viable states in contested regions. Basically, if Vladimir Putin has his way, Ukraine is not going to exist as the modern-day Ukraine of the last 30 years…
…Reynolds: So how do we deal with it? Are sanctions enough?
Hill: Well, we can’t just deal with it as the United States on our own. First of all, this has to be an international response.
Reynolds: Larger than NATO?
Hill: It has to be larger than NATO. Now I’m not saying that that means an international military response that’s larger than NATO, but the push back has to be international.
We first have to think about what Vladimir Putin has done and the nature of what we’re facing. People don’t want to talk about Adolf Hitler and World War II, but I’m going to talk about it. Obviously the major element when you talk about World War II, which is overwhelming, is the Holocaust and the absolute decimation of the Jewish population of Europe, as well as the Roma-Sinti people.
But let’s focus here on the territorial expansionism of Germany, what Germany did under Hitler in that period: seizure of the Sudetenland and the Anschluss or annexation of Austria, all on the basis that they were German speakers. The invasion of Poland. The treaty with the Soviet Union, the Molotov-Ribbentrop pact, that also enabled the Soviet Union to take portions of Poland but then became a prelude to Operation Barbarossa, the German invasion of the Soviet Union. Invasions of France and all of the countries surrounding Germany, including Denmark and further afield to Norway. Germany eventually engaged in a burst of massive territorial expansion and occupation. Eventually the Soviet Union fought back. Vladimir Putin’s own family suffered during the siege of Leningrad, and yet here is Vladimir Putin doing exactly the same thing.
Reynolds: So, similar to Hitler, he’s using a sense of massive historical grievance combined with a veneer of protecting Russians and a dismissal of the rights of minorities and other nations to have independent countries in order to fuel territorial ambitions?
Hill: Correct. And he’s blaming others, for why this has happened, and getting us to blame ourselves.
If people look back to the history of World War II, there were an awful lot of people around Europe who became Nazi German sympathizers before the invasion of Poland. In the United Kingdom, there was a whole host of British politicians who admired Hitler’s strength and his power, for doing what Great Powers do, before the horrors of the Blitz and the Holocaust finally penetrated.
Reynolds: And you see this now.
Hill: You totally see it. Unfortunately, we have politicians and public figures in the United States and around Europe who have embraced the idea that Russia was wronged by NATO and that Putin is a strong, powerful man and has the right to do what he’s doing: Because Ukraine is somehow not worthy of independence, because it’s either Russia’s historical lands or Ukrainians are Russians, or the Ukrainian leaders are — this is what Putin says — “drug addled, fascist Nazis” or whatever labels he wants to apply here.
So sadly, we are treading back through old historical patterns that we said that we would never permit to happen again. The other thing to think about in this larger historic context is how much the German business community helped facilitate the rise of Hitler. Right now, everyone who has been doing business in Russia or buying Russian gas and oil has contributed to Putin’s war chest. Our investments are not just boosting business profits, or Russia’s sovereign wealth funds and its longer-term development. They now are literally the fuel for Russia’s invasion of Ukraine.
4. SPAC Startups Made Lofty Promises. They Aren’t Working Out – Heather Somerville and Eliot Brown
Dozens of startups that went public in a pandemic-fueled stock market frenzy are missing the projections they used to win over investors, many by substantial margins and just a few months after making those forecasts.
Nearly half of all startups with less than $10 million of annual revenue that went public last year through a special-purpose acquisition company, known as SPAC, have failed or are expected to fail to meet the 2021 revenue or earnings targets they provided to investors, according to a Wall Street Journal analysis…
…In November, eight months after electric bus and van maker Arrival SA’s public listing through a SPAC merger, Chief Executive Denis Sverdlov offered an update on an earnings call with investors. “We withdraw our long-term forecasts,” he said, adding that the company was putting forward “a more conservative view.”
It was a different tone from the pitch the company gave investors when it went public in March: Its revenue would grow from zero to $14 billion in just three years. It was a stunningly rapid pace—five years faster than Alphabet Inc.’s Google, the fastest U.S. startup ever to reach that level of revenue—particularly given Arrival hadn’t yet produced any vehicles.
The company declined to comment for this article. Its stock is down roughly 85% since listing.
Investors and academics have criticized speculative companies’ use of projections, saying they are used to create buzz and attract investors. The U.S. Securities and Exchange Commission has indicated it is considering new limits on the practice and some federal lawmakers have advanced bills to curtail it. While regulations around traditional initial public offerings strongly discourage companies from making forecasts about future performance, companies that list publicly by merging with SPACs—which are sometimes called blank-check companies—have freely used forecasts, often presenting investors with charts showing enormous growth…
…Professors who examined the issue found a correlation between ambitious forecasts and poor stock performance. Michael Dambra, an associate professor of accounting at University at Buffalo, and two co-authors looked at SPACs from 2010 through 2020 and concluded in a 2021 working paper that high-growth revenue projections are likely to be “overly optimistic and misleading to uninformed investors.”
“The more aggressive your revenue is, the more likely you are to underperform,” Mr. Dambra said in an interview.
5. TIP421: Expectations Investing w/ Michael Mauboussin – Trey Lockerbie and Michael Mauboussin
Trey Lockerbie (00:06:08):
Well, yeah. And the reason I brought up Bill is because I believe that success leaves clues. And he talked about the Santa Fe Institute and how much that had an impression on you, and how that might have shaped his thinking so to speak. So I know you’ve had a number of years working with the Santa Fe Institute, being chair of the board, etc. Maybe give us a glimpse or maybe even an example of a day you walked out of there and said, “Wow. That really changed my mind on something.”
Michael Mauboussin (00:06:33):
Yeah. So the first just by way of background, the institute was found in the mid ’80s. And the original founders felt that academia had become very siloed. So the biologists talked to the biologists, and the physicists to the physicist, and the economists to the economists. And most of the interesting and truly vexing problems in the world lied at the intersections of disciplines. And science has made incredible strides through reductionism, breaking things down into their components. But the argument is to go forward, we really need to unify different disciplines in some important way.
Michael Mauboussin (00:07:04):
So that was the mission. And if there’s a sort of unifying theme, it’s a study of complex adaptive systems, these evolutionary systems. And the simplest way to think about it is a bunch of different agents, whether they’re investors in the stock market, or neurons in your brain, or ants in ant colony that interact with one another. And then we examine what emerges from that whole set of processes. So you get this sense of it right there, no disciplinary boundaries whatsoever. It’s just interesting people pulled together.
Michael Mauboussin (00:07:30):
Let me maybe give two examples of things I think are super cool. One, and I think profoundly important in the world of investing was Brian Arthur’s work on increasing returns. Of course if you take an economics class, and really this appeals to common sense as well, what you learn is that high returns on capital tend to be competed away, which makes sense. So Trey, if your key business is super profitable, I come along and I say, “Gee, I can do what Trey does and maybe charge a little bit less than he does.” So you have to match my prices, and so on and so forth. So we sort of migrate our way down to earning our cost to capital.
Michael Mauboussin (00:08:07):
What Brian Arthur talked about was under certain conditions and circumstances, businesses could actually enjoy increasing returns. In other words, they end up being winner take most or winner take all markets. And again, this is not broad. This is not everywhere you look, but under certain conditions it could be true.
Michael Mauboussin (00:08:24):
And I think Bill was one of the first people to think about connecting that idea to markets, and thinking about businesses, and what the implications were. So that’s one that was both intellectually interesting, but also could be very lucrative in a market setting.
Michael Mauboussin (00:08:37):
The second bit of work, and this is just sort of a side. It is the work on scaling. And this is probably most associated with Geoffrey West. He wrote a wonderful, beautiful book called Scale for those who are interested in this topic in more detail. And just to set it up, Geoffrey’s trained as a theoretical physicist, but he collaborated with Jim Brown who’s a biologist and Brian Enquist who’s an ecologist. So people from different disciplines.
Michael Mauboussin (00:09:00):
So the simplest description of scale where they started was this idea of do you imagine just an X, Y chart, like one you’d know. But the key is that the X axis in this case is on a logarithmic scale. So instead of one, two, three, four, five, it is 1, 10, 100, 1,000. So the increments are the same percentage differences. So it’s a log scale. And then the Y axis same thing, also log scale.
Michael Mauboussin (00:09:22):
So on the X axis, you put the mass for example of a mammal. So how much they weigh. And on the Y axis, you put their metabolic rate, which is basically how much energy they need. So mass metabolic rate. You plot every mammal from a shrew or mouse to a blue whale, and they all fall on the same line on this log log scale with a three quarters exponent.
Michael Mauboussin (00:09:42):
Totally awesome. Right? So this has been understood for about 100 years. More than 100 years, probably. I think it’s called Kleiber’s law that Kleiber figured it out, but no one knew why. So the mystery was the why. So Geoffrey, along with Jim and Brian got together and figured out the why of why this particular scaling law works. And that immediately opened up a huge threat of research about scaling laws in other social systems, including cities and corporations. So this is really exciting stuff that is really coming out fast and furious.
Michael Mauboussin (00:10:16):
So cities also follow very fascinating scaling properties as do companies. We understand the mechanisms now for biological systems. I think the mechanisms for social systems are still being explored, which is super cool. So that has some implications for investing, for example. But maybe not as direct, but just a cool bunch of ideas, right?
Michael Mauboussin (00:10:35):
And this is just a tiny tasting. So there are many, many other things that are going on that are exciting and other whole initiative and collective intelligence. Collective intelligence work directly maps over to markets and market efficiency. So there are lots of parallels you can draw, but it’s super fun going down the path, right? Because there’s so many interesting people. And last thing I’ll say about SFI is that almost by nature, it draws people who are intellectually curious. Most of the scientists we have there have extraordinary street credibility in their own discipline, their core discipline. But they’re obviously very interested in lots of other stuff. So that makes it so much fun because everybody walks around. Everybody’s actively open-minded, so every conversation tends to be a blast. So that’s a little bit about SFI…
…Trey Lockerbie (00:26:35):
So going back to your restaurant example, it just came to mind a very tangible business, right? Real estate, and book values, and things like that. But you mentioned earlier this rise of intangibles. So also keeping on the theme of earnings that actually don’t create value necessarily. I’d love to break down the idea of intangibles for the audience. Let’s first walk through what constitutes an intangible and how it’s expensed, and then maybe how it could actually even distort a company’s earnings.
Michael Mauboussin (00:27:05):
So a tangible asset, a physical asset’s very much what it sounds like, right? Something you can touch and feel move. So think about factories or machines, inventory, stuff like that. An intangible asset is by definition non-physical. So what should conjure up is brand building, training, software code is considered to be an intangible. So these are ‘softer’ things. But of course, as you know important for building value.
Michael Mauboussin (00:27:31):
Now what’s happened is our global economy has transitioned from a reliance on tangible assets. So think back to the year 1900 and the dominant organization being something like U.S. Steel. So you have these big furnaces, and you’re moving steel around and so forth. That’s very tangible. And then if you think today of the most dominant companies, you’re thinking mostly companies that have intellectual capital. So you’re going to think about the Googles or the world, or big pharmaceutical companies, or something where the primary thing that drives the value are recipes, or ideas, or algorithms, or software basically.
Michael Mauboussin (00:28:06):
So that’s how the world’s changed. And to put a finer point on it, in the 1970s, tangible investment exceeded intangible investment by a factor of about two to one. And today, that relationship’s completely flipped. So intangible investment is twice as big as tangible investment, right? So that’s the first thing is a level set is our global economy has transitioned. By the way, if you think about it, it makes sense. We’ve gone through other transitions before.
Michael Mauboussin (00:28:30):
Now the second interesting question is how this is accounted for. So a physical asset, and let’s just say a restaurant might be a good example or a factory. You have to spend the money today to build it. And the accountants would say, “This is going to deliver value for some period of time. Let’s just make it say it’s 10 years.” There’s a something in accounting called the matching principle. What we want to do is match the expense over that full period of time. So you’d spend $1,000 on your factory. And then we depreciate that factory over 10 years. So $100 a year for 10 years. And that depreciation shows up as an expense, but that’s it. Just one 10th of it per year, over time.
Michael Mauboussin (00:29:08):
Intangible investments by contrast as accounts are like, “We’re not sure about the payback. We’re not sure about the useful life. And to be conservative, what we’re going to do is expense it.” So it’s all in expense day one. So even if you spend a lot of money on R&D or a branding campaign, and you’re completely persuaded that there’s a multi-year payoff, accounts are going to say, “Too uncertain, so we’re going to expense it all.” So again, the same investment in a tangible investment will go on the balance sheet and be depreciated. Whereas the intangible will go on the income statement and be expensed.
Michael Mauboussin (00:29:41):
Okay. So let’s try to make one more concrete example. Let’s say Trey, that you have a subscription business, right? And you want to get people to buy your subscription. And on average, when they buy your subscription, they stick around for five years. Well, the way to break it down is there’s going to be some cost to acquire those customers, right? Whether it’s your marketing spending or whatever it is. And then you’re going to get some stream of cash flows, again contractually for the next five years. And let’s say that’s a great investment. In other words, the cash flows you’re going to get over five years is worth a lot more than the cost to get those customers. So it’s an economically really attractive proposition for you as a business person to do this.
Michael Mauboussin (00:30:15):
Well, what’s going to happen to the accounting, right? It’s going to look horrible, right? Because the faster you grow, the more of these upfront expenses you’re going to be shouldering. Your earnings are going to look horrible, even though you’re building value every single day.
Michael Mauboussin (00:30:27):
Now the parallel back in the traditional world, the tangible world was Walmart. Walmart for the first 15 years it was public had negative free cash. So they earned money, but their investments were bigger than their earnings. So they spent more than they made, right? And by the way, when you’re negative free cash flow, that means you have to raise capital. That means you have to raise equity, or debt, or whatever it is. And Walmart did that for the first 15 years. Was negative free cashflow problem? No, it’s fantastic. Right? Because the stores they were building were wonderful. Great returns on capital. So the faster they grow, the more wealth they would create. Again, negative free cash flow. But really good economic propositions.
Michael Mauboussin (00:31:04):
So this is what’s happening in the world today is that as we’ve transitioned from one tangible world to an intangible world, even good unit economics, good businesses, they’re going to appear very different than they did in generation or two before. And as a consequence, you have to be careful about relying solely on earnings.
6. Berkshire Hathaway 2021 Shareholder Letter – Warren Buffett
Berkshire owns a wide variety of businesses, some in their entirety, some only in part. The second group largely consists of marketable common stocks of major American companies. Additionally, we own a few non-U.S. equities and participate in several joint ventures or other collaborative activities.
Whatever our form of ownership, our goal is to have meaningful investments in businesses with both durable economic advantages and a first-class CEO. Please note particularly that we own stocks based upon our expectations about their long-term business performance and not because we view them as vehicles for timely market moves. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers…
…Last year, Paul Andrews died. Paul was the founder and CEO of TTI, a Fort Worth-based subsidiary of Berkshire. Throughout his life – in both his business and his personal pursuits – Paul quietly displayed all the qualities that Charlie and I admire. His story should be told.
In 1971, Paul was working as a purchasing agent for General Dynamics when the roof fell in. After losing a huge defense contract, the company fired thousands of employees, including Paul.
With his first child due soon, Paul decided to bet on himself, using $500 of his savings to found Tex-Tronics (later renamed TTI). The company set itself up to distribute small electronic components, and first-year sales totaled $112,000. Today, TTI markets more than one million different items with annual volume of $7.7 billion.
But back to 2006: Paul, at 63, then found himself happy with his family, his job, and his associates. But he had one nagging worry, heightened because he had recently witnessed a friend’s early death and the disastrous results that followed for that man’s family and business. What, Paul asked himself in 2006, would happen to the many people depending on him if he should unexpectedly die?
For a year, Paul wrestled with his options. Sell to a competitor? From a strictly economic viewpoint, that course made the most sense. After all, competitors could envision lucrative “synergies” – savings that would be achieved as the acquiror slashed duplicated functions at TTI.
But . . . Such a purchaser would most certainly also retain its CFO, its legal counsel, its HR unit. Their TTI counterparts would therefore be sent packing. And ugh! If a new distribution center were to be needed, the acquirer’s home city would certainly be favored over Fort Worth.
Whatever the financial benefits, Paul quickly concluded that selling to a competitor was not for him. He next considered seeking a financial buyer, a species once labeled – aptly so – a leveraged buyout firm. Paul knew, however, that such a purchaser would be focused on an “exit strategy.” And who could know what that would be? Brooding over it all, Paul found himself having no interest in handing his 35-year-old creation over to a reseller.
When Paul met me, he explained why he had eliminated these two alternatives as buyers. He then summed up his dilemma by saying – in far more tactful phrasing than this – “After a year of pondering the alternatives, I want to sell to Berkshire because you are the only guy left.” So, I made an offer and Paul said “Yes.” One meeting; one lunch; one deal.
To say we both lived happily ever after is an understatement. When Berkshire purchased TTI, the company employed 2,387. Now the number is 8,043. A large percentage of that growth took place in Fort Worth and environs. Earnings have increased 673%.
Annually, I would call Paul and tell him his salary should be substantially increased. Annually, he would tell me, “We can talk about that next year, Warren; I’m too busy now.”
When Greg Abel and I attended Paul’s memorial service, we met children, grandchildren, long-time associates (including TTI’s first employee) and John Roach, the former CEO of a Fort Worth company Berkshire had purchased in 2000. John had steered his friend Paul to Omaha, instinctively knowing we would be a match.
At the service, Greg and I heard about the multitudes of people and organizations that Paul had silently supported. The breadth of his generosity was extraordinary – geared always to improving the lives of others, particularly those in Fort Worth.
In all ways, Paul was a class act.
7. Surprise, Shock, and Uncertainty – Morgan Housel
What Covid-19 and the Ukrainian invasion have in common is that both have happened many times before but westerners considered them relics of history that wouldn’t resurface in their own modern lives. Maybe the common lesson is that there are difficult parts of humanity that can’t be outgrown.
However crazy the world looks, it can get crazier. History is just a long story of the unthinkable happening, precedents being broken, and people reading the news with bewilderment and denial…
…Uncertainty amid danger feels awful. So it’s comforting to have strong opinions even if you have no idea what you’re talking about, because shrugging your shoulders feels reckless when the stakes are high. Complex things are always uncertain, uncertainty feels dangerous, and having an answer makes danger feel reduced. We want firm answers when things are the most uncertain, which is when firm answers don’t exist…
…At the height of the Cuban missile crisis, Defense Secretary Robert McNamara left an emergency briefing at the Pentagon and walked outside. He later wrote: “It was a beautiful fall evening, and I went up into the open air to look and to smell it, because I thought it was the last Saturday I would ever see.” Estimates were that in a full-blown nuclear war there would be 100 million deaths in the first hour.
What was avoided during those days is probably the most important news event in human history. But since it’s something that didn’t happen, it’s now just a neglected footnote. It probably left us with a false sense of security, blind to how dangerous it can be when one or two powerful and often crazy people can hold everyone else hostage.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have no vested interest in any companies mentioned. Holdings are subject to change at any time.
