What We’re Reading (Week Ending 11 October 2020) - 11 Oct 2020
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 11 October 2020):
1. Increasing Returns and the New World of Business – Brian Arthur
Let’s go back to beginnings—to the diminishing-returns view of Alfred Marshall and his contemporaries. Marshall’s world of the 1880s and 1890s was one of bulk production: of metal ores, aniline dyes, pig iron, coal, lumber, heavy chemicals, soybeans, coffee—commodities heavy on resources, light on know-how.
In that world it was reasonable to suppose, for example, that if a coffee plantation expanded production it would ultimately be driven to use land less suitable for coffee. In other words, it would run into diminishing returns. So if coffee plantations competed, each one would expand until it ran into limitations in the form of rising costs or diminishing profits. The market would be shared by many plantations, and a market price would be established at a predictable level—depending on tastes for coffee and the availability of suitable farmland. Planters would produce coffee so long as doing so was profitable, but because the price would be squeezed down to the average cost of production, no one would be able to make a killing. Marshall said such a market was in perfect competition, and the economic world he envisaged fitted beautifully with the Victorian values of his time. It was at equilibrium and therefore orderly, predictable and therefore amenable to scientific analysis, stable and therefore safe, slow to change and therefore continuous. Not too rushed, not too profitable. In a word, mannerly. In a word, genteel…
…Let’s look at the market for operating systems for personal computers in the early 1980s when CP/M, DOS, and Apple’s Macintosh systems were competing. Operating systems show increasing returns: if one system gets ahead, it attracts further software developers and hardware manufacturers to adopt it, which helps it get further ahead.
CP/M was first in the market and by 1979 was well established. The Mac arrived later, but it was wonderfully easy to use. DOS was born when Microsoft locked up a deal in 1980 to supply an operating system for the IBM PC. For a year or two, it was by no means clear which system would prevail. The new IBM PC—DOS’s platform—was a kludge. But the growing base of DOS/IBM users encouraged software developers such as Lotus to write for DOS. DOS’s prevalence—and the IBM PC’s—bred further prevalence, and eventually the DOS/IBM combination came to dominate a considerable portion of the market. That history is now well known. But notice several things: It was not predictable in advance (before the IBM deal) which system would come to dominate. Once DOS/IBM got ahead, it locked in the market because it did not pay for users to switch. The dominant system was not the best: DOS was derided by computer professionals. And once DOS locked in the market, its sponsor, Microsoft, was able to spread its costs over a large base of users. The company enjoyed killer margins.
These properties, then, have become the hallmarks of increasing returns: market instability (the market tilts to favor a product that gets ahead), multiple potential outcomes (under different events in history, different operating systems could have won), unpredictability, the ability to lock in a market, the possible predominance of an inferior product, and fat profits for the winner. They surprised me when I first perceived them in the late 1970s. They were also repulsive to economists brought up on the order, predictability, and optimality of Marshall’s world.
2. The end of the American internet – Ben Evans
First, as I discussed in some detail here, technology is becoming a regulated industry, if only because important and specialised industries are always regulated. That regulation will not only be determined by the USA. Other countries have their own laws, cultures and constitutions, and so we are entering a period of increasing regulatory expansion, overlap and competition from different jurisdictions, from the EU and UK to Singapore or Australia and, of course, China.
Second, you can no longer assume that the important companies and products themselves are American.
Both of these are captured in Tiktok. This is the first time that Americans have really had to deal with their teenagers using a form of mass media that isn’t created in their country by people who mostly share their values. It’s from somewhere else. That’s compounded by the fact that the ‘somewhere else’ is China, with all of the political and geopolitical issues that come with that, but I’d suggest that the core, structural issue is that it’s foreign. This is, of course, a problem that the rest of the world has been wrestling with since 1994, but it comes as something of a shock in Washington DC. There’s an old joke that war is how God teaches Americans geography – now it’s regulation.
3. The Merits of Bottoms Up Investing – Venture Desktop
Perhaps no VC firm embodies structural advantage — from the alignment of its organizational incentives to the brand edge it has built through a consistent approach applied over multiple decades — better than Benchmark.
It is also likely that no other firm is as allergic to the notion of a top down thesis.
You don’t have to wait long in any interview featuring one of Benchmark’s General Partners — and there have been a number of great ones lately — to gain insight into what seems to be the firm’s organizing principle:
“Our job is not to see the future, it’s to see the present very clearly.”
This alignment shines through clearly across the partnership — whether it is Sarah Tavel talking about her investment in Chainalysis, Chetan Puttagunta explaining the logic behind his investment in Sketch, or Eric Vishria responding to a “request for startup” in the Open Source space:
“We’re not top down like that. It is so organic. When an entrepreneur pitches and tells a story that provides an insight that makes you think about the world differently, that’s when I get really, really excited. And that’s why it is really hard to be top-down and why we don’t tend to be particularly thesis-driven..”
In a 2016 interview, Peter Fenton, who joined Benchmark in 2006 from Accel, spoke about the differences between the two iconic firms:
“At Accel I was taught, ‘we need to have a prepared mind’ at really thinking about a segment, a category, and its coherence. So I came to Benchmark and I didn’t know if I agreed with that. And my partner said, “don’t you do that shit here.” Throw that crystal ball out, you can’t predict anything. What you can do is recognize when lightning strikes.”
Fenton also talked about the bottoms up nature of his investments in this Quora Session. Twitter, Yelp, Elastic — all driven by investing in purpose and “tactile reality” than trends.
“I don’t invest in trends. I know it sounds a bit too-cool-for-school but what I’ve found is that you get far more insight from purpose than from trends. So, for example, in the case of Docker I invested in Dotcloud (which became Docker), in the purpose of this radical, intense leader, Solomon, who wanted to give the world’s programmers superpowers, tools of mass innovation. In the case of Yelp, it was Jeremy’s purpose to allow for the truth of great (and bad) local businesses to be visible to all. Or when I met Jack in 2007, he had this unstoppable purpose for Twitter to “bring you closer”. Sometimes that purpose is just this raw force, an energy, like it was in the case of Shay at Elastic in 2012. When I feel like the trend, the space, the concepts vs the tactile reality of a purpose forms the narrative of the investment I lose all interest.”
4. Who Is ‘Andy Bang’? A Ritz-Carlton Mystery Gets Its Day in Court – Jef Feeley and Mark Chediak
The story starts with Wu, an ex-car dealer whose third wife was the granddaughter of former paramount leader Deng Xiaoping. In 2004, Wu set up an insurance company for the growing Chinese middle class. As premiums poured in, he went on an $18-billion buying binge starting in 2014. He snapped up New York’s Waldorf Astoria hotel for nearly $2 billion and bought Dutch insurer Vivat. In 2016, he acquired Blackstone Group’s Strategic Hotels & Resorts unit for $6.5 billion. That company’s luxury lineup featured San Francisco’s Westin St. Francis, the Four Seasons Resort in Jackson Hole, Wyoming, and the Half Moon Bay. (He also began talks to buy 666 Fifth Avenue, the marquee tower owned by the family of President Donald Trump’s son-in-law, Jared Kushner.)
But in 2017, weeks before his arrest, Wu signed an agreement empowering the Delaware limited-liability shell companies to act on his behalf. Under Delaware law, owners of such companies aren’t listed in public records.
The pact, written in Mandarin and referred to in court papers as the “DRAA Blanket Agreement,” relies on the Delaware Rapid Arbitration Act, created in 2015 for speedy recognition and payment of arbitration awards.
The agreement “authorizes the recording of grant deeds transferring ownership of properties held by Anbang” including hotels, banks and bank branches. It gives Wu’s family and other signers of the contract claims to the hotels, including the Waldorf Astoria.
The 15-page contract also specifies that if Chinese regulators seize Anbang, the Delaware companies can sue it. And if the Chinese authorities learn about the existence of the pact, the signers contend their lives are in danger and arbitration panels can impose massive penalties to be paid to the LLCs.
The signers were, on one side, Wu and Chen Xiaolu, an ex-Chinese military officer and son of a former mayor of Shanghai, and on the other, one of the LLCs, the Amer Group, and Andy Bang. After being questioned by the authorities about Anbang two years ago, Chen died of a heart attack.
Zhao wrote in his brief that as part of the collateral backing up the DRAA, Anbang agreed to put up 16 hotels and four other properties valued at at least $9 billion, and pledged $1 billion in cash as a “performance bond.”
The Amer Group owns the U.S. trademark to “An Bang” and has had long-running litigation, both in the U.S. and China, over it with Anbang, although some here and there suspect Amer is working with Wu on the alleged scam. A lawyer for Wu, Chen Youxi, declined to comment on anything related to Anbang.
5. Stillfront: Understanding Gaming’s Dark Horse – Aaron Bush, Abhimanyu Kumar, and Joakim Achren
Stillfront Group is an emerging games business that both industry insiders and curious outsiders should prioritize understanding. Even though the company is making a larger name for itself — especially in 2020, which has turned into a breakout year — it remains, in our eyes, underrated and under-followed. It was (and maybe still is) a dark horse of the games industry. Tripling its market cap year-to-date certainly helps, but most don’t understand how Stillfront’s unique acquisition strategy, group operations culture, and capital allocation skill bring consistency and scalability to an otherwise lumpy, hits-driven industry. In other words, Stillfront’s success is the result of a well engineered strategy designed to predictably grow shareholder value in a highly unpredictable market.
6. Twitter thread on an analysis of Slack’s customers – Weng, @AznWeng
Stat #1: Among companies that use $WORK, 20% of their job openings are engineering. For Teams users, only 11% of their jobs are engineering. Companies with a focus on engineering choose Slack over Teams due to its many integrations with tools like Github/Jira/Pagerduty…
…Stat #3 (a fun one): The average Glassdoor rating for companies that use $WORK was 3.87. The average Glassdoor rating for all companies is 3.3. Causation doesn’t imply correlation, but it seems to suggest companies that allow remote work have higher job satisfaction overall.
Stat #4: $WORK is mentioned in twice the number of job openings as $MSFT Teams. While you wouldn’t think of Slack or Teams as “skills”, there are more roles in companies devoted to improving business workflows/processes by creating Slack bots and integrations.
7. A Closer Look at Ray Dalio’s 1937 Scenario – Ben Carlson
When Donald Trump was elected president, Ray Dalio, the founder of the hedge fund Bridgewater Associates, was optimistic about the new administration’s economic agenda. Since then, his notes have turned increasingly pessimistic. He recently said his firm is reducing risk over worries that the U.S. is becoming politically more divided. Dalio recently compared today’s environment to the situation in the late 1930s:
“It seems to me that we are now economically and socially divided and burdened in ways that are broadly analogous to 1937. During such times conflicts (both internal and external) increase, populism emerges, democracies are threatened, and wars can occur. I can’t say how bad this time around will get. I’m watching how conflict is being handled as a guide, and I’m not encouraged.”
Dalio has made the 1937 analogy before. Yet it’s impossible to quantitatively compare two different eras in these terms. We can, however, make an economic and stock-market comparison to those times to get a better sense of how things played out in the first recession following the Great Depression. There are a few similarities between that period and today. Interest rates were low for a long time in the 1930s. The 10-year Treasury yield began 1937 at 2.7 percent. It currently stands at around 2.2 percent. In both cases, the Federal Reserve was tightening monetary policy, as well. And both periods saw a huge stock market rally following a previous crash and deep recession.
But that’s really where the similarities end. Everything that happened in the 1930s was magnified compared with what we’re experiencing today. After falling in excess of 80 percent during the Great Depression, stocks finally found a bottom in the summer of 1932. The rebound was so pronounced that equities were up more than 90 percent in the months of July and August of 1932 alone. From the bottom in 1932 through early 1937, stocks had an enormous rally, gaining about 415 percent in less than five years. This was good enough for an annual gain of more than 40 percent a year.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation.
