What We’re Reading (Week Ending 13 March 2022)

What We’re Reading (Week Ending 13 March 2022) - 13 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 13 March 2022):

1. Tech and War – Ben Thompson

In response to the invasion Western governments unleashed an unprecedented set of sanctions on Russia; these sanctions were primarily financial in nature, and included:

• Disconnecting sanctioned Russian banks from the SWIFT international payment system
• Cutting off the Russian Central Bank from foreign currency reserves held in the West
• Identifying and freezing the assets of sanctioned Russian individuals

The sanctions, which were announced last weekend, led to the crashing of the ruble and the ongoing closure of the Russian stock market, and are expected to wreak havoc on the Russian economy; now the U.S. and E.U. are discussing banning imports of Russian oil.

This Article is not about those public sanctions, by which I mean sanctions coming from governments (Noah Smith has a useful overview of their impact here); what is interesting to me is the extent to which these public sanctions have been accompanied by private sanctions by companies, including:

• Apple has stopped selling its products in Russia (although still operates the App Store).
• Microsoft has suspended all new sales of Microsoft products and services in Russia, and SAP and Oracle have suspended operations.
• Google and Facebook suspended all advertising in Russia.
• Activision Blizzard, Epic Games, EA, and CD Projekt suspended game sales in Russia.
• Disney, Sony, and Warner Bros. paused film releases in Russia, and Netflix suspended its service.
• Visa and Mastercard cut off Russia from their respective international payment networks, and PayPal suspended service.
• Samsung stopped selling phones and chips, and Nvidia, Intel, and AMD also stopped selling chips to Russia.

This is an incomplete list! The key thing to note, though, is few if any of these actions were required by law; they were decisions made by individual companies…

…Last January I wrote an article entitled Internet 3.0 and the Beginning of (Tech) History that argued that technology broadly has passed through two eras: 1.0 was the technological era, and 2.0 was the economic era.

The technological era was defined by the creation of the technical building blocks and protocols that undergird the Internet; there were few economic incentives beyond building products that people might want to buy, in part because few thought there was any money to be made on the Internet. That changed during the 2000s, as it became increasingly clear that the Internet provided massive returns to scale in a way that benefited both Aggregators and their customers. I wrote:

Google was founded in 1998, in the middle of the dot-com bubble, but it was the company’s IPO in 2004 that, to my mind, marked the beginning of Internet 2.0. This period of the Internet was about the economics of zero friction; specifically, unlike the assumptions that undergird Internet 1.0, it turned out that the Internet does not disperse economic power but in fact centralizes it. This is what undergirds Aggregation Theory: when services compete without the constraints of geography or marginal costs, dominance is achieved by controlling demand, not supply, and winners take most.

Aggregators like Google and Facebook weren’t the only winners though; the smartphone market was so large that it could sustain a duopoly of two platforms with multi-sided networks of developers, users, and OEMs (in the case of Android; Apple was both OEM and platform provider for iOS). Meanwhile, public cloud providers could provide back-end servers for companies of all types, with scale economics that not only lowered costs and increased flexibility, but which also justified far more investments in R&D that were immediately deployable by said companies.

There is no economic reason to ever leave this era, which leads many to assume we never will; services that are centralized work better for more people more cheaply, leaving no obvious product vector on which non-centralized alternatives are better. The exception is politics, and the point of that Article was to argue that we were entering a new era: the political era.

Go back to the two points I raised above:

• If a country, corporation, or individual assumes that the tech platforms of another country are acting in concert with their enemy, they are highly motivated to pursue alternatives to those tech platforms even if those platforms work better, are more popular, are cheaper, etc.
• If a country, corporation, or individual assumes that tech platforms are themselves engaged in political action, they are highly motivated to pursue alternatives to those tech platforms even if those platforms work better, are more popular, are cheaper, etc.

Again, just to be crystal clear, these takeaways are true even if the intentions are pure, and the actions are just, because the question at hand is not about intentions but about capabilities. And while I get it can be hard to appreciate that distinction in the case of a situation like Ukraine, it’s worth noting that similar takeaways could be drawn from de-platforming controversies after January 6 and the attempts to control misinformation during COVID; if anything the fact that there are multiple object lessons in recent history of the willingness of platforms to both act in concert with governments and also of their own volition emphasizes the fact that from a realist perspective capabilities matter more than intentions, because the willingness to exercise those capabilities (to a widely varying degree, to be sure) has not been constrained to a single case.

2. The Secret to Braving a Wild Market – Jason Zweig

In the fall of 1939, just after Adolf Hitler’s forces blasted into Poland and plunged the world into war, a young man from a small town in Tennessee instructed his broker to buy $100 worth of every stock trading on a major U.S. exchange for less than $1 per share.

His broker reported back that he’d bought a sliver of every company trading under $1 that wasn’t bankrupt. “No, no,” exclaimed the client, “I want them all. Every last one, bankrupt or not.” He ended up with 104 companies, 34 of them in bankruptcy.

The customer was named John Templeton. At the tender age of 26, he had to borrow $10,000—more than $200,000 today—to finance his courage…

…The next year, France fell; in 1941 came Pearl Harbor; in 1942, the Nazis were rolling across Russia. Mr. Templeton held on. He finally sold in 1944, after five of the most frightening years in modern history. He made a profit on 100 out of the 104 stocks, more than quadrupling his money.

Mr. Templeton went on to become one of the most successful money managers of all time. The way he positioned his portfolio for a world at war is a reminder that great investors possess seven cardinal virtues: curiosity, skepticism, discipline, independence, humility, patience and—above all—courage.

3. The Changing World Order: Focusing on External Conflict and the Russia-Ukraine-NATO Situation – Ray Dalio

As explained before and more comprehensively in my book Principles for Dealing with the Changing World Order, it seems to me that we are now seeing three big forces that are changing the world order in ways that never happened in our lifetimes but happened many times throughout history:

1) The Financial/Economic One: Classically and currently the world’s leading power (which typically has the leading currency) is spending much more money than it is earning, which is leading it to borrow a lot and print a lot of money to buy the debt, which is reducing the value of the debt and money relative to the value of goods, services, and non-debt investment assets. This is producing inflation in goods, services, and investment assets. History has shown that when the coffers are bare and this sort of money printing takes place, financial weakness is near, and financial weakness causes all sorts of problems and precedes declines. When the coffers are bare and there is the need for more spending on both “guns and butter” there is a lot more printing of money, inflation, and political reactions to inflation.

2) The Internal Conflict One: Classically and currently there is great internal conflict over wealth and values gaps that is leading to populism of the right and populism of the left and fights between the sides. There is a “win at all cost” mentality, which eliminates the compromising and rule-following that is essential for maintaining internal order. The more internal disorder there is the more polarity and fighting there is, which typically leads to some form of civil war.

3) The External Conflict One: Classically and currently the rising of one or more foreign powers to become comparable in power to the leading power(s) leads to power struggles, typically external wars, that determine which power(s) will be in control and what the new order will be.  

Classically and currently these three cycles—i.e., the financial/economic one, the internal conflict one, and the external conflict one—are both individually evolving and influencing each other to create the Big Cycle of rises and declines of empires, countries, dynasties, and world orders…

…Some relevant principles are:

• International relations are driven much more by raw power dynamics than internal relations are. That is because all governance systems require effective and agreed-upon 1) laws and law-making abilities (e.g., legislators), 2) law enforcement capabilities (e.g., police), 3) ways of adjudicating (e.g., judges), and 4) ways of inflicting punishments. None of these has been able to be established on a global basis because the most powerful countries won’t give up power to the majority of countries because it would be unwise for them to do so. For example that is the reason that the US-China trade dispute wasn’t adjudicated by the World Trade Organization.
• There are five major kinds of competitions or wars that exist between countries:

1. Trade/economic wars
2. Technology wars
3. Geopolitical wars
4. Capital wars
5. Military wars   

• These competitions or wars reward the winners and penalize the losers, which reinforce their strengthenings or their weakenings. They vary in severity from healthy competitions to all-out wars. The progression tends to be from the first one on the list (trade/economic wars) toward the last one on the list (military wars), with each growing in intensity. Then, when a military hot war begins, all four of the other types of wars are applied full-on and weaponized. For these reasons, by monitoring the progression and intensities of the conflicts one can pretty well anticipate what is likely to come next.
• To be a leading world power one must be strong in most of the major ways. For example the United States and China are now strong in all of these ways but Russia is not. For that reason Russia needs to align itself with a leading power (China) to win wars.
• The weak will lose to the strong.
• One must be strong internally in order to be strong externally. These ways and how strong each country is in them are measured and shown in the appendix to my book and will be updated on economicprinciples.org. 
• People and countries are more likely to have cooperative relationships during economic good times and to fight during economic bad times.
• Shortly before there is a military war there is an economic war that typically includes:

1. Asset freezes/seizures
2. Blocking capital markets access
3. Embargoes/blockades

Over the weekend we saw significant intensifications of these economic war actions by Western (mostly NATO) powers, inflicting them on Russia. The magnitudes of increases and levels of these are a classic red flag that we should worry about a hot war between the major powers. At this moment we haven’t yet seen a retaliation by Russia, though we are hearing nuclear and other threats. So it appears that we are in the “at the brink” part of the cycle that is just after the big intensification of the economic war attacks and just before the military hot war. In other words, while the military hot war has been confined within the borders of Ukraine, it could spread to include the major powers. Seeing an acceleration and intensification of these economic war actions and/or a retaliation by Russia to hurt the NATO countries would signal a major increase in the risk of a major hot war. When I say that it would signal a major increase in the risk, I wouldn’t yet say that it is probable.  

• The choice that opposing countries face between fighting or backing down is very hard to make because both are costly—fighting in terms of lives and money expended and backing down in terms of the loss of status, since it shows weakness, which leads to reduced support. This is playing a role for both Russia and the opposing Western powers since backing down would be viewed as an unacceptable sign of weakness as the world is now looking to find out who will win this war. Putin now appears trapped. This could be dangerous or it could neuter Russia as a power. We will soon find out which happens.
• Hot wars typically occur when irreconcilable existential issues cannot be resolved by peaceful means. For example existential issues a) for Putin might be having another Western/NATO-supported country on its border, b) for China might be not having control over Taiwan, c) for Iran and/or North Korea might be not having nuclear weapons to protect themselves, and d) for the US and other countries might be these countries having these things.[1]
• The greatest risk of hot war is when both parties have military powers that are roughly comparable because if one side is dominant it typically gets its way by simply threatening war. Russia and NATO have roughly comparable military capability.
• Winning means getting the things that are most important without losing the things that are most important, so wars that cost much more in lives and money than they provide in benefits are stupid. This looks like a stupid war.

While these things sound ominous, my experiences over my lifetime have been that when push came to shove all sides, when faced with the choice of pulling back or experiencing mutually assured destruction, chose pulling back from hot wars. My first encounter with this, which is also the most analogous case to the one at hand, was the Cuban Missile Crisis when Russia had a sympathetic government and arms on the border of the United States and the United States considered that an existential threat and the parties could have gone to nuclear war fighting over it. I remember watching TV news and thinking that it was implausible that either side would back down and then being relieved that the decision makers chose to back down and find a path out of what could have been total destruction. I also remember how close a call that was because some of the leaders and generals favored war over the path that was taken to avoid war. For that reason, I believe it’s too early to consider the movement to a hot war between Russia and NATO countries likely. Instead of trying to anticipate it I’d rather react to the next stepped-up threats and/or some form of actual attack, which I would expect to be more restrained than an all-out military hot war.

4. Eric Mandelblatt – Investing in the Industrial Economy – Patrick O’Shaughnessy and Eric Mandelblatt

[00:11:16] Patrick: I’m sure the answer varies by commodity, by different parts of the world, but I think we’ve become so used to the ability of supply to catch up to demand in the digital world instantly or extremely quickly, whereas in the physical world there are cycles. There’s undersupply, there’s building of supply, there’s a lot on the other side. Walk us through what cycles look like in commodities. What drives them, how long does capex take to get outlaid to start pulling more commodities out of the ground? Give us a tutorial on how this world works, because it’s not this instant supply demand matching like we’ve come to expect in digital economies.

[00:11:51] Eric: We’re not going to reprogram the software. It’s a lot more complicated than that. Let’s use numbers to frame. Global oil and gas capex in the middle part of the last decade was running $0.5 trillion a year. Global metals and mining capex was running $140 billion a year. So, these are big capital-intensive businesses. Frankly, it’s why investors don’t like them. They’re cyclical and they’re capital intensive, but it depends upon the industry. All industries within commodities are not the same, but these tend to be pretty long lead time, long capital cycle commodities. Again, US shale would be an exception to that. But I’ll use copper as an example. First of all, 3 of the largest 10 copper mines in the world today were discovered over 100 years ago. And we estimate that from start to completion, if you and I, Patrick wanted to go build a copper mine in the Andes Mountains today, we estimate based on the mines that were developed over the last 10 years, that is a roughly 10 to 15 year investment cycle. Meaning we’re going to this project to FID and it’s going to take us a decade plus in order to bring supply online.

So, the punchline here is these tend to be relatively long lead time industries. Again, depends upon your sub-industry. It’s tough to be too generic. What’s different this cycle versus previous cycles is what I would call the relative inelasticity of supply growth. This is a key investment theme for us here at Soroban. There’s a saying in commodity land that the cure to high prices is high prices. What that means is that in a traditional commodity cycle, when the price of the commodity goes up, you’ve created an economic incentive for producers to drill new wells, build new mines, bring new supply in. When that supply comes into the market, ultimately it creates an equilibrium and the price comes down. And what we’re seeing this cycle is something that is very different, where not only are the big markets we’re investing behind, aluminum, copper, nickel, oil, as examples, in deep structural undersupply today, meaning inventories are drawn, there’s already shortages emerging up these commodities. But we’re also seeing a lack of a supply response.

And why is that? I think there’s a few factors that are playing into the inelasticity of supply. One, the most important one is I think the decarbonization and ESG backdrop, where governments, politicians, key stakeholders, including shareholders, and society at large is uncomfortable with the notion, particularly in energy, that we’re going to add new fossil fuel resources. So, shareholders are saying, “We don’t want to invest in energy companies. We want to starve the supply base.” That is having real implications. Banks not lending against E&P companies. And therefore the energy sector is probably the best example of this inelasticity, it’s creating supply tightness. Where normally when the price moves up, everybody, the producers are ready to go spend money. This time around because of the government interference, because of differing shareholder and societal pressures, we’re not seeing the same supply response.

So, I think that’s part of it. Part of it is the fear of carbon taxes. A lot of these industries, steel, aluminum, fertilizers are large carbon emitters. We could be stepping into a world, and we can talk more about this, where carbon taxes is a critical driver of the profitability of producers. And right now we don’t know what the rules of the carbon tax and quota world are going to look like. On one hand, we have the US with no carbon taxes today and then many industries in Europe are subject to carbon taxes today that are over $100 a ton in Europe. So, producers are hesitant in these carbon intensive, big emitting industries to add new supply because they don’t know how the carbon intensity of their product is going to be taxed. So, I think there’s an element of it there. I think part of it is just economics. We lived in a major down cycle for the last decade. Use oil as a great example. Less than two years ago, WTI oil was at -$37 a barrel. Today we’re at $93. So, there’s been $130 move in the oil price in less than two years. Now let’s pretend, Patrick, you and I are on the board of Exxon Mobil or Chevron. We’re debating. Should we take to FID? Should we commission a project in the deep water, Nigeria, Angola, Guyana?

Well, we’re not going to get our capital back on that project for probably 10 years. We’re going to get no cash flow for 5 years. So, what commodity price should we be budgeting? Should we budget -$37 or should we be budgeting $93? So part of it is returns on capital were depressed. The commodities themselves are incredibly volatile and that’s creating angst in the shareholder base, in the management teams, and in the boards, as they’re determining what rate of supply growth, how aggressively do they want to attack supply? So, the net of all of this is we’re in an environment right now where the global economy’s booming. We’re hopeful China’s coming back after a really weak 2021. We have a very favorable demand backdrop. We think, for certain commodities, that demand backdrop is going to get exceptionally good because of this decarbonization trend. Think of the green commodities, the coppers and the nickels, the aluminums that are going to see demand spike because we’re pushing decarbonization initiatives. But generally it’s a very favorable demand backdrop and yet we’re having major supply challenges here. And our view at Soroban, each commodity’s different, but we don’t think these supply challenges are going to be rectified in the near term. We think these are potentially decade plus supply challenges in front of us…

…[00:43:47] Patrick: If I wanted to compare businesses within commodity industry, how do you do that? Like how much differentiation is there both from a stock ownership shareholder perspective and also from a customer perspective producer? Because I think about oil, it’s this fungible thing, you’re a price taker, like there’s some lousy features. In the same way you highlight the great features of the railroads, there’s some really lousy features structurally of an oil business. How do you think about Exxon versus Chevron, or the differing nature as you’re building a portfolio of individual securities, not just buying like a sector ETF or something, what do you think about that?

[00:44:20] Eric: Each commodity is different, but you’re correct. These are capital-intensive, they’re cyclical businesses, and you’re price takers. It’s not a railroad that you get three to four points of price. So you have to start with understanding the commodity market itself. If you’re going to invest in steel equities, you have to have a point of view on the steel cycle, and the consolidation that’s happening in North America, or fertilizers, aluminum, copper, et cetera. The interesting thing today, this is an overly generic comment, is almost every market we’re looking at is in deep structural undersupply, and we have this issue around inelasticity around supply. And then in some commodities we’re seeing spiking demand. It’s a backdrop I’ve never witnessed during my career where you have the starting point today – we could talk individuals, aluminum, copper, nickel, zinc, oil, fertilizers – deep structural under supply, real tightness in the underlying commodities, inventories drawing significantly to razor tight levels.

So that’s the starting point. And then let’s talk supply and demand. Demand? Global economy’s booming. It’s booming with China largely having been on its back in 2021. Now the US is going to slow. So I think there’s going to be a bit of a handoff between the US and China, but overall, US nominal GDP is growing, I think grew 12% in 4Q. So we have a pretty strong backdrop of demand. Plus we’re going to get the decarbonization spike in the coppers, and the nickels, and the aluminums. And then on the supply side, we have this inelasticity, the shareholder activism, the resource nationalism that we’re not seeing the supply response. So it’s this incredible cocktail, again, that I’ve never seen of deep, deep under supplied markets today, lack of immediate supply growth, and a demand picture that’s actually quite favorable. Oh, and then we can talk about carbon taxes, which is going to throw this whole system in whack, because carbon’s in everything we consume, and certain end markets that are very carbon-intensive – aluminum, cement, fertilizers as an example – if the world moves to a carbon quota system, if the world becomes Europe, it’s going to throw cost curves completely out of whack. And there’s going to be certain producers, I’d highlight Alcoa in aluminum as an example of this, that are going to make windfall profits for a decade plus because of the new carbon tax regime. So it’s an incredible cocktail in front of us right now.

[00:46:53] Patrick: You mentioned Alcoa, it seems like a really interesting opportunity to dig in on one example of how all this stuff might affect a fairly simple and recognizable business. Most people have probably heard of Alcoa. I like the description you gave of Alcoa to me one time, which is that it’s the physical manifestation or derivation of energy as a concept placed into a physical product. So walk us through Alcoa’s business, just at a high level, and how these exogenous things like carbon taxes, like the carbon scene that you’ve just painted, might affect an individual business like this.

[00:47:23] Eric: That’s great. So what do they do? They make aluminum. They make over 2 million tons of aluminum per year. They’re roughly a 3% supplier into the global market. Now they were the biggest aluminum supplier in the world 20 years ago. So what happened in aluminum? I think it’s an illustrative, a good illustrative market. The Chinese woke up 20 years ago, they said, “We have all this cheap coal, let’s turn it into power. What do we do with the power? Well, let’s make aluminum. Let’s make fertilizers. These are really power-intensive, energy-intensive commodities. And let’s export that all over the world.” So what happened? 20 years ago they essentially had no domestic aluminum industry. Today they’re almost 50% of the global aluminum supply. It’s amazing. They destroyed the aluminum business. Their very cheap, but very dirty and carbon-intensive coal, they turned it into aluminum, and they exported it all over the world. And if you were a developed world producer, if you were Rio Tinto, they own Alcan, if you’re Alcoa, they destroyed your business. And we lived in a 15 year down cycle in the aluminum business.

Now what’s different this time? Well, China’s woken up and they’ve said, “Wait a second, the world doesn’t like us emitting all this carbon, we’re destroying our environment, we’re making no money making this aluminum, maybe we should not continue to grow our domestic aluminum supply.” And they’ve created a cap, the global market’s 70 million tons of aluminum, and they’ve created a cap, I think it’s at 45 million tons, and they’ve said, “We’re just not going to build smelters beyond that. We’re ultimately going to reduce our reliance on aluminum smelting as a country.” The problem is there’s no one taking the handoff, because Alcoa’s not building new smelters, Rio Tinto’s not building new smelters. And the backdrop, aluminum’s one of the highest demand growth commodities, pre-decarbonization, and it’s a major decarbonization winner. So we’ve got a demand backdrop that’s going to grow 4% or 5% a year, the Chinese were more than supplying all of that for the last 15 years, and now they’ve said, “Well, we’re capping out supply.” So what’s going to happen? In our opinion, you’re already seeing the inventory draws. What’s going to happen is the world’s going to be short aluminum.

So let me give you the Alcoa examples here. Let’s put aside carbon taxes, we’ll come back to that. Aluminum’s at $3,200 per ton today. At $3,200 aluminum, Alcoa’s generating low teens EPS per share, no capital allocation, the business has zero debt at the end of the year. So just looking at the EBIT, dropping it to net income, they’re doing $12, $13 of earnings and free cash per share; the stocks at $70. The business being valued at six times free cash flow. So that’s like a 17% unlevered free cash flow yield at $3,200 aluminum. 

But two things. Number one, I think prices are going up. The best commodity forecasters nobody can do it well, none of us know exactly where commodity prices are going to land, the best commodity forecasters out there are Jeff Currie’s group at Goldman Sachs. They’re carrying $3,850 aluminum price forecasts for 2022, and ultimately rising to a $5,000 aluminum price, I think it’s in 2024. At $5,000 aluminum, Alcoa is doing $27 per share of free cash flow. And by the way, that’s before capital allocation. The share count’s coming down dramatically, because they’re sweeping cash now. So you have a business that’s being valued at $72 per share that ultimately is probably going to generate somewhere between $10 and $30 a share of earnings and free cash in the next few years.

You don’t need a lot of $20 per share of free cash flow to eat very quickly into what’s a $73 stock that has no leverage. In three or four years this company has no market cap if they’re paying dividends and buying back stock at the rate that we anticipate. And then on top of that, we have a point of view, it’s not happening tomorrow, it might be a 10+ year journey, but ultimately the world’s going to move to a carbon quota, carbon tax system. We’re not going to let the Chinese dump dirty steel, dirty aluminum, dirty fertilizers, nitrogen, phosphate in the United States and not tax it for the carbon intensity. If you think about it, the average smelter in China today is emitting 16 to 17 metric tons of carbon per ton of aluminum produced. Alcoa’s corporate average is 4.3. So take 16 minus 4. Alcoa is emitting 12 metric tons less carbon per ton of aluminum produced. So if we taxed carbon at $100 per ton, we’re already taxing it higher in Europe, that basically means that the marginal producer is getting priced up by the 12 tons, that’s $1,200 lower on the carbon cost curve that Alcoa is versus the Chinese. 

The Chinese are half the world’s aluminum. They are the marginal producer. $1,200 per ton of P&L for Alcoa is almost doubling what their P&L was in 2021. Said differently, to make it a per-share metric, $100 carbon tax is $8 per share of added earnings power at Alcoa. This is the mega bull case if I just take the Goldman tax $5,000 price forecast, that’s $27 a share free cash flow, I add an $8 per share from a carbon tax, This is ridiculous to even say, but there’s no doubt Alcoa is going to earn over $20, maybe over $30 per share before the share count comes down, so all the per share math is going to get better over time as well. So we look at that as a great thematic beneficiary, structural undersupply, demand’s growing strongly driven by decarbonization. And then the cherry on top is the optionality around carbon taxes.

5. Special: Ho Nam from Altos Ventures — A Different Approach to VC – Benjamin Gilbert, David Rosenthal, and Ho Nam

Ben: Ho, for folks who don’t know, what is the fox and the hedgehog concept?

Ho: Jim Collins wrote about this in Good To Great and his conclusion was these great CEO’s, great companies are run by these hedgehogs that really have one big idea and they have one big mission in life, versus the fox who is very smart and very clever, there may be polymaths, they’re the great serial entrepreneurs, and they’re very popular with VCs. They could hang out at these cocktail parties. They’re very smooth. They’re really, really good at fundraising.

The hedgehog is really this boring creature, not very good at fundraising, does no networking, he doesn’t even like VCs, he doesn’t want to meet anybody. They’re just too busy doing their own thing. Nose to the ground, that’s the hedgehog personality. Collins just perfectly nailed it and when I wrote that blog post, I was thinking this is just like Sam Walton. I had Sam Walton in my mind. He’s one of the all-time great hedgehogs. His book, Made in America, told me what the mind of an amazing entrepreneur looks like.

We’re very, very fortunate that he got sick at the end of his life because he never would have written that book. He would’ve been out duck hunting, visiting his stores, and doing all those things he loved, but he was bound at home. Everybody wanted him to write something and he finally wrote it. We’re very lucky that we got to get a glimpse into his mind.

Buffett, of course, is another amazing hedgehog. You have this guy who, at the time—I don’t know how old he was, in his 80s or 70s—he hasn’t needed to work for money for decades, but he’s still working; he’s now 90 or 91 years old.

David: He didn’t have to work for money when he left Graham Newman.

Ho: That’s right, at age 25 he had enough to retire, but they keep going. They keep going on and on like the Energizer Bunny. They never run out of energy. Why is that? What is it about certain guys that become billionaires and they’re still showing up to work? Not only showing up to work, but they say they tap dance to work. Bezos copied Buffett’s lines, he’s like, I tap dance to work every day. Buffett’s still there. Sam Walton’s still there to the end, to the very end. You have to carry them out with a stretcher.

They’re some of the people who are just like that. We’re trying to study who these people are. We’re trying to incorporate some of that for ourselves as well. How do we structure the work and surround ourselves with the types of people that give us joy, that motivate us to come back, to keep coming back, to keep doing it, rather than to say I’m done, I’m punching out?

We’re always thinking about that because our role model is the Buffett kind of guy. We didn’t set out to start the venture firm for ourselves, so we punch out at the age of 50 or 60 and say, why did I start something so I could give it to the next generation?

I think I’m going to just be around for a while. The next generation could join us. They’re fantastic people and these are people I want to invest in. We think of the next generation as we are both LPs and GPs. We want to invest in that next generation. I think that’s one of the things we observe with some really enduring franchises, where they are no longer thinking about the business as a GP. They’re really thinking about it as an LP. They become both LP and GP…

…Ho, let me ask you a question. This will take us a little bit into the firm history. We’ve thrown around Roblox, we’ve thrown around Coupang, we’ve thrown around Woowa Brothers. At this point, these multi-billion dollar investments, these things keep happening to you. You know what excellence feels like now in terms of the results, and then back-testing that against what those entrepreneurs look like when we invested very early in them. Can you take us back emotionally to what it was like the first time you started to see your first 3X, 5X, 8X, where you knew you had something in the portfolio, where you were looking at each other, like we actually might be good at this. One of these companies might go and what your psychology was around that point in time.

Ho: It’s such an interesting question. It’s complicated. There’s the people equation and then there’s also the business equation. I’ll talk about the people a little bit and then we’re going to talk about the business fundamentals. The people, we already talked about a little bit. We just have a bias towards certain kinds of entrepreneurs, what we call the hedgehog versus the fox.

There’s nothing wrong with foxes and nothing wrong with amazing serial entrepreneurs. They’re incredibly competent people. They will make money over and over again. But I call the great serial entrepreneurs just amazing people who just have not yet found their true life’s calling. You could be a serial entrepreneur, have a bunch of fantastic hits but then you will find something and say, oh my God, this is it. I found what my life’s purpose is. I’m here for the rest of my life. We’re looking for that match—company founder fit.

Sam Walton was like that. Sam Walton was a very successful serial entrepreneur, very successful even as a teenager. He was making all kinds of money. He was making thousands of dollars which is big money back in those days. Just like Buffett was a very successful teenage entrepreneur. He’s always been fairly wealthy, fairly successful, but he did not start Walmart until age 46. He was already a wealthy, successful guy. At 46, he founded Walmart and that was it. That was it for the rest of his life, the one thing.

We’re looking for the people, the one thing. This is our true life’s mission at this point in our lives. We’re not looking for yet another deal to make money. Why would we do that? Don’t show me another deal that just makes money. Show me an opportunity to build something really special with a special group of people that have a mission, their life’s mission (hopefully) and how can we support them on that.

Guess what, if you actually do that, the money will be there. Don’t worry about making money, that cannot be the reason to do any deal. It’s got to be because you want to work with these people and it’s got to because we have a chance to build something. It’s about the people that’s such a critical component.

David: You’ve said a bunch to me and I love adapting a Buffett analogy, but you want to find people and I think you all think of yourselves this way in Altos. Where you’re painting a masterpiece versus your painting by numbers. When you’re painting a masterpiece, there is no formula and it’s never done.

Ho: Yeah. Every time it’s just different. But Buffett calls Berkshire his painting, that’s my painting. When he buys business from one of these great founders who became a billionaire, he tells them, you have this masterpiece. I want to hang it in my museum. I’m not going to touch it. I’m not going to rip it apart, sell it off in pieces. I’m going to hold onto it forever. It’s a beautiful masterpiece.

Sometimes you do the painting and it turns out to be not so good. Sometimes it’s a masterpiece, but it’s just unique. It’s just different every time. We’re looking for an artist. There’s a lot of people out there who want volume, they want scale and paint by numbers will do it. You could build a much, much bigger business that way. Certainly much more predictable and much more repeatable. There’s a lot of people who want that.

David: Or maybe a bigger business faster.

Ho: Yeah. I think it’s the LP’s that are driving it. LPs really want predictability, repeatability. They don’t want to take too much risk. I kind of joke that everybody wants Berny Madoff without the fraud. Nobody wants fraud of course, but I think everybody was Berny Madoff. They want nice, steady. They don’t want to be too greedy. They just want steady returns, and there’s a lot of big funds that are just geared, they’re set up for that. Company after company, deal after deal, it’s like a cookie cutter. Crank them out of a factory and it’s a deal factory, a deal machine and the LP’s want it.

Okay, good for you that’s fine. We’re just going to do something different over here. If you want that, it’s a small piece of your portfolio because we’re not going to be able to crank it up in volume like that. We just have our own little thing going.

6. Moving Money Internationally – Patrick McKenzie

As we’ve covered previously about bank transfers, “moving money” is a misnomer, a simplification which covers a complex coordinated series of offsetting agreements about debts. When you move money domestically, your bank and the recipient’s bank use some intermediary system to coordinate a series of agreements which result in your bank agreeing it owes you less than it did prior and the recipient’s bank agreeing that it owes the recipient more than it did previously.

This same principle is at play in moving money internationally, with one interesting difference: banks largely cannot hold money extraterritorially directly, for most useful values of “directly.” Instead, they rely on a correspondent banking relationship.

Banks can have accounts at other banks, and extremely frequently do. A major reason to do this internationally is to facilitate payments in other currencies and other jurisdictions.

An example which shows the general pattern (with one tiny fib to save a few paragraphs of irrelevant detail): once upon a time, shortly before the global financial crisis, a young American banking at a small institution in Gifu Prefecture, Japan needed to send in his student loan payment to the servicer working for the U.S. government. The U.S. government, somewhat predictably, strongly prefers dollars over yen, and (perhaps less predictably) has incredible difficulty taking payments internationally.

That small institution, which will remain nameless since I still bank with them, holds some dollars on its books (a few hundred million dollars worth) but does not “physically” control more than the tiniest fraction of them. (That tiny fraction is paper dollars which, if you are a Gifuite anticipating a vacation to e.g. Hawaii, you can purchase at your local branch office in small quantities for a fairly hefty spread.) The vast majority of its dollars are owed to it by Mitsubishi UFJ Bank, the largest bank in Japan.

MUFJ is the largest supplier of yen/dollar liquidity in Japan, but it does not have direct access to the U.S. banking system. (In something of an oddity, it does today control a U.S. subsidiary which has full access, but that was not available back in the day.) Instead, it holds accounts at a variety of U.S. banks.

The one which acted as the intermediary bank on the wire (Wachovia) is no longer with us. MUFJ had an account with Wachovia, which is to say that the dollars MUFJ owned were owed to it by that bank. Neither MUFJ nor my own bank had custody of the dollars they were going to move on my behalf.

MUFJ’s intermediary had full access to the U.S. financial system, including to FedWire, which does domestic wire transfers.

When my local bank executed the wire, it passed an instruction to MUFJ, which passed an instruction to Wachovia, which effected a funds transfer through FedWire, which goes through the Federal Reserve, causing Bank of America to be owed slightly more money by the Fed, which it swiftly agreed that it owed me most of (after deducting a fee). And thus an offsetting series of rapid agreements about changes in amounts owed between bilateral counterparties results in me having less yen and the U.S. federal government having more dollars, plus each at least five entities earning a fee.

In broad strokes, this is how correspondent banking has always worked. Note the absence of an explicit technological substrate here: it could be conducted over TCP/IP, by a telegraph, or with a letter carried between countries on horse. And, indeed, all of those have been extensively used in correspondent banking over the centuries.

7. Brinton Johns, Jon Bathgate – Cadence: Software Behind Semiconductor Design – Matt Russell, Brinton Johns, and Jon Bathgate

[00:03:22] Matt: I’m personally excited for this breakdown. I spent my career as an investor dedicated to energy and industrials, so it always felt like we were the Sunday matinee, and software and tech was the primetime programming. So I thought a good place to start with Cadence, where it sits at this interesting intersection of software and hardware, it’s a $40 billion company at the time of this recording, but by no means a household name. I thought maybe we could start working backwards, and Brinton, I’ll start with you. Can you share a product that I interact with on a day to day basis, and how Cadence plays a role in bringing that product to life?

[00:04:00] Brinton: Well, first of all, thanks for saying, that we were the main event, because Jon and I, a semiconductor analyst, really, most of the time, we felt more like the redheaded stepchild than the main event. That’s very flattering. If you think about your phone, let’s just use an iPhone, and we work backwards, then this device, of course, has a lot of chips inside of it. Those chips, a lot of them are now designed by Apple itself, an OEM that became a chip maker. A lot of them are designed by other companies, they’re made at TSMC or Samsung, but probably mostly TSMC. And then they are made behind semiconductor equipment. So we think about ASML and KLA and AMAT, and then we sort of work back. And they’ve got memory in it, which is a different kind of chip. And then, all the way back, and the linking factor throughout all of these things is, you have to have a tool to design all those chips on. I’m going to simplify it, Jon will give a more nuanced answer, but there’s really only two companies in the world that do that. This is the tool that engineers live on, every day, all day long, every company that designs chips has it. And it’s integral to the way the world works today.

[00:05:08] Jon: You described it well, Brinton. I think, if you think about a knowledge worker, if you’re working in financial services, and you come sit at your desk every day, you probably are working in Microsoft Office and Excel or PowerPoint. Unfortunately, I would say, if you’re a creative, you’re are probably in the Adobe suites, you’re working on Photoshop, or illustrator. And EDA tools, so tools from Cadence, and their closest competitor, Synopsys, are the productivity tools for designing a chip. One way you can think about how the software actually works is, the end result, what you’re trying to produce is really a blueprint for a chip. You think about a company like Autodesk, that provides the software for architecture and engineering, when you’re trying to build a house, and you’re trying to build a blueprint for that house. And semiconductors, you’re also trying to build a house and a blueprint. But you’ve got 60 billion rooms in that house, and in each room in the house is one ten thousandth the width of a human hair. That’s the starting point of what EDA software is. It’s highly, highly technical. It’s this productivity platform and design platform for designing a chip. To Brinton’s point, they partner with the chip designer, which would be an engineer at someone like Apple, which is a systems company that designs their own chips, or household chip design names, someone like NVIDIA or Intel or AMD. Some broader context on just how the in works? So semiconductors, to Brinton’s point, it’s a $550 billion industry. Roughly 15% of chip industry sales are spent on R&D. It’s a very highly R&D intensive industry. Actually, 15% of that, give or take, is spent on ESA tools.

Take 15% squared, is 2.25%, I think, going back to my math degree. That gets you about a $10 billion market for EDA software. What I think is fascinating about EDA software is, you have a $10 billion industry, cadence has, give or take, a third of that market. You have this $550 billion industry sitting on top of EDA software and semiconductors, where you literally cannot build a chip or design a chip without this mission critical software. You abstract that one more level, and you think about, I mean, smartphones are a $400 billion industry, PCs are a $250 billion industry, and you’ve got hundreds of billions of dollars going into the Cloud. We’ve realized that you can’t build a car now without semiconductors, you go to medical devices, and this long tail of things that are built on chips. So it feels like the whole global economy that’s going digital, which, I would argue, is most of the economy at this point, is built on the shoulders of these two special companies, which are Cadence and Synopsys. That’s why we’re excited to talk about it…

…[00:09:06] Jon: Cadence, specifically, so they were formed by the merger of two EDA companies, EDCA and SDA, which I think are trivia questions in the semiconductor industry now. Cadence was formed in 1989. What’s interesting about the forming of Cadence, as it was where the semiconductor industry had gone, from a vertical integration model, with everyone doing everything themselves, to Brinton’s point, to specialization. It also coincides with when TSMC was founded in the ’80s. Also, when some of the major equipment manufacturers, like ASML and Lam Research, were also founded. I think part of it was, the writing was on the wall a little bit, like in the ’70s and early ’80s, the number of transistors in a given chip was in the thousands. You could see with the progression of Moore’s Law, that number was doubling in density every two years, basically, that things were going to get extremely complex very quickly. That’s why you had this interest in disaggregating this vertical integration model. Also, I would say, it democratized the chip business because it made it possible for someone, whether it’s a vertically integrated equipment maker, or end device maker, or just a group of engineers, to come in and start a company. Because all of a sudden you don’t need millions of dollars to build a factory and build your own internal tools, and build the equipment. You can just by the software from Cadence, and partner with TSMC, to actually build your design. That’s the founding story, where I think it’s so interesting, as it coincides with this disaggregation of the vertical integration model in Semiconductor Land.

...[00:12:14] Matt: Yeah, maybe you could walk us through the process. I think you touched on this a little bit, in one of your previous answers, but if a company like Apple wants to actually get into the designing of a chip, can you walk us through what the cycle of that looks like, all the way from initial plans, how they integrate Cadence, working with a chip manufacturer, and then into production?

[00:12:36] Brinton: Sure, there’s a couple of good examples. I’ll start at, think about Apple, or even Amazon, for that matter. Apple bought PA Semiconductor in 2008, it was a relatively small transaction, from Apple terms, hundreds of millions of dollars, not billions. We look at what they’ve done with it over time, of course, making the application processor, and now, all the way to displacing Intel into their PCs with an M1 chip, that’s an arm-based trip. You hire a team of engineers, you use these tools, Cadence and Synopsys. You develop IT over time, and then get it fabbed at TSMC. They started a relationship directly with TSMC, and then, that chip then goes to Foxconn. They put your phone together and it gets shipped straight to the customer, right? Most of the time, the brand isn’t even touching the device. It’s sort of fascinating. Also, one of the areas we haven’t hit on yet, that’s been democratized, is IP blocks, and Jon can talk about this a lot more. But just one important point to make is, in semiconductors, there is no GitHub of IP. It’s distributed around a lot of different companies. Developing your own IP is important, but most of the chip is still IP blocks that you’re sourcing from other places, and you have to deal with several companies to get those.

[00:13:53] Jon: This IP point is really important. So the basic building blocks for building a chip is a great team, to Brinton’s point. And you need the basic tools, the EDA tools, from Cadence or Synopsys. On the IP front, most designs, especially in digital semiconductora for a smartphone, in this example, use what we call off-the-shelf IP, where you actually license intellectual property from a third party. Arm Holdings, which is in the news daily right now, because if the failed acquisition attempt by NVIDIA, provides that IP. For the processor that is in your iPhone, or in your Mac and MacBook, and iPad now, the architecture, the instruction set for that chip, was actually licensed from Arm. Then Apple will take their thousands of engineers, and literally, I mean, at one point, that I think is noteworthy on a leading edge chip, like we’re talking about with Apple, where they’re using the most kind of advanced process technology out there, the cost of designing these chips is in the high hundreds of millions of dollars for a five nanometer chip, which is the leading edge.

Right now, there’s numbers out there from McKinsey or Gardner, or other third parties, that would put that number at over 500 million. The basics of designing the chip are incorporating these third party IP blocks, which is almost like Legos. A lot of the process now is actually taking, even something as simple as if you want to have USB in the chip. USB is actually not that differentiated, or USB compatibility, I would say. So you don’t need to invent the next USB, you just need something that is going to charge when you plug it in. The device will understand how that process works. That’s something they could actually license from a company like Cadence or Synopsys. It’s kind of a multi-year journey. You put the IP blocks together. You actually do a lot of simulation on the chip, both in software, and actually in hardware. There are tools, where Cadence does very well, called emulation tools.

You actually will run really heavy simulation, that looks just like a server rack, or racks of servers, like a server container, to actually simulate the chip, to make sure it’ll work. The way the process works is at the end of designing the chip, it’s called taping it out. So you tape out the design. Then you have to put that into a photomask, which is kind of the stencil for the chip, or it’s like the negative, if you’re thinking about a negative of an old photo, or something like that. And those, even the masks themselves, cost $10 million now. The cost of failure on one of these designs is very high, and that’s part of the reason why these tools are so critically important. First of all, they’re enabling a lot of innovation, but also, you have to really trust the tools, that you are going to come out with the outcome that shooting for.

Once you have the photomasks, you actually, you would pass that on to your manufacturing partner. One of the things we haven’t really gone into is just the different kinds of chip companies. Brinton mentioned fabulous companies. That’d be someone like NVIDIA, where a fab is the term for chip manufacturing facility. It’s short for a fabrication facility. A fabless company is a company like NVIDIA, that designs the chips, but they do not own their manufacturing. That’s different from what’s called an IDM, which is the Intel model, which is integrated device manufacturer. And that’s where manufacturing and design are still incorporated into the same company. It is important to distinguish those two. So if you were at NVIDIA, you would hand off that design, and the photo mask, to your manufacturing partner, which is TSMC, or if you were Intel, you would hand that off to your manufacturing group, which is obviously, inside of Intel.

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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 Activision Blizzard, Alphabet (parent of Google), Apple, Coupang, Mastercard, Meta Platforms (parent of Facebook), Microsoft, Netflix, Paypal, and Visa. Holdings are subject to change at any time.