What We’re Reading (Week Ending 21 August 2022) - 21 Aug 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 21 August 2022):
1. Use Your Edge – Peter Lynch
What’s the best way to invest $1 million? Tip one: Don’t buy stocks on tips alone. If your only reason for picking a stock is that an expert likes it, then what you really need is paid professional help. Mutual funds are a great idea (I ran one once) for folks who want this sort of assistance at a reasonable price…
…If I’m right, then large numbers of investors must have lost money outright or badly trailed a market that’s up eightfold since 1982. How did so many do so poorly? Maybe they traded a new stock every week. Maybe they bought stocks in companies they knew little about, companies with shaky prospects and bad balance sheets. Maybe they didn’t follow these companies closely enough to get out when the news got worse. Maybe they stuck with their losers through thin and thinner, without checking the story. Maybe they bought stock options. Whatever the case, they failed at navigating their own course.
Amateurs can beat the Street because, well, they’re amateurs.
At the risk of repeating myself, I’m convinced that this type of failure is unnecessary – that amateurs can not only succeed on their own but beat the Street by (a) taking advantage of the fact that they are amateurs and (b) taking advantage of their personal edge. Almost everyone has an edge. It’s just a matter of identifying it…
…If you put together a portfolio of five to ten of these high achievers, there’s a decent chance one of them will turn out to be a 10-, a 20-, or even a 50-bagger, where you can make 10, 20 or 50 times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns…
…A lot of people mistakenly think they must search far and wide to find a company with this sort of potential. In fact, many such companies are hard to ignore. They show up down the block or inside the house. They stare us in the face.
This is where it helps to have identified your personal investor’s edge. What is it that you know a lot about? Maybe your edge comes from your profession or a hobby. Maybe it comes just from being a parent. An entire generation of Americans grew up on Gerber’s baby food, and Gerber’s stock was a 100-bagger. If you put your money where your baby’s mouth was, you turned $10,000 into $1 million. Fifty-baggers like Home Depot, Wal-Mart, and Dunkin’ Donuts were obvious success stores to large crowds of do-it-yourselfers, shoppers, and policemen. Mention any of these at a party, though, and you’re likely to get the predictable reaction: “Chances like that don’t come along anymore.”
Ah, but they do. Take Microsoft – I wish I had.
You didn’t need a PhD to figure out that Microsoft was going to be powerful.
I avoided buying technology stocks if I didn’t understand the technology, but I’ve begun to rethink that rule. You didn’t need a PhD in programming to recognise the way computers were becoming a bigger and bigger part of our lives, or to figure out that Microsoft owned the rights to MS-DOS, the operating system used in a vast majority of the world’s PCs.
It’s hard to believe that the almighty Microsoft has been a public company for only 11 years. If you bought it during the initial public offering, at 78 cents a share (adjusted for splits), you’ve made 100 times your money. But Apple was the dominant company at the time, so maybe you waited until 1988, when Microsoft had a chance to prove itself.
By then, you have realized that IBM and all its clones were using Microsoft’s operating system MS-DOS. IBM and the clones could fight it out for market share, but Microsoft would prosper regardless of who won. This is the old combat theory of investing: When there’s a war going on, don’t buy the companies that are doing the fighting; buy the companies that sell the bullets. In this case, Microsoft was selling the bullets. The stock has risen 25-fold since 1988.
The next time Microsoft might have got your attention was 1992, when Windows 3.1 made its debut. Three million copies were sold in six weeks. If you bought the stock on the strength of the product, you’ve quadrupled your money to date. Then, at the end of 1995, Windows 95 was released, with more than 7 million copies sold in three months and 40 million copies as of this writing. If you bought the stock on the Windows 95 debut, you’ve doubled your money.
2. Nuclear Fusion Breakthrough Confirmed: California Team Achieved Ignition – Jess Thomson
Researchers at Lawrence Livermore National Laboratory’s (LLNL’s) National Ignition Facility (NIF) recorded the first case of ignition on August 8, 2021, the results of which have now been published in three peer-reviewed papers.
Nuclear fusion is the process that powers the Sun and other stars: heavy hydrogen atoms collide with enough force that they fuse together to form a helium atom, releasing large amounts of energy as a by-product. Once the hydrogen plasma “ignites”, the fusion reaction becomes self-sustaining, with the fusions themselves producing enough power to maintain the temperature without external heating.
Ignition during a fusion reaction essentially means that the reaction itself produced enough energy to be self-sustaining, which would be necessary in the use of fusion to generate electricity.
f we could harness this reaction to generate electricity, it would be one of the most efficient and least polluting sources of energy possible. No fossil fuels would be required as the only fuel would be hydrogen, and the only by-product would be helium, which we use in industry and are actually in short supply of…
…”The record shot was a major scientific advance in fusion research, which establishes that fusion ignition in the lab is possible at NIF,” said Omar Hurricane, chief scientist for LLNL’s inertial confinement fusion program, in a statement.
“Achieving the conditions needed for ignition has been a long-standing goal for all inertial confinement fusion research and opens access to a new experimental regime where alpha-particle self-heating outstrips all the cooling mechanisms in the fusion plasma.”
In the experiments performed to reach this ignition result, researchers heat and compress a central “hot spot” of deuterium-tritium (hydrogen atoms with one and two neutrons, respectively) fuel using a surrounding dense piston also made from deuterium-tritium, creating a super hot, super pressurized hydrogen plasma.
3. You can make any piece of data look bad if you try – Sam Ro
The reports are accurate. For months, layoffs have been affecting an array of companies, including well known names JPMorgan, Netflix, Tesla, Coinbase, Robinhood, and Peloton. And the numbers are not small. According to the BLS, 1.3 million workers were laid off in June alone. It’s an incredibly challenging situation for everyone impacted.
BUT, this is not yet a sign of a labor market downtown. Those 1.3 million layoffs represents represent about 0.9% of the 152 million employed during the period. Believe it or not, this is an unusually low layoff rate. In fact, the layoff rate has been below pre-pandemic lows for 16 straight months. Some experts even believe employers are actually reluctant to layoff workers despite the ongoing economic slowdown…
…The reports are accurate. There’s evidence that parts of the global supply chain continue to be tight. There’s no question there’s room for improvement.
BUT, supply chains have improved dramatically since their most troubled periods last year. Delivery times have gotten shorter, ocean freight rates have come down sharply, trucking capacity is up, and inventory levels are gradually returning to normal…
…The reports are accurate. Mortgage debt, credit card debt, and auto loan debt are all up. And delinquencies are rising.
BUT, any serious conversation about debt should also address the capacity to finance that debt. Asset values, cash levels, GDP … all sorts of metrics associated with the capacity to finance debt are way up relative to history. As result, debt payments as a percentage of income are low relative to historical levels.
And while delinquencies are rising, they remain depressed relative to normal historical levels…
…The reports are accurate. The odds of a recession in the coming months have gone up. Indeed, the Federal Reserve is actively trying to slow growth. And economic data confirms that growth has slowed dramatically.
BUT, not all recessions are created equal. The slowdown — and possible recession — we’re facing is not the result of consumer and business excesses run amok. Consumers and businesses have been pretty disciplined with their finances. This could mean any recession could be shallow and short-lived — and one in which unemployment goes from very low levels to just sorta-low levels…
…The reports are accurate. Mortgage rates have risen to levels last seen during the global financial crisis. This is a problem for prospective homebuyers who are already facing record-high home prices and may now have to wait months, if not years, to buy.
BUT, rising mortgage rates are exactly what the Fed wants as it aims to cool the economy in its effort to bring down inflation. Also, this is not a sign we’re about to enter another financial crisis. According to Goldman Sachs, only 3% of mortgaged properties have negative equity and 99% of outstanding mortgages have a locked-in rate that’s lower than the current market rate (PMMS).
Finally, adjustable rate mortgages are nowhere near as popular as they were during the housing bubble, which means very few mortgage holders are vulnerable to the rising mortgage rates that can come with them…
…The reports are accurate. While energy costs may have ticked lower over the past month, they are still way up from a year ago.
BUT, everything that requires energy continues to become more efficient, meaning energy cost spikes today don’t have the same kind of impact they did years ago. The average car currently gets about 25 miles per gallon (MPG), up from about 13 MPG in 1975. More broadly, spending on energy as a share of total personal spending has been trending lower for decades.
4. The Crypto Geniuses Who Vaporized a Trillion Dollars – Jen Wieczner
No matter that they had originally told friends they were shopping for a $150 million vessel; the superyacht was still the largest by well-established boat builder Sanlorenzo ever to be sold in Asia, a triumph of crypto’s nouveau riche. “It represents the beginning of a fascinating journey,” the yacht broker said in an announcement of the sale last year, saying it looked “forward to witnessing many happy moments aboard.” The name the buyers had in mind was cleverly chosen — an inside joke nodding to the cryptocurrency dogecoin that would both thrill their social-media acolytes and be intelligible to all the pathetic, poor “no coiners” out there: Much Wow.
Her buyers, Su Zhu and Kyle Davies, two Andover graduates who ran a Singapore-based crypto hedge fund called Three Arrows Capital, never got the chance to spray Champagne across Much Wow’s bow. Instead, in July, the same month the boat was set to launch, the duo filed for bankruptcy and disappeared before making their final payment, marooning the unclaimed trophy in her berth in La Spezia on the Italian coast. While she has not been officially listed for resale, the intimate world of international super-yacht dealers has quietly been put on notice that a certain Sanlorenzo 52Steel, the coveted Cayman Islands flag billowing above her empty balconies, is back on the market.
The yacht has since become the subject of endless memes and jokes on Twitter, the functional center of the crypto universe. Pretty much everyone in that world, from the millions of small-scale crypto holders to industry employees and investors, has watched in shock and dismay as Three Arrows Capital, once perhaps the most highly regarded investment fund in a burgeoning global financial sector, collapsed in excruciating and embarrassing fashion. The firm’s implosion, a result of both recklessness and likely criminal misconduct, set off a contagion that not only forced a historic sell-off in bitcoin and its ilk but also wiped out a wide swath of the cryptocurrency industry.
Crypto companies from New York to Singapore were the direct victims of Three Arrows. Voyager Digital, a publicly traded crypto exchange based in New York that once had a multibillion-dollar valuation, filed for Chapter 11 in July, reporting that Three Arrows owed it more than $650 million. Genesis Global Trading, headquartered on Park Avenue, had lent Three Arrows $2.3 billion. Blockchain.com, an early crypto company that provided digital wallets and evolved into a major exchange, faces $270 million in unpaid loans from 3AC and has laid off a quarter of its staff.
Among crypto’s smartest observers, there is a widely held view that Three Arrows is meaningfully responsible for the larger crypto crash of 2022, as market chaos and forced selling sent bitcoin and other digital assets plunging 70 percent or more, erasing more than a trillion dollars in value. “I suspect they might be 80 percent of the total original contagion,” says Sam Bankman-Fried, who as CEO of FTX, a major crypto exchange that has bailed out some of the bankrupt lenders, has perhaps more visibility on the problems than anyone. “They weren’t the only people who blew out, but they did it way bigger than anyone else did. And they had way more trust from the ecosystem prior to that.”
For a firm that had always portrayed itself as playing just with its own money — “We don’t have any external investors,” Zhu, 3AC’s CEO, had told Bloomberg as recently as February — the damage Three Arrows caused was astonishing. By mid-July, creditors had come forward with more than $2.8 billion in claims; the figure is expected to balloon from there. Everyone in crypto, from the largest lenders to wealthy investors, seemed to have lent 3AC their digital coins, even 3AC’s own employees, who deposited their salaries with its “borrowing desk” in exchange for interest. “So many people feel disappointed and some of them embarrassed,” says Alex Svanevik, the CEO of Nansen, a Singapore-based blockchain-analytics company. “And they shouldn’t because a lot of people fell for this, and a lot of people gave them money.”…
…During this early phase, Three Arrows Capital focused on a niche market: arbitraging emerging-market foreign-exchange (or “FX”) derivatives — financial products tied to the future price of smaller currencies (the Thai baht or the Indonesian rupiah, for instance). Access to those markets depends on having strong trading relationships with big banks, and getting in the door was “almost impossible,” BitMEX’s Hayes wrote recently in a Medium post. “When Su and Kyle told me how they got started, I was pretty impressed they had hustled their way into this lucrative market.”
At the time, FX trading was moving to electronic platforms, and it was easy to find differences, or spreads, between the prices quoted at different banks. Three Arrows found its sweet spot trolling the listings for mispricings and “picking them off,” as Wall Street calls it, often pocketing just fractions of a cent on each dollar traded. It was a strategy the banks detested — Zhu and Davies were essentially scooping up money these institutions would otherwise keep. Sometimes, when banks realized they’d quoted Three Arrows the wrong price, they would ask to amend or cancel the trade, but Zhu and Davies wouldn’t budge. Last year, Zhu tweeted out a 2012 photo of himself smiling while sitting in front of 11 screens. Seemingly making a reference to their FX-trading strategy of picking off banks’ bids, he wrote, “You haven’t lived until you’ve hit five dealers on the same quote at 230am.”
By 2017, the banks began cutting them off. “Whenever Three Arrows requested a price, all the bank FX traders were like, ‘Fuck these guys, I’m not going to price them,’ ” says a former trader who was a counterparty to 3AC. Lately, a joke has been going around among FX traders who knew Three Arrows in its early days and watched it collapse with a bit of Schadenfreude. “We FX traders are partly to blame for this because we knew for a fact that these guys were not able to make money in FX,” says the former trader. “But then when they came to crypto, everyone thought they were geniuses.”…
…“The Fund’s investment objective is to achieve consistent market neutral returns while preserving capital,” 3AC’s official documents read. Investing in a way that involves a limited downside no matter what the broader market is doing is, of course, known as “hedging” (where hedge funds get their name). But hedged strategies tend to spin off the most money when executed at scale, so Three Arrows began borrowing money and putting it to work. If all went well, it could generate profits that more than covered the interest it owed on the loan. Then it would do it all over again, continuing to grow its pool of investments, which would allow it to borrow even larger sums.
Beyond heavy borrowing, the firm’s growth strategy depended on another scheme: building lots of social-media clout for the two founders. In crypto, the only social-media platform that counts is Twitter. Many key figures in what has become a global industry are anonymous or pseudo-anonymous Twitter accounts with goofy cartoon profile images. In an unregulated space without legacy institutions and with global markets trading 24/7, Crypto Twitter is the center of the arena, the clearinghouse for the news and views that move markets…
…As it grew, Three Arrows branched out beyond bitcoin into a slew of start-up crypto projects and more obscure cryptocurrencies (sometimes called “shitcoins”). The firm seemed rather indiscriminate about these bets, almost as if it viewed them as a charity. Earlier this year, Davies tweeted that “it doesn’t matter specifically what a VC invests in, more fiat in the system is good for the industry.” Says Chris Burniske, a founding partner of VC firm Placeholder, “They were clearly spray and pray.”
A number of investors remember having their first sense that something might be off with Three Arrows in 2019. That year, the fund began reaching out to industry peers with what it described as a rare opportunity. 3AC had invested in a crypto options exchange called Deribit, and it was selling off a stake; the term sheet set the value of Deribit at $700 million. But some investors noticed the valuation seemed off — and discovered its actual valuation was just $280 million. Three Arrows, it turned out, was attempting to flip a portion of its investment at a steep markup, essentially netting the fund an enormous kickback. It was a sketchy thing to do in venture capital, and it blindsided the outside investors, along with Deribit itself. Says David Fauchier, a portfolio manager at Nickel Digital Asset Management who received the pitch, “Since then, I’ve basically stayed away from them, held them in very low regard, and never wanted to do business with them.”
But the firm was thriving. During the pandemic, as the Federal Reserve pumped money into the economy and the U.S. government sent out stimulus checks, cryptocurrency markets rose for months on end. By late 2020, bitcoin was up fivefold from its March lows. To many, it looked like a supercycle. Three Arrows’ main fund posted a return of more than 5,900 percent, according to its annual report. By the end of that year, it was overseeing more than $2.6 billion in assets and $1.9 billion in liabilities.
One of 3AC’s largest positions — and one that loomed large in its fate — was a kind of stock-exchange-traded form of bitcoin called GBTC (shorthand for Grayscale Bitcoin Trust). Dusting off its old playbook of capturing profits through arbitrage, the firm accumulated as much as $2 billion in GBTC. At the time, it was trading at a premium to regular bitcoin, and 3AC was happy to pocket the difference. On Twitter, Zhu regularly blasted out bullish appraisals of GBTC, at various points observing it was “savvy” or “smart” to be buying it…
…While Zhu and Davies grew accustomed to their new wealth, Three Arrows continued to be a giant funnel for borrowed capital. A lending boom had taken hold of the crypto industry, as DeFi (short for “decentralized finance”) projects offered depositors much higher interest rates than they could get at traditional banks. Three Arrows would, through its “borrowing desk,” take custody of cryptocurrency that belonged to employees, friends, and other rich individuals. When lenders asked Three Arrows to put up collateral, it often pushed back. Instead, it offered to pay an interest rate of 10 percent or more, higher than any competitor was delivering. Because of its “gold standard” reputation, as one trader put it, some lenders didn’t ask for audited financial statements or any documents at all. Even large, well-capitalized, professionally run crypto companies were lending large sums of money uncollateralized to 3AC, among them Voyager, which was ultimately pushed into bankruptcy.
For other investors, Three Arrows’ appetite for cash was another warning sign. In early 2021, a fund called Warbler Capital, managed by a 29-year-old Chicago native, was trying to raise $20 million for a strategy that largely involved outsourcing its capital to 3AC. Matt Walsh, a co-founder of crypto-focused Castle Island Ventures, couldn’t understand why a multibillion-dollar fund like Three Arrows would bother with onboarding such a relatively tiny increment of money; it seemed desperate. “I was sitting there scratching my head,” Walsh recalls. “It started to put up some alarm bells. Maybe these guys were insolvent.”…
…The trouble seems to have started in earnest last year, and Three Arrows’ huge bet on GBTC was the nub of it. Just as the firm reaped the rewards when there was a premium, it felt the pain when GBTC began trading at a discount to bitcoin. GBTC’s premium had been a result of the initial uniqueness of the product — it was a way to own bitcoin in your eTrade account without having to deal with crypto exchanges and esoteric wallets. As more people piled into the trade and new alternatives emerged, that premium disappeared — then went negative. But plenty of smart market participants had seen that coming. “All arbitrages die after a point,” says a trader and former colleague of Zhu’s.
Davies was aware of the risk this posed to Three Arrows, and on a September 2020 episode of a podcast produced by Castle Island, he admitted he expected the trade would fade. But before the show aired, Davies requested that the segment be edited out; the firm obliged. Unwinding the position was somewhat tricky — Three Arrows’ GBTC shares were locked up for six months at a time — but Zhu and Davies had a window to get out sometime that fall. And yet they didn’t.
“They had ample opportunity to get out with a graze but not blow themselves up,” says Fauchier. “I didn’t think they could be stupid enough to be doing this with their own money. I don’t know what possessed them. This was obviously one of those trades you want to be the first one in, and you desperately don’t want to be the last one out.” Colleagues now say Three Arrows hung in its GBTC position because it was betting the SEC would approve GBTC’s long-anticipated conversion to an exchange-traded fund, making it much more liquid and tradable and likely erasing the bitcoin price mismatch. (In June, the SEC rejected GBTC’s application.)
By the spring of 2021, GBTC had fallen below the value of its bitcoins, and Three Arrows was now losing on what was likely its biggest trade. Still, crypto enjoyed a bull run that lasted into April, with bitcoin hitting a record above $60,000 and dogecoin, a cryptocurrency started as a joke, rocketing off on an irrational Elon Musk–boosted rally. Zhu was bullish on dogecoin too. Reports put 3AC’s assets at some $10 billion at the time, citing Nansen (though Nansen’s CEO now clarifies that much of the sum was likely borrowed).
In retrospect, Three Arrows seems to have suffered a fateful loss later that summer — if of the human variety, rather than the financial one. In August, two of the fund’s minority partners, who were based in Hong Kong and routinely worked between 80 and 100 hours a week managing much of 3AC’s operations, simultaneously retired. That left the bulk of their work to Davies, Three Arrows’ chief risk officer, who seemed to take a more laid-back approach to looking out for the firm’s downside. “I think their risk management was a lot better before,” says the former friend.
Around that time, there were signs that Three Arrows was hitting a cash crunch. When lenders asked for collateral for the fund’s margin trades, it often came back pledging its equity in Deribit — a private company — instead of an easily salable asset like bitcoin. Such illiquid assets aren’t ideal collateral. But thThen in early May, luna suddenly collapsed to near zero, wiping out more than $40 billion in market cap in a matter of days. Its value was tied to an associated stablecoin called terraUSD. When terraUSD failed to maintain its dollar peg, both currencies collapsed. Three Arrows’ holdings in luna, once roughly half a billion dollars, were suddenly worth only $604, according to a Singapore-based investor named Herbert Sim who was tracking 3AC’s wallets. As the death spiral unfolded, Scott Odell, a lending executive at Blockchain.com, reached out to the firm to check in about the size of its luna hit; after all, the loan agreement stipulated that Three Arrows notify the company if it experienced an overall drawdown of at least 4 percent. “Was not that big as part of portfolio holdings anyway,” 3AC’s top trader, Edward Zhao, wrote back, according to messages made public by Blockchain.com. A few hours later, Odell informed Zhao that it would need to call back a significant portion of its $270 million loan and would take payment in dollars or stablecoins. Zhao appeared caught off guard. “Yo … uhh … hmm,” he replied in their private chat.
The next day, Odell reached out to Davies directly, who tersely reassured him that everything was fine. He sent Blockchain.com a simple, one-sentence letter with no watermark, asserting that the firm had $2.387 billion under management. Meanwhile, Three Arrows was making similar representations to at least half a dozen lenders. Blockchain.com is “now doubtful that this net asset value statement was accurate,” according to its affidavit, which was included in a 1,157-page document released by 3AC’s liquidators.
Rather than back down, a few days later Davies threatened to “boycott” Blockchain.com if it called back 3AC’s loans. “Once that happened, we knew something was wrong,” says Lane Kasselman, chief business officer of Blockchain.com. Inside the Three Arrows office, the mood had changed. Zhu and Davies used to hold regular pitch meetings on Zoom, but that month, they stopped showing up, then managers stopped scheduling them altogether, according to a former employee.
In late May, Zhu sent out a tweet that may as well be his epitaph: “Supercycle price thesis was regrettably wrong.” Still, he and Davies played it cool as they called up seemingly every wealthy crypto investor they knew, asking to borrow large quantities of bitcoin and offering the same hefty interest rates the firm always had. “They were clearly pumping their prowess as a crypto hedge fund after they already knew they were in trouble,” says someone close to one of the biggest lenders. In reality, Three Arrows was scrounging for funds just to pay its other lenders back. “It was robbing Peter to pay Paul,” says Castle Island’s Walsh. In the middle of June, a month after luna’s collapse, Davies told Charles McGarraugh, chief strategy officer at Blockchain.com, that he was trying to get a 5,000 bitcoin loan — then worth about $125 million — from Genesis to give to yet another lender to avoid liquidating its positions…
…In Three Arrows’ final days, the partners reached out to every wealthy crypto whale they knew to borrow more bitcoin, and top crypto executives and investors — from the U.S. to the Caribbean to Europe to Singapore — believe 3AC found willing lenders of last resort among organized-crime figures. Owing such characters large sums of money could explain why Zhu and Davies have gone into hiding. These are also the kinds of lenders you want to make whole before anyone else, but you may have to route the money through the Caymans. Says the former trader and 3AC business partner, “They paid the Mafia back,” adding, “If you start borrowing from these guys, you must be really desperate.”
After the collapse, executives at crypto exchanges began comparing notes. They were surprised to learn that Three Arrows had no short positions, which is to say it had stopped hedging — the very thing it had maintained was the cornerstone of its strategy. “It’s very easy to do that,” says the major lending executive, “without any of the trading desks knowing you’re doing that.” Investors and exchange executives now estimate that, by the end, 3AC was leveraged around three times its assets, but some suspect it could be magnitudes more.
Three Arrows seems to have kept all the money in commingled accounts — unbeknownst to the owners of those funds — taking from every pot to pay back lenders. “They were probably managing this whole thing on an Excel sheet,” says Walsh. That meant that when 3AC ignored margin calls and ghosted lenders in mid-June, those lenders, including FTX and Genesis, liquidated their accounts, not realizing they were also selling assets that belonged to 3AC’s partners and clients. (This seems to be what happened with 8 Blocks Capital, which complained on Twitter in June that $1 million from its trading account with 3AC had suddenly disappeared.)
After the firm’s traders stopped responding to messages, lenders tried calling, emailing, and messaging them on every platform, even pinging their friends and stopping by their homes before liquidating their collateral. Some peered through the door of 3AC’s Singapore office, where weeks of mail was piled up on the floor. People who had thought of Zhu and Davies as close friends, and had lent them money — even $200,000 or more — just weeks earlier without hearing any mention of distress at the fund, felt outraged and betrayed. “They are certainly sociopaths,” says one former friend. “The numbers they were reporting in May were very, very wrong,” says Kasselman. “We firmly believe they committed fraud. There’s no other way to state it — that’s fraud, they lied.” Genesis Global Trading had lent Three Arrows the most of any lender and has filed a $1.2 billion claim. Others had lent them billions more, much of it in bitcoin and ethereum. So far, liquidators have recovered only $40 million in assets. “It became clear that they were insolvent but were continuing to borrow, which really just looks like a classic Ponzi scheme,” says Kasselman. “Comparisons between them and Bernie Madoff are not far off.”
When Three Arrows Capital filed for Chapter 15 bankruptcy, the process for foreign companies, on July 1 in the Southern District of New York, it was more or less a formality. But the filing itself did contain some surprises. Even as creditors rushed to file their claims, 3AC’s founders had already beaten them to it: The first person in line was Zhu himself, who on June 26 filed a claim for $5 million, along with Davies’s wife, Kelly Kaili Chen, who claimed she had lent the fund close to $66 million. The only documentation they had to back up their claims were simple, self-attested statements that did not specify when the loans had been made or the purpose of the funds. “That’s a total Mickey Mouse type of operation,” says Walsh. While insiders were unaware of Chen’s involvement in the firm, they believe she must have been acting on Davies’s behalf; her name appears on various firm entities, likely for tax reasons. Both Zhu’s and Davies’s mothers have also filed claims, according to people familiar with the situation. (Zhu later told Bloomberg News, “They’re gonna, you know, say that I absconded funds during the last period, where I actually put more of my personal money back in.”)
5. Industry Structure: Fabs are in Favor – LTAs are the Tell – Doug O’Laughlin
One of the things that I have found so fascinating about this inventory cycle in the semiconductor industry is the NCNR (non-cancelable, non-refundable) order. The reasoning behind the NCNR is that investing in a wafer fab is expensive, and recently those costs have been increasing; thus, fabless customers should have to bear some of the financial burdens of investing in a wafer fab and cannot cancel their orders. Foundries and Fabs have managed to enter long-term agreements with most of their customers, whether it’s the demand planning at Micron or the NCNRs at Globalfoundries and the like.
Note: I will refer to foundries and fabs interchangeable in this piece. A fab is the actual building where semiconductors are made; a foundry is a company that sells that building’s production as a service.
Let’s contrast this against history – when Fabs were thought of as cost centers, outsourced to Asia, and disposed of at the earliest possible convenience for the fabless company to flourish. If there is a pendulum of the importance of having a fab, we likely swung from peak fabless and fab-light to a geopolitically fab-hungry world. The entirety of 2020 amplified that.
The 2020-driven shortages highlighted the strategic importance of fabs, especially in industries like automotive. As a result, most companies had to rethink how to treat fabs and stopped treating fabs like an infinite and elastic supply pool when it is a strategic supply if you’re selling electronic goods…
…It wasn’t always this way. Fabs were once a dime a dozen, and I mean that literally. When I talked about the 1996 semiconductor cycle in my semiconductor history series, there were 10s of memory companies ramping capacity in unison, leading to oversupply. That picture is a bit different now – this chart from Yole paints a new picture. Even as recently as 2010, ten companies were at the leading edge. Fast forward ten years, and we are talking about three leading-edge companies with a dominant first-place leader.
This is partially due to the increasing scale and absolute difficulty of making a semiconductor at the leading edge. Companies split the fab and fabless company in two like AMD and Globalfoundries. And eventually, companies like Globalfoundries just gave up at the leading edge, saying it would be uneconomic to continue, and then chose to pivot to specialty technologies such as SOI and RF devices. Another aspect of this transition is that fabs were once considered relatively commoditized compared to excellent design. Designing and marketing the product needed for an end market had much better returns than just making the chips themselves. So why bother with a capital intense fab when you could just use TSMC?
This mantra led to decades of offshoring, first in packaging and then in fabrication. TSMC’s rise can be partially attributed to outsourcing the perceived less critical step of fabrication. Back in the day, everyone had a fab, and that wasn’t precisely a differentiating process in the 1990s.
But as Moore’s law’s torrid pace continued, simply hopping back into the fabrication game became increasingly complex. And as we hit more problems post planar scaling into FinFet and beyond, the fab became a scarce resource. And once you fall off Moore’s law pace, hardly anyone regains it. So fast forward a decade of outsourcing and divestitures, and here we are – fewer fabs than ever and more concentration than ever. In the Michael Porter framework, there are fewer suppliers than customers, and the power is shifting to the suppliers.
We outsourced a backend process that became critical, making it impossible to get that back. Path dependency shapes history, and a series of logical steps to improve your business into an asset-light and higher margin business over decades inadvertently signed over the keys to the kingdom. Fabs became necessary, but the US financed their construction in Taiwan. And what’s more, there are fewer players.
6. Matt Reustle – Union Pacific: Long Train Runnin’ – Dom Cooke and Matt Reustle
[00:03:07] Dom: I’m very excited for today’s conversation. We’re talking Union Pacific, but I think it gives us a great reason to talk about rails in general. The world of freight railroading seems very under discussed relative to its importance in the US and just general global supply chains. So hopefully we can shed some light on how it works and what makes it interesting in the course of breaking down Union Pacific. To start, I think we need to spend some time on the industry itself. There’s a number of ways you can move freight around. Can you walk us through the transportation sector generally and why you would choose rails over, say, shipping, trucks or planes?
[00:03:40] Matt: To answer the second part of the question, you might not choose rails over the other transportation sectors if you had a choice. Many of these businesses, and many of the things that move on rails are just captive volumes that can’t economically move via truck or via plane. When you think about these heavy grains, commodities, steel, things that require a substantial amount of movement and a substantial amount of capacity, and rails are the only option there. But to frame the transportation market as a whole, in North America it’s about $900 billion in terms of market size. Rails make up about 10% of that. And you compare that to the much larger trucking sector, which is 600 billion. So you’re talking about substantially different sizes here. Rails, just owning that one portion where it’s a lot that has to do with the manufacturing economy, a lot that has to do with the industrial economy.
You compare it to something like air freight, where that’s similar in size to the rail economy at about $90 billion. And that’s going to be things that need to move much faster. They’re going to be much lighter in terms of weight and size, but things that you want to be getting to destinations at a much faster speed. So that’s just a high level overview. There’s other factors that come into consideration as well. If you think about something like rail versus truck, there’s a few rules of thumb that shippers generally use.
We’re looking about 400 or 500 miles as threshold, the break even threshold, where it starts to make sense to move something via rail. And if you think about the cost and time that it takes to get something somewhere, a rail, you’re going to save yourself 10 to 15 percent in terms of cost. And you’re going to be getting it about a day late relative to the trucking market, when you’re talking about those distances. But I would say that if many of the shippers that are moving on rail today had a choice, they would like to have lot more options to move their freight than they do today…
…[00:07:39] Dom: And maybe we can go there now and just put some finer details around the oligopolistic structure of the market and how those operate in their twos and twos and twos across the country. How in practice does that play out? Is it a cartel like behavior? Are they colluding on price? Are they colluding in other ways? Can you just give us some detail around that?
[00:07:55] Matt: It’s helpful to really trace back to the beginning of history for rails. And I think this will paint a picture in terms of how we got to where we are today. So if you go back to the 1800s. This was the Gilded Age. This is where you saw this vast amount of wealth generated in the US from the Vanderbilt, Jay Gould. And one of the key milestones was the transcontinental railroad, which was built in the 1860s, not finished until 1869. You could now get from the east coast of the US to the west coast of the US in just over three days. And that, compared to prior to that, being three weeks, if you were going to take a ship or multiple months, if you were going to try to take any other form of transportation. Crazy to think about how groundbreaking that was in terms of changing the dynamics of the markets, changing the entire economy and what was possible, in terms of coast to coast commerce.
So fast forward to the late 1800s, these railroad businesses are really dominating the economy. The first Dow Jones index, that came out in the 1890s, over 60% of it was represented by railroad companies. It got the focus of the regulators, where pricing power, I think Rockefeller was the only one who was able to avoid the pricing power of the railroads, but it became a major focus. And you had the Interstate Commerce Act come into play and start to heavily regulate railroads in terms of what prices looked like and how much control they had over that. And what that really led to was almost a century worth of deterioration in railroad networks, culminating with Penn Central Rail, which was a massive railroad in the US, declaring for bankruptcy in the early 1970s. And it was clear and obvious that, after all these networks were deteriorating, there was no capital even put into them.
It was an industry that was almost left to die. There needed to be a change. And that’s when the Staggers Act came. The Staggers Act came in the form of, really, loosening the regulatory nature around the rail industry, actually allowing for them to charge lower prices. That was before you had all these other forms of transportation around. You didn’t have automobiles at the time, you didn’t have a highway system, you didn’t have planes. So you had all these disruptive technologies at the same time, railroads weren’t able to fully control their business. Staggers Act changed that. And over the next 20 years, you basically saw a massive decline in railroad rates and that allowed for them to capture more business, reinvest back in their network, and that started the uprise, in terms of these businesses turning back into true operating networks. Then you get to the 2000s.
That’s when you start to see, there was consolidation along the way, but somewhat of a shift in behavior, where before it was capturing volume, getting things back onto the system, then it became a focus on operating efficiency, productivity, running these networks within ultimate focus on profitability. And that’s continued on for the past two decades. How that all culminates in terms of oligopolistic nature, there’s a few things that you see, but what I think is most notable is, you haven’t seen volumes increase for the rails, particularly in a large portion of their captive business over the past two decades, essentially. So rails have really just focus on where they have capped the business, that they are 100% the only option to take and exercising as much pricing power as possible. And at the same time, not willing to move or sacrifice their network or sacrifice anything when it comes to economics to move any other volumes.
And the regulatory system enables this in some creative ways. When you look at how the industry is governed today, it’s by the Surface Transportation Board. But in order for any type of review to happen, a shipper has to bring a rate case to the Surface Transportation Board. So it’s not as though rates are actually being set by a regulator. It is that rates could be protested and brought to a regulator. And those are the little pieces of friction that exist that really help rails protect their networks, protect their economics, enforce pricing power. And that’s led them to get to where they are today, which is a business that, at the start of the century, was earning 10% operating margins. And today that number is closer to 40% plus operating margins…
…[00:31:29] Dom: I think you framed the business model itself really well. So it’s probably time we hit on the financial model. Eric Mandelblatt came on Invest Like the Best earlier this year and talked about rails and and he talked about Union Pacific. One thing he mentioned was that they’ve actually got higher EBIT margins than Microsoft, which is surprising given how capital intensive rails are and Microsoft is known as a world class business. So can you walk us through the economic of a rail company through Union Pacific? What allows them to earn such high margins? What are the key markers you would pull out from their financials?
[00:31:51] Matt: It wasn’t always this way. You have businesses now that are earning north of 40% operating margins. It was early 2000s that these were 10 to 15% operating margins, which is insane to think about. Taking a dollar and keeping 10 cents versus taking a dollar and keeping 40 cents, when you’re talking about a 90 billion industry. So a substantial amount of profitability there that was generated. And it traces back to the rail industry outside of Union Pacific. It’s important to pay homage to the pioneer of all of this efficiency focus, Hunter Harrison, who was the godfather of precision scheduled railroading, which he implemented at Canadian National in the early 2000s, then at Canadian Pacific, with the help of Bill Ackman, putting him into place there. And then finally at CSX where he was put in by Ackman’s disciple, who spun out, started his own fund, Paul Hilal. And Hunter Harrison saw massive success at each of these businesses where he took out, we’re not talking about couple hundred basis points of cost, we’re talking about thousands of basis points of margin improvement.
So if you step back and say, okay, well what were the drivers of this? To frame it simply, it was longer trains, fewer stops, less people. And that obsessive focus was what took that dollar, where previously you might have been spending 30 cents of that dollar of revenue on labor, that number’s now closer to 20 cents. So labor being 20% of revenue versus 30% of revenue, major in terms of cost opportunity. That got removed from the system. You also had improvement from a fuel efficiency standpoint. So there’s two drivers to this, there’s fuel efficiency from the standpoint of we’re not going to move locomotives if they only have 40 cars attached to them. We want to have extremely long hauls and length of hauls. So we are going to, rather than come by your grain facility four times a week and take 25 rail cars each time, we’re going to come by once, and we’re going to take a hundred, and we’re going to tell you exactly when that time is.
So that’s going to save you quite a bit from a fuel standpoint, as you can spread whatever that is, in terms of the amount of diesel that it would require to move across many more rail cars, again, improving the economics. So fuel, that fluctuates as well, just in terms of fuel prices. While rails can pass through fuel prices, so they don’t wear the brunt of the impact. It has a funny way of working its way into margins, where just the arithmetic of passing through fuel inflation actually does diminish your margin profile. But that’s gone from basically mid teens to around 10%, even high single digits for periods of time. So that was another main driver of the margin improvement. So there you have labor, 20%, fuel being another 10%, something called purchase transportation, which has to deal with all of the other movements that a rail has to require. Other equipment that factors into things, that makes up another 20% of revenue. That’s stayed more or less the same, that’s probably come down from 25%.
And then the last thing is depreciation and amortization. The reason why that’s important for rails is because of the nature of the assets. Again, these locomotives have a 40 year useful life. The track has been around for decades, so that is held on the books at a substantially lower price than it would cost to build today. DNA being about 10% of revenue is mismatched with what you see from a CapEx perspective. So I think when investors historically have looked at, okay, how much cash am I actually converting from the income statement to the cash flow statement? Where you’ve seen the mismatch was, the DNA being significantly lower than the CapEx that I actually had to go into the network. So earnings conversion was closer to 80% range. Whereas today, as they began, focused on some of that efficiency, pulled back on some of that capital spending, you’ve seen that move slowly higher, and that is what could potentially offer a much more bullish regime for the industry, if you see more and more of that cash conversion come into play.
[00:36:04] Dom: And you mentioned, at the beginning, that people might not want to use the rails, but they have to. And then you just talked about how the rails have become more efficient, and as they’ve become more efficient, their margin profile has, has significantly improved. None of that sounds great for the end customer because they’ve essentially become less flexible to the end customer who wants to move their grain or coal or whatever it might be from place A to place B, and now the rails are turning around and saying, you’re doing it on our schedule, and our schedule just happens to work a bit better for us. Is that dynamic always at play in this industry? You don’t come across many businesses, which are able to treat their customers in quite a similar fashion, and end up retaining them, and improving their economic profile in the process.
[00:36:40] Matt: It gets into the regulatory dynamics again, which are fascinating. If you talk to the rails, they have a regulator who determines rates. And one of the drivers of those rate determinations is revenue adequacy, which is basically, does your revenue and the return that you generate, in terms of your assets, does that cover your cost of capital? And historically rails have shown that they really haven’t covered their cost of capital over time. Now in recent years, that has changed and that has flipped, where they meet revenue adequacy standards. Now the origins of revenue adequacy were created actually to support higher rates for the rails.
It wasn’t necessarily a protective measure, and there wasn’t much discussion around whether this would actually be creating a rate cap for rails, at any point, it would always be thought of as somewhat of a floor. I think what you’ve started to see recently, over the past few years is, shippers really pushing on the service transportation board and the regulators, in general, to have a little bit of a cleaner system allowing for them to protest rate cases, make this a little bit more of a balanced market for them.
So because they’re captive volumes and they really have no other option, they aren’t held completely hostage and they get some type of fair, appropriate market rate. But I think you point out a very interesting point, and that is the shift in focus, I would say, over the past 15 years, has been the shareholder focus, where if you look at the amount of job cuts that have happened in the industry, the frustration of some of the shippers, but the satisfaction of shareholders, where Union Pacific, from 2005 to today, has massively outperformed the index. And there was a stretch of time from 2005 to, I want to say 2020, where they outperformed the market every year, except for one. So just remarkable consistency and then remarkable cumulative outperformance. And that comes from, maybe, shifting focus a little bit away from your customer and being much more focused on the shareholder, which has its positive to negatives.
And the last thing I mentioned is, it’s a really interesting dynamic because if you look at how the class ones operate, there’s been all the shareholder pressure to implement precision scheduled railroading. Union Pacific was one of the last to do it, when you look at Canadian National, again, started, Canadian Pacific then CSX and Union Pacific. And in those interim periods of time, you always have management teams dismiss the benefits of PSR and say, it doesn’t apply here, or it’s not a system that we can implement, but time and time again, it’s proven that it has been a system that they can implement.
And Union Pacific used one of Hunter Harrison’s disciples to do it, so I think, when we look at legendary management trees, similar to coaching trees, the Belichicks and the Bill Walsh’s, who have all these former assistants that are now leading teams other places, you have much of that in the rails as well. Keith Creel at Canadian Pacific, there’s a large team at CSX, and Jim Vena was basically brought in as a free agent to Union Pacific, ran an operating plan for around two years, and has since left, and massively turned around that business by implementing all of these policies in that broader PSR scheme.
[00:40:04] Dom: It brings up an interesting point that you mentioned to me the other day, as we were thinking about Union Pacific, in that the railroad that Buffet and Berkshire your own, which is Burlington Northern, which is Union Pacific’s main competitor out west, haven’t implemented the same policy. Their margin profile looks materially different to Union Pacific than some of the other class ones. Is what you just said the opposite for them, and what are the reasons why they haven’t implemented it, or are there some other things going on there?
[00:40:27] Matt: It’s a lot of the same reasoning in terms of why they choose to vocalize that it wouldn’t necessarily work for them. And I think it’s because they do have a customer focus more than a shareholder focus, but they’re also quick to point out, Matt Rose, who has run Burlington Northern, would often say, by operating this way, you are attracting regulators. So when CSX went through their change to PSR, there was a lot of disruption. So shippers constantly having issues. And what ended up happening was the business was producing incredibly strong numbers, but there was a lot of frustration with shippers, to the point where the STB had a weekly call with CSX. So it was attracting a lot of focus. Who is this really benefiting? There’s often claims of the long term benefits, which I think we do see where you clean up the network, then you can run more efficiently over time.
You have to take a step back before you take a step forward. But Burlington Northern has pushed against this. I think there’s a case to be made that taking volume at 35% margin is reasonable and you don’t have to take every piece of volume at 45% margin or dismiss it completely. So it’s an interesting dynamic where you have what you’re prioritizing, in terms of an enterprise, and then also the regulatory nature and the dynamics there, where the more you push towards this focus on one particular stakeholder, in this case, the shareholder, that can attract things you don’t want to necessarily attract…
…[00:58:25] Dom: And as we wind down the conversation, as you know, the last question tends to be on lessons learned and how they might apply to other industries and other investors. What, from your time covering rails and Union Pacific specifically, would you point to as things that you’ve learned or changed your mind on?
[00:58:41] Matt: So I think one of the biggest items or lessons today is just the idea of revenue and the quality of that revenue. It’s something I tend to have a hyper focus on. But with all of these industries that have gone through massive growth, talking about network effects, here you have, potentially, the original network effect with the rails, the original OG networks themselves, that have actually given up a lot of revenue or have sacrificed from a volume perspective, because it just didn’t make sense in terms of what’s moving through the network. And I think there’s always this idea of riding industry waves and then controlling what you can control. In this case, these management teams have controlled what they can control and done a very effective job in terms of, what I would consider saving in many ways, an industry, as it relates to shareholders, by being so hyper focused on all of those things.
That’s one piece that I think is an interesting lesson. And the second piece, just from an investor perspective is, the importance of understanding how markets trade and how certain sectors trade. And I think we all like to have our own models for intrinsic value, discounted cash flow, the rate of return earned on assets and various different cash on cash returns, return on equity. Whatever metric you want to use, you can have your own methodology, but if you want to outperform in a certain sector, in this case, in transportation, there are usually key metrics which are the drivers and the single driving force of what results in outperformance. So when I started looking at this industry and I wanted to fight the idea of the operating ratio, I wanted to fight the idea that one single person, in this case, Hunter Harrison, could be the sole driver and the sole person with the knowledge and operating chops to implement this.
But the reality was the operating ratio was going to be the driver of outperformance of these stocks, and Hunter Harrison was able to do what many others were not able to do. So it was a bit of humble pie, in some ways, but also made me appreciate it’s healthy to be an outsider, but it’s equally healthy to understand how an industry operates and how the investors within that industry. Again, most of the transportation sector, it’s dominated by, what’s referred to as, the transportation mafia, which is a group of investors who’ve been around for decades and I have known these names ins and outs for decades, and they have strong communication, strong views, and they are a driving force in terms of how these stocks trade. So that was a major lesson and key learning experience for me going through it and trying to fight reality in some ways.
7. Why it is hard to lose when you invest in stocks – Chin Hui Leong
For some, investing is filled with visions of the enormous amounts of money made. The allure is not just in the amount made – but in how it is made.
Terms such as “strike it rich” or “a sudden windfall” are often associated with investing where great wealth is suddenly bestowed on a lucky few. This fervour for instant riches is further fuelled by stories of overnight wealth gained in bull markets. In fact, there are even movies made about how big gambles paid off handsomely for a select group of savvy investors.
Take The Big Short, a movie that raised the profile of hedge fund manager Michael Burry. Based on a book by Michael Lewis, the show had all the right ingredients to spur the imagination of the public.
There was Burry, depicted as a genius at crunching numbers. There was a US housing bubble forming in 2005 but was largely ignored by all but a few traders and hedge fund managers. Subsequently, there was a high-stakes bet by Burry on the bubble bursting.
Of course, by now, we all know what happened next. The stock market suffered one of its worst declines ever between 2007 and 2009 as the US economy fell under the weight of the housing crash.
But for Burry’s fund, which bet against the market, it made out like a bandit. Between November 2000 and June 2008, Burry’s Scion Capital produced a nearly 6-fold return, net of fees and expenses.
So there you have it. A big bet is made and as a result, big money is made. That’s what you need to win big in investing, right? Not so fast.
The movie’s popularity earned Burry the nickname, The Big Short, a label that has stuck with him until today. But here’s the kicker. You’d be wrong to assume that shorting is how he makes most of his money.
In an interview with Bloomberg after the movie’s release, Burry said it was ironic that he is best known for shorting the stock market. To correct the misconception, he made it clear that he does not spend his time looking for opportunities to short the market. Instead, most of his time is spent looking for “good longs”, or stocks that can be held for the long term.
Now that’s something they won’t make a movie about.
Eugene Ng, the founder of Vision Capital, shared some telling historical statistics on the S&P 500 on why you should invest for the long term. Simply said, the longer your time horizon, the higher your odds of a positive return.
So, here’s the deal. If you are trading in and out of the S&P 500 within a single day, your probability of netting a gain is not much better than a coin flip. Lengthen your holding period to a year, and your chances of a positive result will be around 7 out of every 10 1-year periods.
Stretch that out to 10 years, and history shows that you made money almost 90 per cent of the time. To cap it off, buy and hold the S&P 500 for 20 years and more, you will be 100 per cent positive and not lose any money.
Said another way, the path to positive returns depends on how long you are willing to hold.
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 Apple, Microsoft, and TSMC. Holdings are subject to change at any time.
