What We’re Reading (Week Ending 21 July 2024) - 21 Jul 2024
Reading helps us learn about the world and it is a really important aspect of investing. The late Charlie Munger even went so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 21 July 2024):
1. How a brush with death shaped my long game – Eric Markowitz
Last February, I opened my laptop and began writing a goodbye letter to my 18-month-old daughter.
“Dear Bea,” I began. “I want you to know how much I loved you…” I then carefully organized passwords to my computer, e-mail, and online brokerage accounts. My wife and I sat across from each other on the couch in stunned silence.
Hours earlier, I was told by ER doctors that I’d need emergency brain surgery to remove what they called a “rapidly enhancing lesion” in the center of my cerebellum, the part of my brain just above the brainstem. The lesion was about the size of a walnut.
At that point, doctors were unsure what it was. They explained it could either be a Stage 4 glioblastoma — terminal brain cancer — or an abscess that could pop at any point. If it was an abscess, the infection would likely prove fatal as well, given its proximity to my brainstem…
…That night, hours before the brain surgery, I laid in bed unable to sleep. I remember thinking about the crushing irony of my particular situation. For the last several years, I had built my professional identity around the idea of long-termism. I wrote a weekly newsletter about long-term investing; about compounding over many decades…
…And yet, here I was: 35 years old, and out of time. No more compounding. No more long-termism…
…At that precise moment, the idea of long-termism or “playing the long game” began to feel almost embarrassing — or ridiculous. The idea was like an act of hubris. The future isn’t earned; we’re lucky to experience it…
…Before this episode, I never had a significant health problem. But the truth is that I wasn’t living an entirely healthy, long-term-oriented lifestyle. I was constantly stressed at work. I had stopped exercising. I was glued to my phone — and to the market. In the months leading up to my condition, we were having a rough year, and it was all I could think about. I’d dream about stock prices. I’d wake up in a panic.
Despite the ideals of long-termism I professionally and publicly promoted, I was, in fact, living a lifestyle that was just the opposite. I was myopically focused on the short-term —on success, on the day-to-day. I avoided seeing friends; my marriage was becoming strained. Things were unraveling…
…The craniotomy was a tough procedure. They removed a large chunk of skull in the back of my head, spread open my brain with forceps, and removed the lesion…
…Finally — and it’s easy in hindsight to breeze over the days it took — the report came back conclusive: an infection. Not cancer.
Later, I’d find out that typical abscesses rupture after 10 days or so. Mine had been in my head for at least 4 weeks. No doctor could explain it. I had a ticking time bomb in my brain that simply didn’t explode. Maybe the detonator malfunctioned…
…When people ask about how the experience has changed me, I simply say I’m re-committed to playing the long game.
Playing the long game isn’t just about structure and process and systems that are designed to withstand the long-term: it’s about the joy and gratitude of getting to play the game in the first place. For me, up until that point in my life, I had been making short-term decisions that led to stress and burnout. And, in retrospect, my “always on” lifestyle likely led to my near-fatal brush with death. Stress and playing short-term games quite literally nearly killed me.
My focus was all on the wrong things.
Coming out of this experience, I proactively shifted my focus. I decided to make both personal and business decisions that would create an environment where the most important things in my life could flourish long after I was gone. I read more. I talked to new people. I made more effort in my relationships — I no longer think about getting through the day, but what I’m building over the long-run. I put down my phone. I made new connections. I asked, “how can I set up my life today to ensure my kids — and their kids — will be set up?” In business, I asked, “how can I set up my business today to ensure it exists in 50 years — or even 100 years?”
2. A borrower’s struggles highlight risk lurking in a surging corner of finance – Eric Platt and Amelia Pollard
Wall Street’s new titans have differed significantly in valuing the $1.7bn of debts they provided to workforce technology company Pluralsight, highlighting the risk that some private credit marks are untethered from reality…
…Private loans by their very nature rarely trade. That means fund managers do not have market data to rely on for objective valuations.
Instead they must draw on their own understanding of the value of the business, as well as from third-party valuation providers such as Houlihan Lokey and Kroll. They also can see how rivals are marking the debt in securities filings.
The funds share details of each individual business’s financial performance with its valuation provider, which then marks the debt. The fund’s board and audit committee ultimately sign off on those valuations…
…The loans to Pluralsight were extended in 2021, as part of Vista Equity Partners’ $3.5bn buyout of the company. It was a novel loan, based not on Pluralsight’s cash flows or earnings, but how fast its revenue was growing. Regulated banks are unable to provide this type of credit, which is deemed too risky. A who’s who of private credit lenders — including Blue Owl, Ares Management and Golub Capital — stepped in to fill the void.
The seven lenders to Pluralsight who report their marks publicly disclosed a broad range of valuations for the debt, with a Financial Times analysis showing the gulf widened as the company ran into trouble over the past year. The firms disclose the marks to US securities regulators within their publicly traded funds, known as BDCs, which offers a window into how their private funds may be valuing the debt.
Ares and Blue Owl marked the debt down to 84.9 cents and 83.5 cents on the dollar, respectively, as of the end of March. Golub had valued the loan just below par, at 97 cents on the dollar. The other four lenders, Benefit Street Partners, BlackRock, Goldman Sachs and Oaktree, marked within that range…
…The most conservative mark implies a loss across the lenders of nearly $280mn on the $1.7bn debt package. But Golub’s mark would imply a loss of just $50mn for the private lenders.
Some lenders have marked the loan down further since May, people familiar with the matter said.
Vista, for its part, started marking down its valuation of Pluralsight in 2022, cutting it to zero this year. Vista is expected to hand the keys to the business to the lenders in the coming weeks, with one person noting the two sides had made progress in recent talks…
…A publicly traded loan that changes hands below 80 cents on the dollar typically implies meaningful stress, a cue to investors of trouble. But as Pluralsight illustrated, that kind of mark never materialised until it became clear Vista might lose the business.
3. Private Equity’s Creative Wizardry Is Obscuring Danger Signs – Kat Hidalgo, Allison McNeely, Neil Callanan, and Eyk Henning
Even though buyout firms say they see green shoots in the M&A market, they’re deep into a third year of higher rates and scant opportunity to sell assets at decent prices, and they’ve been forced into a host of wheezes to keep things going: “Payment in kind” (PIK) lets PE-owned companies defer crippling interest payments in exchange for taking on even more costly debt; “net asset value” loans allow cash-strapped buyout firms to borrow against their holdings…
…The amount of distressed debt owed by portfolio businesses of the 50 biggest PE firms has climbed 18% since mid-March to $42.7 billion, according to data compiled by Bloomberg News using rankings from Private Equity International. “We expect defaults to go up,” Daniel Garant, executive vice president and global head of public markets at British Columbia Investment Management Corp., another Canadian pensions giant, told Bloomberg recently.
A key challenge for regulators is that much of PE’s borrowing was arranged with loose legal terms at a time when lenders were fighting for deals, making it easier today to use financial wizardry to keep sickly businesses alive.
“You don’t know if there are defaults because there are no covenants, right?” says Zia Uddin of US private credit firm Monroe Capital. “So you see a lot of amend and extend that may be delaying decisions for lenders.”
All this additional debt makes it tougher, too, for PE owners hoping for exits.
Take Advent International and Cinven. They took on heavy debts when buying TK Elevator including a roughly €2 billion ($2.1 billion) PIK note they loaded onto the lift maker that’s swelled to about €3 billion, according to people with knowledge of the situation. The tranches carry an interest rate of 11%-12%…
…In Europe, most private credit borrowers have been turning to PIK when reworking debt obligations, according to data from Lincoln International. In the US, Bloomberg Intelligence reckoned in a February note that 17% of loans at the 10 largest business development companies — essentially vehicles for private credit funds — involved PIK…
…One way firms try to keep investors sweet is by borrowing against a portfolio of their own assets, known as a NAV loan, and using the cash to help fund payouts. NAV lenders sometimes charge interest in the mid to high teens, and some borrowers have used holiday homes, art and cars as collateral…
…The proliferation of NAV, PIK and similar has also deepened connections between PE firms and their credit cousins, a possible contagion risk if things go wrong. In the US almost 80% of private credit deal volume goes to private equity-sponsored firms, according to the Bank for International Settlements…
…CVC Capital Partners came up with a novel use of extra leverage during its March IPO of Douglas AG. It borrowed €300 million from banks, injecting it as equity in the German beauty retailer to strengthen its balance sheet, and pledging Douglas shares as collateral in a so-called margin loan, according to the offering’s prospectus.
A fall of 30% to 50% from the IPO price would trigger a margin call, according to people with knowledge of the matter who declined to be identified as the information is private. The stock is down about a quarter since the listing…
…A new BIS report warns that “a correction in private equity and credit could spark broader financial stress,” citing potential knock-on effects on the insurers that heavily invest in these funds and on banks as the “ultimate providers of liquidity.”
“Some features in the financial markets have probably postponed the impact of the rise on interest rates, for example fixed rates, longer maturities and so on,” Agustin Carstens, BIS’s general manager, told Bloomberg TV last week. “These can change, and will be changing in the near future.”
4. China’s subsidies create, not destroy, value – Han Feizi
A common narrative bandied about by the Western business press is that China’s subsidized industries destroy value because they are not profitable – from residential property to high-speed rail to electric vehicles to solar panels (the subject of the most recent The Economist meltdown).
If The Economist actually knows better and is just doing its usual anti-China sneer, then it is par for the course and we give it a pass. But if this opinion is actually held – and all indications are that it is – then we are dealing with something far more pernicious. 248 years after the publication of Adam Smith’s “The Wealth of Nations” and the West has lost the economic plot…
…To be unable to comprehend this crucial point is to never have properly understood Adam Smith. “The Wealth of Nations” was never about the pursuit of profits.
They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.
The entire point of enlightened self-interest was supposed to be the secondary/tertiary effects that improve outcomes for all.
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.
What we want from the butcher, the brewer and the baker are beef, beer and bread, not for them to be fabulously wealthy shop owners. What China wants from BYD and Jinko Solar (and the US from Tesla and First Solar) should be affordable EVs and solar panels, not trillion-dollar market-cap stocks. In fact, mega-cap valuations indicate that something has gone seriously awry. Do we really want tech billionaires or do we really want tech?…
…The much-heralded multi-trillion dollar valuations of a handful of American companies (Microsoft, Apple, Nvidia, Alphabet, Amazon and Meta) – all of which will swear up and down and all day long that they are not monopolies – are symptoms of serious economic distortion. How much of their valuation is a result of innovation and how much is due to regulatory capture and anti-trust impotence?
It’s hard to say. China stomped on its tech monopolies and now manages to deliver similar if not superior products and services – able to make inroads into international markets (e.g. TikTok, Shein, Temu, Huawei, Xiaomi) – at always much lower prices.
The Western business press, confusing incentives with outcomes, lazily relies on stock markets to determine value creation. The market capitalization of a company is an important but entirely inadequate measure of economic value…
…What China has done in industry after industry is to flatten the supply curve by subsidizing hordes of producers. This spurs innovation, increases output and crushes margins. Value is not being destroyed; it’s accruing to consumers as lower prices, higher quality and/or more innovative products and services.
If you are looking for returns in the financial statements of China’s subsidized companies, you are doing it wrong. If China’s subsidized industries are generating massive profits, policymakers should be investigated for corruption.
A recent CSIS report estimated that China spent $231 billion on EV subsidies. While that is certainly a gross overestimation (the think tank’s assumption for EV sales tax exemption is much too high), we’ll go with it. That comes out at $578 per car when spread over all ~400 million cars (both EV and ICE) on China’s roads.
The result has been a Cambrian explosion of market entrants flooding China’s market with over 250 EV models. Unbridled competition, blistering innovation and price wars have blinged out China’s EVs with performance/features and lowered prices on all cars (both EV and ICE) by $10,000 to $40,000. Assuming average savings of $20,000 per car, Chinese consumers will pocket ~$500 billion of additional consumer surplus in 2024.
What multiple should we put on that? 10x? 15x? 20x? Yes, China’s EV industry is barely scraping a profit. So what? For a measly $231 billion in subsidies, China has created $5 to $10 trillion in value for its consumers. The combined market cap of the world’s 20 largest car companies is less than $2 trillion…
…The more significant outcomes of industrial policy are externalities. And it is all about the externalities.
To name just a few, switching to EVs weens China from oil imports, lowers particulates and CO2 emissions, provides jobs for swarms of new STEM graduates and creates ultra-competitive companies to compete in international markets.
Externalities from the stunning collapse of solar panel prices may be even more transformative. Previously uneconomic engineering solutions may become possible from mass desalinization to synthetic fertilizer, plastics and jet fuel to indoor urban agriculture. China could significantly lower the cost of energy for the Global South with massive geopolitical implications.
The city of Hefei in backwater Anhui province has achieved spectacular growth in recent years through shrewd investments in high-tech industries (e.g. EVs, LCD, quantum computing, AI, robotics, memory chips)…
…While returns for traditional venture capital investments are dictated by company profits, the Hefei model is more flexible. Returns can be collected through multiple channels from taxing employment to upgrading workforces to increasing consumer surplus. The internal hurdle rate can be set lower if positive externalities are part of the incentive structure.
5. Dear AWS, please let me be a cloud engineer again – Luc van Donkersgoed
I’m an AWS Serverless Hero, principal engineer at an AWS centric logistics company, and I build and maintain https://aws-news.com. It’s fair to say that I am very interested in everything AWS does. But I fear AWS is no longer interested in what I do.
This post is about AWS’ obsession with Generative AI (GenAI) and how it pushes away everything that makes AWS, well, AWS…
…Then 2024 came around, and somehow AWS’ focus on GenAI took on hysterical proportions. It started with the global AWS summits, where at least 80% of the talks was about GenAI. Then there was AWS re:Inforce – the annual security conference – which was themed “Security in the era of generative AI”…
…And this is the crux: AWS is now focused so strongly on GenAI that they seem not to care about anything else anymore – including everything that made developers love them and made them the leading cloud provider on almost every metric…
…I like GenAI. I use it extensively at work and for the AWS News Feed. I use ChatGPT to shape new ideas, Copilot to speed up development, and Claude to generate summaries. The point is that all these features add to an existing business. This business has customers, data, business rules, revenue, products, marketing, and all the other things that make a business tick. And most businesses had these things before 2022. GenAI allows us to add new features, and often faster than before. But GenAI has no value without an existing product to apply it to….
…But AWS and I are growing apart. I feel the things I value are no longer the things they value. By only talking about GenAI, they implicitly tell me databases are not important. Scalable infrastructure is not important. Maintainable applications are not important. Only GenAI is…
…In summary, AWS’ implicit messaging tells developers they should no longer focus on core infrastructure, and spend their time on GenAI instead. I believe this is wrong. Because GenAI can only exist if there is a business to serve. Many, if not almost all of us developers got into AWS because we want to build and support these businesses. We’re not here to be gaslighted into the “GenAI will solve every problem” future. We know it won’t.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have a vested interest in Apple, Alphabet (parent of Google), Amazon, Meta Platforms, Microsoft, and Tesla. Holdings are subject to change at any time.
