What We’re Reading (Week Ending 25 October 2020) - 25 Oct 2020
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 25 October 2020):
1. Early Work – Paul Graham
Making new things is itself a new thing for us as a species. It has always happened, but till the last few centuries it happened so slowly as to be invisible to individual humans. And since we didn’t need customs for dealing with new ideas, we didn’t develop any.
We just don’t have enough experience with early versions of ambitious projects to know how to respond to them. We judge them as we would judge more finished work, or less ambitious projects. We don’t realize they’re a special case.
Or at least, most of us don’t. One reason I’m confident we can do better is that it’s already starting to happen. There are already a few places that are living in the future in this respect. Silicon Valley is one of them: an unknown person working on a strange-sounding idea won’t automatically be dismissed the way they would back home. In Silicon Valley, people have learned how dangerous that is.
The right way to deal with new ideas is to treat them as a challenge to your imagination — not just to have lower standards, but to switch polarity entirely, from listing the reasons an idea won’t work to trying to think of ways it could. That’s what I do when I meet people with new ideas. I’ve become quite good at it, but I’ve had a lot of practice. Being a partner at Y Combinator means being practically immersed in strange-sounding ideas proposed by unknown people. Every six months you get thousands of new ones thrown at you and have to sort through them, knowing that in a world with a power-law distribution of outcomes, it will be painfully obvious if you miss the needle in this haystack. Optimism becomes urgent.
But I’m hopeful that, with time, this kind of optimism can become widespread enough that it becomes a social custom, not just a trick used by a few specialists. It is after all an extremely lucrative trick, and those tend to spread quickly.
2. String of Firms That Imploded Have Something in Common: Ernst & Young Audited Them – Patricia Kowsmann, Mark Maurer, and Jing Yang
While it wasn’t possible to pinpoint why EY has had so many recent audit clients with financial scandals, certain elements of EY’s business strategy might help explain the cluster of blowups.
EY had ties with executives and board members at some of its troubled audit clients. In some cases, former EY partners sat on the companies’ boards, including on their audit committees.
EY charges lower fees for audits, which are labor intensive and time consuming, than other Big Four firms in the U.S. and Europe on average, an analysis of data from research firm Audit Analytics shows.
EY also focuses more than other firms on auditing young, fast-growing technology companies. All of the recent troubled clients portrayed themselves as tech-driven industry disrupters. EY helped some prepare for IPOs.
3. Models, Good and Bad – Marcelo P. Lima
Andy Jassy, CEO of Amazon Web Services, gave an interview recently in which he noted that in the early days, Amazon would use a net present value (NPV) analysis for deciding which internal projects they should invest in. This is similar to the discounted cash flow (DCF) models we use internally at Heller House to evaluate investment opportunities and conceptually similar to the internal rate of return (IRR) calculation Adam Fisher made in his Wix memo: the goal is to figure out what types of returns one can earn from a dollar invested in a given opportunity.
When I’m asked about how we value the companies in which we invest—some of which don’t yet produce accounting profits—my answer is always the same: we use DCFs for everything. I know that my models are wrong because I cannot forecast a company’s revenue growth, profits, and margins ten years out. But it’s useful to have guardrails to Fermi-ize our assumptions: do they make sense? Is the outcome of the exercise reasonable based on what I believe is the market size of this opportunity? Is it within a realm of possible futures?
What Jassy and Bezos realized eventually, however, is that some of the most exciting projects they dreamt up weren’t getting funded. It was hard—if not impossible—to assign an NPV to them (in this regard, Adam Fisher did a very good job: it was hard to see the future for Wix, but he took a very good stab at it!).
Amazon ditched the NPV approach and moved to a decision-making process involving five questions:
- If we build it and it’s successful, can it be really big and move the needle?
- Is it being well-served today
- Do we have some kind of differentiated approach to it?
- Do we have some competence in the area, and if not, can we acquire it quickly?
- If we like the answers to the four questions above, can we put a group of single-threaded, focused people on this initiative?
4. 50 Cognitive Biases in the Modern World – Marcus Lu
Fundamental Attribution Error – We judge others on their personality or fundamental character, but we judge ourselves on the situation. [Eg:] Sally is late to class; she’s lazy. You’re late to class; it was a bad morning.
Dunning-Kruger Effect – The less you know, the more confident you are. The more you know, the less confident you are. [Eg:] Francis confidently assures the group that there’s no kelp in ice cream. They do not work in the dairy industry.
Declinism – We tend to romanticize the past and view the future negatively, believing that societies/institutions are by and large in decline. [Eg:] “In my day, kids had more respect!”
Framing Effect – We often draw different conclusions from the same information depending on how it’s presented. [Eg:] Alice hears that her favourite candidate is “killing it” with a 45% approval rating. Sally hears that the candidate is “disappointing the country” with a 45% rating. They have wildly different interpretations of the same statistic.
5. Client Case Study: When You Give Up Being A DIY Investor – Kyith Ng
Adam and his wife, Sabrina, have spent the past 13 years of their lives in successful individual careers as a Technology Engineer in an American MNC and as an Account Manager, respectively. Both realize that their money has built up over the years and do not wish to take the traditional route of wealth building that their parents took. However, being careful with their money, they tried to sift through the vast amount of information to find what is the right way to invest.
When tasked to invest his family’s wealth, Adam believed that a certain criterion was important to building wealth in a fundamentally sound manner. Eventually, they identified that a sound way to build wealth would be to channel their money from work and what they have into Exchange-Traded Funds (ETFs) that track certain regional indexes. Through his research, he understands the concept of having exposure to a portfolio of equities around the world. He also understands the importance of keeping their transactional costs low because costs would compound over time. That is how they started venturing out of safe fixed deposits and lower risk instruments and into higher risk and potentially higher return financial assets.
If you were to ask us to name a fundamentally sound way to invest in a do-it-yourself manner, we would tell you what Sabrina and Adam did was sound. We could even give you the blueprint on how to do it here:
- Identify a brokerage or fund platform that has low transaction charges or low platform fees
- Put the lump-sum you wish to invest, into a low-cost, broadly diversified unit trust or exchange traded fund. You can create a low-cost, broadly diversified portfolio with 1 to 4 funds depending on your preference and sophistication
- Contribute a portion of your cash flow from work into the fund
- On an annual or half-yearly basis, do a rebalancing if you hold more than 1 fund
- In terms of investment setup, that is it
- You should continue to get educated in this way of investing- focusing on a continuous education on market returns, on volatility and how the markets performed at various pivotal junctures
- With such an approach, you can then live a good life, because the investments are rather passive in nature. By not taking a too active approach to wealth building, this frees up your mind to do your best work in your career. The better you do in your career, the greater excess cash flows you will get from work to be channeled back into your wealth portfolio
Given Adam and Sabrina’s initial investible wealth of $600,000, a 30% savings rate which allows them to put away an initial amount of $100,000 a year, a higher than average salary growth of 7% a year, and a projected portfolio compounded return of 5% a year, Sabrina and Adam could grow their wealth to $9,674,623 in 18 years’ time when they are 50 years old.
Adam and Sabrina would have come across materials like the above in their research and they would have implemented something similar.
However, eventually a couple like Adam and Sabrina decided to approach us. Here are some of the challenges that they faced.
6. How Airbnb Pulled Back From the Brink – Preetika Rana and Maureen Farrell
Mr. Chesky quickly switched Airbnb’s strategy. Big cities visited by tourists had been Airbnb’s strength, but it would now focus on local stays. By June, the company had redesigned its website and app so its algorithm would show prospective travelers everything from cabins to lavish beach houses near where they lived.
On July 8, guests booked stays at the rate they were just before the pandemic brought travel and tourism to a halt. In August, more than half of bookings made were for stays within 300 miles of the guest’s location, according to the company.
It was a lucky break, and Airbnb was in position to capitalize on it. The CEO made more changes, including cutting marketing, putting many noncore projects on hold and laying off a quarter of the staff.
“I did not know that I would make 10 years’ worth of decisions in 10 weeks,” Mr. Chesky said in an interview.
The upswing has put the home-sharing giant on a path to go public and report a third-quarter profit this year, according to investors, something that seemed all but impossible months ago.
7. Accountable to Darwin vs. Accountable to Newton – Morgan Housel
Growing a population has rarely been a problem in human history. Virtually every nation could count on a consistent flow of births exceeding deaths. Population growth fueled economies and seemed like a law of nature. But Newton isn’t involved. Darwin runs the show. Things changed, living conditions improved, competition favored something new, and over the last 30 years births have fallen so much that most big nations will have fewer workers in 2050 than in 2020.
For decades, the dividend yield on a company’s stock was usually higher than the interest rate on its bonds. It made sense to people: stocks were riskier than bonds, and you must be paid extra in return. It seemed like an iron law of finance, blessed by Newton. But things changed. Around the 1950s, companies began withholding more profits to finance growth in lieu of dividends. Dividend yields fell below bond yields. Some people thought it was a sign of madness that must revert. But it didn’t. Today we think it’s normal because bonds have no growth upside, so you should be paid more to make the investment worthwhile. That now seems like a Newtonian law of finance. But in both cases investors are just being accountable to Darwin.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation.
