Investment Process

In Search of Mindful Compounders

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Note: It’s a republish of the General & Market Commentary section of 2020 Q3 Letter, for easier reference and access.

This pursuit started from studying my own largest omission mistakes (i.e. failed to buy the companies when I could have), namely Amazon, Microsoft (post Satya Nadella), Netflix. But before we dive in, I need to clarify what “mindful compounder” means. I see “compounder” as who persistently create value (not monetary value alone) for all stakeholders across the value chain, and “mindful” is a generalization of many traits I look for Tao & Commander factor, e.g. mission driven, purposeful, rationality, deep thinking & high awareness. (see more in my investment process post[1]). In all cases, I have identified the managers of these companies as mindful leaders yet didn’t buy for the fear of market being already efficient in pricing these mega cap stocks.

But how efficient has Mr. Market been in pricing the value of these companies really? Below I draw the time series of valuation (TTM P/S ratio), and annualized compounding return to date (i.e. if holding form that point of time to 9/30/2020). I excluded annualized return for recent 2 years since they are not representative for the short history.

One clear lesson to be learn here is that market has been far from efficient in evaluating the intrinsic value of these companies. Taking Amazon for example, the worst time to buy it was in January 2000 when it was priced at 17 P/S ratio, but you would still achieve 20+% annual compounding return if you hold till now. Buying it any other time later than 2004 and hold it till now would give well above 30% annual return! Obviously, valuation still matters, but the worst scenario of 20% is far cry from an efficient market return over 20 years. So, the market must have missed something! Luckily, all three companies have long history for me to study patterns that can help identify value earlier.

The “Stumbled-Upon” Quantum Leaps

The first important pattern is that none of them relied on a single product/service to achieve the substantial value compounding. As old businesses mature, all these companies in their lives experienced some pivotal “quantum leaps” expanding to new products/services, which ultimately contribute heavily to its long-term value but was not fully appreciated by the time. With few exceptions, the leaders later would admit that the leap was not by design, or at least that they didn’t foresee the full potential. For example, Netflix had two major pivots from DVD renting, to streaming & to original content. Microsoft also made a major pivot after Nadella took the helm to “cloud & open source first”. Amazon’s AWS was an internal tool built out of its own frustration of its ability to launch new projects/applications, later became a $40 billion annual run rate revenue monster!

Surrogation Bias & First Principle

All companies try to “leap” too, but more often they end with disappointment. I think what makes mentioned 3 compounders more successful in making such leaps is their mindfulness. Case studies of the failed attempts point to a pervasive, yet understudied bias – Surrogation, whereby the measure of a construct of interest evolve to replace the construct itself. Take Wells Fargo’s fake account scandal as example[2], the management initially use cross selling metrics to measure its relationship with clients. However overtime, subsequent executives started to believe the cross selling is the strategical goal (rather than client relationships), leading to the now-infamous mantra – “Eight is great” (to have 8 Wells Fargo products per customer). What made things worse is management started to tie incentives to this single metric for front line bankers, which ultimately led to faking accounts. Such misalignment is detrimental for company value.

On the other hand, all three mentioned companies deeply embed first principle in their operation to overcome surrogation. Amazon provides probably the best example, from Bezos’ first shareholder letter, Amazon has been obsessively following a “customer-centric” philosophy and repeatedly use this qualitative principle to guide quantitative measures & decision making. For example, Amazon started very early to not only use GMV & MAU to define their performance, but also added repeating customer orders because it was a better way to measure the stickiness, or value created for customers. Pinduoduo (one of our current holdings) is another example in putting a qualitative Polaris for Social E-Commerce (To focus on user engagement) around any measurements. Chairman Colin Huang in many occasions dismissed sell side analysts’ question regarding its ARPU trend & guidance saying:

… raising ARPU is not part of our management’s KPI, but I think it will be a natural result as the users’ engagement increases over time…

– Colin Huang, PDD 2020 Q1 Earnings Call

Also, regarding the measurement of users’ engagement, it uses a unique and well-thought-through metric – MAU/Annual Active Buyers. It is like Amazon’s idea of repeating customers orders, but more consistent in a normalized % form.

Radical & Prescient Decision Making

Another common theme I observed from mentioned companies is that on top of the first principle thinking, management tend to make seemingly radical decisions later proven prescient. Microsoft’s Satya Nadella made an impressive example[3], especially considering his soft-speaking personality (e.g. he’s never seen “upset, raising voices or firing off angry email” by colleagues). Yet he demonstrated assertion in many big decisions even early in his tenure as CEO. For example, Nadella decided to write off $7.6 billion from Nokia purchase first year in 2015 and to terminate its Windows division, which was split into Azure & Office divisions in 2016. Additionally, during the agonizing Windows to Azure reorganization (which one executive called “pulling fingernails”), Nadella showed his exceptional ability to make aggressive changes with little drama.

Netflix’s Reed Hastings, a half-mentor of Nadella (as board of Microsoft), is a hallmark of such decision-making ability[4]. Although the decision of pivoting to streaming & original content are both monumental, I think the most radical & prescient decision may be the one he made in earlier year to call off its streaming hardware right before its launch. I was December 2007 and Netflix has been exploring variety of new business models as its legacy DVD renting line matures. A team of about 20 had been working around the clock for years on a project coded “Griffin”. It was so close to the launch that marketing materials had been printed, advertisements were being shot, and Foxconn, the manufacturing partner, was ready to kick off production. Yet to the surprise of all the insiders, Hastings decided to kill it (subsequently it was spun off and became Roku). The magnitude of this decision is now much more clear, had Hastings chosen to pivot to the hardware business, they would compete with all other hardware players (TVs, Apple etc.) and wouldn’t be able to consolidate the demand side which is a conner stone of its later licensing streaming flying wheel. Roku, even at today’s steep valuation, would be worth 1/10 of the current Netflix. According to one inside source, Hastings explained this hard decision in a very simple but vivid way:

“I want to be able to call Steve Jobs and talk to him about putting Netflix on Apple TV, but if I’m making my own hardware, Steve’s not going to take my call.”

[1] Tao Value Investment Process: https://taovalue.net/2017/07/17/sun-tzus-five-factors-business-analysis-framework/

[2] Don’t Let Metrics Undermine Your Business, Harvard Business Review, https://hbr.org/2019/09/dont-let-metrics-undermine-your-business

[3] The Most Valuable Company (for Now) Is Having a Nadellaissance https://www.bloomberg.com/news/features/2019-05-02/satya-nadella-remade-microsoft-as-world-s-most-valuable-company

[4] Inside Netflix’s Project Griffin: The Forgotten History Of Roku Under Reed Hastings https://www.fastcompany.com/3004709/inside-netflixs-project-griffin-forgotten-history-roku-under-reed-hastings

Shoulders of Giants – Charlie Munger & Li Lu Interview 08/2018

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Note: I have shared these videos via my Twitter account before, however may have missed readers who only follow the blog. Copyright of Weekly in Stocks, all contents are shared for non-commercial knowledge sharing purpose.

These are interviews conducted by a Chinese finance/business media called Weekly in Stocks. Overall, I really enjoyed it and think all questions are really well prepared. As expected, many questions are around China (both philosophy & capital markets).

I think this might be the first time Munger explicitly drew parallel between his & Buffett’s philosophy & practices and oriental philosophies. Quoting from Munger: “…why are these people in China so interested in Berkshire Hathaway and Charlie Munger… and why do the Chinese like the book (Poor Charlie’s Almanack), I think the answer is it sounds Confucian…”, “…If you are a better person, you are likely to be a better investor; If you are a wiser person, you are likely to be a better investor…”

The follow-up interview with Li Lu alone is also of great interest, where he, may be for the first time, talked in details about Munger’s life, their interactions & his lessons learned from Munger, as well as his unique views of Chinese capital market.

Interview with Charlie Munger along with Li Lu [3 parts]

Follow-up Interview with Li Lu [2 parts]

 

 

Book Notes – Big Money Thinks Small (by Joel Tillinghast)

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Joel Tillinghast is a tenured Fidelity portfolio manager for its Low-Priced fund, however his name was known by few, including me, until recently. Tillinghast recently published his first book – Big Money Thinks Small last month, and was featured in a Barron’s interview in 08/12/2017 (Link here). When I first saw his interview, I found this manager interesting for his ability to consistently beat his benchmark, Russell 2000, for years with 100+ holdings. This diversified approach is very different than the “traditional” school of value investing, who advocates concentrated bets. Another impressive trait of Tillinghast’s fund is the extreme low turnover – only 9% a year. This means he on average holds each position for over 10 years!

For the sake of these special traits, I decide to pick up his book and try to see if there is anything I could learn from him.

BigMoneyThinksSmall

Overall, I think it is a valuable book, especially for someone had some investing experiences and is eager for historical investing case studies. Here are my key thoughts/lessons:

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All About Moats – Book Notes of Pat Dorsey’s Two Books

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If you haven’t heard of Pat Dorsey, here is a quick intro for you: He started his career at Morningstar as a sell side analyst, moved up to the head of the reach team in a few year and stayed there for about a decade. After leaving Morningstar, he started his own firm Dorsey Asset Management in 2014. Although his track record as a fund manager is yet to be tested, I found his books very insightful, especially for firm’s economic moat/competitiveness study.

 

Dorsey is the author of below two books:

Image result for The Five Rules for Successful Stock InvestingImage result for The Little Book that Builds Wealth

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“Sun Tzu’s Five Factors” Business Analysis Framework

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[I recently finished my first quarterly letter to my investors, who are some close family members and friends. Below is an excerpt from the investment process section, where I spent most of the time explaining my unique (at least I think) business analysis framework, which is a combination of Sun Tzu‘s Five Factors (based on the Art of War) & checklist method.]

 

Investment Approach – The Process

I will start with where I spend my resources and our capital to. It’s mainly 3 investment themes: special situations, distressed assets and great operations at reasonable price. The core idea of all three is “buy low sell high”, however the way of analysis for each is somewhat different.

  • In special situations category, I look for entities undergoing some type of corporate event that might lead to a mismatch of value and price (e.g. depressed prices due to forced sells, or under-appreciated prospect that could increase the value). Examples of special situation investments include, but are not limited to, spinoffs, corporate restructurings, mergers, liquidations, and rights
  • In distressed assets category, I look for asset that is priced well below its value due to unfavorable developments. a.k.a. “There is always a price to make a crappy business an attractive investment.” Since the risky nature of distressed assets, heavy analysis is performed on balance sheet and solvency side. It also is the most time consuming from tracking perspective as any new development and disclosure could significantly change the value evaluation outcome. I typically size ideas in this category conservatively. Examples of distressed assets investment include, but are not limited to, cigar butts, scandals and high yield corporate debts.
  • In great operations at reasonable price category, I look for, as the name itself says, great operating businesses at reasonable price. This is what Buffett does for the late part of his career, and examples include well known Berkshire Hathaway’s holdings of Coca Cola, American Express and Wells Fargo, etc. The return of this category comes not from the price/value mismatch in current day per se, rather from the compounding growth of the value in future. Thus, my research spent on this category is mainly on the industry, business model and moat of the business, which drive the value compounding ability of an entity.

Next, I will talk about the process of how I approach analyzing an opportunity. I usually start with the business itself, trying to understand the business model, industry landscape & whether there is moat around the business. Then I will move on to balance sheet, to get an idea of what assets it has, last to its profitability (i.e. income statement). There are well documented metrics and valuation methods for analyzing the latter two, but the first (also the most important, in my opinion) item – business analysis – may worth more elaboration.

I use a self-developed “Sun Tzu’s 5 factors” method to analyze businesses. Sun Tzu’s classical military treatise, The Art of War, starts with the 5 most important factors affecting wars: Tao/Dao (道), Meteorology (天), Topography (地), Commander (将), System (法).

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