INTERVIEW TOOK PLACE JULY 22 2020
Summary of partnership
- Looking for 5-10 stocks
- 30% IRRs (5x'ers over 3-5 years) — materially higher for overseas investments (see adjusted IRR concept below)
- Businesses that exhibit ecosystem control in
- Marketplace business model
- Vertically integrated business model
- Cognitive referent business model
- Often some kind of mystery
- e.g. Carvana...income statement was terrible in early days, burning tons of cash, etc. Unit economics are not always apparent.
- e.g. some kind of hidden asset e.g. $IAC > $MTCH > Tinder, huge growth and operating margins.
- e.g. larger player that seemingly is threatening franchise e.g. Just Eat...looked like Amazon, Uber, Deliveroo where going to destroy them. But Just Eat had first mover advantage in marketplace dynamic which makes "getting Amazon'd" uncommon.
- Target: Generate hall of fame returns on behalf of 15-20 partners
Most interesting managers (seen at Yale endowment)
- 1-2 person shops, not household names
- 5-12 stocks, concentrated
- Limited number of partners
- Competitive advantage via simplifying all variables down to one optimization problem — generate great returns through being:
- Concentrated
- Long-term
- Deeply researched investments
- With a limited number of partners
ShawSpring: 8 institutions + HNWIs.
When launching a firm — two optimization problems:
- Raise AUM
- Generate great returns
Focus on #2 — develop a wonderful strategy, the rest will follow
Take time attracting institutions; let them get to know you
"Reverse engineer great returns through focusing on the variables you can control."
Maximize return on time and effort spent.
What is scalable, repeatable, and replicable over time?
What we are trying to do: find investments that are compounding constant continuous dogged improvement over very long time frames.
This biases us towards finding businesses that are growing their intrinsic values — and the only way I understand how intrinsic value grows is revenue, earnings and FCF grow with constant, continuous dogged improvement over very long time frames. This indicates quality.
Invested time in early years to think through "how do we identify high quality quickly?" to maximize return on time and effort spent. This began with defining a mental model for high quality.
Every business exists in an ecosystem of:
Itself > Customer > cash flow passes through supply chain, partners, employees etc.
The very best companies exhibit ecosystem control.
Key question: do the businesses' ecosystem constituents love the business? Customers, employees, suppliers, etc. (have ways to measure this internally)
If any component of the ecosystem does not love the business, then it gets thrown out.
Over six years developed a shopping list of c. 300 companies wherein the hypothesis is that the businesses exhibit ecosystem control. Key areas:
- Scaled Aggregators, such as Marketplaces or Networks. Elegant, asset-light way in which they scale. Leads to winner-take-most dynamic, high base rates of success, good business for very long time. Enormous return on time and effort spent by just understanding this mental model.
- Horizontal marketplaces e.g. classifieds such as Craig's List
- Vertical marketplaces dating, cars, etc.
- Vertically-Integrated, Capital-Intensive Businesses
- e.g. JD.com, Carvana
- both involved in activity of directly procuring supply, warehousing and prep for sale, logistics, all the way to last mile delivery
- both were able to grow effectively unimpeded through Covid since they control the full value chain of customer experience.
- take a long time to grow, very hard to replicate, can become very good businesses for very long time periods
- need a hack/advantage (e.g. Carvana had DriveTime) that gives competitive advantage over anyone else
- Product cognitive referents e.g. Kleenex, Ping Pong balls, Hoovers, Band Aids
- Service cognitive referents (even more interesting) e.g. Uber, Airbnb, etc. Harder to replicate than products but have controlled distribution via native app. Huge competitive advantages in unit economics:
- Competitive advantages in CAC: immediate recall of service
- Competitive advantage in LTV: high levels of customer attention
- e.g. Expedia + Booking.com have to spend $9B+ on Google Adwords vs. Airbnb spending very little
- Consumer research e.g. evidence of universality of praise
- NPS scores — the very best businesses have very high NPS scores therefore higher loyalty and retention
- ENPS — employee net promoter score
- Management quality — look for evidence of structures and incentives for how a manger wins. Do shareholders win when management wins? All current holdings are owner-operators. e.g. all have ownership stakes in their businesses that are a substantial amount of their net worth. "Show me the incentives and I'll show you the outcomes."
3. Cognitive Referents
How do you measure that people love businesses?
Add 1-2 ideas per year.
Spend most of time studying businesses already in the portfolio.
Anything getting into portfolio has to represent a higher quality and return threshold than anything already in the book.
Run fully invested, so must sell current holding to buy new holding.
If we can't understand unit-level profitability, replicability, scalability over time etc. then wait.
Cash is a call option on future ideas and existing ideas in book. Avg. selloff in the market is 13%, 2/3 years market is positive.
Learned over time that when opportunities are very attractive, partners come through (add capital), therefore no need to hold cash on the books. Can access cash on partners balance sheets when opportunities are attractive — huge competitive advantage.
Also: staying in cash waiting for e.g. 30% discount (when recessions happen every c. 10 years) is likely counter-productive because you don't know when a recession will come. It is market timing, and we're not hired to do that.
Sometimes businesses age-out. Scale runs into base-rate effects and get linear decay in growth.
Need to fail fast to maximize return on time and effort spent.
Trying to allocate all efforts to 1-2 great ideas per year.
When to sell?
- If wrong, its out
- Have external data science service that tracks KPIs setup for each business
- e.g. markers along the way that prove 30%+ annualized growth is happening
Portfolio construction is one of the hardest things we do
- From many interviews: many people use gut instinct...probably to minimize personal stress vs. maximize returns
- Not all IRRs are created equally e.g. some businesses are more predictable than others, some business models are easier to execute than others
- For each IRR, adjust on a 1-10 scale for:
- Predictability of cash flows (e.g. SaaS businesses have more predictable revenue)
- Ease of execution (e.g. vertical integration businesses much harder to pull off)
- Catch-all macro (e.g. we know US far better than Asia...need to be paid better to invest outside US)
- This creates adjusted IRR, which goes into simple portfolio model
- Starter positions are 10% (if don't have conviction to put 10% of capital in, why buy at all)...cap out at 20% at cost.
- For trimming: realistic about growth in intrinsic value, so if stock runs way ahead of intrinsic value portfolio optimization process will dictate trimming
- Portfolio optimization is very pragmatic — again TRYING TO MAXIMIZE VALUE ON TIME AND EFFORT SPENT
- Rational, quantitative portfolio construction removes use of inclinations in portfolio construction
In China, many businesses that are growing very fast, partly because baseline annual growth is already 20-30% as Chinese get wealthier and upgrade their lifestyles.
Chinese e-commerce space much more competitive vs. what Amazon has built.
How do you discount political risks?
China is a remarkable place to be an investor. It is a closed ecosystem, but within it China has an incredible capitalist dynamism. It is like day 1 every day in China. It can be one of the most entrepreneurial and dynamic places to invest. Lots of competition chasing ideas...margins get competed away very quickly. "Long-term" to an entrepreneur in China means c. 18 months. There is a very fast validation of business strategies or investments.
It's been over 20 years since Tencent went public, and CCP has had relatively little interference. So...should I be worried about CCP messing up Tencent and Alibaba, or the EU breaking apart the FAANGs? Hard to say.
Back to: when investing overseas, need to get paid.
In March 2020, assessed businesses on three dimensions:
- Is there risk of permanent capital impairments (is the stock worth $0...even if business shuts down for 1-3 years)?
- Are long-term theses still intact?
- Will our businesses be improved / be even more competitively advantaged by this crisis?
Best chart of 2020:
It takes 6 weeks to develop a habit. Covid forced new habits.