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We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 11 September 2022:

1. The Stock Market’s Real Inflation Fighters Might Surprise You – Jason Zweig

We need to realize, though, that when we look back at the past, we don’t recapture it; we reconstitute it. We turn it into something it never was: clear from the start.

The stagflation of the past, so obvious to us now, was ambiguous then.

The rate of inflation fell sharply in 1971-72 and again in 1975-76 before going bonkers in 1979. Economic growth was flat in 1970; it went negative in 1974 and 1975 and again in 1980 and 1982, but exceeded 4% in five years of the 1970s.

The term “stagflation” didn’t even appear in The Wall Street Journal until April 1973 (although it was evidently coined by a British politician in 1965).

Like a funhouse mirror, hindsight distorts other facts.

Knowing today that the price of oil exploded over that period—crude went from under $3 a barrel to more than $39 between 1966 and 1980—you might expect that the energy industry dominated the list of the best-performing stocks of the time.

Nope.

Sure, a few, such as Texas Oil & Gas Corp., Southland Royalty Co. and Gearhart Industries Inc., were among the top performers.

The single-best performing stock between early 1966 and late 1982, however, was Tandy Corp. (later known as RadioShack Corp.). According to the Center for Research in Security Prices, Tandy returned 14,175% over that period.

The second-biggest winner? O’Sullivan Corp., a plastics manufacturer that also made rubber shoe heels, returned 4,820%.

Not far behind were media and entertainment giant Harcourt General Inc., up 3,196%; theater, tobacco and insurance conglomerate Loews Corp., up 3,190%; and retailer House of Fabrics Inc., up 2,916%.

Among those biggest winners, only Loews is still publicly traded, although a few stocks lower on the list of top performers, including CVS Health Corp. (up 2,005%) and Altria Group Inc. (up 1,738%), still exist.

CVS, however, wasn’t a huge drugstore chain then. It was part of Melville Corp.—the second discount footwear and apparel retailer, along with Scoa Industries, near the top of the list.

Say what?

Most of the companies that turned out to be the “superstocks” of this stagflationary period don’t seem to have had the ability to foist rising costs onto their customers without losing business.

That’s what professional investors call pricing power—and conventional wisdom says it’s what companies must have to prosper amid stagflation.

Certainly Altria Group, then Philip Morris Inc., had pricing power: Smokers generally don’t resist paying more over time for something they’re addicted to.

Also, products like tobacco and movies offer consolation in tough times. Alcohol and sugar companies did well, too.

Many other stars of that stagflationary time tell a different story, though.

Tandy’s TRS-80 desktop microcomputer was one of the first personal computers to hit the market. In a Wall Street Journal advertisement for the TRS-80 in 1978, Tandy emphasized its “affordability” at $599; by 1980, a far more powerful version cost just $699.

Between 1976 and 1982, Tandy’s earnings roughly quadrupled—not because it had pricing power, but because its business boomed in a stagnant economy.

Meanwhile, House of Fabrics, which sold sewing machines, textiles, “notions” and other cheap tchotchkes, also had little pricing power—but raked in cash anyway as consumers, reluctant to buy new clothes at ever-climbing prices, took to mending old ones at home.

2. YWR: 7 things I learned in Zimbabwe – Erik Renander

When I left HSBC in 2013 to join some friends investing in Africa, I didn’t know where in the continent I should expect to be focused, but probably something like Kenya. Instead, our firm had an office in Zimbabwe and was deeply engaged in the local market both in public and private equities. So my life took a turn and I went from living in San Francisco to spending a considerable amount of time at B&B’s in Harare. It turns out Harare is actually a really nice place. The people are pleasant and friendly, and it has the world’s best weather. 65-85 degrees all the time.

The Guinea Fowl’s Rest was my favorite B&B and run by a couple who had lost their dairy farm during the 1980’s farm invasions. This had forced them to move to the city and ‘make a plan’ as they say, which was to get into the hotel business. The routine on these trips was that after my day’s meetings I would return to the Guinea Fowl and enjoy a can of Castle Lager with the husband and talk about the history of Zimbabwe. We covered the big events from the 1980’s to the first hyperinflation in 2000 and then eventually the beginning of the second hyperinflation in 2016. The other fun thing was that at dinner we would all eat together at a big table with the other guests, so it was like the Zimbabwe version of the Joe Rogan show with lots of unexpected people and experiences.

The main story is that economically speaking Zimbabwe used to be well run with some of Africa’s best farms. They used to call it the bread basket of Africa. Harare used to be called Salisbury and was planned with wide roads, large parks and golf courses throughout the city. It’s quite unique in that way and why I always think Harare has amazing real estate potential.

Nowadays many of the farms are abandoned. It’s weird to mountain bike around and see rusty irrigation pivots which haven’t moved in 40 years. Zimbabwe has gone from the bread basket to importing most of its food from South Africa and Zambia. The power supply is barely functioning and generators run for hours a day. The buildings look like you have gone back in a time machine to the 1980’s.

Depending on the state of the hyperinflations sometimes you can get a wide variety of food items in the supermarkets, sometimes you can’t. There are also persistent problems in getting your money out of the country because the central bank tries to manage the currency at unrealistic levels. If you need dollars you go to the guys on the street. There are also the sanctions. The UK government is only sanctioning three insignificant entities, but try telling that to a western bank. All they know is Zimbabwe = Sanctions and they don’t care about the fine print. Which is a shame for 15 million people in the country. In summary, it’s been a disaster…

…The market can go up a surprising amount even though things are ‘bad’. In fact the worse things are the more the market rises. ‘Bad’ = ‘Bull Market’. Yes, there can be abrupt shake outs, but that is part of the bull market. I also draw your attention to the 50% sell off from 2014 to 2015. That was when I was there. Things were definitely deteriorating and sliding from a period of calm into the hyperinflation. As you can see there was a 50% market decline before the 87x gain. Maybe with the current situation in the world we get a 2014-2015 type situation in global markets, followed by a Zimbabwe style bull market. Then again it’s hard to call. If your time frame is long enough maybe you just sit tight…

…Even though the pie is shrinking the big can get bigger. When the economy is going into a recession it’s easy to think it will be bad for everyone, but what I noticed is for the well run companies this can actually be the best of times. I’ve watched smart CEO’s acquire all their struggling competitors during the downturns and actually post great earnings growth even as the economy is crashing. The economic pie is shrinking but they keep eating a bigger and bigger slice. It’s almost as if the bad times are good for them. Again, ‘bad economy’ can paradoxically equal good returns.

As inflation kicks in earnings grow tremendously. This is kind of obvious but worth remembering. Inflation increases the prices of everything in nominal terms, so stated company earnings explode. Economists always talk about ‘real’ earnings but stock market prices are based on nominal earnings. It’s something to remember with 8% inflation in the U.S. Corporate earnings might surprise quite positively this year. Below is the Commercial Bank of Zimbabwe’s 4 year earnings trend from when they earned 5 ZWL/share in 2017 when the FX rate was 1 ZWL/$ to 1,184/per share when it is 220 ZWL/$.

Successful entrepreneurs carefully leverage their assets. There is a key realisation which happens when you are in a hyper-inflationary environment. You realise the real way to preserve value is to leverage your business or real estate and that you aren’t really making money from the house price going up, but rather from the value of the loan going down. It seems like you are buying an asset, but really you are shorting the currency. The balancing act is to make sure you aren’t over leveraged, and have stable cash flows so you can stay in the game. The smart entrepreneurs would obsess about the cash flows of the businesses they were buying because as soon as they were done buying the business they would go to the bank to borrow more money.

3. The quantum computing bubble – Nikita Gourianov

Quantum computing is often portrayed as an up-and-coming technology whose eventual impact will only be rivalled by artificial intelligence. According to the quantum evangelists, it is only a matter of time before a fully-functional quantum computer will appear and do everything from revolutionising drug development to cracking internet encryption schemes.

Billions of dollars have poured into the field in recent years, culminating with the public market debuts of prominent quantum computing companies like IonQ, Rigetti and D-Wave through 2021’s favourite frothy market phenomenon, special purpose acquisition vehicles (Spacs)…

…The reality is that none of these companies — or any other quantum computing firm, for that matter — are actually earning any real money. The little revenue they generate mostly comes from consulting missions aimed at teaching other companies about “how quantum computers will help their business”, as opposed to genuinely harnessing any advantages that quantum computers have over classical computers.

The simple reason for this is that despite years of effort nobody has yet come close to building a quantum machine that is actually capable of solving practical problems. The current devices are so error-prone that any information one tries to process with them will almost instantly degenerate into noise. The problem only grows worse if the computer is scaled up (ie, the number of “qubits” increased).

A convincing strategy for overcoming these errors has not yet been demonstrated, making it unclear as to when — if ever — it will become possible to build a large-scale, fault-tolerant quantum computer. Yet according to the evangelists, we are apparently in the middle of a Quantum Moore’s Law (aka “Rose’s Law”, after D-Wave founder Geordie Rose) analogous to the microchip revolution of the 1970s — 2010s.

Another fundamental issue is that it is unclear what commercially-useful problems can even be solved with quantum computers — if any.

The most prominent application by far is the Shor algorithm for factorising large numbers into their constituent primes, which is exponentially faster than any known corresponding scheme running on a classical computer. Since most cryptography currently used to protect our internet traffic are based on the assumed hardness of the prime factorisation problem, the sudden appearance of an actually functional quantum computer capable of running Shor’s algorithm would indeed pose a major security risk.

Shor’s algorithm has been a godsend to the quantum industry, leading to untold amounts of funding from government security agencies all over the world. However, the commonly forgotten caveat here is that there are many alternative cryptographic schemes that are not vulnerable to quantum computers. It would be far from impossible to simply replace these vulnerable schemes with so-called “quantum-secure” ones.

And the uncertain practical viability of Shor’s algorithm is only the tip of the iceberg. There has been much controversy regarding where and when quantum computing can actually offer any practical advantage. The latest research points out that there is no evidence that even quantum chemistry calculations can be significantly sped up with quantum computers. That is bad news for the much-touted idea of quantum computers being useful for drug design.

4. The Long Tail: The Internet and the Business of Niche – Rex Woodbury

The concept of the long tail was popularized by Chris Anderson in an October 2004 article in WIRED. Anderson’s opening lines read like a prophecy of YouTube, which would be founded the following year:

“Forget squeezing millions from a few megahits at the top of the charts. The future of entertainment is in the millions of niche markets at the shallow end of the bitstream.”

I’ve written in the past about another quote in WIRED, one that didn’t age quite so well. In 2005, the media mogul Barry Diller declared:

“There is not that much talent in the world. There are very few people in very few closets in very few rooms that are really talented and can’t get out. People with talent and expertise at making entertainment products are not going to be displaced by 1,800 people coming up with their videos that they think are going to have an appeal.”

Yikes. It turned out that there was a lot of talent in the world—many people in many closets in many rooms. The same year that Barry Diller uttered those words, YouTube was born in a small room above a pizzeria in San Mateo. On April 23, 2005, the first YouTube video was posted. The video is titled “Me at the zoo” and features YouTube cofounder Jawed Karim…at the zoo. In the 18-second clip, he talks about elephants and their trunks 🐘

The concept of the long tail remains one of the best investing frameworks for internet companies. Many of the most successful technology companies in history have been built on the long tail. Google and Facebook turn to small businesses for the lion’s share of their advertising revenue. Ebay grew by tapping into a variety of niche interests and markets. Some of our most successful investments at Index have harnessed the power of niche: Etsy showed that a lot of people are interested in buying (and making) artisanal products; GOAT showed that sneakers are a deceptively large market; Discord has 19 million (!) weekly active servers.

One of the powers of the long tail is its ability to expand selection. Amazon might be the best example. As Anderson put it in 2004:

What’s really amazing about the Long Tail is the sheer size of it. Combine enough non-hits on the Long Tail and you’ve got a market bigger than the hits. Take books: The average Barnes & Noble carries 130,000 titles. Yet more than half of Amazon’s book sales come from outside its top 130,000 titles…

…The two major categories for the long tail framework are content and commerce.

Let’s start with content. TikTok is the best modern extension of this framework. Building on the concept of recommendations, TikTok’s For You Page is entirely algorithmically-generated, tailor-made to the user’s tastes and preferences. And TikTok’s built-in creation tools make producing content easier, enabling the long tail to be even longer than it is on YouTube.

TikTok relies heavily on remix culture, allowing people to build on each other’s sounds and trends; this removes the friction to create that exists even with robust creation tools (“What video should I make?”) and leads to a stunning amount of creativity..

…As creation gets even easier, the long tail will continue to lengthen. Innovations like Midjourney, DALL-E, and StableDiffusion—which provide text to image AI generation—may unlock new levels of creativity and expression. This will shift content even more away from the handful of big-budget hits, and more to the long tail of creators.

5. The Transcript Q2 2022 Letter – The Transcript

Despite concerns of a recession, we’ve cataloged more positive macroeconomic commentary than negative commentary in recent weeks. Still, we’ve recently been noticing that there is a negative divergence between macroeconomic and microeconomic commentary. Many companies are seeing signs that could indicate that we are in the early stages of deceleration. These signs include bloated retail inventories, lower-income consumers trading down, falling used car prices, the pace of hiring slowing down, and weak consumer electronics sales, to name but a few.

“So as used car prices are moderating there, we’re sort of — we’re buying and as the prices are falling. So we’re having to sell at a — the spread that we’ve established isn’t as wide as we would have expected.” – IAA CEO John Kett (22nd Aug: Under Pressure)

“We are observing some trade-down behavior within various classes at home..It’s not that specific types of goods are getting traded down, other types of goods aren’t. It’s more a little bit across the board” – Wayfair CEO Niraj Shah (8th Aug: Optimism Prevails)

“At the end of Q2, Walmart U.S. inventory growth was 26% versus last year, reflecting over 750 basis points of improvement from Q1 levels — We have cleared most summer seasonal inventory, but we are still focused on reducing exposure to other areas such as electronics, home, and sporting goods.” – Walmart CFO John Rainey (22nd Aug: Under Pressure)…

…Internationally, global economies seem to be fighting the same forces as the US economy. In many countries, the trouble appears even more severe than in the US. In Europe, energy prices are weighing heavily on economic activity. There appears to be particular concern about the way that high energy prices will impact the European economy as we approach winter.

“Turning to gas prices — The outlook for global gas prices is heavily dependent on Russian pipeline flows. We expect prices to remain elevated and volatile during the third quarter, due to a lack of supply to Europe.” – BP CFO Murray Auchincloss (8th Aug: Optimism Prevails)

“One of the areas that I’m keeping a close eye on is Europe. We’re seeing a lot of challenges in Europe, seeing energy prices, for example, are really, really high over in Europe. We’re coming into the winter session. So you could see potentially less graphic related to people cutting subscriptions or doing things like that, less shopping online” – Akamai CFO Edward McGowan (16th Aug: Cost Pressures Falling)…

…Credit quality still remains strong overall at US banks. There aren’t any signs of deterioration despite economic pressure. There are some pockets where credit card delinquency rates are up slightly but still at historical lows:

“While delinquency rates have increased slightly, they remain near historical lows. We expect credit cards to be less negatively impacted by a mild recession than personal loans. In the mild recession of ‘01-02, credit card originations declined only a few points. And for context, credit cards represent nearly half of credit card revenue in fiscal year 2022.” – Intuit CEO Sasan Goodarzi (29th Aug: Until the Job is Done)…

…In general consumer spending has remained strong but is facing a myriad of challenges. The consumers are now under pressure and there are some signs that low-income consumers are feeling especially squeezed by the environment. 

“The consumer, which is the backbone of the U.S. economy, well, he may still be spending but this confidence is the lowest point it’s been in decades and it’s even worse in Europe. So there’s no question that the consumer will stop spending the way he has spent in my mind…he’s facing dwindling savings rates because he’s spending his money on gas, food, rents and housing prices, and interest expense. I don’t see the offset” – Starwood Property Trust CEO Barry Sternlicht (8th Aug: Optimism Prevails)

The big question going forward is whether this pressure will extend to higher-income consumers. We have recently seen comments from Walmart and Dollar General indicating that they are seeing households making $100,000 per year trading down. If higher-income consumer spending is starting to weaken then it would likely be a factor pointing towards recession.

“We believe we’ll be able to capitalize on that trade-down that we’re already seeing. And that trade-down is coming from income levels that are upwards of $100,000 which we really are encouraged in seeing a younger consumer, a little bit more affluent, and again, very digitally and tech-savvy.” – Dollar General CEO Todd J. Vasos (29th Aug: Until the Job is Done)…

…We’ve also seen signs that tech spending is under pressure. We’ve heard that consumers are spending less on PCs and smartphones, which is impacting semiconductor companies. 

“…we anticipated there would be inventory adjustments in PC and smartphones and then some isolated adjustments in some other areas like enterprise. And that happened, of course — But actually, in the quarter here that we’re in, the August quarter, it’s broadened and actually weakened more. We’re seeing inventory adjustments across most end markets. That includes the cloud” – Micron CFO Mark Murphy (16th Aug: Cost Pressures Falling)

Salesforce also indicated that IT spending has been more cautious recently, which would be another significant change in trend and a negative macro data point.

“…we started to see more measured buying behavior from our customers, which began in the last month of the quarter. This resulted in stretched sales cycles, additional deal approval layers, and deal compression.” – Salesforce CFO Amy Weaver (29th Aug: Until the Job is Done)..

…Oil companies are generating strong profits in the current environment and are very bullish on their long-term prospects. Executives say that oil supply and demand are out of balance: demand has rebounded but new supply is not coming online. Given the source, we take these forecasts with a grain of salt, but the facts do not sound inaccurate. If it is true that there is an upside to oil prices, it would be an unwelcome inflationary surprise.

“Global oil demand is now similar to pre-pandemic levels. And while there are growing concerns about potential demand impacts from a recessionary environment, supply factors may overwhelm those demand impacts. In previous cycles, high oil prices have led to significantly oversupplied markets. In the current situation, however, major sources of supply are below pre-pandemic levels and trending lower” – Pason Systems CEO Jon Faber President (22nd Aug: Under Pressure)

6. Good Enough – Morgan Housel

Small, brightly colored, and terrible at defense, the guppy faces an unusually high rate of predator attacks. Birds eat guppies. Small fish eat guppies. Big fish eat guppies. Crabs eat guppies. It’s everyone’s favorite lunch.

How does a species under so much threat avoid extinction?

In short, guppies get busy as soon as they’re born. They can reproduce at seven weeks old, and deliver new offspring every 30 days. By the time a six-month-old guppy is eaten by a bird it might be a great-great-grandmother. The family lives on.

But this evolutionary trick has a nasty flip side.

Knowing how much danger they’re in, guppies expend nearly all their energy on reproducing from the moment they’re born. They grow as fast as possible, then devote a huge portion of their resources to nourishing their young.

That leaves little energy left to care for themselves. Their bodies are thrown together slipshod, like cheap plastic toys, and few resources are available for cell repair and maintenance. By the age of a year or two old it’s a crusty senior citizen, crippled by disease and decline, soon to go belly up. That’s how it should be: No use investing in the future when you’re likely to be eaten anyway.

Now compare the guppy with the Greenland shark, whose life is nearly a mirror image.

The Greenland shark has no natural predator. It rules its habitat like a dictator.

With few threats, it takes its sweet time becoming an adult. It’s one of the slowest-growing creatures we’ve discovered, reaching sexual maturity at – and this isn’t a typo – 150 years old.

In the meantime it spends more than a century devoting its energy to building itself a perfect body. Slow and methodical, with all of its resources going to cell repair and maintenance, it becomes virtually immune to cancer and infectious disease. As best we can tell a Greenland shark can live for 500 years, maybe more.

The point is that nature is very good at assessing future risk and uncertainty and allocating resources accordingly…

…Everyone knows the economy is hard to predict, and the history of economic predictions is abysmal.

But leaving it at that is too simplistic.

I think we’re actually very good at predicting the future – except for the surprises, which tend to be all that matter.

In most years the biggest economic risk turns out to be something nobody could have seen coming at the beginning of that year. 9/11, or Covid, or Lehman Brothers’ failure to find a buyer, or Russia invading Ukraine – the biggest risk is always what you don’t and can’t see coming…

…Investing in your long-term future is of course great, because the odds that you’ll be around and everyone else will become more productive are pretty good.

But trying to predict the exact path we’ll take to get there can be such a waste of resources.

I describe my forecasting model as “good enough.”

I’m confident people will solve problems and become more productive over time.

I’m confident markets will allocate the rewards of that productivity to investors over time.

I’m confident in other people’s overconfidence, so I know there will be mistakes and accidents and booms and busts along the way.

It’s not detailed, but it’s good enough.

When you keep forecasting that simple, you free up time and bandwidth to invest elsewhere. I like studying the investing behaviors that never change, and I’d never have the time to do that if I spent my day predicting what the economy will do next quarter. For others it’s operating a business, or understanding an industry. Or something else entirely.

7. The Weakness of Xi Jinping – Cai Xia

I have long had a front-row seat to the CCP’s court intrigue. For 15 years, I was a professor in the Central Party School, where I helped train thousands of high-ranking CCP cadres who staff China’s bureaucracy. During my tenure at the school, I advised the CCP’s top leadership on building the party, and I continued to do so after retiring in 2012. In 2020, after I criticized Xi, I was expelled from the party, stripped of my retirement benefits, and warned that my safety was in danger. I now live in exile in the United States, but I stay in touch with many of my contacts in China…

…Another feature of the party system has remained constant: the importance of personal connections. When it comes to one’s rise within the party hierarchy, individual relationships, including one’s family reputation and Communist pedigree, matter as much as competence and ideology.

That was certainly the case with Xi’s career. Contrary to Chinese propaganda and the assessment of many Western analysts that he rose through his talent, the opposite is true. Xi benefited immensely from the connections of his father, Xi Zhongxun, a CCP leader with impeccable revolutionary credentials who served briefly as propaganda minister under Mao. When Xi Jinping was a county party chief in the northern province of Hebei in the early 1980s, his mother wrote a note to the province’s party chief asking him to take an interest in Xi’s advancement. But that official, Gao Yang, ended up disclosing the note’s content at a meeting of the province’s Politburo Standing Committee. The revelation was a great embarrassment to the family since it violated the CCP’s new campaign against seeking favors. (Xi would never forget the incident: in 2009, when Gao died, he pointedly declined to attend his funeral, a breach of custom given that both had served as president of the Central Party School.) Such a scandal would have ruined the average rising cadre’s career, but Xi’s connections came to the rescue: the father of Fujian’s party chief had been a close confidant of Xi’s father, and the families arranged a rare reassignment to that province.

Xi would continue to fail upward. In 1988, after losing his bid for deputy mayor in a local election, he was promoted to district party chief. Once there, however, Xi languished on account of his middling performance. In the CCP, moving from the district level to the provincial level is a major hurdle, and for years, he could not overcome it. But once again, family connections intervened. In 1992, after Xi’s mother wrote a plea to the new party leader in Fujian, Jia Qinglin, Xi was transferred to the provincial capital. At that point, his career took off…

…When Xi took the reins, many in the West hailed him as a Chinese Mikhail Gorbachev. Some imagined that, like the Soviet Union’s final leader, Xi would embrace radical reforms, releasing the state’s grip on the economy and democratizing the political system. That, of course, turned out to be a fantasy. Instead, Xi, a devoted student of Mao and just as eager to leave his mark on history, has worked to establish his absolute power. And because previous reforms failed to place real checks and balances on the party leader, he has succeeded. Now, as under Mao, China is a one-man show.

One part of Xi’s plot to consolidate power was to solve what he characterized as an ideological crisis. The Internet, he said, was an existential threat to the CCP, having caused the party to lose control of people’s minds. So Xi cracked down on bloggers and online activists, censored dissent, and strengthened China’s “great firewall” to restrict access to foreign websites. The effect was to strangle a nascent civil society and eliminate public opinion as a check on Xi.

Another step he took was to launch an anti­corruption campaign, framing it as a mission to save the party from self-destruction. Since corruption was endemic in China, with nearly every official a potential target, Xi was able to use the campaign as a political purge. Official data show that from December 2012 to June 2021, the CCP investigated 393 leading cadres above the provincial ministerial level, officials who are often being groomed for top positions, as well as 631,000 section-level cadres, foot soldiers who implement the CCP’s policies at the grassroots level. The purge has ensnared some of the most powerful officials whom Xi deemed threatening, including Zhou Yongkang, a former Standing Committee member and the head of China’s security apparatus, and Sun Zhengcai, a Politburo member whom many saw as a rival and potential successor to Xi.

Tellingly, those who helped Xi rise have been left untouched. Jia Qinglin, Fujian’s party chief in the 1990s and eventually a member of the Standing Committee, was instrumental in helping Xi climb the ranks of power. Although there is reason to believe that he and his family are exceedingly corrupt—the Panama Papers, the trove of leaked documents from a law firm, revealed that his granddaughter and son-in-law own several secret offshore companies—they have not been caught up in Xi’s anticorruption campaign.

Xi’s tactics are not subtle. As I learned from one party insider whom I cannot name for fear of getting him in trouble, around 2014, Xi’s men went to a high-ranking official who had openly criticized Xi and threatened him with a corruption investigation if he didn’t stop. (He shut up.) In pursuing their targets, Xi’s subordinates often pressure officials’ family members and assistants. Wang Min, the party chief of Liaoning Province, whom I knew well from our days as students at the Central Party School, was arrested in 2016 on the basis of statements from his chauffeur, who said that while in the car, Wang had complained to a fellow passenger about being passed over for promotion. Wang was sentenced to life in prison, with one of the charges being resistance to Xi’s leadership.

After ejecting his rivals from key positions, Xi installed his own people. Xi’s lineage within the party is known as the “New Zhijiang Army.” The group consists of his former subordinates during his time as governor of Fujian and Zhejiang Provinces and even university classmates and old friends going back to middle school. Since assuming power, Xi has quickly promoted his acolytes, often beyond their level of competence. His roommate from his days at Tsinghua University, Chen Xi, was named head of the CCP’s Organization Department, a position that comes with a seat on the Politburo and the power to decide who can move up the hierarchy. Yet Chen has no relevant qualifications: his five immediate predecessors had experience with local party affairs, whereas he spent nearly all his career at Tsinghua University.

Xi undid another major reform: “the separation of party and state,” an effort to reduce the degree to which ideologically driven party cadres interfered with technical and managerial decisions in government agencies. In an attempt to professionalize the bureaucracy, Deng and his successors tried, with varying degrees of success, to insulate the administration from CCP interference. Xi has backtracked, introducing some 40 ad hoc party commissions that end up directing governmental agencies. Unlike his predecessors, for example, he has his own team to handle issues regarding the South China Sea, bypassing the Foreign Ministry and the State Oceanic Administration.

The effect of these commissions has been to take significant power away from the head of China’s government, Premier Li Keqiang, and turn what was once a position of co-captain into a sidekick. The change can be seen in the way Li comports himself in public appearances. Whereas Li’s two immediate predecessors, Zhu Rongji and Wen Jiabao, stood side by side with Jiang and Hu, respectively, Li knows to keep his distance from Xi, as if to emphasize the power differential. Moreover, in the past, official communications and state media referred to the “Jiang-Zhu system” and the “Hu-Wen system,” but almost no one today speaks of a “Xi-Li system.” There has long been a push and pull between the party and the government in China—what insiders call the struggle between the “South Courtyard” and the “North Courtyard” of Zhongnanhai, the imperial compound that hosts the headquarters of both institutions. But by insisting that everyone look up to him as the highest authority, Xi has exacerbated tensions…

…In any political system, unchecked power is dangerous. Detached from reality and freed from the constraint of consensus, a leader can act rashly, implementing policies that are unwise, unpopular, or both. Not surprisingly, then, Xi’s know-it-all style of rule has led to a number of disastrous decisions. The common theme is an inability to grasp the practical effect of his directives.

Consider foreign policy. Breaking with Deng’s dictum that China “hide its strength and bide its time,” Xi has decided to directly challenge the United States and pursue a China-centric world order. That is why he has engaged in risky and aggressive behavior abroad, militarizing the South China Sea, threatening Taiwan, and encouraging his diplomats to engage in an abrasive style of foreign policy known as “Wolf Warrior” diplomacy. Xi has formed a de facto alliance with Russian President Vladimir Putin, further alienating China from the international community. His Belt and Road Initiative has generated growing resistance as countries tire of the associated debt and corruption.

Xi’s economic policies are similarly counterproductive. The introduction of market reforms was one of the CCP’s signature achievements, allowing hundreds of millions of Chinese to escape poverty. But when Xi came to power, he came to see the private sector as a threat to his rule and revived the planned economy of the Maoist era. He strengthened state-owned enterprises and established party organizations in the private sector that direct the way businesses are run. Under the guise of fighting corruption and enforcing antitrust law, he has plundered assets from private companies and entrepreneurs. Over the past few years, some of China’s most dynamic companies, including the Anbang Insurance Group and the conglomerate HNA Group, have effectively been forced to hand over control of their businesses to the state. Others, such as the conglomerate Tencent and the e-commerce giant Alibaba, have been brought to heel through a combination of new regulations, investigations, and fines. In 2020, Sun Dawu, the billionaire owner of an agricultural conglomerate who had publicly criticized Xi for his crackdown on human rights lawyers, was arrested on false charges and soon sentenced to 18 years in prison. His business was sold to a hastily formed state company in a sham auction for a fraction of its true value.

Predictably, China has seen its economic growth slow, and most analysts believe it will slow even more in the coming years. Although several factors are at play—including U.S. sanctions against Chinese tech companies, the war in Ukraine, and the COVID-19 pandemic—the fundamental problem is the CCP’s interference in the economy. The government constantly meddles in the private sector to achieve political goals, a proven poison for productivity. Many Chinese entrepreneurs live in fear that their businesses will be seized or that they themselves will be detained, hardly the kind of mindset inclined to innovation. In April, as China’s growth prospects worsened, Xi hosted a meeting of the Politburo to unveil his remedy for the country’s economic woes: a combination of tax rebates, fee reductions, infrastructure investment, and monetary easing. But since none of these proposals solve the underlying problem of excessive state intervention in the economy, they are doomed to fail.

Nowhere has Xi’s desire for control been more disastrous than in his reaction to COVID-19. When the disease first spread in the city of Wuhan in December 2019, Xi withheld information about it from the public in an attempt to preserve the image of a flourishing China. Local officials, meanwhile, were paralyzed. As Wuhan’s mayor, Zhou Xianwang, admitted the next month on state television, without approval from above, he had been unable to publicly disclose the outbreak. When eight brave health professionals blew the whistle about it, the government detained and silenced them. One of the eight later revealed that he had been forced to sign a false confession.

Xi’s tendency to micromanage also inhibited his response to the pandemic. Instead of leaving the details of policy to the government’s health team, Xi insisted that he himself coordinate China’s efforts. Later, Xi would boast that he “personally commanded, planned the response, oversaw the general situation, acted decisively, and pointed the way forward.” To the extent that this was true, it was not for the better. In fact, his interference led to confusion and inaction, with local health officials receiving mixed messages from Beijing and refusing to act. As I learned from a source on the State Council (China’s chief administrative authority), Premier Li Keqiang proposed activating an emergency-response protocol in early January 2020, but Xi refused to approve it for fear of spoiling the ongoing Chinese New Year celebrations.

When the Omicron variant of the virus surged in Shanghai in February 2022, Xi yet again chose a baffling way to respond. The details of the decision-making process were relayed to me by a contact who works at the State Council. In an online gathering of about 60 pandemic experts held shortly after the outbreak began, everyone agreed that if Shanghai simply followed the latest official guidelines, which relaxed the quarantine requirements, then life in the city could go on more or less as usual. Many of the city’s party and health officials were on board with this approach. But when Xi heard about it, he became furious. Refusing to listen to the experts, he insisted on enforcing his “zero COVID” policy. Shanghai’s tens of millions of residents were forbidden from going outside, even to get groceries or receive life-saving health care. Some died at the gates of hospitals; others leaped to their deaths from their apartment buildings.

Just like that, a modern, prosperous city was turned into the site of a humanitarian disaster, with people starving and babies separated from their parents. A leader more open to influence or subject to greater checks would not likely have implemented such a draconian policy, or at least would have corrected course once its costs and unpopularity became evident. But for Xi, backtracking would have been an unthinkable admission of error…

…Indignation at the elite level is replicating itself further down the bureaucracy. Early in Xi’s tenure, as he began to shuffle power, many in the bureaucracy grew disgruntled and disillusioned. But their resistance was passive, expressed through inaction. Local cadres took sick leave en masse or came up with excuses to stall Xi’s anticorruption initiatives. At the end of 2021, the CCP’s disciplinary commission announced that in the first ten months of that year, it had found 247,000 cases of “ineffective implementation of Xi Jinping’s and the Central Committee’s important instructions.” During the Shanghai lockdown, however, resistance became more overt. On social media, local officials openly criticized the zero-COVID policy. In April, members of the residents’ committee of Sanlin Town, a neighborhood in Shanghai, collectively resigned, complaining in an open letter that they had been sealed in their offices for 24 days with no access to their families.

Even more troubling for Xi, elite dissatisfaction is now spreading to the general public. In an authoritarian state, it is impossible to accurately measure public opinion, but Xi’s harsh COVID measures may well have lost him the affection of most Chinese. An early note of dissent came in February 2020, when the real estate tycoon Ren Zhiqiang called him a “clown” for bungling the response to the pandemic. (After a one-day trial, Ren was sentenced to 18 years in prison.) Chinese social media platforms are awash in videos in which ordinary people beg Xi to end his zero-COVID policy. In May, a group calling itself the “Shanghai Self-Saving Autonomous Committee” released a manifesto online titled, “Don’t be a slave—save yourself.” The document called on the city’s residents to fight the lockdown and form self-governing bodies to help one another. On social media, some Chinese have sarcastically proposed that the most effective plan for fighting the pandemic would be to convene the 20th National Congress as soon as possible to prevent Xi from staying in power.

Meanwhile, despite Xi’s claims of having vanquished poverty, most Chinese continue to struggle to make ends meet. As Li revealed in 2020, 600 million people in China—some 40 percent of its population—barely earned $140 a month. According to data obtained by the South China Morning Post, a Hong Kong newspaper, some 4.4 million small businesses closed between January and November 2021, more than three times the number of newly registered companies in the same period. Facing a financial crisis, local governments have been forced to slash government salaries—sometimes by as much as 50 percent, including pay for teachers. They will likely resort to finding new ways of plundering wealth from the private sector and ordinary citizens, in turn generating even more economic misery. After four decades of opening up, most Chinese don’t want to go back to the days of Mao. Within the CCP elite, many resent Xi’s disruption of the traditional power distribution and think his reckless policies are jeopardizing the future of the party. The result is that for the first time since the 1989 Tiananmen Square protests, China’s leader is facing not only internal dissent but also an intense popular backlash and a real risk of social unrest…

…Despite all this, the most likely outcome this fall is that Xi, having so rigged the process and intimidated his rivals, will get his third presidential term and, with it, the right to continue as head of the party and the military for another term. And just like that, the only meaningful political reform made since Deng’s rule will go up in smoke.

What then? Xi will no doubt see his victory as a mandate to do whatever he wants to achieve the party’s stated goal of rejuvenating China. His ambitions will rise to new heights. In a futile attempt to invigorate the economy without empowering the private sector, Xi will double down on his statist economic policies. To maintain his grip on power, he will continue to preemptively eliminate any potential rivals and tighten social control, making China look increasingly like North Korea. Xi might even try to stay in power well beyond a third term. An emboldened Xi may well accelerate his militarization of disputed areas of the South China Sea and try to forcibly take over Taiwan. As he continues China’s quest for dominance, he will further its isolation from the rest of the world.

But none of these moves would make discontent within the party magically disappear. The feat of gaining a third term would not mollify those within the CCP who resent his accumulation of power and reject his cult of personality, nor would it solve his growing legitimacy problem among the people. In fact, the moves he would likely make in a third term would raise the odds of war, social unrest, and economic crisis, exacerbating existing grievances. Even in China, it takes more than sheer force and intimidation to stay in power; performance still matters. Mao and Deng earned their authority through accomplishments—Mao by liberating China from the Nationalists, and Deng by opening it up and unleashing an economic boom. But Xi can point to no such concrete triumphs. He has less margin for error.

The only viable way of changing course, so far as I can see, is also the scariest and deadliest: a humiliating defeat in a war. If Xi were to attack Taiwan, his likeliest target, there is a good chance that the war would not go as planned, and Taiwan, with American help, would be able to resist invasion and inflict grave damage on mainland China. In that event, the elites and the masses would abandon Xi, paving the way for not only his personal downfall but perhaps even the collapse of the CCP as we know it. For precedent, one would have to go back to the nineteenth century, when Emperor Qianlong failed in his quest to expand China’s realm to Central Asia, Burma, and Vietnam. Predictably, China suffered a mortifying loss in the First Sino-Japanese War, setting the stage for the downfall of the Qing dynasty and kicking off a long period of political upheaval. Emperors are not always forever.

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We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

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But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 04 September 2022:

1. David Senra – Passion & Pain – Patrick O’Shaughnessy and David Senra

[00:27:10] Patrick: What about the people underneath these leaders? I probably listened to 50 episodes or something of founders. If I had to summarize one of the interesting lessons, is the dramatic importance of the individual. Which I think runs a little counter to maybe how a lot of people wish the world was, where if it was more communal and Steve Jobs was going to emerge if Steve Jobs particularly wasn’t him, or I think the great individual theory or thesis, a lot of people don’t like. But as I listen to a lot of your episodes and these stories, it strikes me that the person matters a lot. And I’m curious what you’ve learned about the layer of leadership underneath the founders, and if there’s any common stories, themes, traits that you’ve sussed out there.

[00:27:57] David: I want to start with a quote, because you just nailed it. And I’m a Edwin Land fanboy. I am on a mission, because I meet a ton of smart people who don’t even know who he is. So maybe people listening just don’t know it, that he was Steve Jobs before Steve Jobs. Steve Jobs met him when he was in his 20s, Edwin was 70 years old. And Steve came over from the meeting saying, meeting Edwin Land was like visiting a shrine.” These ideas that you’ve undoubtedly heard from Steve Jobs, did not originate with him. He literally took them from Edwin Land. The idea of building a technology company at the intersection of technology and liberal arts. That’s not Steve. That was on every single presentation that he made on Apple. He got that idea from Edwin Land. He literally talked about him over and over again. He said, “This is my hero.”

And Steve also had this deep historical knowledge, which all these founders definitely have, all of them. I have not come across a founder that was not curious about what the great people before them did. I actually made a 30 minute, in between episode. It’s called Steve Jobs and His Heroes. And I break down 39 podcasts on either Steve Jobs or the people that he talked about influencing him. Even when he was young, he was in his 20’s, and he could tell you how he felt the invention of the Macintosh was similar to Alexander Graham Bell’s invention of the telephone. It’s like, how the hell do you know that at that age? That’s remarkable. But Edwin said that there’s no such thing as group originality or group creativity. He goes, “I do believe wholeheartedly in the individual capacity for greatness.” And he says, “Originality are attributes of a single mind, not a group.”

What happens is, even if you have a bunch of co-founders, there’s usually one. A lot of these people had co-founders. You could say one A, one B, whatever the case is, but it’s always singular. It’s never a joint thing. And what’s good is, they find people that can play the role of the second or third. It’s not like, “Hey, I want to be the smartest person in a company.” They all obsess. This is in Warren buffet, David Ogilvy, Enzo Ferrari, Steve Jobs. They only surround themselves with A players. There’s a great book called In the Company of Giants. It’s on the floor next to me right now. What’s fascinating about that is, it’s two Stanford MBA students in 1997, go and interview all these technology founders. If you think about the growth of technology industry from ’97 until now, they were clearly ahead of time.

And what’s fascinating is, Steve Jobs, young Steve Jobs, he just came back to Apple, sits for the interview. They start the interview. They’re like, “Hey, startup founder doesn’t have that much time to recruit.” And I forgot the exact terminology, but he cuts off. He’s like, “I disagree completely.” Recruiting talent is the most important job as a founder. Think about the first 10 people in your company. Every individual is 10% of the company. You don’t transition from a startup, a nascent idea, to a super successful company that creates a great product, if you fuck up that part. That was his point that he was making there. And he knows that because, this is the crazy thing. So you mentioned Mike Moritz earlier, Mike Moritz wrote this fantastic book, the little kingdom. I read the updated version called the Return to the Little Kingdom. And what’s fascinating about that is, that’s way before Mike was an investor.

It’s the first, I think six years of the history of Apple. And when the book ends, the Apple 2’s doing really well. Steve Jobs is still at the company, but we don’t know how the story’s going to end. So then I would read that book, and then what you need to jump into right after that, there’s another book called Steve Jobs and the Next Big Thing. I think it was written by Randall Strauss. That book is about the 13 years between, he left Apple and then he returned. I call it bizzaro Steve Jobs, because it’s a gifted, intelligent entrepreneur, making every wrong decision in the book. That book ends in ’97, he gives this interview. Think about this, how crazy this is. He starts NeXT. One of his first 10 hires at NeXT is an interior designer for the office. What the hell is happening here?

You’re reading that book and you’re like, “I know Steve Jobs is smart. I know he is talented. How the hell did he do this?” We talked a little bit about ego before we started recording, where it’s very prone to let your ego get the best of you. People admire you because the work. What happens is, you usually isolate yourself. You’ll work really hard. You’ll do a lot of work. That work draws the attention of other people because it adds value to their life. And then suddenly, over time, you confuse us. It’s like, “Oh, they don’t like the work. They like me. And then I could just show up without having to do the work and everything will be fine.” And at NeXT, he just showed up. He’s like, “I’m Steve Jobs.

[00:31:51] Patrick: Ego’s such an interesting one. That lesson is fascinating. Confusing people liking the work for liking you. I’ve never heard it phrased that way. And that is so damn interesting. Where else do you see ego rear its head, good or bad? It strikes me that ego’s a negative connotation. You don’t want to have an ego, but you do want to be confident. You do want to be charismatic. You do want to be a good salesperson, some of the things that high ego people might be good at. What other things have you learned about ego? That phrasing is so helpful.

[00:32:21] David: I actually don’t think that you build a great company with a giant ego. I don’t think that exists. Sam Walton has a good idea about that. He’s like, “Listen, your ego should use to drive you, but you should not be on public display.” And he’s like, “I hire people at Walmart with big egos, that know how to hide it, because there is some weird thing where it drives you.” What’s the problem is, when you make it apparent that you think that you’re better than everybody else. In almost every story, you have a young entrepreneur that needs some help. They’re usually helped by people that are older, have a lot more access to resources. So think about how people are funding private companies now. You have super smart and determined founders, a lot of potential. Who knows what a person like that is going to be in 10 or 20 years, but they need assistance.

Whether it’s they need resources, they need personnel, they need money. What I realized this morning is, there’s this guy named Thomas Mellon and Thomas Mellon is one of the most important people in American business history, because he’s the patriarch of the Mellon Family Dynasty. What he did is, he made a lot of money before and after the American Civil War. He’s maybe 50 years old, super rich, owns a bunch of banks and stuff like that. He comes across a 21 year old Henry Clay Frick. Henry Clay Frick shows a lot of potential at this time. What Mellon can’t possibly know yet, 40 years in the future, Frick is going to be considered one of the best entrepreneurs to ever do it. So much so that Andrew Carnegie sees him and is like, “I need this guy on my team.” And then they have a falling out. There’s a fantastic book called Meet You in Hell.

I recommend everybody reads if you want to learn about Andrew Carnegie and Frick. It’s about what Frick told him. They had a falling out. Later, when Andrew’s about to die, he sends a letter to Frick. It’s like, “Hey, let’s reconcile. We’re living in the same city. We live a few blocks away. Let’s get together.” And he writes back. He’s like, “I’ll meet you in hell.” What was fascinating is, Mellon sees Frick. Frick is at the very beginning of building this Coke empire, that’s eventually going to be acquired by Carnegie’s company. And Mellon sees him. He’s like, “Oh, this is another me. This is me when I was younger.” He approves the loan. Then Frick takes that money, immediately deploys it, starts scaling up because he’s like, “Hey, I got an opportunity. I need to do this as fast as possible.” Goes back to Mellon, I think he borrowed $1000, this is in 1800.

So it’s a lot more money than $100 today. So he borrowed $100, goes back almost immediately, says, “Give me $10,000.” Mellon’s like, “Yo, what the hell are you doing kid?” So he sends one of his partners. He says, “Go check out this Frick guy. He seems to have potential to me, but I need to make sure this guy’s not full of crap.” So Mellon’s partner goes and shadows Frick, and he writes back to Mellon and he’s like, “The guy works in the Coke plants all day long. Studies his books at night, knows his business down to the ground.” Make the loan. And that is the first hand up that he gets, that causes him to build a monopoly in his industry. There was no one B to Frick’s Coke empire. It was clearly him. What was fascinating is, I didn’t put this together the first time I read that book, because I probably read 150 books, 150 biography since I read it the first time.

But I had just recently been rereading books on John D Rockefeller. And this guy named Jay Gold pops up in Rockefeller’s biography, every single one, which is really weird. Everybody’s read Titan, the most famous biography of johnny Rockefeller. What I did is, I went in the bibliography of Titan, found a book that the author, Ron Chernow, used as research and ordered it. It’s a very old book. It’s 40 something years old. It’s very hard to find. I read that book and I’m like, “Wait, this is a biography of Rockefeller, and this is an entire chapter is based on Jay Gold. What the hell is happening here?” And then you see when people would ask, and Rockefeller is probably the most famous entrepreneur in history. And they asked him, “Who’s the best businessman you know?” And he said, without hesitation, “Jay Gold.” Without hesitation. Then you have Cornelius Vanderbilt. This is another thing we should talk about, is how all these people wind up knowing each other.

There is something to be talking to other A players, and then you have cornea Vanderbilt who’s the richest person in America at the time. 40 or 50 years older than Jay Gold. And he’s like, “Jay, Gold’s the smartest person in America.” So I was like, “Okay, what the hell happened?” So the author actually sent me the book, a biography of Jay Gold, came in 15 years ago and I think it’s called Dark Genius of Wall Street or something like that. These are formidable people saying, “This is the one.” You got to pay attention to that. Why is that happening? So I’m reading Jay Gold’s biography, same situation. He’s 20 years old, 21, needs a leg up, meets this older, more successful businessman. But where Mellon did is I’m successful, but he didn’t know his ego get in the way. He’s like, “I want to be this guy’s partner. His success does not threaten me at all.”

The difference between Jay Gold’s life is, Jay Gold winds up taking on an older partner, this guy named Zadock Pratt, I think is his name. I’m going off memory here. So I might get his name wrong. But that guy was super rich, owned a ton of land in the Northeast at the time, owned 30 different factories that would produce leather goods. And all the different factories would have different partners. So he winds up doing a partnership. Jay winds up doing some surveying work for him on some of his land. And Zadock’s like, “Oh, this guy’s smart. I’ll partner with him. I’ll put up the money. I’ll give you the expertise. And then you run with it.” Well, Jay Gold is a straight up genius, way smarter than Ill ever be. And he runs with it. He’ll hit you up for advice and money, but eventually he’s like, “Oh, I got this. I can figure it out.”

He’s coming up with ideas. The crazy thing about Jay is, this guy’s been in the leather business for 40 years. I’m coming up with ideas that he doesn’t see. That threatens Zadock’s ego. How do I know it’s Zadock’s ego? Because the guy was so rich, he started his own bank, printed his own currency. Guess whose face he put on his currency? His face. You know Mount Rushmore, in this town is a big granite wall or a big rock formation. So Mount Rushmore, you got all the presidents on there. He hired somebody to carve his own face. Think about how egotistical you have to be. I want people to come through my town and see my giant head hovering above everybody. They started partnering. He didn’t like that Jay stopped asking him for advice. He thought his success and Jay was managing his leather factory, they call him tanneries, better than his other partners.

He didn’t like that. He felt threatened. So he tried to maneuver and he said, “Hey, we’re going to end the partnership. You have to either buy me out for $60,000, which is the money I put in. Or I buy you out for $10,000, which is the money you put in. “He did that because he’s like, “This guy doesn’t have $60,000.” Didn’t know that Jay has a brain. He knew this was coming and he had secretly set up financing and he was waiting for that to happen. Rockefeller is the exact same story, for his first partners in the oil industry. He had older partners who to try to screw them, and he says a great line. He’s like, “While they were talking so loud, my mind was running.” What happens is, “Okay, I’m hitting this provision in our contract. You have to come up with $60,00.”. Jay’s like, “Here it is.” And he takes off running. You had the opportunity to partner with one of the greatest entrepreneurs to ever do it, and you fumbled it because of ego…

…[00:58:38] Patrick: It reminds me of a conversation I had with Tony Xu who started DoorDash. Tony’s a very mild mannered, very humble, almost quiet person, which is why this quote from him stands out in my memory so strongly, which is I asked him something about culture. How do you think about constructing the culture of a company? His answer is basically, “I think a culture of a company should be like 80 or 90% just the personality of the founder. That’s it. It should be the extreme characteristics of the personality of the founder. Because if you try to make it generic, nothing stands out and there’s no progress and there’s your dominates.” I think that’s basically what you’re saying. These stories are fundamentally the stories of individuals replicating themselves in some interesting way like you mentioned with Jobs. And the marketing thing is such an interesting angle that I don’t think you and I have ever really talked about. Because so much of the time we think about the products and that’s mostly what we’ve talked about, the phone, the Polaroid, the airplane, the whatever, and we don’t think about as much the story and the marketing. What have you learned about all of these people as it relates to marketing? Did they all tend to be good at it? Was it just a means to an end for them? What have you learned about how these people distributed or got the word out about their products over time?

[00:59:48] David: I’m a collector of maxims and aphorisms. I think my favorite one might be actions express priority. I don’t look at what you say. Just look at what you do. They’re marketing geniuses, all of them. What do you call a person that’s gifted at customer acquisition or distribution? A founder. There’s a ton of people that have great products and no one knows about, so you’ve failed that aspect of it. I’ve read a book called Insanely Simple which is written by one of the guys that worked at the ad agency that Apple used. He compares and contrast in the book Dell’s approach to marketing when he worked for them and Apple’s.

He’s like, Steve told you with his actions that marketing was important. How do he do that? Every Wednesday we had a three hour meeting. This is maybe post-iPod and before iPhone. Somewhere in there. But after, they were already having a lot more success, when he came back. He goes, we had a three hour meeting and Steve would review every single marketing ad. Every single thing. There was not a fucking billboard that was going to go up until Steve said that was okay. The reason it is important is because there’s a lot of people that preach in their companies, “Marketing’s important and it just works.” Steve showed with his actions.

Then you have Enzo Ferrari’s just on top of mind because I read three biographies of him and I just read all of my highlights again yesterday. But he was a marketing genius too, because he’s winning Le Mans. That’s how he jumpstarted his company. And because of Ferrari stands for victory, you have all these rich Americans flying to Italy and they’d want to meet Enzo Ferrari.

Ferrari is very mysterious. He wouldn’t let you see his eyes. He’d wear sunglasses in every meeting. He did that on purpose. He thought they were like the windows of the soul and he didn’t want you reading his soul. What he’d do is his employees would catch him giving a tour of this rich guy. The guy’s like, “Oh, my God, Enzo, these cars are fantastic. I must have one.” He goes, “I appreciate that. I’ll see what I can do. I might be able to get you one maybe six months, maybe 12 months from now.” Then the guy would leave and the employee would go up and be like, “Enzo, we have a parking lot full of unsold Ferraris.” He’s like, “A Ferrari has to be desired.” He knew it. It’s very similar to that fantastic podcast you just did with Rolex, with Ben Clymer. You see that same idea with a purposely limit production or don’t even tell you how much they’re making. There is a secrecy element to it.

Edwin Land, same thing. When we think of how much Steve Jobs would practice for his presentations, he got that from Edwin Land. Edwin Land would do all kinds of crazy stuff. Way before he invented a camera, he invented polarization. So one of his main inventions was when you were driving at night, you would be blinded by the oncoming headlights of the other car. So he has that film they put over it. He was trying to sell it to a bunch of other car companies. There’s a story in one of his biographies where he rents a hotel room. He figures out where the sun is going to be at what specific time, which hotel room that he needs to get that has a window that faces it. He puts a fishbowl there and then he invites the people he was trying to sell. Then at the perfect time, it shows the light emanating through the windows with the fishbowl, with and without the polarization. That’s how he sold them. It’s that thought process.

Walt Disney, fantastic, fantastic book. Enzo Ferrari and Walt Disney have one thing in common. Both their first companies went bankrupt. That’s a lot people don’t know. Walt Disney, everybody’s like, “Oh, one of the best founders ever.” How could he not be, right? Everybody thinks he was a cartoonist. Yes, he invented animation, first successful full-length animation movie. But if you ask, “Well, Disney, what is he most proud of?” He’s most proud of two things. One, starting his company and keeping control of it, because he lost control of his first company. And two, Disneyland. He did not mention animation. When he was dying. He’s in the hospital dying, his brother is his partner, Roy. They’re looking on the ceiling-

He’s in the hospital, dying. His brother is his partner, Roy. They’re looking at the ceiling of his hospital room and they’re going over the plans for EPCOT. He never got to see it, because he was dying. This is very common. Coco Chanel? It’s a thing. They work to the day they die. Enzo Ferrari? Day they die. There’s no retirement. There’s not going to be a retirement for James Dyson. There wasn’t a retirement for Steve Jobs.

What Walt Disney was gifted at is also the amusement park. It’s like, “Hey, why are you making an amusement park?” What people don’t understand is that back then, amusement parks were seen as lowlife stuff. They were dirty, full of scam artists, more like a circus kind of thing. Walt Disney said something that was genius. They’re like, “Why are you building an amusement park? They’re dirty, low-class places.” He goes, “Exactly. Mine won’t be.” The way I frame that in my mind is, “Their mediocrity is my opportunity. There is not a great amusement park. I will be the first.”

He’s like, “Okay, I need to raise money to fund Disneyland.” He borrowed against his house, borrowed against his life insurance. He was crazy. He didn’t give a shit about money. He should have been way more wealthier than he was. He packaged the financing and the marketing together. He’s like, “ABC, I’ll do this weekly show. I’ll be the one hosting it.” The founder is the guardian of the company’s soul. They would show some things from his animation, but then they would also show, “Hey, this is what we’re doing in the park,” essentially like a weekly ad that people were watching willingly.

As a result, he gets money from that. He gets perfect marketing and advertising for that, maybe the best ever, and ABC puts up a large percentage of the money needed to make the park. What happens? As a result of people watching this … it was one of the highest-rated shows on television for a year … the day he opens the park, it’s the biggest traffic jam in Orange County history. It’s not just, “I’m going to make the very best product.” He considered the amusement park like a cast. It’s just a physical movie. “I’m building a physical movie, so I’m going to make the very best amusement park ever, and it’s going to have the very best marketing.”

[01:04:38] Patrick: It sounds like a common theme in all these stories, is process as art by revealing the process behind the product, because they’re so obsessed with that. That is a common marketing story. Is that right? Do you see that over and over?

[01:04:49] David: I read Warren Buffett’s shareholder letters. To me it’s like how many people have studied more founders and more businesses than Warren? He says in there, “David Ogilvy is a genius.” I’m like, “Who’s David Ogilvy?” This is years ago. I find David Ogilvy, and he’s now one of my personal heroes. I read five books on him. What did he do? He did exactly what every single other entrepreneur did. Figured out what was the best shit that happened before I was alive. “Hey, those are good ideas. Human nature doesn’t change. Let’s use them.”

David Ogilvy winds up, in the very last chapter of Ogilvy on Advertising, he talks about the six people, the six advertising giants that came before him, that he studied, that if they were alive, he’d befriend. That’s another thing Bill Gurley’s talked about that’s important, is going out and actually meeting these people if you can. Then he would just take all these ideas and build on it. His point was there’s no such thing as a business that is boring. It’s only boring advertising. He says, “Listen, it’s boring to you because you do it every day. If you explain to the customer the process, they’ll find it interesting.”

He did this for explaining the brewery process for one of the beer accounts he had. The person that owned the beer company was like, “I don’t want to do this. Every other brewery does it this way too.” He goes, “Yeah, but we’re the only one telling the story.” He spends three weeks … or three months, can’t remember … researching the hell out of Rolls-Royce, talking to the engineers, reading all the material. He winds up reading a 50-page document. There’s one line in it that says, “The loudest thing in the car at 50 miles an hour was the clock inside.” He used that as a tagline, and then put a couple thousand words of copy.

Walt Disney too. Maybe the best, if you want to call it a media company. I can’t think of another company that has the assets that Disney has. It started with a huge fight with Roy Disney, who is the brother, the business aspect of that, and Walt Disney. They were having this fight in one of their books where it was just like, “How much is this going to cost?” Walt says, “We’re innovating. I’ll tell you when I’m done.”

To go into the process behind it, that book, Disneyland, goes into it. To your point, it’s almost like opening the kimono. He shared, with the entire country, all the work and effort and detail that went into it. I shopped at Trader Joe’s for a long time. It’s a weird place. Interesting. I liked it. Okay. Reading the biography of the guy that started it, you have to understand why they’re doing what they’re doing.

The example I would use is one I talk about sometimes on the podcast, because people are like, “It sounds like you have really good recall or you can remember this stuff. You must have a really good memory.” Absolutely not. The way I make the podcast, I read a book, make the highlight. That’s the first time I read the highlight. The book is done. The night before I record … I usually record in the morning … the night before, I’ll reread all the highlights. That’s the second time I’ve read the highlights now. I record the podcast. That is the third time I’ve read the highlights. I edit the podcast. That is the fourth time I’ve heard the highlights. Then the fifth time is I have to take pictures with the Readwise app and literally input them physically, one by one. It usually take hours to do this. That’s the fifth time.

People knowing that, when they feel comfortable pressing Play when they listen to Founders … because like, “first of all, this dude, every single episode, he’s got to read an entire book to prepare. That’s kind of crazy. Then second of all, he’s not just reading it casually, doing it once. He’s read these words five times,” and then I’ll reference them in future episodes. The only reason I’m able to reference them in future episodes is because I did that five times.

If there’s any part of your product that seems banal or ordinary to you, I promise you, no one is thinking about your business as much as you. The favorite business of mine in the world, you think about it less than probably five minutes a week. Nobody is thinking about it. You have shit in your brain that is interesting to customers, and then you could package that up and use that as marketing to get more customers.

2. ‘Gama- Gaeru’: The Most Celebrated Ceramic Toad in Stock Market History – O-Tone 

This little post will neatly encapsulate the popular delusions and sheer madness of crowds brought forth by the Japanese stock market bubble of the late 1980’s.

The genesis of this story? The fourth floor of an awfully exclusive “Ryotei” restaurant in Osaka, which accommodated, prominently positioned, an ugly ceramic toad.

Within Osaka, the toad is known as “Gama-Gaeru” or “toad-frog” and is regarded as a minor deity, which possesses a good luck charm and has the power to attract wealth to its owner.

The restaurant was owned by Nui Onoue, a grandmotherly lady in her 60’s. She was a fervent disciple of bizarre rituals and her toad was one of a kind: An amphibian Warren Buffett. It was incredibly successful in its role as a money magnet. At the peak of the Japanese stock market bubble, the toad would control a 20bn US Dollar stock portfolio, make Mrs. Onoue the largest individual shareholder in three of the world’s biggest companies and the wealthiest woman in Japan…

…As word about Mrs. Onoue’s Midas touch spread, she was also visited by senior executives from the most prominent Japanese investment banks in the late 1980’s. According to the author Alex Kerr, by 1991 the Industrial Bank of Japan (IBJ) alone had passed Y240bn over to her, and 29 other banks and financial institutions had advanced her the staggering sum of Y2,800bn for her spiritual endeavor.

Unfortunately, the toad lost its divine touch shortly after. At the beginning of 1990, the biggest stock market boom in modern history had come to a grinding halt and was slowly morphing into a giant crash.

As Mrs. Onoue’s portfolio collapsed in synchrony with the Nikkei 225, she was forced to borrow massively to cover losses and to back loans. She would leave the spiritual path to riches and start a criminal career forging deposit documents. Helped by a branch manager of a small Osaka credit association she faked certificates worth a Y460 billion, almost as much as the entire deposit base held by the tiny bank, in order to obtain loans from other banks and non-bank financiers worth a 172 billion Yen.

Slowly, the public started to question how on earth a restaurant owner was able to amass such a fortune, and leading banks handing over to her ungodly amounts of money. Doubts were also raised about whose voice she was really listening to before she made her investment decisions.

Although in the past “Gama- Gaeru” got all the credit, more and more it dawned on the public that maybe her sugar daddy, and later a senior executive from Yamaichi Securities, a broker house that was already up to its neck involved in scandals surrounding stock loss compensation and Yakuza connections, had also been whispering into Mrs. Onoue’s ear.

Mrs. Onoue was  arrested in 1991 and eventually sentenced to 12 years in jail in 1998 for involvement in Japan’s largest loan fraud. But there was further collateral damage. The most infamous being the chairman of the International Bank of Japan, the predominant man of the Japanese business elite. He was forced to resign in shame because of his strong ties with Mrs. Onoue.

3. TIP370: Inflation Masterclass w/ Cullen Roche – Stig Brodersen and Cullen Roche

Cullen Roche (00:02:46):

And I’ll tell you why I don’t find this to be a terribly useful definition. Because in the type of monetary system that we have, we actually experience the growth of the quantity of money over any sustained period of time due to, mainly, because of economic growth. And so, people have this view that money necessarily causes inflation. And this is old-school monetarist thinking or some Austrian School thinking that leads people to believe that the more money you create, the more inflation we’ll have and the worse off we’ll be.

Cullen Roche (00:03:22):

And the reality is that the way that the modern monetary system works is that most of the money supply is in existence, basically, because money in today’s economy is mostly deposits. And deposits come into existence through the lending process. And so, what ends up happening is from an accounting perspective, money is just a really simple credit agreement. It is both an asset for the lender and liability for the borrower. And that, in and of itself, is never necessarily a good or a bad thing.

Cullen Roche (00:03:58):

People like to talk about the liability side of balance sheets but they often neglect that there’s an asset side of a balance sheet. And so, from a deposit creation perspective, when a bank makes a loan and that has become the dominant form of money in the modern monetary system, the deposit is an asset for the borrower and liability for the bank. And so, from a pure just balance sheet perspective, from an accounting perspective, when a loan is made, no one is necessarily better or worse off and it depends on all sorts of other factors.

Cullen Roche (00:04:32):

And the fact that the money supply increases because of this, it really doesn’t tell you much about anything. It just tells you that balance sheets have expanded. And over the course of very long periods of economic growth, we actually want balance sheets to expand. And so, even though people like to focus on the liability aspect of this, the reality is that the asset aspect is just as important. And whether or not that has a positive or negative impact on the economy, in the long run, depends on all sorts of different variables.

Cullen Roche (00:05:04):

I mean, to cherry-pick an example, for instance, I mean, if somebody borrows a million dollars and creates some world-changing invention that makes all of our lives fantastically better, well, yeah, technically, there’s a million dollars more of money that is in supply. But this invention, whatever it may be, will dramatically improve our living standards across time. And so, it’s a lot more complex than money and the sheer quantity of it.

Cullen Roche (00:05:35):

And I think that a lot of people have a tendency to fall into a political bias with a lot of these conversations, where you think of the government primarily as being a money creator. And the reality is that most of the money today is created in, really, a fairly market-based type of system where it’s almost a meritocracy in terms of who can borrow and who cannot. And the banks are mostly assessing your lending capabilities, your borrowing capacity based on, really, how valuable they think those loans might end up being, or what the collateral is that exists.

Cullen Roche (00:06:11):

And so, it’s a really complex issue. And narrowing it down to purely the money supply just doesn’t tell you anything because, frankly, the money supply pretty much always increases over any long period of time…

…Cullen Roche (00:19:12):

I mean, the ’70s were really more so an oil crisis than anything else. But I don’t think we’re in an environment where we’re likely to see very high sustained to say 10% inflation or something like that just because I think that the secular headwinds are… they’re so big. They’re so much different this time around where you have not necessarily a Japanese type of demographic issue in the developed world, but it’s much more similar to Japan than it is, say, like a baby boom situation or something like that, where the population is growing pretty significantly, meaningfully.

Cullen Roche (00:19:47):

But in addition, you have all these other factors like the technological factor, the globalization factor is one of the biggest. I mean, you could argue that the world has never had so much accessible, cheap labor in its existence. And so, globalization puts a huge secular downward trend on inflation. And so, a lot of these big macro trends, I think, they don’t necessarily put a ceiling on inflation, but they make it very, very difficult especially for policymakers to create a lot of inflation.

Cullen Roche (00:20:18):

And I think that the thing that is most interesting about the last 18 months is that you had this big, huge policy response. It wasn’t really the Fed so much, it was mostly the US Treasury, I would argue, that really caused a lot of the inflation because the government… the Treasury spend six and a half-trillion dollars in the last 12 to 18 months. The numbers are colossal. And so, it’s interesting because mainly going forward, those numbers are not going to continue.

Cullen Roche (00:20:51):

We’re likely to run trillion-dollar deficits going forward, but we’re not likely to run six and a half-trillion dollars of spending year after year after year. And so, you don’t have the sustained fiscal tailwind that caused a lot of the inflation that we’re experiencing right now. And I think as a lot of these things taper off, you are likely to see prices that look what the Fed would call transitory but that will end up probably not being as transitory as the Fed, I think, expects…

…Cullen Roche (00:33:11):

But I think we tend to have this view that the central bank is the money printing entity, and that the central bank has the big bazooka. And I think what we’ve learned in the post-COVID period is that it’s actually the treasuries that have the big bazookas. And a lot of what the central banks do, and I discussed this in a lot of my papers on the operational dynamics of things like the monetary system and quantitative easing, that the central bank, to a large degree, is a secondary actor in all this.

Cullen Roche (00:33:43):

That the real money printing, if you want to call it that, is done by the Treasury. And so, to use a concrete example, when the Treasury runs a deficit, meaning that they spend more than they actually take in in tax revenue and they end up having to borrow, you could call those bonds. They’re printed from thin air. They’re completely net financial assets. If the government was to finance their spending by dumping cash on the ground, for instance, rather than dumping bonds on the public sector or the private sector, they would literally be printing cash.

Cullen Roche (00:34:18):

They would literally be printing money. And so, of course, we don’t do that in the modern era. We finance spending by printing bonds, basically. But those bonds are net financial assets. And what the Federal Reserve does, to a large degree, is they come in after the fact. And when they implement something like quantitative easing, they’re just changing the composition of the financial assets that the private sector then holds. So, they’re printing a reserve deposit and they’re exchanging it with the bond.

Cullen Roche (00:34:49):

And if you think about this from the order of operations, well, they’re just exchanging the different types of financial assets. They’re adding a deposit and they’re taking the Treasury bond out of the market. So, where did the real money printing occur in this order of operations? Well, it occurred at the Treasury level. The Treasury’s deficit was the net financial asset. It was the balance sheet expansion that really matters. The Fed technically expands its balance sheet.

Cullen Roche (00:35:13):

But in the process of doing so, the way to think of it is that, yeah, they expand their balance sheets to create reserves and they buy the bonds with them, but then they remove the bond from the private sector. And so, what impact does that have? From a consumers’ perspective, it’s a lot like swapping a savings account, which is basically what a treasury bond is for a checking account. And ask yourself, how does your financial situation change when you swap a checking account with a savings account?

Cullen Roche (00:35:44):

It doesn’t really meaningfully change at all, except for the fact that you actually have a lower income now. So, I think you could make an argument that something like quantitative easing is marginally deflationary because it reduces the private sectors’ income. But that’s the big lesson from the post-COVID period versus the post-financial crisis period is that fiscal policy has a much, much bigger impact. You have to look at it comprehensively.

Cullen Roche (00:36:12):

You can’t just look at the Fed’s balance sheet and say, “Oh, look, we’ve printed all this money because”… let’s say we were Europe in the post-financial crisis period and we were running basically budget surpluses or negative or flat balance sheet expansion from the Treasury level. Well, who cares if you’re doing quantitative easing in that environment, because then, there really is no meaningful balance sheet expansion at the Treasury level. And the Fed or the European Central Bank is just swapping those bonds for deposits.

Cullen Roche (00:36:48):

And so, you’ve got to look at things comprehensively. And to make all of this even more confusing in the case of something like Japan, you have to consider all these other factors like demographics. And so, all else equal, fiscal policy is hugely, hugely important. And the degree to which those policies are implemented and then sustained will have a meaningful impact on aggregate demand and future inflation…

…Cullen Roche (00:56:42):

But the reality is that I think that those boring inflationary environments are much more important to protect yourself against because they’re just so much more likely to occur. I mean, the likelihood of the Weimar Republic occurring in the United States or something like that, or Zimbabwe, in my mind, it’s just super low. And so, if you’re going out planning for some environment and you’re building your whole portfolio around something like that, you’re building your portfolio around a really low probability, asymmetric bet that, yeah, it might have a huge potential upside.

Cullen Roche (00:57:17):

But the likelihood of it actually coming to fruition is just not very high. And so, it’s a lot more important to build your portfolio around the more likely outcomes, which is just that inflation, yeah, it’s always going to go up from the bottom left of that chart to the top right, and you have to protect yourself from that. And that means that the risk of a two and a half percent or 3% inflation is much higher. It has a much bigger impact on your overall quality of life than sitting around worrying about a Weimer Republic or a Zimbabwe.

Cullen Roche (00:57:49):

And so, the equity market as a whole has been a fantastic way to protect yourself and generate a real return, regardless of whether or not there was ever going to be hyperinflation. And so, from a pure purchasing power protection perspective, stocks as a whole are a wonderful way to protect yourself from inflation. And so, you’ve got to get really comprehensive about it. But from just a very boring macro perspective, thinking of stocks as a continual purchasing power protector is, I think, a useful mental model, a good framework to start with when you’re considering your purchasing power protection.

Stig Brodersen (00:58:34):

Let’s talk a bit more about it. Very practical about it because it’s often said that we should invest in real assets and not financial assets in a time of inflation. And so, your real assets, that could be precious metals, commodities, real estate, land equipment, natural resources. And to some people, including myself, some of that can sound quite intimidating because you want to have the actual physical asset. Do you want to store gold in your own home?

Stig Brodersen (00:59:02):

What do you do with those 100 barrels of oil, or whatnot, that you’re going to put somewhere in your garage, right? So, many investors, therefore, prefer to buy paper assets due to the convenience of not having to go through transactions with real assets. And this might sound confusing, since you can have paper assets, for instance, stocks where you own a company with many real assets. And so, could you clear that up for us, Cullen? What is the relationship between a paper asset and then this hedge against inflation through real assets?

Cullen Roche (00:59:38):

We call what we do investing. And a lot of what people do in the financial markets, it’s not from an economic perspective, it’s not technically investing. It’s really, we’re just reallocating our savings. And so, what I mean by that is that when a firm goes out, when an oil company goes out and they buy a million barrels of oil, well, they’re not going to do what you just described. They’re not going to take those barrels of oil and just stick them in their backyard and hope that the price changes.

Cullen Roche (01:00:07):

No, they’re typically going to do something with that oil. They’re going to literally spend for investment on it. So, they’re buying the barrels of oil, and then they’re doing something. Who knows, they’re turning it into gasoline or they’re reselling it to someone who is going to be able to purchase it to turn it into, who knows, tires or some other product that is actually useful in the long run. And so, what they’re doing is spending for future production.

Cullen Roche (01:00:36):

And that’s one of the things that, I think, people have to be cognizant of when they’re analyzing all this. And it’s one of the reasons why I generally if you’re going to apply like a macro rule of thumb to inflation protection, it’s nice to own the financial assets in large part because the financial assets reflect what the underlying spending for future production is actually resulting in. So, for instance, when you buy Exxon Mobil, you’re not just buying some piece of paper that reflects the craziness of what people think on Robin Hood.

Cullen Roche (01:01:16):

To a large degree, you’re buying a piece of paper that reflects the underlying value of what Exxon Corporation does with their spending for future production. And so, you’re getting embedded inflation protection in there, not because of just the underlying commodity, but really, you’re making a bet, to some degree, on how innovative Exxon Mobil is able to be with their barrels of oil and what they end up ultimately doing with those barrels of oil. Corporation is really… it is a real entity.

4. TIP472: Inflation Masterclass Continued w/ Cullen Roche – Stig Brodersen and Cullen Roche

Cullen Roche (00:02:46):

I’m sort of relatively well known for having been sort of a disinflationist or deflationist coming out of the financial crisis, because basically I understood that from studying Japan and their bouts with deflation and implementing quantitative easing, that when you look at it from an operational level, quantitative easing is essentially just an asset swap. It’s the central bank comes in after the treasury deficit spends, and then they exchange types of assets essentially. So the private sector ends up… losing a treasury bond and gaining a reserve deposit. And from a monetary perspective, you can have this big sort of boring debate about what is money, and is a treasury bond money-like. And in my view, a treasury bond is essentially like a savings account. And so, the private sector from QE, it gets a savings account and loses a checking account. So people don’t feel wealthier, even though from a very technical sort of economic perspective, the government has printed money, people would say, because people consider reserve deposits obviously to be more money-like than a treasury bond.

Cullen Roche (00:03:57):

And so in a traditional economic model, QE looks like it should be inflationary or even hyperinflationary when they’re doing trillions and trillions of dollars of it. But from a really, I think basic household perspective, all the household did was exchange the composition of its assets. And so the Fed’s response to… COVID was very, very similar. They had this huge balance sheet ramp up, they cut rates, they did all the same sort of stuff that they did during the financial crisis. But the difference between the financial crisis and COVID was that the treasury was the one that really ramped up their balance sheet and had this huge explosion. And so that’s why I was much more worried about inflation coming out of COVID than I was with the financial crisis, because of the treasuries humongous response.

Cullen Roche (00:04:49):

And so while I got the direction of inflation right, I think the tricky thing with all of this has obviously been the magnitude and the longer lasting effect of it. And I think a lot of that is just that I didn’t think there’d be… God, I didn’t think we’d still be talking about this thing at this point. Who could have predicted the Ukraine war, which Russia basically shuts down one of the largest commodity producing countries in the whole world. So there’s been all these sort of weird impacts that have, I think elongated the impact of inflation and made it a much trickier environment to navigate.

Cullen Roche (00:05:30):

But to me that’s the big lesson coming out of this, is the treasury and fiscal policy is really, really important. And that’s really important to understand going forward, because again, let’s put this in perspective. In 2021, as of the end of June at this time last year, the treasury had run a deficit of $1,7 trillion. These are huge, huge numbers again. So at this time last year, we’re still in the throes of really heavy duty fiscal stimulus responding to COVID. So far this year, through June of this year, the treasury has run a deficit of $137 billion. I mean, in terms of the way the US government usually spends and runs a deficit, this is almost a surplus, which is very, very unusual. So on a relative basis, there has been a huge fiscal tightening. So people talk about the Fed and how the Fed has raised interest rates. And a lot of that has caused this sort of retrenchment in demand and tightening of the economy. And the thing that’s lesser talked about is this huge decline in the relative size of the government’s deficit.

Cullen Roche (00:06:50):

I think when you combine these two things, raising interest rates is a very, very powerful mechanism, because especially in a time right now, it can cause a lot of turmoil in the housing market. We’re starting to see that already. And if you adhere to the theory that the US economy basically is a housing economy, well that’s troublesome from a demand perspective. So high mortgage rates have snuffed out demand for mortgages, made it basically unaffordable for… they’ve locked out another 40 million people with the rate increases from the last few months. So huge, huge numbers. So demand is coming way back, and that has this huge knock-on effect through the whole economy, because when you think about everything that goes into a house, think about the demand for how furniture now goes down, and refrigerators and appliances and all these other things that have a knock-on effect through housing.

Cullen Roche (00:07:45):

But then when you combine that with the fiscal retrenchment, there’s been a big, big government tightening. So we had this big explosion in government spending, in government stimulus in general, and now we’re having a big, big give back. And if the government had continued to do these big programs in perpetuity, that would’ve worried me. I hesitate to say anything like hyperinflation, but a much more prolonged, a 1970s style rate of inflation, where you had double digit inflation that lasted for basically 10 years, that’s a much more plausible scenario under those circumstances. But right now the opposite is happening. And so, how fast will it come down? I think it’s going to come down relatively slow, but I think that we’re now… I think disinflation, meaning a falling rate of positive inflation is going to become fairly well entrenched in the economy over the course of the next 18 to 24 months.

Stig Brodersen (00:08:44):

On your wonderful blog pragcap.com, you said, and I quote, “There is no chance of hyperinflation. I would argue that the risk of deflation is substantially higher at this point than the risk of hyperinflation.” Could I please ask you to elaborate on that?

Cullen Roche (00:09:00):

Yeah, so I think going back to that forward-looking expectation of a recent trend in the fiscal retrenchment, and the Fed’s big attempt to really snuff out inflation, I think that the risk of deflation now becomes greater, because I think that these are both very, very outlier events. So we’re talking about pretty unusual things to begin with, but the risk of a mini 2008 repeat, where let’s say housing prices. I expect housing prices to fall 5% to 10% over the course of the next 18 months, and that’s kind of my base case. So housing is going to be relatively weak I think over the course of the next year at a minimum. There is a chance that I’m wrong about that, that the Fed response is much bigger than we expect, that they’re much more aggressive and much more prolonged with it than we expect. And that housing falls more than I expect.

Cullen Roche (00:09:59):

I mean, housing boomed so much during the pre-COVID period and then the COVID period that you could easily get a 20% retracement in house prices. It wouldn’t surprise me at all if something like that happened, and that would have a very big negative impact on the economy. I think that if that happened, by the time that plays out, let’s say it’s 2024 and housing prices have fallen 20% from their peak, I think at that point, there’s a very good chance that CPI readings and the Fed’s preferred measure core PCE, Personal Consumption Expenditures is negative at that point. And that’s just going to be a function of demand just falling off of a cliff, and this huge knock-on effect from the negative housing market.

Cullen Roche (00:10:46):

So to me, that’s a much, much more likely scenario than a hyperinflation, because in large part, because if you’ve read my research in past years, you know that hyperinflation generally occurs under very, very unusual specific scenarios, usually scenarios such as very corrupt regimes, a government losing a war, a complete regime change in the government, these sort of really seismic events that are very disruptive at a government level. And the government usually responds to that by then printing huge amounts of money. So while we’ve technically printed a lot of money in the last two, three years, you haven’t had this big sort of disruptive geopolitical event at a government level that I think has caused a complete collapse in the faith in the currency. And in fact, I would argue that if anything, what we’ve seen in the last, especially the last 12 months is, if anything, we’ve seen increasing demand for the dollar in a relative sense.

Cullen Roche (00:11:50):

So to me, it’s very hard to envision… yeah, if we were having this discussion and we were sitting in Nigeria or something, it would be a totally different discussion. But when you’re talking about the world’s reserve currency, you’re still talking about on a relative basis. And even if you believe all fiat currencies are trash, the US dollar is the least trashy of the trashy currencies. So it’s very hard for me to envision a scenario where you get this huge collapse in demand for the currency in large part, just because the US economy’s important role in the global economy, and combine that with just the fact that you don’t have the environment for this sort of seismic shift in faith in the currency…

…Stig Brodersen (00:47:42):

Cullen, let’s continue with this thought experiment. Let’s say that we would go into a prolonged period of not only disinflation, but for example, two decades of deflation. And I just wanted to clarify, disinflation is a lower but still positive inflation rate, whereas deflation is a negative inflation rate. So how would consumers and investors need to adjust to this prolonged deflationary period?

Cullen Roche (00:48:06):

Man, one of the most interesting charts I’ve ever seen is Japanese real estate in the last 20 to 30 years. I mean, we’re so used to, in developed world, real estate prices just always going up pretty much. That was a part of what everyone kind of knows. That was part of what caused the financial crisis to be so bad, was that in the economic models, all these investment banks assume that real estate prices just either wouldn’t go down or wouldn’t go down very much. And so when real estate prices went down 20%, 30%, obviously that caused… it threw a wrench in everything. And in Japan though, real estate prices have been going down for 20, 30 years, which is sort of unfathomable in the United States. But it’s something that… that sort of a scenario, I mean, it keeps me up at night to be honest, because again, the real estate market is such an impactful instrument in the entire US economy. You’d have very, very low rates of growth.

Cullen Roche (00:49:11):

I mean, in that sort of a scenario, if that’s something that you expected or if you thought it was a risk, counterintuitively you’d want to own a ton of bonds. So bonds in Japan were the thing that hedged people from… people talk about how the Japanese equity market has been down over this lost decade or whatever. Well, the thing that people don’t always point out is that if you owned a 60/40 portfolio denominated in yen, where you own the Nikkei for instance, and Japanese government bonds, well, you actually did okay, because the government bonds performed so well that your relative performance was okay. So diversification actually worked out in Japan, because of the bond component.

Cullen Roche (00:49:59):

But the same sort of scenario would play out in the United States, where people are worried about inflation now. And they’re worried that, oh, bonds are dead. But if you got prolonged entrenched deflation, the bonds are the things that would perform really well in that in terms of an asset allocation. So again, going back to that all-duration or all-weather sort of perspective, it’s why I always advocate, I always tell people, you always need to hold some cash and short-term bonds, and even some intermediate potentially long-term bonds. Treasury bonds, they’re sort that deflation insurance product, super long duration instrument.

Cullen Roche (00:50:37):

But yet, in terms of an economic outcome, it’s hard for me to imagine that wouldn’t be a disastrous scenario, that it wouldn’t be coinciding with something much more negative in terms of what’s occurring, just because in order to get the 20-year period of entrenched deflation, you’d have to have not just negative probably demographic growth, you’d have to have declines in productivity, and really almost like 0% GDP probably for decades, which would not be… obviously would not be great.

Cullen Roche (00:51:14):

So is that going to happen? Personally, I think that’s a low probability, just because the demographic trends, even as bad as they are in the United States and some of the developed world, they’re not necessarily going to be negative. And I think productivity will continue to be relatively strong. And it’s hard for me, united States is still such a real estate based economy that when you look at it in the long run, I mean, God, looking at it from a supply perspective, one of the problems in housing is there’s a huge shortage of housing. And so in the long run, are we going to stop building homes in the United States? Using a crude “housing is the economy” sort of model, it’s hard for me to imagine that even with the ebbs and flows in the long run, there is a lot of building to be done in the United States in terms of building out the real estate market.

Stig Brodersen (00:52:09):

Well said. Now Cullen, let’s transition into the next topic of today, which is the concept of the Fed put, which dates back to the era of Alan Greenspan, the former chair of the Fed. Starting with the stock crash of 1987, the Fed cut rates whenever share price is plunged. If you are an investor, it resembles the benefit of a put option where your downside is getting cut. Some argue that we’re now heading for a time with a Fed call, which is exactly the opposite, meaning capping the investors’ upside. We know from studies of the Wealth Effect that the wealthier people feel they are from their stock holdings, the more they spend. One study from Howard University shows 3 cents of increased spending of each dollar an increased stock wealth, plus increased employment and wages. All of this adds to inflation, which currently seems to counter the main objective of the Fed. So with all of that being said, do you think Cullen that we’re heading into a period of the Fed call?

Cullen Roche (00:53:03):

There’s a lot of different transmission mechanisms for monetary policy. And to me, interest rates are a very powerful policy lever. I do not think… people tend to think, when people talk about the Fed put, they often talk about quantitative easing and the balance sheet expansion. And I don’t think quantitative easing is as powerful as a lot of other people tend to think. And I think that drawing these correlations between the Fed’s balance sheet and the stock market, to me is just sort of silly. I mean the Bank of Japan increased their balance sheet for decades, and the Nikkei had a marginal correlation to these changes. Or ECB also, the European stock markets performed, on a relative basis, horribly compared to the US stock market, and the ECB was ramping up their balance sheet. It seems like there’s very mixed evidence on whether or not the balance sheet expansion really is the… is that the Fed put?

5. Milan lab man brings unorthodox science to Premier League – Sean Ingle

The patient is lying half naked on the treatment table in a clinic not far from Harley Street watching his feet being pressed together, rotated, tested. His pelvis is checked and he is asked to open his mouth. Finally Jean-Pierre Meersseman, founder of the world-renowned Milan Lab and special advisor to Milan, speaks. “Your pelvis is tilted, one leg is shorter than the other and you have suffered from groin injuries,” he says, correctly. He then applies local anaesthetic to an impacted wisdom tooth and suddenly the range of movement in the right leg significantly widens. “Ah, just like Clarence Seedorf!” he exclaims.

“When Seedorf came to see me he had continuous groin pain which had been bugging him for a year and a half,” Meersseman says. “He couldn’t practise properly and was on a downward spiral. I remember the first day he was at Milan I had his wisdom teeth pulled out. The pain in his groin went away immediately and that helped rebuild his career.”

It is an anecdote that short-circuits the senses. It sounds too fantastical to be true. But this is Meersseman’s forte: doing the unusual with the unorthodox, combining his specialisms of kinesiology and chiropractic with traditional approaches. Still the question needs to be asked: what would the sceptics make of how he treated Seedorf?

“It’s not accepted in evidence-based medicine but I don’t give a damn about that,” he says, genially but firmly. “I’ve seen it work. We’ve done over one million tests at Milan. And our mathematicians and engineers have developed a formula which has a high success rate of predicting and managing injuries.”

Meersseman backs up his case by citing the steep decline in days lost to injury after Milan Lab was set up in 2002 thanks to a programme that also helped enabled Paolo Maldini and Alessandro Costacurta to play into their 40s, with Serginho and Cafu not far behind.

“Paolo Maldini was written off at 32 and he played another nine years,” Meersseman says. “And I remember when Cafu came in, somebody called me up – I won’t say who – and said I know for sure he is gone. He played another four years at a very high level.”…

…Meersseman was given the task of reducing injury rates at Milan after Fernando Redondo, the brilliant Argentina midfielder, suffered an injury that was to end his career shortly after joining from Real Madrid in 2000. The club asked itself: why did we not see that? They started to talk about prevention. And Meersseman starting looking for answers.

“With Redondo we did a complete medical examination when he signed – and I mean complete as it involved 10-12 different specialists, from the tip of his head to his toes,” Meersseman says. “He was in perfect condition. And then he was walking on the treadmill and he tore a muscle. I’d never heard of anyone doing that. He never really came back.”

So what changed? “Just by using kinesiology we are able to see better what is going on but that was my opinion against someone else’s,” he says. “That was one of the reasons why I started measuring everything. All the top clubs have cardiologists, knee specialists and so on – but sometimes it’s difficult to look at the whole and that’s what we are trying to do.”

6. RWH012: Fear The Fed w/ Jim Grant – William Green and Jim Grant 

William Green (00:18:35):

Then you went to Barron’s, right? From something like ’75 to ’83? And you originated the current yield column. And I wanted to ask you about that period because it must have been an incredibly formative period, because for those of us who… I was born in 1968. So I wasn’t really aware of what was going on at the time, but this great inflation that ran from 1965 to 1981 was forming the backdrop of your career in those days as a financial writer. And I wondered if you could describe for us for those of us who didn’t experience it firsthand, what you saw and how it shaped your views about the importance of sound money, fiscal discipline and the like. Because it must have been kind of a rude awakening to see. I think, didn’t inflation hit something like 15% in 1980? I mean it was a terrifying time.

Jim Grant (00:19:26):

Yes. Although it became rather… One became rather acclimated to it. I think never wholly adapted to it. But my goodness. Inflation rate had been tripping up since 1965. And the authorities then as today said, first of all, “Not us. Oh, we didn’t do it.” And then, “This’ll pass.” And then actually before very many years had gone by, William McChesney Martin, who was then the Fed chairman and a great rhetorical foe of inflation, would give these speeches say condemning it and vowing to slay it like a beast. But towards the end of 1967, in close confines of the meeting of the Federal Open Market Committee, he said, “The horse of inflation is out the barn.” So he was about ready to give up.

Jim Grant (00:20:21):

I said, “Most we can do is make sure this steed does not gallop too far, too fast.” So then ensued, year upon year, the deteriorating purchasing power of the dollar, of rising interest rates, of contracting, what we call valuations for stocks and the price you pay in relation to what the company can earn. Is valuation. Where we express this as a ratio of stock price to profits. Call it a price earnings ratio.

Jim Grant (00:20:53):

And during the good times the stock prices go up and people are going to pay a higher and higher price for a given dollar of profit. And when inflation hits and when interest rates go up, the opposite happens and people pull back and they’re willing to pay less and less per dollar of profit. And that was the story of this great inflation. There were of course ebbs and peaks and undulations. And one of the things that happened then, that I think is very great relevance today, is people were all too ready to declare an end to things when inflation receded. Now nothing says that today is going to repeat the experience of yesteryear. In fact, rather the odds are against that just simply because history is never… It’s never so helpful as to repeat itself literally, otherwise imagine how rich the historians would be. They say, and what they say is true, that one’s first experience in markets and with money is deeply formative, imprints itself on you. And the best investors, the nimblest and most successful are the ones who can put that formative experience aside, or at least put it into perspective and not imagine that they must repeat the experiences of their youth in their middle years. And perhaps that experience was too deeply imprinted on [inaudible 00:22:18]. I have, I guess, have seen inflation under rather too many bedposts, under too many mattresses as the years have gone by…

…William Green (00:45:07):

… No, it’s really good. And I’ll include a link to it in the show notes here. You said at one point the Federal Reserve is the most dangerous financial institution on the face of the earth, and then you described them as the handsiest people in finance, which I liked. So you were saying how they’re always meddling and having to improve and intervene and interject. Before we get to the current problem, is there just this illusion that it’s helpful to intervene and interject? Why … where’s the philosophical difference that you have and that someone like Jerome Powell, the Fed chief, has, in terms of believing that it’s worth meddling, or actually dangerous to meddle?

Jim Grant (00:45:49):

Well, I think that the Fed believes … I know the Fed believes, because they do this stuff, the Fed believes that they can select a rate of interest, a policy rate of interest, that will at once encourage maximum employment, minimize the rate of inflation, and keep the financial markets percolating. And I say, many of us say, that that rate is known not to God, but to individuals operating in a free and untrammeled market, and discovering, that word is price discovery, the phrase is price discovery, discovering a rate of interest. And what makes the discovered rate of interest better than the artificial or the imposed one, is the discovered rate of interest is the product of decisions taken by people who have no idea what their counterparties are doing, but they are all trying to maximize their own welfare, and the world. They all go to work in the morning, wanting to do better. They make decisions, so the conflation of these million decisions is going to give us a better outcome than the somewhat arbitrary and necessarily ill-informed pronouncements of the former college economics professors who populate the halls of the Federal Reserve.

Jim Grant (00:47:08):

We call this … we call the current standard, we call it PhD standard, a stigma from the gold standard or other standards of yesteryear, and ages ago, in 1930s, so that’s ages ago, a while ago, there was an economist named I think Henry Simons, University of Chicago, who said that business enterprise ought not to be a speculation on the future of monetary policy. That’s kind of what it’s become. Everyone has to know what the Fed is doing. The Fed has become ubiquitous, or handsy, as some politicians we know. It has become like the referee in the football game, or a soccer game. Or cricket or baseball. I’m trying to help you.

William Green (00:47:56):

Proper game. Cricket.

Jim Grant (00:47:59):

So when you get to know the name of the umpire or referee, you know that umpire or referee is not doing a job, not doing his or her job right. That person is supposed to be invisible. The game is the thing, right, and not the rules. When the rules are paramount, and the arbitrary decisions of the referees are paramount, that is not a game, it is a … I don’t know, Kabuki theater, whatever it is, it’s not the game we came to play. And I think that we’re not playing the game of enterprise as we ought, because the Fed is too much with us.

William Green (00:48:35):

So now we’ve explained to some degree the causes, the backdrop that led to this mess. Let’s talk in some detail about what can or should be done to fix it. So yesterday … this podcast will be coming out in a couple of weeks, but yesterday the Labor Department announced that inflation has been rising at a rate of 9.1%, cost of food was up, I think, 12%, in the last 12 months, electricity up nearly 14%, gasoline up about 60%. So first of all, I mean the most obvious question, it sounds so mundane, but I actually like to ask it, why is inflation so fearsome? Why is this thing that we’d kind of forgotten, this looming Loch Ness monster, beneath the surface of the financial waters, so terrifying? Why suddenly is everyone sitting up and saying, “Oh God, there’s a real problem here”?

Jim Grant (00:49:24):

Well Nessie, I think, might not exist. I don’t know for sure. But inflation was consigned to the status of Nessie by a generation of economists who, like preceding generations of economists, 1960s, believed that they had found the philosopher’s stone. And they, through their dextrous manipulation of this and that lever of policy, could forestall and ameliorate, as I said in the case of … Okay, so that was the conceit, but I think, to go back to a sporting metaphor, I think that muscle memory played a great part in conditioning everyone to expect everything except inflation. Now, if you were to simply ask the following question, the answer is going to be, yeah, inflation. And the question is this. What will happen when the government pays people not to work, when indeed it subsidizes the lack of production through various rules and regulations, when it materializes money as it has never materialized those dollar bills before, and as it borrows and spends in the space of 18 months as it has never done before. What is likely to be the outcome? And any schoolboy of yours would say, “Yeah, inflation.”

Jim Grant (00:50:47):

Notice that no one said, “Of course, inflation.” There’s a baseball story, 1968, Bob Gibson was the reigning pitcher in baseball. Imperious, majestic, dominating and domineering figure, was Bob Gibson, St. Louis Cardinals. He played with an infielder named Ducky Schofield. Ducky was very good in the field, not much of a batsman. Batsman, that’s cricket term.

William Green (00:51:15):

Yeah.

Jim Grant (00:51:16):

And one day Ducky strikes out, storms back to the bench and curses up a blue streak, smashes the water cooler, and Gibson can’t stand him. He summons Ducky to the end of the bench and points to his batting average, which was .226. He says, “Ducky, what did you expect?” So similarly, today, with inflation, what did they expect? Well what they did not expect was the obvious [inaudible 00:51:47] piece it together by all of us, but the fact that it was not obvious speaks to muscle memory and speaks to the conceit of the economic forecasting fraternity, and it speaks simply to, I guess, to the foibles of human perception…

…Jim Grant (00:52:19):

Ah, okay, I want to digress with a story. Years ago there was a bunch of medical scientists, got together to examine a cadaver discovered in the melting ice in the Italian Alps. This thing was called the Iceman, right? So the greatest heart specialist and physiologist, I mean, anatomist, people with a scientific interest in the human form, came to the relevant hospital in Italy to examine this Iceman, right? And they spent weeks going over it with the advanced tools then available to them, x-rays and things that I can’t know. And it wasn’t until the very end that someone said, “Yeah, there’s the arrowhead right there.” And the relevance of this is that … and the ones who missed it were so embarrassed and so humbled. And we wrote a piece about this and headline was Perils of Perception, and our story wound up that the scientists who missed this were not … they didn’t have financial … they weren’t leveraged in the market betting on some outcome. They didn’t have an options position open. They had no financial interest in the outcome. They were studying this as disinterested academics. They missed it. So we wound up saying, [inaudible 00:53:41], So how is it that with people through force of financial interest, client interest, how are any of us solvent, given all of the impediments to clear perception of finance?

Jim Grant (00:53:59):

So that’s why things periodically get so messed up. Everyone has a different set of perceptions, but the population of people who are paid to have a disinterested perception, it’s a very small population. And of course they are human, right?…

…William Green (01:03:04):

Is your bet that the US economy can escape a recession, or is your bet that it’s going to get pretty ugly? I mean, I know that-

Jim Grant (01:03:14):

Well, here we come face-to-face with personality and character and vested interest, right? So, what would be better for Grant’s than calling another disaster? I can imagine the motion pictures. I can imagine … a parade is probably a trope, but I can imagine our circulation going up a lot, so I-

William Green (01:03:38):

The Big Short Part 2.

Jim Grant (01:03:39):

Right? So, without obsessing on interior dialogue and motivation, what I try to do is to reserve mind share, mind space, for the not impossible outcome that things work out. The United States economy is something that has demonstrated the greatest resiliency over the years. And I mean, I think one hears rather too much about American … What is it called? American … not singularity, but exceptionalism, right? But America is exceptional in many ways. Certainly, its economic history is exceptional. There’s a can-do spirit here, there’s a spirit of enterprise that not even the Fed can extinguish through its maladroit policy maneuvers, or President Biden extinguish through recent elections, from the pulpit. So yeah, it’s possible that through luck, and maybe the Fed’s learned something.

Jim Grant (01:04:37):

So I think that the question then becomes, where do the risks lie, and where do the opportunities lie, given that the outcome is indeterminate? Are you being paid well to think one thing that is possible, indeed probably? Are there bargains, in other words, are there bargains that people are neglecting because the world was so single-mindedly focused on- And I don’t see many just yet, but we have a very good equity analyst here, who does other things well, but his name’s Evan Lorenz. He’s the deputy editor for Grant’s, and he does fabulous work in analyzing individual stocks. So, we had been very bearish on Facebook. But the current issue came out, and Evan did this fine work, and he says that Facebook is now buy. It’s cheap on its merits, on its earning power. It has been unduly punished for its foibles and its managerial errors. And now, we ought to pay attention, because it is now a value-laded stock. There’s a margin of safety.

Jim Grant (01:05:37):

So there are these opportunities cropping up. The risk is, I see this a lot in people who manage what’s called valued portfolios, is that the cheap stocks do go down with ones that are too expensive. I know of value investors who have suffered losses this year on the order of 20% or more, although they thought the stocks they owned were so cheap that they were inured to such things, but no. So it’s been a brutal year for many people. But in answer to your question, what we try to do is keep scouting for opportunities. We don’t see it in the bottom market, although if there’s a recession, bonds will go up in price, and down, and interest rates will fall, likely. We see opportunity in gold stocks, which are almost universally ignored and scorned. They’re about as cheap as they’re ever been in relation to the metal. But if the Fed is seen not to have the great answer, if the Fed is seen to be the institution you must protect yourself against rather than to trust in, in that case, this is an area, especially for as long as I’ve been alive, almost, in that case, gold’s going to do very well.

7. It’s OK to Be Bearish But It’s Not OK to Stay Bearish – Ben Carlson

Things don’t seem great at the moment.

The Federal Reserve is actively trying to push the stock market down. Inflation is the highest its been in four decades. Interest rates are rising. Both stocks and bonds are down double-digits from the highs.

There is a good chance the Fed will try to push the U.S. economy off a cliff right into a recession.

“Don’t fight the Fed” has taken on a new meaning when they’re openly rooting against the stock market.

It’s easy to be bearish right now.

Plus you have the fact that this is the first prolonged bear market since the Great Financial Crisis:..

…There have been a handful of corrections and bear markets since early 2009 but the only one that came close to matching the length of the current iteration was in 2011.

But the 2011 bear market (-19.4%…close enough) at this point was already in the midst of a recovery. We’re not back at the lows but the stock market has been heading back down yet again. And we’re now heading into month 9 of this drawdown.

It’s easy to be negative right now but it’s always easy to be negative during a bear market…

…Instead of going back and forth between being bullish or bearish, I prefer to remain calm-ish.

We already know stocks are going to be volatile. Why should you care about market fluctuations if you know they’re not going to last forever?

This bear market could last longer. Stocks could go down more. Or we could see new highs in a matter of months.

I honestly don’t know.

But successful long-term investing comes from letting go of the desire to pretend like you know what’s going to happen all of the time.

If you don’t need the spend the money in the near-term, you’re going to have to become comfortable with seeing the value of your portfolio go down at times.

And if you do need to spend the money in the near-term, why is it invested in the stock market in the first place?

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, we currently have a vested interest in Apple. Holdings are subject to change at any time.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 28 August 2022:

1. Once Science Fiction, Gene Editing Is Now a Looming Reality – Katie Hafner

Ask any expectant couple what they hope their baby will be, and one answer is likely to be “healthy.”

But one gene gone awry can imperil a child’s health, causing serious disease or a disability that leaves one more susceptible to health issues. With advances in gene-editing technology, though, biomedicine is entering an uncharted era in which a genetic mutation can be reversed, not only for one person but also for subsequent generations.

Public debate has swirled around genetic engineering since the first experiments in gene splicing in the 1970s. But the debate has taken on new urgency in recent years as gene modification has been simplified with CRISPR (short for Clustered Regularly Interspaced Short Palindromic Repeats) technology.

Scientists have compared the technology to word processing software: It acts like a cursor placed next to a typo, capable of editing a gene at a level so granular it can change a single letter in a long genetic sequence.

While still highly theoretical when it comes to eliminating disabilities, gene editing has drawn the attention of the disability community. The prospect of erasing some disabilities and perceived deficiencies hovers at the margins of what people consider ethically acceptable.

“People are understandably very scared of it, of the many different roads it could take us down as a society,” said Meghan Halley, a bioethics researcher at Stanford University and mother of three children, including a 5-year-old with a disability. “Broadly speaking, this is always going to be problematic because of the many things that disability means.”

CRISPR is widely seen as holding great promise for treating diseases that until now have been intractable.

There are two main types of CRISPR-based editing. One is the correction of a gene in an individual living with a condition or disease. This is known as somatic cell editing (“somatic” refers to the body). In June, NPR reported that Victoria Gray, a woman with sickle cell disease, experienced a significant decrease in her episodes of painful sickle crises in the first year after gene-editing treatment.

In the future, Ms. Gray’s children or grandchildren may be able to take advantage of the other type of CRISPR “fix”: an edit to the human germ line. This involves making changes to a fertilized egg that not only last  through the life of an individual but also are passed on to future generations.

This type of “inheritable” gene editing is inapplicable to conditions like autism or diabetes, in which the hereditary component is caused by many different genes. But it is suited to disorders caused by variation in a single gene. Sickle cell disease fits into that category, as do cystic fibrosis and Duchenne muscular dystrophy.

Yet bioethicists point out that inheritable gene editing raises large societal questions, given the dire consequences of an error, as well as the ethical questions that arise at the prospect of erasing disability from human existence. There is also concern that gene editing for health reasons will be out of reach for many because of its cost…

…The debate grew more heated in 2018, after a scientist in China announced the birth of the world’s first gene-edited babies — twin girls — using CRISPR to give them immunity to H.I.V. The announcement generated outrage around the world. In December 2019, a court in China sentenced the scientist to three years in prison for carrying out “illegal medical practices.”

Last year, a group of scientists from seven countries called for a global moratorium on changing inheritable DNA to make genetically modified children.

Professor Halley’s middle child, Philip, was born with multiple anomalies of his gastrointestinal system. In addition, Philip has had a succession of health complications, including a stroke just before age 2, leading his doctors to suspect a still-unidentified genetic disorder.

Families like hers, Professor Halley said, offer good examples of “very ripe cognitive dissonance” around the topic of inheritable gene editing. As a mother, she said, she would do anything to prevent the pain her son has been through.

Yet she is aware of the inconsistency between that desire and her unwillingness to “do anything that would take away him, take away who he is,” she said. “And he is who he is partly because of the challenges he has faced.”…

…That ambivalence toward gene editing was reflected in a 2018 Pew Research Center survey, which found that a majority of Americans approved of gene editing that would result in direct health benefits while they considered the use of such techniques to bolster a baby’s intelligence to be going “too far.”

The survey also found that the biggest worry was that gene editing would be available only to those who could afford it.

“That’s a critical ethical issue,” Dr. Marson said. “We have a real responsibility when we develop these technologies to think about how to make them scalable and accessible.”

2. Mark Tomasovic – ChargePoint: Leading the EV Charge – Jesse Pujji and Mark Tomasovic

[00:06:27] Jesse: Talk about how they evolved with the industry. It’s somewhat of an obvious business model, electric cars on the road. Something needs to charge them. Let’s make the stuff that’s going to allow them to be charged all over. But how has the industry evolved? What are sort of the important pieces to understand, if you’re going to get into a business like this?

[00:06:43] Mark: If we go back to that 1% number, 1% of the total number of cars on the road today are electric. What that means is there’s 2 million electric vehicles in the US. And what that means is one in every 15 cars sold in the US is an electric vehicle. So about 7% of all cars sold today in the US are electric vehicles. But what we’ve seen historically in other countries, for instance, in Norway, when a country reaches 5% adoption of electric vehicle adoption in new sales, a tipping point occurs and the adoption becomes exponential. And we think today we’re at that tipping point. And just to put it in context, in 2018, there were 12 car commercials that ran during the Super Bowl. None of them were for an electric vehicle, but this year there were nine car commercials that ran during the Super Bowl, and seven of those nine commercials featured an EV.

So it’s still pretty early and overall relative market share of EVs versus combustion engine vehicles. But we think over the next five years, the US EV growth rate will be a 40% CAGR. And we’re going to four X the total number of EVs on the road by 2027, as there are today. So a lot of those kind of going back to your question on what’s causing EV charging infrastructure adoption. A lot of that adoption is based on the improvement of battery technologies, which is decreasing the cost of electric vehicles and increasing their range and making them broadly more affordable and more attractive to the average consumer.

[00:08:19] Jesse: And the infrastructure, who are the players in all of this? Not just competitors, but even the value chain a bit. It seems like ChargePoint has the vast majority of market share, but help us break it down a little bit to better understand it.

[00:08:30] Mark: There’s about four main players across the whole EV charging infrastructure layer. And the first is the equipment supplier itself. So the first is people like ChargePoint, that are the hardware OEMs, or the OEMs at the physical charging infrastructure. Their role involves engineering and manufacturing of the chargers. And we think of this space as a pretty competitive space. So we expect over time that margins in the hardware OEM category will decrease, as the hardware becomes more commoditized. And so these suppliers will have to find some way to differentiate, which could involve having yet unique, go to market motion, or unique partnerships, or involve selling proprietary software systems to run their chargers. And they’ll have to figure out ways to be cost efficient in how they source and manufacture their products. The second important part in the value chain is that software layer. As I mentioned, one way that the equipment suppliers could differentiate, is by offering software systems to run their chargers. And these software systems provide capabilities like payments and the ability to lock and unlock charge points and see into ChargePoint performance and even manage electrical load on the chargers themselves.

And so a lot of the hardware providers, the OEMs of the equipment are really good at building hardware, but they’re not really good at building software. So there’s this whole second ecosystem of just software providers that can work with certain types of hardware, or across all different hardware types.They’ve really established themselves as software only capital like businesses, that are just the operating system for hardware, for the charging infrastructure itself. The third player in the value chain is the installer and the installer is, think of them as mid to large scale electrician shops. Some of them are specialized charger installation companies, or engineering and procurement firms that offer turnkey solutions, this super fragmented, low barriers to entry. They actually do the physical construction installation. And then finally the last players are the site owners and the ChargePoint operators. And the site owners typically the one that owns the physical real estate and sells the electricity. And if they don’t want to operate the actual charger itself, then they’ll hire a ChargePoint operator that can monitor the charging status and coordinate maintenance.

[00:10:47] Jesse: How do the auto manufacturers play into this? How do they have relationships with ChargePoint, or what’s their relationship to this world?

[00:10:55] Mark: Yeah, well, auto manufacturers like to stay agnostic, because the goal of the auto manufacturer is decrease range anxiety across potential customers. And what I mean by range anxiety is, the inability to find a charger when you’re traveling across the state or traveling to work. It’s one of the major reasons why people are hesitant to purchase an EV, is because they feel like, “Hey, if I need to travel a couple hundred miles, I won’t be able to fill up, like I do a traditional gas station.” The auto OEMs like to stay agnostic to the different types of hardware players, because they want to minimize range anxiety and they want to sell more cars. What’s interesting is, ChargePoint has actually been able to capitalize on this by partnering with a couple auto OEMs. So ChargePoint has what’s called an open-wall network. And so, any auto OEM can charge on ChargePoint chargers, and ChargePoint has partnered with a couple of these OEMs so that you can have the ChargePoint app as part of your car’s dashboard. And so, you can control things like payments, reserving parking spots, from the ChargePoint app in your car.

[00:12:07] Jesse: Whenever I’m with my dad in his Tesla, he’s searching in Tesla, and is he finding ChargePoint things or they have their own system? And how do you view that?

[00:12:14] Mark: So Tesla is a closed-wall network. So if you want to use a Tesla charger, you can find Tesla chargers that only work with Tesla vehicles, to do things like super fast charging, where you can charge your vehicle within 30 minutes. But you can also use Teslas on ChargePoints. For instance, because ChargePoint likes to stay agnostic to the type of auto OEM brand.

[00:12:37] Jesse: They say at Switzerland they’re like, “We’ll charge anyone. We don’t care.” And obviously if you’re a gas station or whoever wants to buy these things, you want it to be open to as many people as possible.

[00:12:46] Mark: Exactly, because the gas station will make a margin on the electricity that they sell. And also, in certain instances, if you have a charger at your location, then it becomes a strategic advantage because the folks that are charging can come in and buy your products, whether it’s at a grocery store or a retail location or something like a gas station.

[00:13:07] Jesse: You guys expect this market to be very competitive over time. What do people compete on? What are the big areas and why is ChargePoint winning so far? And why do you think they’ll probably continue to keep winning?

[00:13:19] Mark: When we look across just the overall EV charging infrastructure and landscape, it is a land grab. It’s a physical land grab, because you’re out there and you’re trying to secure these parking lots or these locations before anyone else does. So ChargePoint definitely has the first mover advantage in this land grab. They were the first to market for all intents and purposes. They’re the first public company in this space and they developed significant first mover advantage before many of their competitors. So I would say overall, first mover advantage is a clear advantage in the space because the hardware is getting commoditized. The second advantage are things like, being able to offer services that make these ChargePoints relatively simple and easy to maintain with high uptime. So if I’m a ChargePoint owner and I want to have ChargePoints at my apartment complex, for instance, I don’t know how to operate a ChargePoint.

I don’t want to deal with it. I don’t want to schedule maintenance. I want someone else to do that for me and ChargePoint, because they offer their proprietary app and they also offer other services, like ChargePoint Assure or even one called ChargePoint as a Service. They can be this fully integrated, hands off solution, where they say, “Hey, buy our hardware and buy our services, and we’ll take care of it all for you.” So that becomes an advantage, because it becomes relatively low touch for the actual ChargePoint owner themselves. I would say the third is actually partnerships too. So if I’m ChargePoint and I need to acquire site-by-site retail locations, there’s not very much distribution leverage in that. And it becomes really difficult and high customer acquisition costs, if I need to go around to individual shopping malls or whatever it may be, apartment complexes and acquire these individual customers.

But if I can form relationships with the installers, the local electricians, the engineering and procurement firms, for example, and I can have those installers recommend ChargePoint to their networks. Well, then I just gained a whole bunch of distribution leverage. So I can have one partnership with one installer, and then let the installer recommend the hardware and recommend the ChargePoint software on top of that. And so, ChargePoint has done a really good job of forming these partnerships within the industry, whether it’s with the auto OEM themselves or with the installers, or within real estate owners that own massive amounts of real estate across the US…

…[00:19:36] Jesse: How much does one of these things cost?

[00:19:37] Mark: They can be expensive. Let me use this quickly to get into the difference between level one, level two and level three chargers, because they all have various degree of costs. Level one chargers are, what are called trickle charge chargers. And what they’re used for is, primarily charging your EV at home, overnight. So they plug into your standard 120 volt household outlet. They usually require no installation costs, and actually most EVs are sold with one of these level one chargers. They charge at a rate of one to two kilowatts, which means it can often take several days to charge a full car battery. The second type of charger is a level two charger, and these chargers can be found in the home, the workplace or public settings. And if you want to install a level two charger at home, they require a 240 volt outlet, which is typically what you would need for your washer and dryer.

The level two chargers are more expensive. They’re about 10 to $30,000, but they can charge significantly faster than those level one chargers. So the level two chargers can fully charge an EV between four to 10 hours and over 80% of public charge points in the US are level two chargers. So they’re great for places where your car is stationary for a while, which is workplaces or parking garages, things of that nature. And then finally, ChargePoint also sells level three chargers, and level three chargers are also known as DC fast chargers. These can charge your car in about 20 to 30 minutes, but the downside is, they’re significantly more expensive. So a level three charger can cost over $150,000. And a site upgrade for a level three charger could be over a million dollars for a site. So currently, they only make up about 20% of overall chargers available in the US, but they work well with fleets and they work well in locations where you need a quick charge. So in highway corridors, for example…

…[00:33:14] Jesse: Can you speak a little bit to the regulatory environment?

[00:33:17] Mark: We’ll, mainly focus on the US here, but first there’s obviously the infrastructure bill. So in November of last year, the infrastructure bill was passed in the house with $75 billion of investment in EV charging over the next five years, which includes $5 billion of corridor charging for highway corridors and then $2.5 billion for alternative fueling infrastructure to support Biden’s executive order. But actually, there’s also electric vehicle tax credits, which we expect to contribute to the overall adoption of EVs in general. And certain EVs can get up to a $7,500 tax credit. If they’re currently purchased from companies who have sold less than 200,000 electric vehicles.

So this will change with the inflation reduction act, but currently it doesn’t apply to Tesla, GM or Toyota, but there are EV tax credits available for these other brands where you can get up to $7,500 if you are to purchase an EV brand. And then finally the LCFS. So LCFS is the low carbon fuel standard. It’s an emission tradings act enacted in California and 2007. And if a fuel has a carbon intensity lower than certain guidelines, that asset can create an LCFS credit. So ChargePoint can actually create these credits by selling electricity in California, and then those credits can be sold to other regulated parties under LCFS.

3. Meditations: A Requiem for Descartes Labs – Mark Johnson

Descartes Labs was on a mission to better understand our planet through satellite imagery. To enable such a lofty mission, we built a data refinery, a petabyte scale repository of satellite and other geospatial data combined with petaflop scale supercomputing power. Because of our platform, we attracted some of the best scientists from around the world, often fleeing universities and government institutions, looking for an intellectual island to do impactful science. Our Cartesians built some of the most remarkable demonstrations of technology I’ve ever seen in my career.

Even with almost $100m of invested capital (strangely, Crunchbase doesn’t list the last two rounds), >$200m in total going into the company (revenue+investment), ending 2021 with over $17m in revenue, and multiple 8-figure government contracts, the company was sold in a fire sale.

Writing that sentence is absolutely shocking to me. How is it possible that a company with an incredible team, so many successes, so much revenue, and so much invested into the underlying technology could possibly be worth close to nothing?

Given the wild ride of Covid and the economic rollercoaster ride we’re currently on, it’s easy to dismiss Descartes Labs as a victim of macroeconomic circumstances. I don’t believe that to be the case and will make the argument that there were two main reasons for the mismatch in the actual value of the company versus the price that was paid:

1. The company was burning too much cash.
2. The sales process was run poorly. (i.e., the process of selling the company)

At fault is the management team, who executed poorly, and especially the board, who knew these facts and chose to do nothing…

…Though I, too, was extremely skeptical of their business plan, I hopped on a plane to New Mexico on Bastille Day 2014 because I had been obsessed with The Manhattan Project since I was a little kid. When I met the cofounders, I was blown away by their brilliance and humility. Immediately after that first meeting, I knew we needed to start a company.

By the end of 2014, we had settled on satellite imagery instead of media search, we created a company, gave it a “temporary” name of Descartes Labs, raised $275k in angel capital by October, signed a deal with LANL, and closed a $3m seed funding with Crosslink Capital in December of 2014…

…And did we ever! After releasing our predictions ahead of a very important US Department of Agriculture (USDA) forecast, we singlehandedly moved the market 3%, thanks to a well-timed Bloomberg article. Even though we moved the price in the wrong direction (2015 wasn’t our most accurate prediction), it didn’t matter. Big agricultural companies who weren’t returning our phone calls started answering and we were able to raise another $5m from AgTech VC Cultivian-Sandbox.

In 2016, we focused on selling our global agricultural yield forecasts. Cargill, the largest agricultural company in the world and largest privately-held company in the US by revenue (~$130b), approached us with a challenge: could we combine our data with their proprietary data to create better models for their agricultural supply chain business. After many months of hard work, Cargill decided to partner with us, becoming both a customer and an investor.

It’s hard to understate the importance of Cargill to Descartes Labs. Not only did the relationship provide revenue to the company, allowing us to raise a Series B and hire a lot more people, but the thought partnership between Cargill and our team helped us to figure out who we were. They realized before we did that the magic of Descartes Labs wasn’t in a SaaS product to democratize satellite imagery. No, we were a modern AI consulting company (cf., Palantir) who had assembled brilliant minds, built an internal set of tools that gave our scientists access to huge amounts of data, and created a collaborative internal environment to solve complex problems…

…By the end of 2016, we were feeling pretty good about defying the odds of being a New Mexico spinout of a National Lab. We were even profitable in Q4 2016, unheard of for a science startup.

Descartes Labs had become the Miracle on the Mesa.

All the while, a debate was brewing within the company, known as the Descartes Labs Dialectic: are we building a product or a services company?

Descartes Labs crossed $10m of revenue in 2017, typically a massive milestone for software startups. The problem was that 90% of our revenue was in just a handful of accounts. Thanks to a brilliant cofounder in sales and a technical team to back up whatever custom deal was sold, we scored some really big wins for ourselves and for our customers.

The problem was that we hadn’t built any products yet.

Our corn (and eventually soy) forecast was a product of sorts, but we had trouble selling it. Proving that it had “alpha” (i.e., an edge that gives a trader an information advantage) was difficult and the value of a straight forecast was limited. I came to believe that selling data products was the wrong business model for AI startups. (A post from a16z penned by two of their partners in early 2020 is an even better statement of the sentiment.)

Another potential product was the underlying data refinery. Perhaps we were building a platform? We used it to great effect with our customers in building custom models for them. But, the companies that could derive the most value out of our platform were typically in commodities like agriculture, shipping, metals & mining, and forestry. They didn’t have the technical expertise to extract the full value out of the data or computing power within our platform.

We, like many AI companies like Palantir, were a hybrid consulting company: we built a robust platform that we were the best in the world at using and charged our clients lots of money for building unique, extremely valuable, proprietary (read: cannot be sold to others) models. Even if we structured the revenue cleverly by selling our customers a platform subscription and subscriptions to the models we built for them, we still weren’t a SaaS company.

If I could go back and change just one thing, it would be the resolution of the Descartes Labs Dialectic. I would have shut down internal debate in the company from the crowd that thought we should be building a software company. I would have been much clearer in our fundraising decks about what strategy we were pursuing: AI companies can build an enormous amount of enterprise value though specialized consulting contracts.

I succumbed to the market narrative, pushing startup founders to pursue a Software-as-a-Service (SaaS) business model.

To “solve” the Dialectic and package Descartes Labs as a software company, we separated the team into the Platform Team and the Applied Science team. The Platform Team built the tools and the Applied Science team built the models. Our typical customer engagement started off with a pilot project, usually around $100k, and our theory was “land-and-expand” (another popular SaaS trope): grow the small account into a much larger account, paying >$1m / year. Even though we were taking consulting contracts in the short term, in the long term, a product would emerge from the engineering team.

Or, at least that’s the theory on which we raised our $30m series B from March Capital in the Summer of 2017. Series B was another pre-emptive round, raised without me having to go through a full process and shake the money trees on Sand Hill Road. This new capital was intended to grow our sales & marketing team, build out our “product,” and move into a growth stage so we could raise a healthy series C.

Looking back on Series B, I’m conflicted. On one hand, I absolutely believe in taking money when it’s available. In 2017, we were 8 years into a bull run and we wondered how long the gravy train would keep running. On the other hand, when you take a big round, it’s important to be prudent with the cash and expand only when you believe that there is a viable business model. This requires investors and the company to be aligned around what constitutes product-market fit and what signals indicate that the business model is ready to be scaled.

In 2018, we scored a few minor wins, which kept our revenue up and to the right, close to $20m. Thanks to superior performance against our original DARPA contract, we were able to translate that contract into a much larger deal to build a geospatial data refinery for the government, in a contract worth up to $7.2m. We also made a considerable amount of progress booking pilot contracts from $50-$150k, not bad for initial projects. For 2019, our plan was to continue that pipeline of pilots and translate some of those pilots into large, multi-year 7-figure contracts and we’d be flying high.

However, by the end of 2018, we realized that our land-and-expand thesis was encountering roadblocks. We were losing money on pilots (read: negative gross margins) and translating those pilots into larger deals was difficult. Predicting revenue was nearly impossible (read: not a repeatable business model), driven by long lead times and uncertainty around how much value our pilot projects would deliver to the customer.

Things got dicey around our Q4 2018 board meeting, where we presented our 2019 plan. We projected that 2019 would be a 50% increase in revenue year-over-year, given that we hadn’t quite figured out our sales process or product . The board was not pleased, they wanted to see a much steeper growth curve.

Now the Descartes Labs Dialectic reared its head. Our investors wanted us to be a SaaS company with SaaS metrics and SaaS growth. We simply were not. We should have structured our entire business around being a high-end consulting company. Perhaps we wouldn’t have gotten SaaS multiples. Perhaps. Or perhaps we would have focused our energy on what we did best. I’d rather have $100m / year of long-term consulting contracts than burning expensive venture capital on a fantasy SaaS product.

Ultimately we capitulated to the board’s desire for an unrealistic revenue expectation because, in my mind, isn’t that what I signed up for when I raised the money? Unfortunately, it caused the company to focus on improbable but high-value deals instead of getting our product philosophy and sales strategy in order. By pushing us into unreasonable growth expectations, the board drove us to hit our numbers in the short term, not build a long-term engine for growth.

4. Robert F. Smith – Investing in Enterprise Software – Patrick O’Shaughnessy and Robert F. Smith

So Robert, I was toying with where to begin our discussion. And because we’re in such an interesting market for software companies, let’s say, if you just looked at public equities where multiples have come way down, my first question is one of perspective. You’ve been investing in software, maybe more specifically enterprise software, for a very long time. I think if you have to find the right pond to fish in, you found this pond earlier than most. Maybe just lend some perspective to us on what this market looks and feels like to you versus your long history backing these sorts of businesses.

Robert [00:03:03] The whole reason I even got into this space, I started my career as a chemical engineer. It was at a time when we were really doing some interesting things in that area. And part of it was we were digitizing the operational elements of what we call unit operations, i.e., running plants and facilities, et cetera. And we were going from an analog model, where you’re, what I call, observing an event, might be a reaction, a state of reaction, and then making the adjustment, adjusting various inputs to modulate that reaction.

Well, when you introduce computing technology into that environment, you go from an observation being episodic or periodic, depending upon who’s the operator and what they happen to be thinking about at that moment in time or human foibles, yes, exactly, literally, to you’re actually measuring the output of a system thousands of times a second, which gives you the ability to then make changes to the inputs at a similar rate. The nature of that is it actually eliminated a tremendous amount of waste in process industries.

And then once Moore’s Law kicked in and computing capacity became more readily available and the insights and the skill sets of people like myself and others expanded to our colleges and university systems, we’re able to bring that productivity into the broader industrial environment and then, of course, the office environment, where we went from doing things quite manually in the office environment to automated, things as simple as Word processing and calculations and spreadsheets and ultimately utilizing things like artificial intelligence to aid in decision-making, created massive efficiency and productivity in our economy. The insight around all of this was, well, at the end of all of this, that is enterprise software, business software that ultimately has now been identified as the most productive tool introduced in our business economy over the last 50 years and likely for the next 50…

...Patrick [00:05:53] If you think about the percent of the time that a given person that’s a professional working somewhere or spends in some form of software, it’s crazy high. I don’t know what the percentage is, but it’s really, really high. And I think about it almost like an oil well or something, how much is there left to mine or extract of people’s time and their workflow? And my question is how mature it feels to you in the world of enterprise software. Like in the one sense, we’re all using software all the time, so it seems like it’s a penetrated story. Like lots of people use software in their daily work all the time. When you got started, that probably was much less the case. As you think about the next 50 years, what drives that? Do you share that sense that there is some saturation in this market? We’ll talk about the business model and a million other things in a minute. But just at a high level, how far into this does it feel to you?

Robert [00:06:41] Not to be too much of a cliche, but we are in the early innings of this. You have to remember, in the early days, the access to computing power was the rate-limiting step. It was like who could afford a computer? Governments and large corporations and ultimately, universities, et cetera, and then you went through the micros and the minis and now the next generation of this, the superscalers, even the hosted computing systems, cloud computing is how people really think about it.

What that has done, in many cases, you look at some of these businesses that have multibillion-dollar valuations, all they really did, in some cases, was to digitize a manual workflow. There’s some that you can think about now for managing sales flows. Before, you had a bunch of salespeople sitting around, and they put together their information about, “Oh, yes. All right. Here’s what I think I’m going to do, and here’s my prospect list.”And they’d send it to the regional manager, and that person kind of moved their Ouija board around and say, “Here’s what I think it is.” They’d go to the national manager and then they report to the CEO and the Head of Finance and, “Okay, here’s what we think our sales are going to be for this month, this quarter, this year,” whatever it might be.

And a lot of big companies, actually what they’ll do is they digitize that. But did they really bring any insights or start to create predictive analysis? That is just now starting. That’s why I talk about the data that now has been digitized across these systems is now accessible. And then you can start to implement algorithmic systems on those to now make it predictive and a little more accurate and, in some cases, now reach forward and saying, “Here’s where you ought to spend your time.” Or how do you now bring in 2 or 3 of those systems and platforms together so that it’s not just one system of record, i.e., what your salesperson put in, but also starts to evaluate what your customers are actually doing every day. What are their buying and spending patterns? And that confluence brings some insights into that.

If you think about it, I call it the second order effect of enterprise software, which is data. The analytics of that data is in its infancy. And that is where the actual true expansion of productivity will now come. I do think there’s a lot of opportunity set there. I think it is orders of magnitude bigger than what we’ve seen in the productivity to date but is going to continue to require the adoption, I’ll call it, of the platforms and then, of course, the application of the analytics on top of those platforms.

And frankly, there are constraints still around how we do that. One of the biggest constraints, of course, is finding capable people. We always talk about this war for talent in our space. 7.5 billion people on the planet, there’s only 29 million of us who write code for a living. I mean it’s the most productive tool out there. It impacts every business. During the time of COVID, we all “went home” or went to some place I wasn’t working. We’re accessing our work through these systems, but there’s only 29 million of us who actually write the code for those systems…

…Patrick [00:14:33] If you think about the landscape, if I had every single eligible, let’s say, enterprise software business in the world together and I wanted to arrange them in a room from lowest quality to highest quality, they’re not all created equal, right? Everyone seems to have come to accept that software businesses can be the best businesses in the world based on just some economic features of them, but some are very bad. So if you think about that spectrum from bad to great, how is the spectrum itself defined? What’s a Vista company? What are the qualities boiled down that are most critical to you when evaluating one of these businesses?

Robert [00:15:07] Sure. And I’ll give you some of the things that are critically important to have and some of the things we really do, I’ll call it, in a differentiated way versus anyone else out there. So look, everybody knows the nature of enterprise software lends itself to what we call these mission-critical, business-critical type of businesses. And if you run them well, you’ll have high retention rates with your customers. You’ll be able to have businesses that have visible recurring revenue components to the business. Those are things that we look at, not surprisingly, and understanding the quality of all of those elements and what are the quality of the relationships and the quality of the product. Where are they in the stages of what I call product superiority? And then what are the elements of execution excellence that the company needs to emphasize or support?

But on the other side, and this is when people get it wrong, they get it wrong here most of the time, of the businesses, the enterprise software companies that have failed and gone bankrupt or had all sorts of financial challenges, it’s because, typically, they have too much technical debt. Most people don’t really understand what that is. They think about debt in terms of financial debt. But technical debt is compounding. And as you write code over a year, 5 years or 10 years or 20 years, often, if you don’t take the right product development approach to it, you create a tremendous amount of code that has some flaws. It has some bugs. It has some architectural idiosyncrasies that might work for 8 customers or 200 but not for the other 5,000, that every time you make an upgrade in the code, you have to go back and make those adjustments, so that your customers’ products continue to work with their solutions, how they use and continue to work. And that is often an oversight for almost every investor that I know of outside of Vista that they don’t really spend enough time on that.

And if and when you do, this is when we take a pass on a company, it’s often because they have too much technical debt relative to the pace of the market that they are in. We have a whole set of best practices around reducing and then ultimately eliminating technical debt. To me, that is one of the more liberating elements that one can do in managing these businesses. And it’s not something that you just naturally know how to do as an investor. A lot of investors think, “Oh, let me just buy a good company and hope the management team can figure it out.” But you’d be surprised at how many management teams I know that we spend time with in due diligence evaluating businesses that actually don’t really have a sense for the amount of technical debt that they currently have and never thought of that, yet they provide increasing levels of resources against managing their existing code base and not really realizing that they’re losing ground every day because they actually haven’t taken the right approach to eliminating technical debt. They just figure it’s just the cost of doing business…

…Patrick [00:20:32] And in terms of just now software has become so proliferated, there’s lots of subcategories. There’s cyber software, there’s critical market, operating system-type software. Are there categories that you’ve gravitated to or away from that you feel most lend themselves to this sort of engineered approach that you’ve outlined to managing them?

Robert [00:20:51] There are some industries where the participants, the software providers have relinquished or given up a lot of their intellectual property to their customers. You think about pharmaceuticals, those are sort of areas, for instance, where, often, the end user environment is so concentrated, they actually have the market power in how that software and that code advances. We look for more broadly distributed customer bases, where you don’t have high concentration risk in your customers, and we look for where there’s actually still a high ROI, return on investment, of the products that you were selling to your customer base. I mean this is just an internal statistic. But we measure every year what’s the average return on investment for the products that we sell to our customers.

Think about we have 80-plus software companies, 300 million users of our software over, I think, it’s now 2.2 million customers, I think 800,000-plus enterprise, 1.4 million small to medium businesses. But we look for what is the value of the software that we’re selling. The average ROI of the products that we sell to our average customer is 640% ROI. Now think about it. There’s very little business investment that you can make that gives you that level of ROI. So a small to medium business, actually typically higher, more like 900% enterprise, depending upon what it is in terms of the product, again the average is 640%, maybe a little lower. But what that says is your next incremental dollar, as almost any business in any industry, is best spent on buying more software.

Patrick [00:22:24] How do you measure that? That seems like a hard thing to measure and capture.

Robert [00:22:27] Not really. It’s as simple as if I implement, pick it, a solution for payroll, okay, if I implement — this is old school, but just how many payroll clerks do I no longer need if I implement a payroll software system? Pretty easy to calculate. Here’s how much it costs, all right? Or waste, how much of a waste do I eliminate by implementing this software solution to measure some energy usage or something? It’s math at the end of the day, and you’ve got to have some analytics around the math. But that’s what we do. And we do it for every one of the companies. And so that gives you a sense for, okay, here’s how valuable that software is to that industry. Media industry, “Okay, if we give you this system to manage how your media spins or buys are done, how much more efficiently can you promote and/or sell it? How fewer resources do you need to develop or to devote to that activity?”

Robotic process automation, so you asked me an earlier question about, “Okay, where are we in the inning?” Okay, if you’ve got a bunch of people going around and doing some clerical work, let’s say, and moving one set of data from one system to another day-to-day, I call it a swivel chair kind of an enterprise, pull it out of one system, put it in another, versus put a robotic process automation system and, guess what, ROI is massive. It could be as simple as transaction reconciliation, how you reconcile a purchase order versus what was shipped. And if that’s done manually versus put an RPA system in it, guess what, you get massive, massive implications of ROI.

Patrick [00:23:56] So the 640% or whatever the number is, that napkin math is an absolute no-brainer for the customer. If we take that napkin math, I’ll call it, IRR napkin math now to the investing side, as you think about what you’re willing to pay in terms of a multiple, let’s say, for one of these businesses, how has that evolved over time? Like public multiples on enterprise software got so crazy a year ago, and now they’ve come basically back down to their long-term norm. But what are the key things in the napkin math that you’ve evolved over time as you think about the price you’re willing to pay for a single one of these businesses?

Robert [00:24:26] We kind of look at it in 2 buckets: there are the companies that are growing faster, and then there’s what I call the companies that have met their addressable market and they’re operating on a profitability metric, take out the last 6 months. But the prior 2 years has been the most frothy from a valuation perspective that we’ve seen in the history of enterprise software and the history of software, period. We at Vista took advantage of that and took 6 companies public and sold into that market. Valuations are rough, guess what, let’s sell into that market, right? And we actually were one of the few, and actually one of our investors pointed that out, that actually decelerated in the investing in that marketplace in terms of public market, not in the break of investing, but public market, which were really experiencing those lofty valuations.

Interestingly enough, we actually maintained the same market multiple. It actually biases down over those 2 years that we did than the prior 5. We used a thing called a growth adjusted multiple in the first, call it, half of the decade. A growth adjusted multiple, on average, in the overall market was like 0.43. The market in the last couple of years maxed out at twice that amount, 0.93.

Patrick [00:25:42] And what does that number mean? What is the growth adjustment?

Robert [00:25:44] How do you think about a price revenue growth multiple? What’s the price that you’re paying something relative to the growth multiple of that business? So you’ve heard of PEG ratios, price-to-earnings ratio?

Patrick [00:25:56] Yes, of course. Sure.

Robert [00:25:58] Rather than earnings, for a fast-growing software company, use revenue. So you do that, and you divide it basically by the growth rate of that business. So it’s kind of doubled over those 2 years. Our average was still, over the last 2 years, below that 0.43. Whereas the market went as high as 0.93, the market average went to 0.61, 0.62. These are people buying into these enterprise software businesses. We’ve always maintained a very disciplined approach to how we buy those businesses. In the last couple of years, we’ve been buying them at half the price the last 2 years of the overall market. The vast majority of those businesses we bought the last couple of years were private.

We only did 2 take privates in that period of time. Whereas any time there’s a downturn, we took 6 before that and 2 before that, 2 before that in terms of public to private type of models because those public markets were experiencing those lofty valuations. That’s one way that we really think about it, really evaluate and understanding that when the markets are being lofty, that’s a good time to sell into them, not surprisingly, makes sense. And when the markets have come down where they are today, and if you look at our overall market, these growth adjusted revenue multiples back down towards 0.41 type of a level, which is just slightly above where we’ve been buying our companies over the last couple of years.

Patrick [00:27:15] What have you learned about the role of churn, like customer churn inside these businesses? That seems to be a variable that’s coming at me from every direction, that this is the ultimate arbiter of revenue quality for a software business, not net dollar retention but just actual customers leaving and why. What did you learn about that over the 22 years?

Robert [00:27:34] We have a couple of metrics. One is recurring revenues, and one is retention rate. And we look at net dollar retention rate as an important statistic or KPI that we measure. In many cases, I mean, our overall portfolio, which is, whatever, call it fifth-largest enterprise software company if you just added all of it up together, over these last 2 years, it’s a 104% net retention rate. Think about that. That’s pretty staggering in terms of, okay, showing that what we provide to our customers is of value. The thing you have to think about in an environment like this, in a recessionary environment is, okay, where do you get that churn? We just walked through the mission-critical nature of these businesses, the actual ROI of the products that we sell to our customer base and how important it is.

So if you’ve got churn, you’ve got to look at it. Is it because the customers picked another solution or they went out of business? If they’ve gone out of business, is there some fundamental underlying element of that industry that you’re serving that gives you some suggestion that this is not one that you want to necessarily invest in?

Our teams — and I’ve just got a marvelous investment team, frankly, really think about that and unpack that and get very granular by geography, by segment, by customer, by customer size. And we really spend a lot of time on it to understand, are there some inherent issues with the industry or the product’s position in that marketplace that should give us some pause or confidence on how mission-critical, business-critical, not only the solution is, but that specific solution is with the company that we’re evaluating or the company that we own? And then that informs us as to how we bring forward our value creation motion and what are the things we want to focus on. Because that may inform me, guess what, here’s a segment in the marketplace that we need to spend more time on or invest in or build a different set of solutions for or enhance, call it, the go-to-market opportunity with that segment.

5. An Interview With Eric Seufert About the Future of Digital Advertising – Ben Thompson and Eric Seufert 

Let’s start there. Walk me through SKAdNetwork 4.0 and the changes that are coming.

ES: SKAdNetwork 4.0 is basically like a page one rewrite of SKAdNetwork. It seems like they just burned down the schematic and built something totally new with a blank page. It’s better across the board and so all credit due to Apple, this is a welcome change, I think there’s a lot of potential here. I wrote a post about it, there’s a lot of detail.

There’s three big buckets of change — really four but three that I care about. Basically at a high level, big concept, SKAdNetwork 3.0 very much operates on this binary conception of privacy, you either surpass some threshold that Apple has determined for privacy or you don’t, and if you don’t, then you get almost no in-app context back in the postback that gets sent, you basically just get an install log but it’s sent on this random timer system and so you don’t get it in real time, you get it on this delay. There’s this privacy threshold which is not public, we don’t know if it’s dynamic, there’s a lot of mystery around it. But either you surpass that or you don’t in terms of the number of events that have been captured from a specific campaign from a specific app, and if you don’t then you get no context.

What they’ve done is they’ve added gradations now. It’s not just binary yes or no, but there’s gradations, and if you reach the highest level of what they’ve called now in the new terminology they’re using here — it’s not new but it’s new to this — is Crowd Anonymity. Basically the more people that you have in a group the harder it is to identify any single one of them, that’s the crux of that idea. So what they’ve done is, as you increase the level of Crowd Anonymity with the number of events that are generated, then you unlock more value from the system. At the highest level of Crowd Anonymity, you get very many source identifiers that pertain to the campaign and you could codify those however you want. You could get potentially creative information embedded in that and various parameters of the campaign information encoded in that. You can set it up however you want, but if you don’t, then you get just the normal 100. They’ve done the same with Conversion Values. Now, if you reach the highest level of Crowd Anonymity, you get the 6-bit options of Conversion Values. But if you don’t, if you just reach that middle tier and there’s three tiers, then you get what they call a coarse grained Conversion Value, which it’s just three values. It’s high, medium, low. But you could encode information in that it helps you understand whether that’s a good campaign or not.

Just to jump in on this because I think this is actually a really important point. Big picture, we were pretty grumpy at Apple last time, we could try to put on our “Let’s try to give the best possible explanation for what Apple is doing” hats here. I think the concern is if you are sending super specific feedback and you only have ten users just to use an extreme example, you can back out who specific users are and so what they’re saying is if you have millions of users we can send you very specific events because it’s basically impossible to figure out whoever every single one was. I just want to put a stake in the ground on that, because I think that it’s actually super critical to understanding broader changes in the ecosystem. We’ll talk about the Unity stuff later, but by implication you have to be large because if you’re going to get the best feedback, you have to have a huge number of impressions and events to make this all work. I just wanted to double down on that specific point.

ES: What I would add to that, I’m not going to dig into the details here because I think it goes beyond the scope of the conversation, but yes you just described it really well. But the problem was before, there was a chicken-and-egg problem. I have a campaign, and I’m spending some minimum amount of money against it because I want to measure the performance before I start increasing the amount of money that I spend against it. But I’m not getting any data from the postbacks, because I’m not spending enough money to generate enough events.

You don’t want to dump millions of dollars into that campaign, you don’t know if it works.

ES: I’m at an impasse, I don’t want to spend more money on it because I’m not getting any performance feedback, but I’m not getting any performance feedback cause I’m not spending any money on it — so, chicken-and-egg. Now with this, if I spend a little bit more money and I get to that middle level of crowd anonymity, I get the high, medium, low feedback, and I can encode that to mean something that is relevant to me to give me some signal as to whether this campaign could be a good one. Just having that intermediary step gives me a lot of really valuable context that prevents this from being binary yes or no and breaks me out of that chicken-and-egg problem. Now I could spend a little bit more money because I’m getting some signal that, “Hey, this is all coming back with the high value” and if I’ve set that to mean the predicted value of this user after ninety days, “Okay that’s high”, that means these are good users, I should spend more money, and it gives you the signal that you need in that early stage to determine whether you can spend more money against the campaign or not to really unlock all the value.

Are they also speeding up the feedback loop so that once you start spending high, you can immediately see if this is worth it or not before you’ve spent too much and make changes?

ES: Yes. The other thing that I’m really excited about is they just did away with the timer system, which was overly engineered, complex, and convoluted. Now there’s just attribution windows, and there’s three. So now you can potentially get up to three postbacks, it’s not just a single postback and the attribution windows are fixed. Now they’re not zero day, it’s zero to two days is the first window, but it’s fixed and so you know when you’ll get that postback. On top of that, because you know what the fixed interval is, you can actually model much more easily on top of that to get to install estimates whereas before you couldn’t, because the timer system was random…

…Just to rewind though, you had three things about SKAdNetwork. You had the gradation sort of privacy, you had the faster and set time limits for when they’re giving you feedback, what was the third one?

ES: Just to recapitulate, so there’s hierarchical source identifiers, hierarchical conversion values, the third one is multiple conversions and then there’s a fourth one — those three are the primary considerations for me. There’s a fourth one that SKAdNetwork can now handle attributions from the web, so there’s four big new pieces of functionality coming.

There is one more point I wanted to make about SKAdNetwork: I would say that if at the outset, if at WWDC 2020, what Apple had presented to advertisers was SKAdNetwork 4.0, the spec, and they had unified the personalized ads texts across Apple’s own opt-in prompt and the ATT prompt, and Apple Search Ads used SKAdNetwork instead of the Apple Ads Attribution API, if all those things were true, and those all seem like reasonable things to ask for, I would’ve applauded ATT. I would’ve said, “This is the right thing to do, this is good for consumers, this is the direction that advertisers should have predicted they were going to have to move in.” I would’ve said, “ATT is excellent and I fully support this.”

The problem was SKAdNetwork 2.0 — 2.0 is what they unveiled at WWDC 2020 — was just totally dysfunctional and didn’t work. Then the differences in treatment between their own network and their own opt-in prompts between the ATT prompt and other ad networks. If all those things were addressed, I would be absolutely an advocate for ATT, I think it would’ve been the right policy, but it’s just the preferential treatment in addition to this totally dysfunctional SKAdNetwork, which to your point, was unnecessarily dysfunctional, it created pain that wasn’t necessary to protect consumer privacy…

…You mentioned this a little bit earlier, but as we’re wrapping up here, looking forward you can see Apple maybe doing some more crackdowns on fingerprinting or some of this third party stuff, there’s potential regulation. It kind of feels inescapable to me that there’s going to be more consolidation. The returns to being very large are going to be huge and I think particularly for Meta, it’s pretty interesting because if you have this situation where 1) you need to be large and 2) ads need to be increasingly contextual, which is going to just require a lot more computing capacity and modeling and things along those lines relative to an IDFA, which was kind of straightforward — you just match column A to column B. Is it wrong to actually be somewhat optimistic about Meta’s fortunes looking forward?

ES: No, I think you’re exactly right. So Sheryl [Sandberg] — what a run she had at Meta — in her last earnings call, brought up click-to-message ads like five times or ten times.

We’ll miss the Sheryl anecdotes in general, I should note.

ES: Yeah, she seems very optimistic about those and that kind of aligns with my content fortress thesis. [CEO] Mark [Zuckerberg] even said that one of the big initiatives of the company is to grow first party understanding of people’s interests by making it easier for people to engage with businesses in our own apps. So just to generate much more first party data that they can use to target ads. The other thing is Reels, obviously if your ability to target ads has been degraded, the value of the ads decrease. Well, how do you maintain the same amount of revenue? You show more ads, and you probably don’t want to increase the ad load — ad load is the number of ads seen per session. So then you want to increase the session length, or per minute of session or whatever is ad load and so if you increase the session length, then ad load can stay the same, you get more ads. Even though they’re lower CPM, which is exactly what happened to them last quarter, they had total ad impressions was up 15%, average price for ad was down 14% and they were down 1% year over year on revenue.

This is the counterintuitive thing about these businesses, that’s great news! I remember back when Google first IPOed and people would look at, “Oh, the cost per ad is going down.” It’s like, “That’s good!” It’s very counterintuitive because it’s dangerous when — this happened to Facebook a couple times — where they just run out of places to grow as far as ads goes.

This happened right before Stories. Their price per ad was going up, and people were getting excited about this, “Wow, look at the pricing power.” And it was like, “No”, this is actually a very problematic sign because that means they don’t have sufficient inventory to show, that also means advertisers are going to other platforms, it’s giving other platforms money and the ability to increase their competitive product, and Stories was this huge triumph from a business perspective because they just exploded their ad inventory and their price-per-ad plummeted.

It’s hilarious, because their stock got killed, the second biggest drop after Facebook’s first greatest drop this year was Facebook after the Stories earnings, when they announced that this was happening. I remember at the time I’m like, “No, this is really great news,” because it basically sets them up for multiple years of growth opportunities, which is what happened. And just to double down on your Reels point, them focusing on Reels, it’s kind of like of all the stuff that’s gone wrong for Meta/Facebook, the fact that they’re doing this Reels double down at the same time they’re having these ad business challenges is actually a piece of good fortune in my opinion.

ES: Yeah, I think so. Sheryl even mentioned that this is the playbook. It’s like we get a toe hold, we find a new front and we expand our inventory and then we get better at targeting ads in that inventory, so the value of the ads goes up. But that’s a process, you have to find the new port point of entry for showing these ads and then you’ll over time increase the value of them because you’ll get better at understanding what signals to use for targeting.

Just to follow up on what you said, it’s important, I think we’re getting to a point where size, scale, sophistication, all of those things are going to be really important just for any sort of competitive staying power, and especially with SKAdNetwork 4.0. Because 2.0 and 3.0 kind of leveled the playing field.

(laughing)It was terrible for everyone.

ES: Yes, exactly. With 4.0 your ability to parse out meaning from the added context that you’ll get with potentially three postbacks with the hierarchical conversion values, Facebook’s going to be able to do a lot more with that than probably any other ad platform except for maybe Google. So they’ll be better positioned to take that new context and build value out of it. If you’re thinking about — and Sheryl said this too — we’re at the beginning stages of clawing back the measurement that we lost. But I think they’re very realistic about where they are in this process. Just giving them more surface area to extract value from will benefit them in a way that a lot of the app install networks probably can’t do. Maybe even like a Snap, a Pinterest, a Twitter can’t do, I think it’s going to make the topography more diverse again so the playing field will no longer be level.

Yeah, you just need rules of the road. I think the problem with SKAdNetwork 2.0 is because it was worthless, everyone was just adrift on the sea and with the new SKAdNetwork, if you actually know the rules to play by, yeah those rules might be crappier than the rules you had previously so you’re going to have to build it again, but as long as there’s something you can rely on, and something you can model against, you can build something again. But to the degree it’s hard to do, the more that favors Facebook. It’s kind of like the GDPR thing, I wrote this at the beginning, I’m like, “This is so clearly going to benefit the biggest companies because they can afford to hire all the compliance officers, they can afford to do all this work.” I think it’s going to be a similar dynamic here.

ES: 100% and I think it’s doubly true with the AI initiatives. I think when Zuckerberg talks about AI, he doesn’t mean it in the way that most people interpret it. He’s talking about parsing signal out of video.

And it’s going to be the same problem. Show the right video to someone in Reels, and show them the right ad, it’s the same challenge.

ES: Exactly. But it’s a much more appreciable challenge than doing that with text, and who can compete there? Facebook’s got its own data centers with its own hardware, that was always Snap’s problem, by the way, their cost of revenue was so high because they were totally dependent on Google Cloud and Amazon Cloud.

That’s a great point. That’s going to actually get worse for them now that they have to start doing this AI analysis of video.

ES: Yeah, Facebook said they’re doubling or tripling a number of GPUs that they’re going to have in their own proprietary hardware, in their own owned data centers. Who can compete with that?

6. Why Huawei founder Ren Zhengfei’s new memo has gone viral on China’s internet – Iris Deng

A leaked internal memo by Ren Zhengfei, founder of Huawei Technologies Co., has gone viral on China’s social media, as his bleak outlook of the global economy strikes a chord in the country’s business and technology sectors.

The memo, which was first reported by Chinese media outlet Yicai on Tuesday, painted a gloomy picture of a world heading into economic recession. It called for employees to focus on the company’s survival and give up on wishful thinking.

Huawei declined to confirm or deny the memo, but sources told the Post that the text, which has been widely reported locally and shared on the internet, is authentic.

“The next 10 years will come down as a painful period in history, as the world economy goes into recession … Huawei needs to tone down on any over-optimistic forecast and make survival its most important creed in the next three years,” Ren wrote.

This is not the first time that Ren, 77, has reminded Huawei employees that the firm is navigating a business crisis. Huawei’s rotating chairman, Eric Xu Zhijun, also repeatedly said in 2020 and 2021 that the company’s goal was to survive US sanctions, which barred its access to US-origin technology, such as advanced smartphone chips.

However, Ren’s new warnings come amid fresh challenges, as Beijing carries on with draconian Covid-19 controls despite the Chinese economy being in its worst shape in decades.

China’s gross domestic product grew only 0.4 per cent in the second quarter, the worst since the first quarter of 2020, when the coronavirus shut down large swathes of the country, driving GDP down by 6.8 per cent.

7. Big beliefs – Morgan Housel

Most fields are a hierarchy of truths with big ideas at the top and laws, rules, and finer details branching off below them. Viewing ideas in isolation, without recognizing the family tree of where they came from, gives a distorted view of how a field works and can overcomplicate what are often simple answers.

Beliefs are the same. How many business and investing beliefs do I have – opinions, ideas, models, etc? I don’t know, thousands probably. It’s a complex topic. But most of them derive from a few core beliefs.

A few big things I believe:

The inability to forecast the past has no impact on our desire to forecast the future. Certainty is so valuable that we’ll never give up the quest for it, and most people couldn’t get out of bed in the morning if they were honest about how uncertain the future is…

...It takes less effort to increase confidence than it does ability. Confidence gives the impression of removing uncertainty, which we desperately want and are quick to embrace, while ability is constantly under attack from competition and an evolving economy…

…Sitting still feels reckless in a fast-moving world, even in situations where it offers the best odds of long-term compounding. It’s like being told that you should play dead if a grizzly charges you – running for your life just feels more practical. The bias towards action is one of the strongest forces in business investing for three reasons: It can be the only signal to yourself and others that you’re not oblivious to risks. It can be the only signal to others that you’re worth your salary. And it can provide the illusion of control in a world where so much is out of your hands.

It’s hard to determine what is dumb luck and what is unfortunate risk. Investing is a game of probabilities, and almost all probabilities are less than 100%. You can make a good bet with the odds in your favor and still lose, and a reckless bet and still win. It makes it difficult to judge others’ performance – lots of good decisions end up on the unfortunate side of risk and vice versa.

Calm plants the seeds of crazy. If markets never crashed they wouldn’t be risky. If they weren’t risky they would get expensive. When they’re expensive they crash. Same for recessions. When the economy is stable people become optimistic. When they get optimistic they go into debt. When they go into debt the economy becomes unstable. Crazy times aren’t an accident – they’re an inevitability. The same cycle works in reverse, as depressed times create opportunities that plant the seeds of the next boom. One way to summarize it: Nothing too good or too bad lasts indefinitely.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, we currently have a vested interest in Alphabet (parent of Google), Apple, Meta Platforms (parent of Facebook), and Tesla. Holdings are subject to change at any time.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles 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.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, we currently have a vested interest in Apple, Microsoft, and TSMC. Holdings are subject to change at any time.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 14 August 2022:

1. Everywhere you look there’s lag – Stacey (Trust, but verify)

What do London Heathrow’s flight caps, the inventory of retailers, interest rate policies, and the energy transition have in common? All are subject to systems lag and experiencing the effects.

Current world events show the importance of understanding systems and the inherent delays therein. By knowing what to look for, one can better see the forest from the trees. The best way to view the world is as it is. The tangible and intangible components of our lives are comprised of embedded systems…

…Every human, organization, animal, economy, and government is a complex system (with systems within this system which are called embedded systems). Another way to state this is as:

“an interconnected set of elements that is coherently organized in a way that achieves something. The system may be buffeted, constricted, triggered, or driven by outside forces. But the system’s response to these forces is characteristic of itself, and that response is seldom simple in the real world.” – Thinking in Systems

It is more than the sum of its parts – it can exhibit adaptive, dynamic, goal-seeking, self-preserving, and sometimes evolutionary behavior. They can be self-organizing, self-repairing, and resilient. Get all that? Let’s break it down into its essential parts.

A system must contain three things:

1. Elements: the building blocks; for a tree it’s the roots, branches, and leaves.7 Includes the intangible and tangible. For example, the bits within a computer are intangible.

2. Interconnections: relationships holding the elements together. In a tree system, it would be the physical flows and chemical reactions. Interconnections often operate via the flow of information. These flows of information are signals for the decision/action/leverage points within a system.

3. Function/Purpose: what is its aim; can only be deduced by its behavior. The purpose of nearly every system is to safeguard its survival. Further, successful systems work to keep sub-purposes and overall system purposes in harmony. The cells in your heart are different from your liver, but both function to keep you alive.

Of the three building blocks, changing the elements typically has the smallest effect on the whole. Swapping out all the players on a football team still makes it a football team. A human body regularly replaces its cells but continues to be a human body. Countries have regular elections, with different politicians occupying offices, yet nothing seems to change. As long as the interconnections and functions remain intact, a system generally goes on doing its thing.

Altering the function is often the most crucial determinant of a system’s behavior. It would be like if an animal’s purpose was changed from survival/reproduction to pleasure.

However, this is not to take away from the fact that elements, interconnections, and purpose are essential. If changing an element results in a changed relationship or purpose, de facto behavior is modified. Adjusting interconnections (the information flows) can materially affect a system – imagine changing the rules of football to those of soccer.

The system interacts with outside forces, but, importantly, its response is of its own character. Another way to say it is it has its own latent behavior within its structure.

However, a system’s behavior cannot be known based purely upon adding together its elements. Humans tend to think linearly, which is not necessarily how systems act.

Systems are often nested within other systems. As such there are purposes within purposes. According to Friedman’s economic theory, the purpose of a corporation is to maximize shareholder returns. Within that business, the purpose of the C-Suite may be to serve customers well or make as much money as possible anyway possible. Down at the middle manager role, the goal may be not to get fired. At the junior level it could be promotion and earning more money.

As you can see, often the sub-purposes come into conflict with the overall purpose at businesses. Like with individuals, the greater the sense of coherence within the corporation, the better the results.

What is not a system? An assortment of things without any specific interconnection or function.

“Sand scattered on a road by happenstance is not, itself, a system. You can add sand or take away sand and you still have just sand on the road.” – Thinking in Systems

Lags are inherent in systems due to their structure – it takes time for a given input to result in an output. Goods ordered from China do not instantaneously appear in a company’s warehouse.

To understand lags, first we need to take a step back into how the elements of a system are set up. The foundation of any system is its stock. These are the store, the quantity, the accumulation of material or information built up over time. You can see, count, or measure these items. The money in your bank account, the water in a bathtub, trees in a forest, or the population of a country are all examples of stocks.

Flows cause stocks to change. It’s the bathtub filling and draining, the births and deaths within a country, the dying and planting of trees in a forest, deposits and withdraws in a bank account. To understand much of the behavior of complex systems, one must understand the interplay of its stocks and flows.

A critical point is stocks typically change slowly. A forest doesn’t become deforested all at once. It takes a while for the population to unlearn skills. Groundwater can be pumped out at a faster rate than it is replenished for a long time. This occurs even when flows into or out of them change suddenly. Think of how much long it takes for trees to accumulate into a forest. Or for a productive labor force to be built up.

As such, stocks form the basis of system delays. They can also serve as system buffers. Just-in-time inventory has reduced the buffer of stocks. Taking slack out of the system results in decreased resiliency.

Time lags aren’t all bad – the stocks can be sources of stability…for a while. These delays allow room to experiment and revise policies that aren’t working.

Stocks allow inflows and outflows to be independent of each other and temporarily out of balance. Reservoirs allows residents and farmers to live downriver without adjusting their lives to a river’s yearly flows. But if hard rains happen for years, eventually the river will flood.

“Systems thinkers see the world as a collection of stocks along with the mechanisms for regulating the levels in the stocks by manipulating flows. That means system thinkers see the world as a collection of ‘feedback processes.’” – Thinking in Systems

If a system demonstrates a persistent behavior over time, the odds are good there’s a mechanism creating this consistency. It is manifested through a feedback loop. To find feedback loops, look for a system’s consistent behavior.10 Feedback loops can stabilize or de-stabilize systems. They can cause stocks to increase or decrease.

Donella Meadows in her excellent book on systems speaks of three types of delays: 1) perception delay; 2) response delay; and 3) delivery delay. Below shows the system flows for a car dealership’s inventory…

…The perception delay is intentional in this case. How often does the dealer react to changes in sales? Does he go off of daily, weekly, monthly, or some average? It’s key to pick the right time period to sort out real trends from noise.

Response delay is how much he orders. Does he order the whole lot needed or make partial adjustments to make sure the perceived trend is real?

The delivery delay is how long it takes to receive vehicle orders onto the lot.

Inventory oscillations result in a system where there are delays…

…Think about it: sales increase, causing vehicles on the lot to drop. Once they are sure the higher sales rate will last, more cars are ordered. The delivery delay means it takes time for the orders to actually arrive.

Yet during the interim period before orders hit the lot, inventory drops further if sales sustainably rise, meaning available inventory continues to decrease, so orders bump up a little more to bring inventory back to prior levels.

The larger volume of orders begins arriving, and, instead of recovering, inventory can shoot up more than expected, and the dealership can quickly turn from under-inventoried to over-inventoried. Orders are cut back, but elevated past orders are coming in, so less is ordered. Inventory eventually falls and can become too low. 

2. DeepMind found the structure of nearly every protein known to science – Nicole Westman

DeepMind is releasing a free expanded database with its predictions of the structure of nearly every protein known to science, the company, a subsidiary of Google parent Alphabet, announced today.

DeepMind transformed science in 2020 with its AlphaFold AI software, which produces highly accurate predictions of the structures of proteins — information that can help scientists understand how they work, which can help treat diseases and develop medications. It first started publicly releasing AlphaFold’s predictions last summer through a database built in collaboration with the European Molecular Biology Laboratory (EMBL). That initial set included 98 percent of all human proteins.

Now, the database is expanding to over 200 million structures, “covering almost every organism on Earth that has had its genome sequenced,” DeepMind said in a statement.

“You can think of it as covering the entire protein universe,” Demis Hassabis, CEO of DeepMind, said during a press briefing. “We’re at the beginning of a new era now in digital biology.”

3. Taiwan reports 1st child with cancer cured by CAR T-cell therapy – Keoni Everington

A 10-year-old girl suffering from leukemia is the first child in Taiwan to receive CAR T-cell therapy and to have fully recovered from the cancer as a result.

The girl, identified as Tingting (亭亭), was diagnosed with childhood B-cell acute lymphoblastic lymphoma four years ago. After undergoing first-line therapy, she still relapsed.

In the past, such a patient would have to wait for a stem cell transplant to save their lives. However, with the assistance of doctors at National Taiwan University Hospital (NTUH), she became the first CD19-targeted chimeric antigen receptor-engineered (CD19 CAR) T-cell recipient in Taiwan and has fully recovered, with no residual cancer cells detected in her body…

…Chou explained that the treatment principle relies on high-tech genetic engineering. First, T-cells are isolated from the patient’s body, and are genetically modified by adding a gene for a receptor called chimeric antigen receptor (CAR), which enables the T-cells to attach to a specific cancer cell antigen.

The cancer cells from childhood B-cell acute lymphoblastic lymphoma contain an antigen called CD19. Therefore, in this patient’s case, the CART T-cell technique was used to design T-cells to attach to the CD19 antigen.

Chou compared it to a precise “immunization army” that can accurately and continuously destroy cancer cells. The advantage is that a one-time injection can generate these results, said Chou, as was the case with Tingting.

In April of this year, NTUH became the first medical center in Taiwan to provide formal clinical use of CD19-targeted CAR T-cell therapy. Tingting was the first patient in Taiwan to receive the treatment and experience a full recovery.

4. An engineering breakthrough using DNA could unlock the quantum computing revolution – Chris Young

Scientists from the University of Virginia School of Medicine and collaborators used the building blocks of life to potentially revolutionize electronics.

The scientists utilized DNA to guide a chemical reaction that would overcome the barrier to Little’s superconductor, which was once thought to be “insurmountable”, a press statement reveals.

They used chemistry to perform incredibly precise structural engineering, allowing them to assemble a lattice of carbon nanotubes for Little’s room-temperature superconductor.

More than 50 years ago, Stanford physicist William A. Little proposed a type of superconductor that could be used at room temperature. This could potentially be used to enable hyper-fast computers and shrink the size of electronics devices, among a list of other benefits. In 2020, researchers from the University of Rochester revealed the first room-temperature superconductor, but high-pressure requirements make it difficult to utilize.

Edward H. Egelman, Ph.D., of UVA’s Department of Biochemistry and Molecular Genetics and graduate student Leticia Beltran applied their knowledge in the field of cryo-electron microscopy (cryo-EM) to the problem. Their work, outlined in a new paper in the journal Science, “demonstrates that the cryo-EM technique has great potential in materials research,” Egelman explained.

The researchers set about trying to realize Little idea for a superconductor by modifying lattices of carbon nanotubes. The main obstacle was controlling the chemical reaction along the nanotubes so that the lattice could be assembled as precisely as possible. According to Egelman, their “work demonstrates that ordered carbon nanotube modification can be achieved by taking advantage of DNA-sequence control over the spacing between adjacent reaction sites.”

The lattice the scientists built has not yet been tested for superconductivity, but it offers proof of principle, according to the researchers. “While cryo-EM has emerged as the main technique in biology for determining the atomic structures of protein assemblies, it has had much less impact thus far in materials science,” Egelman described.

5. Walmart – Benjamin Gilbert and David Rosenthal

David: There, one night at a bowling alley in Claremore, he meets and falls in love with a girl named Helen Robson. Helen was from Claremore, but her father, L.S. Robson, unlike Sam’s family, was a very wealthy and successful businessman, financier, and trader in the broader Tulsa area.

He ends up taking a big shine to Sam and would become hugely influential along with Helen because he marries Helen, of course. Sam would say, “The Robsons were very smart about the way they handled their finances: Helen’s father organized his ranch and family businesses as a partnership, and Helen and her brothers were all partners. Helen has a college degree in finance, which back then was really unusual for a woman, and Mr. Robson advised us to do the same thing with our family, which we did way back in 1953.”

That partnership that Helen and Sam set up is today Walton Enterprises which owns 36% of Walmart, and then individual family members and trusts—I think mostly Bud’s [Sam Walton’s brother] family—own the other 11%–12%.

Ben: This is the interesting seed plant of Walmart being a family business from the very get-go. They organized it interestingly. Each store was actually its own company so that different people could hold shares in each store—the management, different people who wanted to invest in the store, and that sort of thing—but at a really high level, Walmart always was a family partnership. It was always something where the economic and spiritual ownership and decision-making always was the Walton family. Of course, Sam’s the guy, but there were a lot of family meetings to make decisions for the business.

David: This is why, because the family was all partners in Walton Enterprises. They couldn’t just sell their stock and the partnership. The family as a whole had to decide to sell. That allowed them to keep majority control of Walmart all through history.

Sam talks about this. He says he thinks it’s the big reason why corporate raiders or larger companies like Kmart never came and acquired them because the stock was never splintered. It was all within the partnership. Then, he actually writes, “One of the real reasons I’m writing this book is so my grandchildren and great-grandchildren will read it years from now and know this: If you start any of that foolishness like changing the structure, selling off stock, going off and doing fancy thing—”

Ben: Buying NBA and NFL teams.

David: Buying NBA and NFL teams which they do now. “—I will come back and haunt you. So don’t even think about it.”…

…David: Sam and Helen get married and Sam gets posted in a bunch of places all around the country doing internal intelligence work for the army. He goes to Utah and plenty of other places. He decides that when the war ends and he gets out of the Army, he’s going to go back into retailing, but now, he has the support of Helen, her family, and her father, L.S. They’re financiers, so he knows, I now have access to some amount of capital. I can be an entrepreneur. I don’t necessarily have to work for somebody.

When the war ends, L.S. initially wants them to move back to Claremore, but Helen and Sam decide together. They’re like, well, we want your support, but we don’t want to be totally under your wing and in your shadow.

Sam got big ambitions. He and a buddy decide that they want to buy a Federated Department Store franchise in St. Louis. They’re going to be big. He comes from JCPenney in Des Moines. He wants to be a big city department store owner, magnate, and entrepreneur.

Helen vetoes this outright. We would not be talking about Walmart if Sam had moved the family to St. Louis. Helen says, look, one, I don’t want you doing any partnerships with non-family members. Sam says, “Her family had seen some partnerships go sour, and she was dead-set in the notion that the only way to go was to work for yourself and for your family.”

Two, she says, “I don’t want to live in a big city. I want to go live in a small town where I grew up just like Claremore. I don’t want to live in Claremore itself, but we are not allowed to move to any town that has a population of more than 10,000 people.”

Ben: Her whole thing was I want to raise my kids the way that I was raised. She looked at Sam and said, you were raised the same way in a small town and that’s what we’re going to do. Whatever business he did had to be family owned and controlled and have a small town-based strategy. What seems so intentional and so genius actually stems from the fact that she just vetoed his original idea….

…David: …Sam doesn’t stay down for long. I think he was a little disappointed that his wife had overruled him, but he finds a way. He goes back to the company that owned Federated, which is a company called Butler Brothers. They were franchisors of Federated. They’re based in Chicago.

He asks, well, do you have any department store locations that might be available in a small town of say 10,000 people or less? The Butler Brothers guys are like, we don’t really do department stores in towns like that, but we do have another spin-off operation that we run, which is our variety store franchising business.

Ben: There literally weren’t enough people they believed to support a department store. Variety stores are like glorified general stores. When you think about a town that’s 2000, 3000, or 4000 people, it really is like if you visited an old west town and looked at a general store. It’s like on steroids, but a few decades later.

David: Variety store businesses, that’s exactly it after the Depression and World War II. That was how small towns and areas were serviced to retail. They’re mostly franchise operations. This particular one was Ben Franklin, the brand name. Benjamin Franklin general store type of place.

Ben: When you say franchise operation, because it’s way too much of a burden to source your own inventory, carry your own inventory, and maintain all those different vendor relationships, if you’re in one of those towns, you’re serving 2000 people and you’re the one store there, what you really want is to sign a contract and just get the shipment of the stuff that goes into the Ben Franklin stores in all the small towns.

David: Yeah, and just be literally the merchant serving your customers. That mindset dominated. It’s worth a pause here to talk about what these stores were because it’s a very foreign concept to anything we’re familiar with today. These variety stores were also called five and dimes if you’ve ever heard that term.

Ben: A 5¢, 10¢ store.

David: The reason for that is that in most of them, every item in the store was either priced at 5¢ or 10¢. That was the level of sophistication here. The other big, big difference between how the stores operated in modern retail today, which says I’m really invented, was they weren’t self-service.

Ben: He didn’t invent that. He stole that.

David: We’re going to get to it. So you would walk into these stores and there would just be a counter area upfront that had clerks. You would tell the clerk what you wanted, and then the clerk would go back into the store, pick out what you wanted, bring it up to the front, and check you out.

Ben: Because there wasn’t really a choice. You’d be like, I need a hose, and they would go get the hose. It’s not like, well, let me see all the different brands, sizes, and colors. It was like, I know you have hoses here. Can you get me one?

David: The merchants weren’t making the decisions on the inventory. It was all just being handed down on high from Butler Brothers back in Chicago.

Ben: Yeah. I did not understand when reading this book when he kept referencing stores that were not stores where you walked around and got your own stuff off the shelf, that that is a modern concept. That is crazy.

…David: …Butler Brothers—Sam’s having this conversation with them—are like, well, probably, you want a Ben Franklin franchise, and it just so happens that we’ve got the perfect store for you in the little town of Newport, Arkansas. The current owner of the Ben Franklin franchise there wants to sell.

Newport is a little town of about 7000 people. It’s in eastern Arkansas. If you know where Bentonville, Arkansas and Walmart are today, it’s not in eastern Arkansas. Sam is like, great, I’ll take it. Now, you have to ask yourself, it is 1945 in America. The war has just ended. Unlike 1945 in Japan like we talked about with the Sony story, retail in the US is booming.

Ben: Everyone’s coming home, there was the G.I. Bill, everyone’s got new homes, everyone’s starting families, and there’s a lot of stuff to buy.

David: There’s a lot of stuff to buy. It doesn’t matter if you’re a department store in a big city or a variety store in a 7000-person town. Everybody in retail should be making money hand over fist right now.

The question that Sam didn’t ask himself and should have was why does this guy want to sell? He says in the book, “A guy from St. Louis owned it, and things weren’t working out at all for him. He was losing money, and he wanted to unload the store as fast as he could. I realize now that I was the sucker Butler Brothers sent to save him. I was twenty-seven years old and full of confidence, but I didn’t know the first thing about how to evaluate a proposition like this so I jumped right in with both feet. My naiveté about contracts and such would later come back to haunt me in a big way.”

He and Helen buy this store.

Ben: This distressed asset at not a distressed price.

David: Yes. They buy it for $25,000, $5000 of their own savings and a $20,000 loan from L.S., Helen’s father. Sam says, this isn’t what I dreamt, but I’m still going to set big goals. He decides that he’s going to set a goal that this store is going to become the most profitable variety store in Arkansas within five years.

Ben: It’s quite the turnaround and is also the first indication of Sam setting these big, hairy audacious goals. He has this subsequent obsession with set a goal, hit it, set a goal, hit it. That really does drive all of his need for experimentation because he finds himself in these situations where he has a goal set and he must invent some way to hit it.

David: It also sets the stage for what was to come. He sets this goal, and then he gets there. This is not a realistic goal.

He says, “Only after we closed the deal, of course, did I learn that the store was a real dog. It had sales of about $72,000 a year, but its rent was 5 percent of sales—which I thought sounded fine at the time—but which, it turned out, was the highest rent anybody had ever heard of in the variety store business. No one paid 5 percent of sales for rent. And it had a strong competitor—a Sterling Store which was another franchise across the street—whose excellent manager, John Dunham, was doing more than $150,000 a year in sales, double mine.”

Not only is it unlikely that he’s going to be the most profitable store in Arkansas, it’s unlikely he’s going to be the most profitable store in Newport. What does Sam do? He goes right across the street into the Dunham Store and he starts trying to figure out why Dunham is twice as successful as he is.

Ben: Yeah. Speaking of the first time Sam does something that he then does forever, he becomes notorious for going into competitor stores, bringing in a little notebook, later bringing in a little tape recorder, and just seeing what he can get away with interviewing clerks and associates at these stores.

Anytime he’s traveling with the family on vacation or anything, he’s just going into all these other stores, observing, taking notes, and figuring out what their systems are, what’s working, and what’s not working, so here he learns that valuable lesson for the first time.

David: So great. I was going to bring this up later, but I think he says in the book that he believes he has spent more time in Kmarts than any nonindividual store employee of Kmart including Kmart’s senior management.

Ben: Yeah. Also, we keep referencing Kmart. When I was growing up, it was like Walmart, Kmart. I think Kmart is kind of like Walmart, about the same scale, same size, and kind of a little lower end. That was my perception as a kid of Kmart. I didn’t realize that Kmart for a very long time was much, much larger than Walmart. They were Walmart’s big brother incumbent.

David: They were the gorillas.

Ben: I don’t remember what year this was, but I remember some quote from Walton where he’s talking about when we reached 5% the scale of Kmart. It’s like, well, that really puts it into perspective how big a lead they had.

David: You mentioned a notepad. It’s actually a yellow legal pad that Sam uses. Famously, he has this yellow legal pad and he’s going into competitor stores. He starts diving into dumpsters trying to get sales receipts, inventory orders, and stuff to figure out how these stores are operating.

He quickly realizes from both Dunham across the street—and also, he’s doing this all over the countryside, going into small variety stores all over Arkansas just trying to learn—that price, running promotions, and cutting prices on big marquee attractive items like health and beauty aids, toothpaste, mouthwash, makeup, and that stuff really drives customers in.

He starts doing that and he has some success, but there’s a problem. We talked about Butler Brothers as the franchisor. They’re controlling all the inventory. Sam as the merchant is just getting whatever they send to him at whatever cost they prescribe.

The Butler Brothers are doing great. They get about a 25% markup on all the inventory and they don’t even do anything. It’s almost like they set up the whole system just to keep these prices high out in the countryside and they just get a 25% skim off the top.

What does Sam do? He starts figuring out who the manufacturers are of some of these goods. For manufacturers that are also located there in the south in the Midwest, he starts driving around, knocking on their doors, and asking if they’ll do side deals with him and just clandestinely sell him some of the merchandise that he otherwise would be ordering from Butler Brothers and that they would be selling to Butler Brothers. They just give him a deal directly on that.

Ben: He’s operating a small enough scale that Butler Brothers doesn’t really notice. To be frank, there wasn’t good tracking or accountability at this point. There weren’t computers yet.

David: There’s no computerized inventory here.

Ben: You’d have to really be paying attention to figure out, oh, maybe Sam is not ordering quite as much of this stuff from us as he should be.

David: He’s driving around himself. There’s no management. He has some clerks working in the store, but it’s just Sam and Helen running the place. He’s out, he drives to visit them, and he’s got to get a deal done on the spot.

He goes, knocks on the door, and meets these people. He’s like, I want to buy it right now. I’ve got a trailer hooked up to my pickup truck outside. Can you just load the inventory right into the back and I’ll drive it back to Newport? He says, I bring them the inventory, bring it back, price it low, and just blow that stuff out of the store.

Ben: Which is an invention. This is a brand-new concept that we take for granted now, but it’s totally a Sam Walton invention to meet his own needs which is to create something that is astonishingly low price to get people in the store, take no margin on it, and make it a loss leader. Who cares? Get people in the door spending time in your store and they look at other stuff.

This would become a cornerstone of Walmart forever after this and for every other retailer. Even in the pricing of SaaS products now, when you look at it, it’s like, oh, I’m on the free plan. It’s not that he invented loss leadership as a category, but he figured out how to make it work in the retail model.

David: He figured out how to really merchandise and operationalize. Dunham’s across the street running promotions, but Dunham wasn’t thinking about, oh, well, maybe I could sell even lower if I go haul my pickup truck out to these manufacturers and get goods at a lower price.

Ben: Right. Of course, once you’re hauling your pickup truck to go meet the vendors directly, it’s not that far of a cry to say, well, what don’t I have in the store that I’m getting from Butler Brothers? What could be interesting? You start getting good at doing these direct deals, sourcing your own inventory, and figuring out how to merchandise products that you personally believe will sell.

This is really where he started to hone that skill, craft, and sixth sense for deeply knowing the American consumer—or let’s say consumers in this area in his communities—and having a real spidey sense of what would make them go crazy and have a real product-market fit in people’s homes.

David: Price, selection, and convenience are the holy trinity of retail, but nobody really knew this yet. Frankly, all of those things are important, but for the majority of people out there in the world, in America at the time, and certainly the vast majority of people in these small towns, it’s selection and convenience.

Ben: Life was inconvenient, so you’re going to go through some inconvenience to get things. Selection, there wasn’t much of no matter what. We just came out of the Great Depression. Price is very important.

David: Customers will go to great lengths to get lower prices.

Ben: People would make day trips. People would drive five hours to other cities to get a deal on goods.

David: It’s crazy. He says, “Here’s the simple lesson we learned—which others were learning at the same time and which eventually changed the way retailers sell and customers buy all across America: say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater. Simple enough. But this is really the essence of discounting: by cutting your price, you can boost your sales to a point where you earn far more at the cheaper retail price than you would have by selling the item at a higher price.”…

…This is incredible. He actually hits his goal. By year five of the Newport store, he’s doing $250,000 in sales at a $30,000–$40,000 annual profit. Remember, he bought the thing for $25,000. That’s including the crazy 5% rent charge in his expenses.

Ben: His operating margin on this is 24%. He’s making very, very real profits on this little store that he’s got.

David: If he had a better rent deal it could be 28%. But at those numbers, it is the most profitable store in Arkansas and the biggest store by sales not just in Arkansas but the whole Midwest and South region. He has found a winning formula here.

Ben: Which is interesting because I’m pretty sure at this point, he’s got a bunch of direct deals cut with the suppliers and he’s added a bunch of products of his own. He’s really merchandising. He’s really showing up on Ben Franklin’s radar and the Butler Brothers Corporation’s radar, and they know what he’s doing at this point. But it’s good for them. Even though it’s good for Sam, it’s also good for them because of volume and customers.

David: Right. He’s by far the best-performing Ben Franklin store in the country at this point. Unfortunately though, like I said, there’s a reason that Walmart is not headquartered in Newport, Arkansas. Butler Brothers weren’t the only related party to Sam who figured out what was going on here. His landlord that had pulled one over on the previous owner and had the super onerous rent terms also figures out, of course, how great Sam is doing despite having the deck stacked against him.

He decides he wants to take over the store. Year five is when the lease expires and there wasn’t an option in the contract to renew the lease. The landlord goes to Sam. He’s like, you know what, son, you’ve done a great job. Thank you for turning this property of mine around. I’m going to take it from here.

Ben: Just to contextualize this, it’s a 7000-person town. There are not really many other available storefronts. He’s got tons of shelves in there with tons of goods. It’s a meaningful amount of inventory that’s being carried on the business. It’s not like you can be like, oh, cool, I’ll move next door. That option does not exist.

His landlord comes to him and says this and he’s like, wait, oh my God, I have no other options.

David: He says, “It was the low point of my business life. I felt sick to my stomach. I couldn’t believe it was happening to me. It really was like a nightmare.”

I say this as a saving grace although the reality is Helen’s father would have financed Sam’s next venture no matter what. But the saving grace for Sam’s pride at least was that the landlord did buy out the value of the Ben Franklin franchise license, the hard assets, the inventory, the fixtures, et cetera in the store. He pays Sam and Helen $50,000 to take over the store. I’m going to guess that’s a 2X return.

Ben: What was the operating income from the previous year?

David: Thirty to forty thousand dollars.

Ben: Wow, brutal.

David: But at least they get the $50,000 out. This is now 1950. Sam and Helen hit the road again looking for a new town to bring their traveling circus to.

Ben: And have a little bit more knowledge on lease negotiation.

David: Yes. They go up to the other corner of the state in Northwest Arkansas. This is where they started looking around for the next place to set up shop for two reasons.

One, closer to Helen’s family in Oklahoma, Claremore. Two, like I said, Sam keeps it real. He was like, there’s some really good quail hunting up there and I really wanted to be closer so I could drag my bird dogs out and go hunting.

Ben: Yes, and more specifically, it’s not just that there’s good quail hunting. It is that he will be very close to four states which each have their own quail hunting season so that he can get the maximum amount of quail hunting in with an easy drive from his house.

Lots of business decisions being made here on family—we need to be in a small town and we need to only work with family. For Sam, I need to be able to hunt quail in the maximum amount of time that I possibly can.

David: The opportunity that they find and settle on is in a little town of 3000 people—less than half the size of Newport—that already in this town of 3000 people had 3 variety stores operating. Newport had 2 for 7000 people. This town has 3 for 3000 people.

As Sam says, he loves competition. That town is Bentonville, Arkansas. Sam probably almost assuredly is rolling over in his grave right now.

Ben: The new Walmart campus.

David: The new Walmart campus that they’re building. It looks absolutely gorgeous, which I’m sure he would be furious about.

Ben: Yes. If you thought Warren was a penny-pinching, very plain, no frills, no fancy things entrepreneur, Sam Walton—hard to argue who’s more frugal and less showy. Sam eventually got into airplanes for very practical use, but Sam was not a showy guy.

David: Actually, the anecdote that he and John Huey open Made in America with is I think it’s 1985 when Forbes ranked him the richest man in America and all these reporters start descending on Bentonville. They want to go interview the richest man in America. He still drives an old pickup truck that has cages in the back for his bird dogs because he goes hunting in the four states nearby.

It’s this big sensation that the richest man in America drives a beat-up, old pickup truck with cages in the back. He’s like, well, what am I going to drive my dogs around, in a Rolls Royce?

Ben: All right, so they arrive in Bentonville. Bentonville and the world are forever changed, but it doesn’t happen all at once.

David: No. The store that they buy is another Ben Franklin franchise that had done $32,000 in revenue the year before, quite a distance from the $250,000 that they left Newport with. Sam decides, all right, well, this is a small market. This is a small store. There’s a lot of competition, but I have big ambitions. He’s got his ear to the ground in retail and particularly in the Ben Franklin franchise network.

He hears through the grapevine that there are two Ben Franklin stores up in Minnesota that were trying a radical new concept. They were redoing the whole way. The store was laid out, the way it worked. They were removing the upfront counters, turning them into checkout counters, and letting customers go into the store, browse the merchandise, pick it up themselves, select it themselves, and then checkout.

He’s like, I got to go see this. He takes the overnight bus up from Arkansas up to Minnesota and checks them out. He’s taking notes the whole time on his yellow legal pad. He says about that trip, “I liked it. So I did that too”

Ben: I love how he’s so obsessed with first-hand experience. He couldn’t just hear about this and then implement it. He’s like, I must see it for myself because he so fervently believes that he picks up insights from actually spending time in stores and actually talking to customers. It seems like he does that more than any other entrepreneur we’ve ever talked about on this show, this obsession with first-hand experience.

David: I think everybody can apply this to their business. I was thinking about it while reading the book. I started so many passages and I already listened to lots of other podcasts unlike when we started Acquired and I didn’t listen to any other podcasts.

Ben: We should find the best ideas and incorporate them, yeah.

David: There’s a great quote about this when Walmart actually gets started later. I’m going to tease it for now. On July 29th, 1950, just about 72 years ago, they reopened the Ben Franklin store that they bought.

Ben: Still a franchise.

David: Still a Ben Franklin franchise, still working with Butler Brothers for “most of the inventory.” But they want to send a message that this is a new era, doing the self-service new store in Bentonville. They renamed it Walton’s Five and Dime and it became the third self-service variety store in the entire country.

Ben: It’s fascinating that they picked this name because part of the reason why you do a franchise is the brand. Sure, it’s nice to get the inventory, negotiated relationships, prices, and all this stuff, but really what you’re buying is people who know what a Ben Franklin is, so they would come to the store.

What Sam is saying is, eh, I feel pretty good about building my own brand. I know I’m in one way or another paying to use the Ben Franklin brand, but we’re not going to use it.

David: It really was rational because even though Sam on the margins is doing his own direct deals with manufacturers at this point, it’s a ludicrous concept that somebody in a little store in Arkansas could source all of their inventory and do all of their logistics by themselves. That is completely freaking crazy that a store servicing 3000 people in a little town would handle all of that themselves.

But they launched with a new name. It’s a new concept. It’s self-service. It causes quite a stir. I couldn’t find this exactly, but I believe, in that first year when Walton’s Five and Dime is open—remember, the previous Ben Franklin iteration of the store had done $32,000 a year in revenue, something like that—Walton’s Five and Dime did $90,000 in sales the first year.

I don’t know what the competitive dynamics were between the 3 stores in Bentonville, but remember, the town only had 3000 people. If you assume the previous three stores roughly had an equal market share—it’s a big assumption but just for argument’s sake—that would mean that the whole market size of Bentonville, the whole TAM, is $90,000. They did $90,000 in revenue, so what was happening here?

Ben: Yeah, is there a massively expanding TAM, did they expand that market because people are just buying more stuff than they otherwise would have?

David: I don’t know what happened to the other two stores, whether they went out of business or not. Certainly, they wouldn’t have right away. I think what happened was this caused such a stir that people started coming to shop at Walton’s Five and Dime from other towns.

Ben: I think it was the first time that Sam realized that shock value would bring customers much like I didn’t need anything the first time I went to an Amazon Go to try the cashierless checkout. People came for novelty value here. That taught him the lesson of, oh, maybe we should always have novelty value. Maybe there are reasons why people should be coming to Walmart even if they aren’t necessarily looking to buy something.

David: Yup. If you think about it, put yourself in the shoes of customers back then. Sam talks about this a lot in the book. For so long—we’ll get into the competition with Kmart—everybody thought Walmart, Sam, and all their customers were just kicks in the sticks. They are just complete morons out there. Nothing could be farther from the truth.

He says, my customers were also sophisticated retail customers. They knew about what was going on in the cities. They had relatives there they’d go visit. It’s not like they didn’t want first-class shopping experiences in their own hometowns.

Clearly, this makes a big splash. Sam realizes that he might have a tiger by the tail here so he starts looking. Unlike in Newport where he was satisfied, the store kept growing and he did $250,000 a year in sales. He starts looking to open up more locations.

Ben: More Five and Dimes.

David: He also doesn’t want to have all of his eggs in one basket and one lease like he did in Newport.

Ben: Right. Didn’t he open a store directly next door to one of his competitors just so that his competitor couldn’t expand their store? It wasn’t a high-performing store for him, but at least it didn’t let them get the square footage.

David: Yes. Clearly, he’s very competitor-focused. It’s funny. There are so many Jeff Bezos-isms that when you read this book and you learn about Walmart and Sam Walton, you realize that they were originally Walton-isms, Sam-isms, but in the whole Amazon we’re customer-focused and we’re not competitor-focused, Sam would have said absolutely not. We are absolutely competitor-focused. We’re focused on taking the best stuff from our competitors and implementing it here.

Ben: While we’re here, we have to say it. Eventually, a Walmart does go back to Newport. There is a little store that is run by a family member of the landlord that screwed over Sam that does get put out of business by that Walmart going in.

Sam makes the point, “You can’t say we ran that guy—the landlord’s son—out of business. His customers were the ones who shut him down. They voted with their feet.” To me, this is that perfect overlap of are you competitor-focused or customer focused? Well, both. You have to win in a market by counter positioning in some way. Walton did it by discounting but that obviously has an impact on your competitors.

You need to be able to counter a position against someone like a competitor. So when the big realization is, oh, customers always want lower prices, and satisfaction guaranteed, and all the other Walmart-isms, that will have impacts on your competitors. You have to pay attention to those competitors. But ultimately…

David: The customers decide.

Ben: Sam is willing to blame the customer for putting the competitor out of business.

David: In 1952, just a short while later, Sam opens up a second store in nearby Fayetteville, Arkansas, because again, it’s just Sam and Helen, when she can, helping out with the bookkeeping, managing the first store. Sam needs to hire somebody to go manage Fayetteville because he’s working in Bentonville. So he brings on a guy named Willard Walker, who was managing a variety store in Tulsa before that.

The way they convinced him to move to Fayetteville and take over this new concept is they make him an offer he can’t refuse. They make him a partner in the store. This is what you were referring to earlier. They give him a percentage of the profits that that individual store makes. In fact, they set up that store and all future stores as their own partnerships. This is something I didn’t understand until reading the book.

It became a huge part of the playbook for Walmart for decades, in which every store manager in a new store opening was given first equity and individual partnerships, and then later profit sharing incentives in that individual store. That sets up a true alignment of incentives. I don’t think anybody else was doing this at that point in time and then even better.

So all the pool of existing store managers, whenever they open up another store, Sam and Helen give them the opportunity to invest dollars in the new stores and the new partnerships. Now you’re incentivized on the success of the whole network, and you’re incentivized to share information. You want everybody to do better.

Ben: They get carry and they should make a GP commit.

David: Exactly. I think this is super brilliant. I was thinking about this, with regard to tech companies today and everything. Even though employees of tech companies get much better economic deals with stock options, I think psychologically, this is a better way to do it. What Sam was doing, you’re putting your own money at work. You’re incentivized both on your own personal performance in the store…

…David: Then reading more in the book about this. So during this period and in the early Walmart Corporation period, it was just the store managers who were doing this, not the hourly employees.

Ben: There was a gigantic chasm. I mean, there’s still a big chasm today but two completely different classes of humans in those early days between the store managers who were salaried and employed by the partnership and of course the to be called associates but the hourly workers who were not.

David: So a couple of interesting things. One, the people who were the store managers, this wasn’t quite like white collar workers. It’s somewhere in between. Most of these people didn’t have college degrees. They were salaried. Then they got equity in these partnerships. It wasn’t like these were Wharton graduates that were coming in and doing this.

Ben: Intentionally not. Those folks were discriminated against in the Walmart culture, especially in the early days of think you’re better than us, college boy.

David: Totally. One of the first managers was nicknamed The Bear and he had one eye. There are some crazy stories out there. They were bringing donkeys into the store.

Ben: Right. We’re talking Walmart. So take us to Walmart, how did we get from the Walton’s Five and Dime.

David: On the employee front, after Walmart went public, Sam instituted both profit sharing at the store level with the associates, with the hourly employees, but then also an employee stock purchase program. This is cool. Home Depot modeled their employee stock purchase program after Walmart’s and it’s brilliant. It’s the same thing. You put up your own money, but you can do it pre-tax dollars out of your paycheck at a 15% discount to the stock price.

Ben: This is what Microsoft let me do when I was a PM there. In addition to your stock-based compensation, they call it an ESPP (Employee Stock Purchase Program), Microsoft only lets us have a 10% discount, so it’s very kind of Walmart to give a 15% discount for market price.

David: There are stories in the book of hourly associates that made millions of dollars in the ’70s and ’80s off of the employee stock purchase program. It’s pretty cool…

…David: I’m totally inspired by Sam, Walmart, and everything. Okay, so back to the ’50s in Arkansas. Remember, we talked all the way back in the beginning of the episode about Sam’s brother, Bud. Well, Bud had gotten into the Ben Franklin business himself after the war in Missouri. One day, Sam is visiting Kansas City and he hears about a new suburb development going in just southeast of the city called Ruskin Heights, and it’s going to have a shopping center.

This newfangled concept is right in the middle of this suburb subdivision, and there’s going to be a grocery store, a drugstore, and real estate for a big Ben Franklin store. So Sam calls up Bud and he’s like, we got to go in 50-50 on this, this is a huge opportunity. They do, and it is a banger to earn $50,000 in annual sales the first year in Ruskin Heights, then $350,000 the year after and just keeps growing and growing.

Sam says when I saw that shopping center catch on the way it did, I thought, man, this is the forerunner of many, many things to come. The only problem was Ruskin was actually kind of a red herring. This was the future. This was the forerunner of many things to come, but it was still a little bit ahead of its time. This is really a 1960s thing, not only a ’50s thing. Sam is convinced though, that it’s the future. So he starts going around Arkansas and Missouri evangelizing the towns and city planners about putting in the shopping centers.

Ben: For which they would be the anchor tenant.

David: But it’s super slow dealing with local governments. It’s hard. It takes a long time. He wants to move fast. So he starts trying to put his own real estate deals together for multi-tenant shopping centers and fails. Eventually, because back to Helen’s advice, these multi-tenant shopping centers, I see the power in Ruskin, but it’s dependent on too many other people. But if I’m willing to invest some capital, I could just put bigger stores in the same locations myself. That’s what he starts to do.

Ben: Does he become his own landlord then and just buy the land or what requires more capital?

David: That’s a good question. I don’t know at this point if they were doing real estate themselves, but certainly, they are building out bigger store concepts, requiring capital to build the stores. It’s not like there were existing structures there then to outfit them with all the fixtures and all the inventory for the larger stores. But he and Bud together, start doing this. They call these new stores “family centers” and they start doing unheard of numbers—$1 million, $2 million.

Ben: Are they still sourcing the inventory from Ben Franklin from Butler brothers?

David: Yes. They don’t yet have their own distribution, inventory, and logistics network setup. That was the big step of Walmart. These were still just like much larger versions of Ben Franklins and they were working with them to get all the inventory to them.

Ben: Already at this point, they’ve bent so many rules with Ben Franklin like changing the store layout and concept, where they’re going, starting to dictate more terms, and naming them on their own. At this point, they’re really starting to treat Butler brothers as more of a component of the Walton business rather than Walton being a franchisee of Butler brothers.

David: Exactly. So these “family centers” that Sam and Bud were building are still Ben Franklin franchises. The Waltons are now taking over more and more of control of the concept, their self-service, they’re larger format, but it’s still part of the Butler brothers’ cartel, shall we say? Because they were part of Butler brothers, Sam and Bud were limited on how much discounting they could really do.

They were aggressive on pricing, probably more so than other merchants at the time, and they had self-service, the large format, and all this interesting stuff. But the prices weren’t that much different than other stores.

Ben: It’s worth knowing that we don’t think about the notion of discount stores today being counter positioned against something like all big stores have things at kind of the lowest price you can find them.

David: Because they’re all discounters now. I think 87% of market share in America is discounters.

Ben: Yeah. So there’s either specialty high end retail, which is often directly from the manufacturer sort of like vertically integrated or specialty sourced or something, or if you’re buying things that we consider a big regular store, they’re all discounters. At the time, there were no discounters. Everyone was marking up their goods by about 45%. If you’re buying something and then marking it up 45%, it means your gross margin is about 33% as a retailer.

David: And that was on top of the markups in the middle from the franchise operators.

Ben: The competition was so low that you totally could just do this. For reference, just so people have a sense today, Walmart probably has a gross margin between 20–24% at any given time, and every store had like a 33% gross margin. Even though Target is like a high end discounter—it’s sort of a nicer stuff, more expensive—they’re in the 29% category, but everyone was 33% or above gross margin at this point in history….

…Basically, everyone’s marking up their goods 45% and nobody has done other than Ann & Hope and a few other select folks that haven’t really rolled it out at scale or really popularized the movement. No one has done discounting, but what is discounting? Two major components. One is big loss leadership. Blow it out in order to get people in the store, do it in dramatic fashion, and then people buy other stuff.

Two is we make it up on volume, just don’t mark stuff up that much period across the whole store. Decide that you’re only going to mark things up 25% instead of 45%. Then when you do that, of course, you don’t make as much money per item. But everybody buys more stuff in your store. This hadn’t really been proven yet.

David: Yeah, and there’s another component. What you’re saying, which is Sam’s original lesson of, you actually make more profit dollars selling items at the dollar than you do at $120 because you sell three times as many. But there’s also the peace in the middle, the franchisor, the Butler brothers, remember, they’re taking 25% from the manufacturer to Butler brothers, and then out to the stores. That’s how most everything operated.

These discounters are like no, we’re going to go direct to the manufacturers for everything, just like Sam was starting to do in this but on the margins. We’re just going to completely not be a franchise operation. We’re going to own and operate everything. We’re going to operate our own back end, our own supplier relationships, and our own distribution.

Ben: There’s a great quote, this is again later in Walmart’s development. It’s when Sam Walton is informing the Walmart vendor relations team and merchandisers on how to deal with vendors.

He’s telling them, “Don’t leave in any room for a kickback because we don’t do that here. And we don’t want your advertising program or your delivery program. Our truck will pick it up at your warehouse. Now what is your best price? And if they told me it’s a dollar, I would say, Fine, I’ll consider it, but I’m going to go to your competitor, and if he says 90 cents, he’s going to get the business. So make sure a dollar is your best price.

If that’s being hard-nosed, then we ought to be as hard-nosed as we can be. You have to be fair and upfront and honest, but you have to drive your bargain because you’re dealing with millions and millions of customers who expect the best price they can get. If you buy that thing for $1.25, you’ve just bought somebody else’s inefficiency.”

David: Totally.

Ben: I love that. I mean, it is brutal but that encapsulates the philosophy so well.

David: There’s so much baked into that that people don’t even realize. To get to the point where you could do that, you need to operate the entire back-end of retail yourself. Sam and Bud and Walmart, they’re starting from they don’t have anything. To get to a point where you can have conversations with suppliers like that, you need your own shipping carriers, trucks. You need your own distribution centers. You need your own ordering systems. You need your own technology. They don’t have any of that.

Ben: You need to forecast. You need to be able to understand we’re going to sell enough of these units to go buy a crap ton at this super low price. We need to be able to be so confident that we can tell the supplier to spin up new inventory so that we will buy it to increase their production. Okay, that’s all the future. So at this moment.

David: Okay, so at this moment, Sam of course goes out. He goes and shops. He travels to the northeast. He shops in Ann & Hope. He goes out. He meets Sol Price, who he already knew.

Ben: And we’re in like the 1960s?

David: Late ’50s, early ’60s at this point, before 1962. He sees what they’re doing. They’re doing this proto discounting in big cities, and rings around big cities, not necessarily in the primo real estate downtown but where you have access to logistics hubs. You can sort of scrounge together and make this work. The idea that Sam could copy this and go do it back in Arkansas, it’s crazy. What manufacturers are going to ship stuff to Arkansas, especially big volume stuff?

He goes, he meets with Sol and Ann & Hope and he’s like, you know what, I think I can make this work. I think I can do it. Even he knows what a huge undertaking this is. He actually goes back to the Butler brothers. He’s like, we’ve been great partners. We’ve really innovated on a lot of stuff together. I’ve seen this discounting model. I think it’s the future. I know customers like low prices. I’ve got these new large format stores. Why don’t we work together on this? I need you to handle the backend. You have the scale to be able to do this. You already distribute out to small towns like mine. Let’s partner on this and do it together. And Butler brothers says no…

…David: In Butler brothers’ defense, they signed their own death warrant here, but that was the rational thing to do. This is like a counter positioning thing. they had all these other Ben Franklin franchises out there. If they had done what Sam is proposing and essentially taken out their markup on goods that they would provide to Sam’s stores, what are all the rest of their franchisees going to say?

Ben: It is literally the innovator’s dilemma because they have too much baggage to actually pull this new thing off. To be more specific about that, there is too much ongoing revenue that they would cannibalize in the short term by messing up all those relationships they had with their other franchisees where they would probably churn too much of that and risk the whole business so they could not take advantage of what could be the new wave.

David: Yep. The thing that Sam knew, the minute he saw discounting, was all of those stores were dead anyway.

Ben: Yeah, just a matter of time.

David: Somebody is going to bring discounting to Arkansas, Missouri, Texas, Florida, and everywhere else and those stores are dead.

Ben: It’s that insight that people who are out from cities want the same thing as people in cities, and so they’re just as bright. They want the same things in life. They just happen to not live in cities, so let’s not be pejorative. Let’s serve them with high quality retail experience.

David: Totally. So 1962, Sam and Bud secured a site in Rogers, Arkansas, which is pretty close to Bentonville. It’s got to say, they’re going to do this. It’s going to be chaos, but they’re going to figure out the backend, do this new discounting concept. They just need a name. Sam’s got a bunch of candidate names for what to call this new retail concept.

He’s talking with one of the early store managers, Bob Bogle, about his ideas. He says, what do you think? Bob says, you’ve got all these fancy names, but it’s pretty expensive. Building the neon signs of Walton’s Five and Dime and Ben Franklin. That’s a lot of letters. What if you just take part of the Walton name, keep that, make it a place to shop, and call it Walmart. Seven letters, that’ll be pretty cheap.

Ben: I love it.

David: The legend is born.

6. The Greatest Value Investor You’ve Never Heard Of – Macro Ops

The investor is Floyd Odlum.

Buried somewhere in the junk drawer of investing lore, Odlum’s story remains unknown. A quick Google search reveals his Wikipedia and IMDB pages. Yet in typical deep-value fashion, the last link on the page revealed Odlum’s investing story.

The Holy Financier’s blog post was that last link. The blog proved an excellent springboard for a deeper investigation into Odlum’s early life, initial career and his path to market fortunes. Although Odlum (pictured on the right) and Ben Graham never met, their investment philosophies are one in the same.

We’ll journey through his upbringing, his days as a struggling lawyer and his initial attempt at market speculation. Then we’ll see how Odlum turned $39,000 into $700,000 in two years.

Odlum wasn’t just a great investor. He also had a knack for choosing the most generic partnership names, such as his first “The United States Company”. The partnership, formed in 1923, was a couple’s affair. Odlum, George Howard and their wives seeded the partnership with $39,000 ($573K adj. for inflation).

What followed over the next two years was nothing short of incredible. According to Odlum’s biography, The United States Company grew 17x from 1923 – 1925. What started as a small partnership amongst friends turned into a $660,000 behemoth ($9.47M adjusted for inflation).

Odlum’s two-year CAGR is mind-numbing. If that wasn’t impressive enough, he generated these returns while working full-time as a law clerk!

How did he generate such outsized returns?

Well, he was a deep value investor. He searched for fifty-cent dollars and  scoured every corner of the market. According to documents from the Eisenhower Library, Odlum preferred two kinds of investments:

• Utility stocks
• Special situations

He defined a special situation as “an investment […] involving not only primary financial sponsorship, but usually also responsibility for [the] management of the enterprise.” The former lawyer wasn’t interested in flipping a business for a quick buck, either.

Embedded in Odlum’s strategy was the determination to see a special situation through until success, “[We will] stay with the investment until the essentials of the job have been done, and then move on [to] another special situation”.

Between 1925 – 1928, Odlum steadily grew the partnership. By investing in utilities and special situations, The United States Company AUM grew to $6M (over $88M adjusted for inflation). It was around this time that Odlum began sensing euphoria in the market. He smelled a top and he decided it was time for him to act.

In 1929, he rolled his original partnership into a new vehicle, The Atlas Corporation. Wary of a market top, Odlum sold half his assets. He stayed in cash and issued $9M worth of Atlas Corporation securities. With $14M in cash, Floyd sat on his hands. Waiting for the next market crash, which shortly followed.

But his bread and butter during the Depression was buying investment trusts. His strategy was simple. He found investment trusts that had fallen so much their stock prices were trading less than the value of their marketable securities. A good example of this in today’s markets is Manning & Napier (note: I do not hold shares).

He discovered he could buy these trusts, liquidate their assets, and reap large profits for his stakeholders. He was buying dollar bills for $0.60 and he milked this strategy for all it’s worth. He ended up buying and merging investment trust twenty-two times. The newspaper article profiled these dealings:

“He figured out that by buying all the outstanding shares of a particular trust, he was really buying cash or its equivalent at sixty cents on the dollar.”

When he didn’t have the cash to buy the trusts, he sold shares in his own company, Atlas, to fund the purchases. After exchanging his stock for the trust’s stock, Odlum would merge or dissolved the existing trust, keeping the cash and assets within Atlas Corp.

This strategy helped grow his assets to $150M ($2.2B adjusted for inflation).

Between 1929 and 1935, Odlum invested (and controlled) many diverse businesses. He owned Greyhound Bus, a little motion picture studio named Paramount, Hilton Hotels, three women’s apparel companies, uranium mines, a bank, an office building, and an oil company….

…He then pooled together another $39,000 to form his first partnership. That original $39,000 grew to $150M in controlled assets. All that during a span of just twelve years.

The math is incredible. Odlum grew assets 384,515% in a bit over a decade. That’s a 32,042% CAGR for asset growth.

And his early partnership returns are just as impressive. Odlum grew assets from $39,000 to $6M between 1923 – 1929. That’s a cumulative 15,284% return. In other words, Odlum compounded capital at an annual rate of 2,547%.

7. The Complex Case of Floyd Odlum – Frederik Gieschen

This is a piece about Floyd Odlum, a once-upon-a-time famous investor who made his fortune doing distressed deals during the Great Depression. But I want to start with a reflection on my process and the challenges of diving into a story. Here’s why.

I had read some twenty articles about Odlum, and his life seemed straightforward: a young lawyer from Colorado made his way to New York to become a dealmaker in utilities, one of the growth industries of the 1920s. He started an investment fund on the side, raised cash in 1929, and avoided the carnage. Through Atlas Corp., his publicly-listed investment trust, he masterfully acquired other trusts at steep discounts to their undervalued portfolios. By the time that Graham and Dodd published Security Analysis in 1934, Odlum had closed 22 transactions and amassed assets of $150 million. Once wealthy and famous, he married his second wife, racing pilot Jacqueline Cochran, served in the government during WWII, and retired to an estate in Palm Springs where he did deals by the pool and was visited by Eisenhower from time to time.

This story and its lessons seemed so clean. Stand back during the bubble, swing for the fences when opportunity presents itself, case closed.

I knew that Odlum’s records were kept in the Eisenhower Presidential Library. What I did not know until this week was that someone had combed through them all and put together a voluminous draft of a biography. After reading the outline, I reached out to the author, David Clarke, bought a copy of his unpublished work for $19.95, and dug in.

But then I stopped myself. This was supposed to be a short piece. Something that I could churn out on a weekly basis with a moderate amount of research. Reading an unfinished 700-page biography would blow up my schedule — and for what?

However, I quickly realized that the neat little narrative about Odlum’s life was wrong. I had no choice but to at least skim the work if I wanted to learn the real lessons of his life.

For example:

Odlum didn’t cash out before the crash. His utility stocks just didn’t decline as much and made a brief comeback, allowing him to redeploy the capital. It seems he never bothered to correct the origin story of his prescience which was repeated by one paper after another.

He made his early capital trading in utility stocks while being employed at one of the largest utility holding companies and running their foreign M&A efforts. While there is no evidence, and insider trading was not illegal at that time, Clarke suspects that this information edge played a significant role in Odlum’s early success.

Also, taking over investment trusts required convincing the board and key shareholders who often had no interest in selling. And it seems that Odlum was willing to bribe directors to get the deals done.

Around the end of WWII, Odlum made his last successful distressed investments, in oil and defense defense contractors, before departing from his circle of competence. Large bets on an airline, uranium mining, and a motorcycle manufacturer turned into sinkholes for capital in which he kept doubling down. His fortune started to dwindle.

His personal life was rife with tragedy as both of his sons died before him: one of alcoholism, the other of suicide after a string of failed deals and enterprises. In the end, Odlum’s wealth had been lost and spent. He and his wife, famous pilot Jackie Cochran, had to leave their beautiful ranch and live out retirement in a modest home.

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