Collaborative Fund partner Morgan Housel has a knack for elucidating important truisms through stories. This time around, the former Wall Street Journal columnist uses evolution to highlight the need for continuous change in business and investing. "Startups have their obvious challenges," he writes. "They're trying to find their niche. But once that niche is found and perfected, old companies discover a whole new minefield. They get complacent, bureaucratic, cocky, and unwilling to discard what once worked so well. There is never a point where a company can indefinitely coast along, cashing the chips of past success. Everyone has to keep running." Though exhausting, continuously running is how businesses best serve customers and remain relevant. As a counterexample, consider the April 14th edition of Beach Reads, which examined the risks associated with bailouts for industries (think airlines) that are poor at evolving (specifically, the ossification and entrenchment of such companies is a net-negative to society). So, like Housel, I hope companies keep running. I also hope that we, as investors, continue to evolve to stay current in a changing world.
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01. Investment Philosophy
The headwinds experienced by value investors over the last 13 years or so are often chalked up to strength in another investment style: growth. However, often underlying growth is the all-important "quality" factor. This piece from investment firm Lindsell Train examines what quality is and how it relates to its own portfolios. Importantly, author James Bullock highlights how improving quality is an important element of returns. Bullock writes that a number of holdings were "not obviously textbook quality companies when we first bought them. The business vitals were ok with mid-single digit returns and margins, but certainly nothing that would jump out at you from a screen. All, though, have improved dramatically in the eight or nine years that we've held them...and missing out on any would have made a noticeable difference to our performance." This is where factors or screens may fall short: the human eye and analyst mind seem better positioned to predict changes - improvements - in businesses, and the market rewards improving returns.
I owe a personal debt of gratitude to Aswath Damodaran, professor of Finance at NYU Stern, whose free online resources were a critical part of my early investing education. His blog, Musings on Markets, is great. He was recently interviewed by Barron's and I wanted to highlight a couple of fantastic quotes. First, I loved his take on continuous learning. "Improvise is the key word," he says. "It's how I've finagled my way to where I am today, by improvising. Because every time I run into something I've never seen before, I go back to basics, and amazingly there's so much give in the basics that I can stretch them to meet just about any requirement that I need, any conditions I face. But to me, every crisis is a crucible. It tests my faith. It checks my philosophy. And it teaches me new things." He suggests that others adopt this improvisation strategy, too, when cautioning against relying on old methods or assumptions when valuing companies. "My overriding message—get away from static to dynamic, from backward-looking to forward-looking. And that scares people." There is a delicate balance between extrapolating from historical facts while avoiding hindsight bias as we try to assess possible future outcomes. This may be where frameworks and pattern recognition are most important. And here is another snippet of wisdom that we should all live by: "You've got to be willing to change how you do things when you're wrong. There is this deeply held view that there is smart money on Wall Street. I'm looking for humble money."
02. Thinking About Growth and Moats
In investing, as in many aspects of life, it is easy to over-complicate things. Enter the KISS principle - keep it simple, stupid. Sage advice. This substack keeps it simple while yielding interesting insights by trying to answer one question: what makes stocks go up? The author determines that sales and earnings growth are most correlated with stock performance. Pretty simple, right? So does inverting the question yield additional insight? "People rarely spend the time to think about what makes a bad business. It is just not a thought that crosses many people's minds. But when you step back and think about it there are far more businesses dead and gone than are operating today. They all went away for some reason." Failed enterprises have common traits: "Stocks that go down or otherwise experience irrecoverable loss generally exhibit characteristics of financial leverage, operational leverage and cyclicality." As Berkshire Hathaway's Charlie Munger says, invert!
While much of public equity investing is described in books, venture capital (VC) approaches tend to be codified online (e.g. Sarah Tavel's hierarchies here). This has has the benefit of allowing audiences to track the evolution of thinking in real time and apply concepts to their own frameworks. As an example, I enjoyed this recent substack piece that highlights some tools that can help readers find potential growth opportunities in VC land. The author focuses on three areas: businesses that serve "young" customers, businesses that have gaps between engagement and monetization, and artificial barriers that may hold back scale. Combing all three, he writes "the breakdown of artificial barriers has the potential to serve as a catalyst for new emerging markets, vaulting them across the chasm to mass adoption and monetization." Putting theory into practice, the author highlights areas that may be ripe for potential future growth: video games, micro mobility, and creator economy.
Critical to assessing how defensible companies are and how durable their growth will be is developing a good understanding of their moat(s). This can be a tricky project: companies that initially appear to have wide moats may turn out to be vulnerable once they are attacked, while others turn out to be more resilient than people thought. "When a moat is attacked, and that attack is repelled, it should greatly increase your confidence in the durability of a company's competitive advantage, and your valuation of the asset," writes the author of this blog post. "Moat attacks are happening constantly. In fact, just off the top of my head, I can think of attacks on Moody's moat after the financial crisis, or Visa/Mastercard facing attacks from new fintech players and digital wallets. In each of these cases, the moat was sufficient to defend the castle and the stocks have soared to new highs." But companies that succeed in fending off one attack aren't immune to future raids, since disruptors and the strategies they use to breech moats continually evolve. With the average lifespan of a S&P 500 company coming in at less than 20 years, eventually most moats fail, making well worth studying the rare company that can fend of multiple attacks.
03. Outdoor Voices' New Strategy, Video Games in the Olympics, and Semiconductors
A green shoot emerges among fallen direct to consumer (DTC) stars. As highlighted in past Beach Reads, Outdoor Voices (OV) is an athleisure brand with a turbulent past (see here). According to this Vogue article, though, ousted CEO and founder Tyler Haney is active with the OV board again and is looking to set the company on the right path. "Details of the structural rehaul of Outdoor Voices are still slim, but the idea, according to Haney, is to focus the company around mission and longer term company sustainability and hire leadership that is aligned with these things...Indeed, from the outside Haney has always seemed to put female empowerment and dedication to diversity, equity, and inclusion at the forefront of her brand." Now past the churn-and-burn phase of startup life, I'm curious to see what success OV may have as it deepens the brand and focuses on a long term, sustainable vision for the future. If successful, OV could write the playbook for other troubled DTC companies to get back on their feet.
Previous Beach Reads generally refer to video games and eSports in the context of the metaverse. A recent Economist article suggests an alternative use for video games as Olympic events. There is a serious case to be made here. Consider the following: "Electronic sports such as 'Fortnite'...are vastly more popular than Olympic oddities such as dressage or curling. In fact, they are more popular than most mainstream sports. Only 28% of British boys aged 16-19 watch any traditional live sports; 57% play video games." Compared with many traditional sports, video games are cheap, accessible, and provide an important social outlet. I can see a day in the near future when eSports are in the Olympics, although figuring out which game to feature is difficult. Whichever title ends up being picked would significantly increase its longevity, providing a massive boon to the publisher, which would undoubtedly upset rival game producers. So perhaps an equitable solution would be to rotate games or publishers - a task that I'm sure has plenty of conflicts, too.
NZS Capital took a multimedia approach comprising a written essay and a podcast to illustrate its thinking on the semiconductor sector and to highlight how critical chips are to everyday life. Importantly, the content illustrates how a combination of consolidation and ever-increasing complexity and cost in leading-edge chip making have left just a handful of companies with the capability to advance semiconductor technology. NZS believes that these businesses have wide moats and should continue to grow for years thanks to the still nascent digital transformation of the global economy. Additionally, the authors examine why China's attempt to catch up by building its own semiconductor industry may be futile. "As a nation China remains several years behind its American and European counterparts, a gap that would likely be decades without access to western tools. Moreover, China has little to no hope of closing the gap, since it's impossible to reverse engineer the complex processes, making traditional industrial espionage techniques pointless."
COVID-19 has kept many of us indoors for extended periods, forcing us to look with increasingly critical eyes at the design and function of our bedrooms, home offices, kitchens, bathrooms, and living rooms. One immediate response has been more customization and change to our spaces: as evidence, look no further than the increased sales of DIY materials and home furnishings. Tracking longer-term changes will be more difficult but this New Yorker article does a good job of framing how architecture may change as a result of the pandemic by looking at how the discipline responded to past disruptions. One interesting idea is the potential for increased domestic eclecticism. "The pandemic brought the whirl of the culture industry to a halt," the article says. "No more leaving the continent to check on a project, participate in an award panel, or attend an opening before flying back home...As travel has been forced to slow, perhaps the trend toward a homogeneity of space has, too. Or at least now there's time to stop and question it." As a counterpoint to the rise of the AirBnB aesthetic, we may see a bifurcation of architectural modalities: while shared social spaces become more sterile, personal spaces become more individualized. Taking this one step further, I'm curious what the personal equivalent of architectural or design individuality is. If people are creating more unique homes, how else are they expressing individuality? Spending more time on hobbies? Is Shopify seeing an influx of new businesses? Are book sales up?
When growing up, I had a "tadpole kit," which challenged me (and, frankly, my parents) to raise a frog from its juvenile state. We succeeded and to this day I remember driving down to a local creek to let my beloved frog go free. Watching it hop from dirt to rock to water's edge was both liberating and upsetting. Traumatizing as this was, it seems tame compared with its successor, the butterfly kit, which exposes kids to altogether more horrifying levels of potential anguish, according to this Wall Street Journal article. "Some parents found the nature lessons exceeded expectations, teaching their young children about cannibalism and death. 'They ate their friends!' said 2-year-old Emberly Bastide, who lives outside Denver. Two caterpillars had lunched on a weaker one, said her mother, Stephanie Bastide." In these turbulent times, lessons about the circle of life are important to understand. Perhaps cannibal caterpillars are a bit much, though.
Disclaimer: To the extent that Beach Reads discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. The companies and or securities referenced and discussed do not constitute an offer nor recommendation to buy, sell or hold such security, and the information may not be current. The companies identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the companies identified was or will be profitable. Beach Reads does not constitute a recommendation or a statement of opinion, or a report of either of those things and does not, and is not intended, to take into account the particular investment objectives, financial conditions, or needs of individual clients.