Invest Like the Best with Patrick O'Shaughnessy - Gavin Baker - The Cyclone Under the Surface - [Invest Like the Best, EP. 260]

Episode Date: January 25, 2022

My guest today is past guest Gavin Baker, managing partner and CIO of Atreides Management. Gavin’s focus is on consumer and tech growth investing, which makes him the perfect person to discuss the bloodbath we’ve seen in many growth equities over the past few months. We also cover inflation, semiconductors, and the disconnect between private and public markets. Please enjoy this conversation with the always great Gavin Baker.   For the full show notes, transcript, and links to the best content to learn more, check out the episode page here.   -----   This episode is brought to you by Canalyst. Canalyst is the leading destination for public company data and analysis. If you're a professional equity investor and haven't talked to Canalyst recently, you should give them a shout. Learn more and try Canalyst for yourself at canalyst.com/Patrick.   -----   This episode is brought to you by Lemon.io. The team at Lemon.io has built a network of Eastern European developers ready to pair with fast-growing startups. We have faced challenges hiring engineering talent for various projects - and Lemon.io offered developers for one-off projects, developers for full start to finish product development, or developers that could be add-ons to the existing team. Check out lemon.io/patrick to learn more.   -----   Invest Like the Best is a property of Colossus, LLC. For more episodes of Invest Like the Best, visit joincolossus.com/episodes.    Past guests include Tobi Lutke, Kevin Systrom, Mike Krieger, John Collison, Kat Cole, Marc Andreessen, Matthew Ball, Bill Gurley, Anu Hariharan, Ben Thompson, and many more.   Stay up to date on all our podcasts by signing up to Colossus Weekly, our quick dive every Sunday highlighting the top business and investing concepts from our podcasts and the best of what we read that week. Sign up here.   Follow us on Twitter: @patrick_oshag | @JoinColossus   Show Notes [00:02:30] - [First question] - What it’s been like investing over the pandemic  [00:06:14] - The way he thinks about multiples, how they’ve done, and where they’re going [00:09:14] - Themes that most have his attention in our current economic landscape [00:19:25] - The ways in which wage inflation negatively impacts the market [00:25:39] - How semiconductors have evolved and what matters in that subsector [00:32:47] - Software volatility and the roller coaster it's been on lately [00:35:52] - A future state where infrastructure overtakes apps  [00:41:03] - Key differences between internet and software and how they behave [00:43:44] - The coming trend of the metaverse and his reaction to public adoption [00:49:26] - Investor and business opportunities in adopting tech trends [00:53:54] - An unfolding mismatch between private and public market multiples [00:57:17] - How the competitive landscape of venture capital might evolve [01:05:54] - Differences in recruiting and training talent in private and public markets [01:10:20] - Sci-Fi novels that he’s read recently; Dune, A Wizard of Earthsea, Culture, Hyperion 

This episode of Invest Like the Best is sponsored by Canalyst. Canalyst is the leading destination for public company data and analysis. Founded by a former byside analyst who encountered friction sourcing, building, and updating models, Canalyst is now used by over 400 institutions, including the largest money managers globally, and by a number of guests on the show. With detailed company-specific models and data on virtually every public company, panelists clients are able to ramp up faster, update models instantly, and incorporate the highest quality fundamental data into any workflow. If you're a professional equity investor and haven't talked

to Canalyst recently, you should give them a shout. Learn more and try Canalyst for yourself at canalyst.com slash Patrick. That's C-A-N-A-L-Y-StT dot com slash Patrick. Stay tuned after the episode to hear more about Canales's new quaint product, Candace. This episode is brought to you by lemon.io. The team at lemon.com has built a network of Eastern European developers ready to pair with fast-growing startups. We have faced challenges hiring engineering talent for various projects, and Lemon.io offered developers for one-off projects, developers for full start-to-finish product development, or developers that could be add-ons to an existing team. Check out Lemon.io slash Patrick to learn more. Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best.

This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the colossus. family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi asset management. This podcast is for informational purposes only and should not be relied upon as a basis for

investment decisions. clients of Oshonnessy asset management may maintain positions and the securities discussed in this podcast. My guest today is past guest Gavin Baker, managing partner and CIO of a tradee's management. Gavin's focus is on consumer and tech growth investing, which makes him the perfect person to discuss the bloodbath we've seen in many growth equities over the past few months. We also cover inflation, semiconductors, and the disconnect between private and public markets. Please enjoy this conversation with the always great Gavin Baker. So Gavin, here's our traditional every 18 month or so podcast. I'm so excited to talk to you again.

Markets have changed a lot. I think the last time we talked was not maybe at the bottom, but pretty damn close to the bottom in the beginning of COVID. Mark, it was off 30% or something crazy like that. We sure have come a long way. If you just look at the index levels, it's been a wild, wild ride. Maybe we'll just start at the very highest level. What's it been like investing since our last conversation?

How would you characterize the period relative to the rest of your career? Well, I think 2020 was, I mean, statistically, probably the most alpha-rich year. Any active fund manager we'll see in their lifetime. COVID gave you such an opportunity from evaluation perspective. And then there was such massive dispersion in the relative fundamentals of different industries and companies, mostly based on whether or not you benefited from a remote work, work from home, remote schooling environment, it's hard for me to imagine you will see that kind of dispersion again. I would say for me, not to generalize, but I do think it was statistically a very hard

year, 2021 for most growth-oriented fund managers, most tech-oriented fund managers, whatever the vehicle. I think 2021 was a tough year, but it was an awesome year for the market. Probably the reason I originally started texting on the last week or something was around this crazy setup where because the largest companies have continued to do very well fundamentally and with their prices, the market's like at or near all-time highs and kind of has been for a long time. Meanwhile, there's complete carnage in a lot of the heavier growth parts of the market. And I think most people don't feel it because they're not focused on that growth part if you just have a broad portfolio. I don't think people appreciate how viciously bad it's been. and Zoom as like the extreme examples of like high flying COVID names, but it's been brutal.

So curious how it's felt for you. Well, it's felt brutal. These are not facts. This is just kind of the way it feels. I'd say probably the average tech or consumer-oriented growth stock that's below $100 billion in market cap is probably somewhere between 40 and 65% off its all-time high. Some of the cases, you mentioned some of them,

they're off more. And the multiples have compressed by significantly more than that move, because the underlying fundamentals have continued to grow and compound. You're not at 2001-2002 level of crash, but it really has been a crash underneath the surface for any small mid-cap. I might even say I lose track of what's a large cap, what's a mega cap these days, but let's just say under $100 billion, it has been really very, very painful. The market return, particularly for the NASDAQ, was really dominated by a few stocks. Google, Microsoft, Nvidia, Tesla. You just either

had 50, 60% plus of your portfolio in those names, which was the right thing to do. As a professional investor, your job is to make the right decisions. But if you did not have an overwhelming allocation to those four or five names, it was a very, very hard year, which is I think why a lot of growth fund managers, a lot of whether long only or hedge fund struggled, particularly relative to the NASDAQ, that's failure. It just is. The multiple thing has been kind of the craziest thing to watch from the cheap seats, public markets are pretty broadly diversified quantitative investor, not taking big active positions, but looking at like the next 12 months revenue multiple or gross profit multiple or whatever on internet stocks and software stocks, it's a crazy round trip.

You just said it like this is a job where you're evaluated very clearly on a scoreboard every year. How do you think about multiples in your investing process? A lot of people like to pay lip service to buying great businesses that compound over time, but But multiple contraction expansion has been the story. So if you didn't heat it, like you said, had a very bad year last year. So how would you describe the way that you think about multiples, what they've done and kind of where they're going? I am a Navy-Free Cash Flow investor. I mean, I do think that if you're going to pick a single source of truth from a multiples perspective, that's at least my single source of truth.

multiples have kind of round trip back to, I'd say, broadly speaking, 2018 levels. And I find that pretty encouraging because in 2018, the tenure was at 3%. You were already deep, deep into a massive tightening cycle that began in 2016. And so now you have companies that are at, or in some cases, well below their trough multiples from 2018. And I do find that encouraging. But yeah, I do find it encouraging from a go-forward perspective that we're already where we were or below where we were in 2018. When rates were higher, you're much deeper in a tightening cycle. And I think one thing that is missed in these analyses that you kind of see whether on multiples today versus in is these companies are much better.

Okay, so software multiples are back to where they were at 18, but software companies today are growing faster. and broadly speaking, have better margins. Same thing with a lot of the internet companies. These industries have continued to mature from a cash generation perspective, but they're not really maturing from a growth perspective, although I do think we have to really separate software in Internet. I think a lot of Internet companies are likely to disappoint in this upcoming earnings season. There is reasonable telemetry into a lot of these stocks between app downloads,

web traffic, credit card data, A lot of these companies, COVID took them to a place that was way above trend, and now that's normalizing you. That's painful. Whereas software, you don't have that same dynamic. Maybe there was a little bit of pull forward, but I don't think you're going to have broad base weakness in software companies that you're going to see in a lot of these kind of smithcap internet names. And by the way, God forbid some of these smithcap internet names don't mess because some of them have gotten really, really, really, really cheap. Good, high quality businesses. you've got to work through the sakeover.

But I think it's important. I think software and the internet are in pretty different places fundamentally, let alone semiconductors. And those are kind of the three big sub-sectors of tech. If we had talked, I don't know, nine, 10, 11 months ago, the setup arguably would not have been nearly as good. Who knows what we would have said then? Maybe we would have thought multiples would just continue to expand.

But today, undoubtedly, like you said, they're at or below. There are 2018 levels. The businesses are better. So it stands to reason sort of that there's more. interesting opportunity set in those three major subsectors of semi's software and internet. I want to come back to those in a minute. Before we do that, I'd love to level set with the things in the market or the economy or the world that you're most carefully interested in and watching relative to the last time we talked when obviously it was sort of all COVID. But the world has

changed a lot since then. We're sort of settled into COVID. Inflation has become a dominant theme. What are the themes that outside of just individual companies have your interest most, that you think most matter for general market returns from this point forward? I think for me, inflation is the only thing that matters. And I think there's a lot of focus on the Fed. To me, the Fed is a little bit of a side show. Like, I've lived through a lot of Fed tightening cycles. There's a lot of great work that's been done on how equities do.

Generally, stocks are up. Actually, to get every tightening cycle dating back something like 25 years, stocks are up 12 months after the first rate hike. By the way, the reason they're up, up is they generally sell off into the first rate height because the market isn't anticipatory. And everybody sees these studies. Things happen faster. The market is becoming even more anticipatory over time.

And what's different about this Fed tightening cycle is you just had the highest CPI printed 40 years. And I do think, like, in terms of kind of mistakes I made, like, I really underreacted to Powell's appointment. I'm not somebody who's mindlessly bullish on growth. I'd say I was very cautious, high multiple growth stocks. from probably the summer of 2020 to April, May of 2021, wrote this big piece on Medium explaining why I was getting more positive. That was way too early, but a lot of those stocks, even back in May,

there are multiples that already corrected 50, 60% plus. We digested a pretty big move in the 10-year. Powell was reappointed, clearly with a mandate to crush inflation. The market got that right, the market. I mean, it was right away. the data power was appointed. That was a sea change in the market that is persistent through today. And I think just what's different is this 7% CPI number.

And if you think about what drives the market, just like stocks, it just comes down to earnings and multiples. And liquidity drives the multiples and GDP growth drives earnings growth. The Fed, because inflation is at 7%, I think that's why this selloff has been so severe, just because this is different than it. Anything, any professional, I mean, maybe there's some people who were, I guess Warren Buffett was investing in 1982. Okay, you know, maybe there are a couple of people who were professional investors and active

investors in 1982, but not many. The bottom's up investor, you do kind of have to be macro aware. And I think there's two parts to inflation. The first one is supply chain driven, the shortage of goods, everybody's read about, ships stacked up the port. We can't get enough semiconductors to make cars. I am so relaxed about that. It is very rare for me to have a view on something like that.

I just think we now have hundreds of years of history and capitalism is amazing at solving problems. It is so good. And we have seen a massive supply response. This is a statistic. I actually just ran this this morning. Amazon has spent more money on KPEX. And this is just illustrative.

It's not a comment on Amazon. It's just a comment on the supply response. They have spent more money on CAPX in the last two years than they did in the preceding 20 years. Insane. Think about that. From 1999 to 2019, they spent $62 billion on CAPX. They're going to spend $87 billion in 2020 and 2021. That is unimaginable.

And no, I did not go through and nerdily adjust every year for capitalized leases, okay? And maybe it makes it more striking, maybe it makes it less striking. other way, it's crazy. Taiwan Simi, their 2022, CapEx is going to be many multiples of 2019. 2021 and 2022, they'll spend more than they did in the preceding five years. So there is a massive supply response coming. We know that the economy is slow. We know it from credit card data, retail sales, which is a government report, they're up 16% for the year. They're flat in November, down to December. And then the Atlanta Fed does this thing they call the the GDP now, and that was 10 to November 5 in December. So the economy is slowing rapidly.

So we've got this massive supply response, an economy rapidly slowing before the Fed begins to take away the punch bowl. I think you're about to have a truly massive shift in consumer spending away from goods towards services. If you trined out and look at real personal consumption expenditures, good spending is roughly 500 billion above the pre-COVID trend line. services spending is $500 billion below the trend line. And that shift, Omicron is probably the end of COVID. To me, as a factor for investing for daily life. So do you think the economy will finally normalize?

So when you have this supply response meeting a selling economy and I shipped away from goods towards services, I just think all of that inflation goes away. Colman did this analysis. Auto was accounted for half of the overshoot in core inflation. auto prices, they're kind of flat for forever and then they went up 50% at 18 months. All that goes away. Maybe it doesn't want to be appropriately humbled, but I think highly likely that all that is going to go away.

But it doesn't go away, wow, okay, I'm going to be horribly, horribly wrong. And I do think this post-World War II period is an interesting get along for this. You had a 20% CPI, basically because there is a huge boom, factories, really good at making tanks and fighter jets are not going to make you anything else. there was a supply response, and CPI went right back down. And so I think for that component, that is for sure going to normalize. I think the other thing is wage inflation. And this is something where there are things happening in the economy that have literally

never happened before. Like the ratio, there's more unemployed people looking for work than there are job openings. Now there's more job openings than there are people looking for work. The ratio of job openings that unemployed hit an all-time high. Hi. Something happened that's never happened before. I think it's important to like think about it with an open mind. And it's like, okay, why? Why has this happened? Well, point number one, we had massive stimulus since the New Deal. And on top of that, we had a debt jubilee. And I don't think we really fully understand how powerful that debt jubilee was. We basically said, you don't have to pay rent. Student loan, forgiveness, eviction, moratoriums, all the stuff. You had all of that. You had people, a lot of people over the age of 62 left the workforce. And I think part of that is people probably took these voluntary buyouts that companies,

I'm sure they wish they had not given in the spring of 2020. Then I do think you have to give people credit for being rational. I think you didn't take COVID as much, Gary, or if you're over 60, then if you're under 40, I'm sad to say I'm over 40. So you had a lot of people retire. And then I also think you had a lot of people who, because of remote learning, a lot of of two-income households went to one-income households. All of that is normalizing. The debt jubilee's over, stimulus is fading, consumer savings are beginning to draw down. I do think after Omicron,

kids are going to be able to sustainably go back to school. So a lot of that stuff is fading, but really, really, who knows? And if wage inflation is here to stay, I think it means very bad things for the market. It's just that simple. I mean, I think on balance, it's probably not here to stay. These forces of globalization, they're just too powerful. I'm not sure that the idler movement is here to stay. It's one thing to be an idler while you have a debt to Jubilee and a lot of savings. It's another thing when you burn all of that down.

But I just think it's important to be humble. You know, anytime you're talking about forecasting the future, you want to be humble. People have been trying to do it for thousands of years unsuccessfully. And at the end of the day, that is what fundamentally investing is you are forecasting the future. You have a differential opinion on the future, full stop. People don't like to admit that, but that is what it is. As hard as that is to do for individual companies, it's way harder to do for the entire economy, which is the world's most complex, chaotic system, high sensitivity to initial conditions,

unpredictable interactions. Everything I'm saying, I want to caveat with that. I don't know if I've given you my two examples before Patrick and feel free to stop me if I have, but like I always think about the Fed, Federal Reserve, they employ more, more PhD economists than anyone. They have more information on the economy than anyone, like way more information than anyone, but they have vast amounts of computing power,

and they have no ability to forecast the economy more than six months. And so, A, I'm way less smart, B, I have way less information, certainly have less computing power. So there was a letter written, an op-ed written in the Wall Street Journal, they're somewhere between 2010 and 2012. And I think a majority of the world's PhD economists signed it. Every famous macro investor you can think I've signed it.

But it basically said, hey, Ben Bernanke, you have no idea what you're doing. This quantitative easing is going to cause massive inflation. It's going to ruin America. You're going to bring about hyperinflation. It's going to be the ruin of America. They were dead wrong. Horribly wrong. I remember that op-ed really well.

And it's such a good point to, like, copy out that this stuff is incredibly hard to predict, but I think maybe even more interesting is, let's just assume it comes to pass. So predicting is one thing, but the impact is another that maybe we can explain more coherently than we can forecast the future. I'm just curious how you think about the ways in which wage inflation is bad for the market. It seems at a top level, kind of obvious, but maybe it's not obvious and maybe there's a lot of nuance behind how you think about it. So just walk us through that. Like, why on average should it be bad for stocks if there's a lot of wage inflation? So it is very, very simple.

And I've written about this. The best thinking of this comes from Buffett. And it is first principles thinking. So Buffett and Charlie Munger, if you listen to what they say, a lot of it is basically a long-term return of an equity, should have a progress made. It's return on equity, which makes sense for a lot of reasons, mostly having to do with reinvestment, simple DuPont equation. And so then you can think of today we'd say RIC, not REOE.

And Warren Buffett wrote this amazing article in the 1970s, that the United States, that is by far the best thinking I've ever read on why inflation is bad for the stock market. And the reason it is bad for the stock market, and you kind of go back to the DuPont formula, is that inflation, let's just say everybody just takes price increases in line with whatever their input costs are. So their margins stay the same, but inflation ultimately inflates your asset base instead that depresses your ROE or your ROIC. So thereby your expected return goes down. And it's even worse because at some level, you know,

what you really care about as an equity investor is the gap between the ROE or the RIC of your portfolio, your equity portfolio relative to the yield on government bonds. So that obviously gets way worse in an inflationary environment. That actually gives me a great deal of comfort about secular growth in technology. And I think it's probably one reason I am right now as bullish, and I'm sure I'm early, always early. I'm addicted to the 52-week low list, okay? I cannot stop myself from buying weakness. I almost always have a negative exposure to momentum.

I'm wired differently in some ways and a lot of other growth investors. I always buy early. I always sell early, and I wish I weren't that way. But I am 100% I'm early. But I do think if you think about that from first principles, everyone does. analysis, they look back to the 1970s and tech was one of the worst performing sectors in the 70s. Well, tech companies in the 70s had nothing to do with tech companies today. They were really asset-heavy companies. They made stuff. They had relatively low gross profit dollars per employee.

And I do think that is a metric to really focus on revenue and gross profit dollar and free cash flow per employee. And so, of course, they did badly in this Buffett framework. Today, tech companies, they're super asset light. They have the highest ROICs. They have massive pricing power. Got probably, broadly speaking, has a sector the lowest of employees per dollar of gross profit or free cash flow. I don't think tech will perform going forward the way it did in the 70s. And I think from a first principles perspective, they should be some of the companies that do the best. I'm not mindlessly bullish on tech. Like I go through periods where I'm so cautious on tech and growth. But today, I would say I'm as bullish as I've ever been on these

names that are down 60 to 70 percent, where in some cases the estimates continue to be revised up. You're trading at multiples below where you were back in 2018. And look, if we do have persistent wage inflation, all equities are in a world of paying. But just on a relative basis, I think from here, looking out 12 to 18 months, a lot of these mid-cap tech names are going to be a reasonably good place to be relative to the market. The only caveat I would add is I do have a big bias towards the ones that generate free cash flow. I think one thing that's actually happening today and a little bit last week for the first time, it used to be correlation one sell-offs. every name over 10 or 15 times EV sales is down the same amount.

Well, you're seeing the market differentiate today and starting last week around free cash flow because some of these names are at two or three or a four percent free cash flow yield looking out to 2023. And that's very different than if you're still burning cash in 23. So I am, I do think that's kind of an encouraging thing to decide. But look, it's like if wage inflation is here to stay,

basically there are these two calculations that everybody does to make them feel better about rates. What is what it will do to the American consumer, if rates go significantly above the average mortgage rate, because you do have all these adjustable mortgages that reset, it will almost semi-automatically cause a massive recession. So people think that that's one governor. Other governor, of course, is the fact that the U.S. government at the end of the day is at some level in control of all of this. they're running a massive deficit. So by raising rates, they're kind of raising their own borrowing costs. I think everybody looks at those things and thinks, oh, well, you know, the 10-year can't go

above 2.75 or 2.75 or 3.25. Everybody does these calculations in different ways. My point is all those calculations go out the window if wage inflation is here to stay. I think you could have more pain for broad equity markets if wage inflation is here to stay and all this ROEs begin to compress. But I do feel reasonably okay about these mid-cap growth tech names. You've already taken the pain on the multiple, the terminal value. Now you're in many cases back to a pretty reasonable place.

Their relative fundamentals should be the best. And in short timeframes, because of the economy slowing and everything we talked about, and in short 12 to 18 months timeframes, relative fundamentals generally drive relative performance. I'd love to dive in a little bit just underneath that big trend. You mentioned the three subsectors of semis, software, internet. Maybe we could also talk about a fourth category, which is the big five or the big 10 technology companies that are sort of conglomerates at this point. Maybe we'll start with semis.

You know, I've talked to you about this in the past. I'm just totally fascinated by the semiconductor industry. I know this is where you cut your teeth a lot, followed it since its beginning and since the start of your career. A lot of people had never heard of Taiwan semiconductor two years ago. And I think a lot more people have now, for a variety of reasons. not just the shortages and the importance of supply chain, but also the geopolitical stuff. Walk us through your take on semis today and what's evolved and what matters in that subsector

in tech, since it's such a key one. Let's step back and look at the last 15 years of STEMIs. The industry has completely consolidated to where you almost have these monopolies and almost monopolies or duopolis. In every subsector of semis, you either have a monopoly, duopoly, or in the worst case, an oligopoly of three. And then even their suppliers to capital equipment companies, they're all either monopolies or duoplies.

So the industry is massively consolidated over the last 15 to 20 years in a way that maybe should have never been allowed to happen, although the fact is that a lot of these markets they do for a lot of reasons, they do mostly because a network affects around software code and in economies of scale, they do tend towards being a monopoly, a monopoly or duopoly. So in bass bands, there's a duopoly. CPUs, there's a duopoly. GPUs, there's a duopoly. Now, it's an oligopoly because Intel's entry in that industry.

Memory, it's an oligopoly for both band and DRAM. Analog, almost part by part, it's generally a duopoly. Same thing for FPGX. So it's a very consolidated, concentrated industry. And you have had demand, I think, structurally shipped up. And this has always been a secular growth industry. It's always grown, I call it between 1.5 to low 2s multiple of GDP, global GDP. So it's always been a secular growth industry, but that multiplier shifted up.

And the reason it shifted up is broadly speaking because of artificial intelligence. Human beings, when they write software code, they make a big effort to minimize their use of, at least good programmers do, use of resources like compute and memory. You used to have to have a budget you had to work with before the data is a cloud. computing, only so much memory, only so much storage. The way cloud computing can throw that all up the window, and AI is just the inverse. The way you make AI better is you train it on more data. That's it. It's really just that simple.

And there's just a really good rule of thumb. And Microsoft wrote about this in a research paper 10 years ago, or maybe not 12 years ago, the quality of a given AI algorithm doubles with every 10x increasing the amount of data you used to train that algorithm. And Mark Andreessen wrote this op-ed, whatever it was, 10 years ago, about how software is eating the world. Now AI is eating software. And that just means that the world is getting much, much more compute and semiconductor intensive. And then on top of that, you have all these, at the end of the day, cars are a massive, massive consumer market. And has those become EVs and next AVs, the semiconductor content for car is really

exploding and you put those two things together, the world is just becoming a lot more semiconductor intensive. The bummer, and I would say I'm probably as cautious as I've been on semiconductors in a long time right now, it is still a cyclical industry. If you look at the history in the industry in the 80s and 90s, you have these capacity cycles and they're driven by the fact that God, I can't remember his last name, but he was hilarious. T.J., he ran Cypress Subminecter. He famously said real men own fabs. Because there was this trend of going. There was this trend of going fabulous, but it used to be, you know, in the 80s and 90s,

if you ran out of capacity, well, the only thing you could do was build a new fab. And everybody intended to run out of capacity at the same time. So all these fabs would come on at the same time. And so you can think of demand as being the smooth underlying true demand, the smooth, relatively smooth line. and then capacity comes on in this stairstep pattern. So you would have these vicious cycles, and companies were always going out of business,

but then the world moved to Fabless with few exceptions today, Intel, Samsung, Taiwan, Semi. There are the only companies in the world that can make leading edge logic. There's only three companies that can kind of make leading edge DRAM, maybe four for NAND. And so they got much better about aggregating capacity smoothly. And as a result of that, the cycles you've seen the last 20 years are just inventory cycles. And the reason for that is the fundamental equation that covers simis is customer inventories must equal lead times. Because if they don't, then you're purchasing manager, you get fired. So whatever lead times are, that is what customer inventories are. And that leads to this

crazy positive feedback loop where if lead times are going up, inventories are building, which causes lead times to go up, which causes inventories to build further. And then as soon as something changes, all that unwinds. And then lead times are going down, you're burning an inventory. So if you're a semiconductor company, you're never seeing true in demand. You're either seeing above market demand because lead times are going out and inventories are building are below market demand, are below true in demand. And so you've had these inventory cycles really consistently for the last 20 years.

What you have right now is, I think, a massive inventory cycle. and everything we talked about, the economy slowing, even before the Fed hikes hit, PCEs shifting away from goods towards experiences. I think demand for Simeas is almost inevitably going to decelerate a little, and that's going to lead to an unwind of this inventory cycle. And then all the capacity that's being brought on probably makes it worse. But then I think you get to the other side of that, and you're left with an industry that used to grow at 2x nominal GDP to one that probably now is a 3x nominal GDP grower. And you still have that super consolidated supply structure. You're now having people saying civic director companies should be valued software companies. And no, they shouldn't.

You have a bunch of people. every fund I know that's under $50 billion is frantically looking for a simic conductor analyst for somebody who's really good at Simi's. I have a lot of tourists in the sector. And it's just when these companies miss, they miss big. Just go back to the fourth quarter of 2018. You can see some really, really, really big misses. So I'd say relatively cautious on simis.

Last time we talked to, I think there was a big question about how secure these incredible retention numbers and net dollar expansion numbers were for software companies in the depths of COVID. Curious how you're thinking there has changed. I mean, just to use Zoom as like the obvious example of just insane run up and now insane run down. The fundamentals of the business are pretty amazing, as we've all adopted it. We're talking on it right now. Talk me through your views on software and kind of the roller coaster that it's been on. Yeah, well, first I have to say, Mea culpa, I was wrong, predicting the future being very, very hard. I think last time I was on your podcast, I said something to the effect of software is not going to be better than firstly debt.

Well, I was wrong. Software was better than firstly debt. It just was really across the board. So I was really, really wrong. And today, I think now you're looking at, I do have this bias for companies that are generating cash flow. That's a big line in the sand for me. And there's a huge difference to me when I look at a company over 10 times sales, over 15 times sales, between having a two, two and a half, three percent free cash full yield, looking out to 23 and a company that's still burning cash. I'm really, really bullish on software. It is, particularly in a world of slowing growth, which I do think for sure we are in for, it's the consumer staple of tech. It should have the best relative fundamentals.

And a lot of ways, their fundamentals should be more stable than even staples. I'm really, really positive on it. I do have a bias, I would say, towards infrastructure companies relative to application software companies. You know, there are a lot of application software companies that don't have a lot of true technology. And I do think they're a little bit at risk from, you know, as it gets easier and easier and easier in the cloud to build your own applications, use your own data, not share it. It used to be like the CIOs were scared of going to the cloud because they thought they'd

lose all their budgets, they'd lose being able to fly around on the corporate jet and go to the Super Bowl or whatever it was. Their nominal excuse was security and then a couple of high-profile hacks that everybody realized it was more of a risk to not be in the cloud than to be in the cloud from a security perspective. But now I think it's, you really can at these big cloud vendors. Similarly, everybody thought IT services were going to be destroyed. These IT services companies here are reporting record quarters, record backlogs, it's great for them.

And the reason is, is now if you're that CIO at a Fortune 50 company, you can build your own apps, control your own data. It's way easier than it ever was. At the end of the day, that is what a lot of these CIOs, want to do. So I do have a big bias towards infrastructure software that rides on top of these cloud computing giants. Does that true in terminal value too? So if you just look at, I don't know, the top 10 or 15 software companies, most of them are still application heavy or dominant, you know, Salesforce, Adobe, and Tuit, lots of companies like this, Activision Blizzard, which got bought today

by Microsoft, which we should riff on and have fun with. But it doesn't. It doesn't. seem very app-heavy still at the top end of the market cap spectrum, whereas some of these companies are still private, but the stripes of the world, the Twilios of the world, the cloud providers, the data dogs, all these kinds of companies that are more infrastructure-focused are still up and coming. How do you think about like the end state of all this? Does that opinion of yours extend beyond just the current opportunity set to some future state where infrastructure is dominant? For sure, extends to a future state. It is definitely a belief that at some level, And I do think Google was the first cloud to say, okay, Mark Bini off would tell this parable about AWS and them diligenceing software companies about how they just couldn't help themselves. And it was a parable of kind of the scorpion and the elephant. The elephant got across like a raging river that's flooded. And the scorpion has to get across it. There's a fire or a flood behind it. And the scorpion says, hey, will you take me across elephant? Because I'll die otherwise. And the elephant is like, yeah, sure. I want to be nice.

How do I trust you that you're not going to sting me to death? And the scorpion's like, well, if I sting you to death, I'm going to die. Then we'll both die. So, of course, I'm not going to do that. And then the elephant's like, okay, get on my back. Scorpion gets on its back. They're going across the river. And then the scorpion stings the elephant.

And the elephant's like, why did you do that? As they're both dying and the scorpion says, it's in my nature. I couldn't help it. I love that. Yeah. So Bidiof tell that story about how don't let AWS diligence your company because they cannot help themselves. They're not going to buy you. They're going to try and build. You've seen them try to build their own. Badmo with Elasticsearch. It happened. You can seven a much time.

Exactly. Yeah, many, many times. They try and fork the open source infrastructure building themselves. And I think Google was the first one to realize like, hey, this is kind of silly. There's a lot of innovation happening outside of us. B, there's a lot of money to be made just in providing these primitives. Let's stop trying to compete with these independent infrastructure software providers right on top of the cloud. They can be a channel for us. They can drive demand for us. By the way, a lot of these companies now are also very important and strategic because

some of them have on-print businesses too. And on-prim just means private cloud now. You make it easier for these companies to migrate to the public cloud if you kind of embrace the same infrastructure software that they're using in their own data centers. But I do think it is a little bit of a view that, hey, the world of software is not just going to be AWS, GCP, and Azure. They're not going to go up the stack and consume every infrastructure function that is a view. And I do think it's interesting. You touched on terminal value, but broadly speaking, this view that these app providers who kind of have a

traditional enterprise go to market and they should have a pretty UI and a lot of Oracle and SAP salespeople selling a product that replaces a spreadsheet or whatever it is. is those terminal multiples, the multiples today are much lower. Like, I do think the market understands that this is a risk. But yeah, you for sure have to believe that the world of software is not going to be an oligopoly. And I believe that. And I think AWS is the last one that's slowly giving up on this. GCP was the first to embrace it, then Azure.

And it's like if Azure is embracing these third-party infrastructure software providers, everybody is, because they have more software capability than anyone. And then the other interesting thing is, I do have a bias. Like, I don't own any of these, but if you are going to own an application software company, I have a bias towards ones that serve S&Bs. Because those S&Bs are not going to be able to roll their own apps in AWS. So they're shielded from that. Cybersecurity, that's another thing I was, I guess I was open-minded to this,

but I was always structurally bearish on cybersecurity because cybersecurity is the area, of the market. It was always easiest to go from zero to a billion, but basically, it was previously impossible to go over $15 to $20 billion. And the reason was success sowed the seeds of your own destruction, because the

attackers would start to optimize for you. The VCs knew this. They were always funding competitors. It's size and scale. It was one of the only areas of tech where it hurts you rather than help to you. Well, AI has changed that. Now that attack surface, if your models are

learning, if you're truly an AI-driven cybersecurity company, skill is good for you. And that's why, for the first time ever, for a long time, I mean, you know, I've forget the exact numbers, but you've never had a cybersecurity outcome over 20 billion. Now you have companies that have blown through that, still going fast from a market value perspective and kind of similar thing for this is how big an independent could get before they collapse under their own weight. So AI has really changed cybersecurity. The last category to touch on briefly, recent news is excused to talk about a few of the fangs and then maybe talk about a couple other fun topics before we close. The first is the difference, I guess, between Internet and software.

If those are two separate categories, it's kind of obvious, like what defines the difference, but maybe define the difference in a little more detail, how they trade, the variables that matter, you know, your view on them today, say a bit more about Internet specifically as a category. I'd say there's broadly speaking three kinds of Internet companies. And one in a lot of ways is software companies. So the three kinds of Internet companies are e-commerce companies. advertising companies, and then subscription companies, you know, like Netflix and Spotify. And I would just say definitionally, e-commerce and advertising are way more GDP-sensitive

than software. So they're feeling this slowdown that's happening right now in the economy. And on top of that, they're suffering a COVID hangover. Then I just, software is not. Price always leads to invented narratives. So now that software has been weak, there's all this, oh, MuleSoft was weak. and they're a leading indicator because API integrations. Now, this is an invented narrative.

But there is real legitimate fundamental weakness in almost all of the internet names, maybe with the exception of search, and that's just because probably search is the only part of the internet that is levered to this resurgence and services spending. So you do see pretty broad-based week. Maybe if I say this on the podcast, somebody will do this. In my mind, I always just look at software companies, the subscription internet companies, any franchise business model, and any data business model, they're all the same to me.

You know, they have recurring revenues. They have pricing power. And it's interesting to think about the relative fundamentals, the relative RICs, and the relative value ofations. There's not a lot of differences. If you're a franchise restaurant or hotel company, you just have a royalty. Now, it's an economically sensitive royalty, but it's a royalty. You're very asset light. People effectively set up for subscriptions with overage.

That respect franchisers, they look more like a next-gen software company that doesn't sell contracts, but they sell on consumption, which is good when it's working for you, but then when it stops working for you, wish you had those contracts. But I would just say internet, broadly speaking, is just suffering from a COVID hangar over that it doesn't appear software is. I mean, JP Morgan just came out and said, we're in a panic to go to the cloud. We're going to spend way more money than anyone thought. And I think you're going to see

2022 be the active investment year from a lot of companies. And by the way, there's all sorts of surveys that support this from CIOs. Maybe a couple of recent events to just talk about some favorite topics. I'll start with the change of Facebook's name to meta and just the entire metaverse trend.

I think the way that you and I originally got to know one another was talking about sci-fi. And I know sci-fi is played a huge role in you're sticking with tech in the early part of your career and just your interest in technology, generally speaking. Important to remember, I can't remember who said it,

that a lot of the sci-fi novels with the Metaverse, it was dystopian, not utopian. But talk to me about the Metaverse. I mean, it's such a huge topic that, you know, I've done some episodes on. People are fascinated by this idea. It's a big idea. One of the biggest companies in the world is betting on it in a major way. What's been your reaction to all of a sudden everyone knowing what the Metaverse is and caring? Well, I feel embarrassed to use the word now.

Yeah, it is annoying. I like to be early and dirty when you have, I don't know, consumer products. companies, they're going to have our own bedaverse and we're going to do this. It feels a little overdone to me, but it's still real. It's still coming. I'm excited for the PlayStation VR headset. I'm excited to see what Apple does. Meta is going to keep going, keep iterating.

It's just this trend that's going to continue until we all have brain computer interfaces and we can close our eyes and whatever. There'll be an elephant warrior or do whatever I want to do. And so I still really, really blitz. believe in it. And by the way, I would say that's another thing I've been wrong about. To me, the only real metaverse is today. What are they? Well, there's a military metaverse and it's pretty much dominated by Call of Duty. There's two cartooty, friends fiddly, kids friendly metaverses, Roblox and Fortnite. Then there's fantasy

metaverse and that's World Warcraft. And these really are metaverses where commerce happens, people live their lives. Science fiction metaverse. That's destiny. I spend a lot of time in that. you still got to play that, Patrick. But those stocks, A, it hasn't, I would say, broadly speaking, really filtered through to their fundamentals and are their prices. But I do still think that in terms of where are metaverses, well, they're video games. And these are real metaverses today. But yeah, the metaverse, I think it's still coming.

And do you think that, to use the other headline of the day, you know, Activision, joining Microsoft, is a lot of this just about wanting to own the place where people spend their digital time. And fundamentally, that's just the arc of that bends towards active participation, which means video games versus social networks or Netflix or streaming entertainment. How do you think about the long arc of this trend and why it seems like the big technology companies all of a sudden need to have a metaverse strategy? And I don't know if that's what Microsoft's doing with Activision, but it sure seems interesting. How do you think about that? Yeah, it is for sure. I think what is happening with Microsoft and Activision. It's why they

about Bethesda, Fallout, the Elder Scrolls online, those are also little metaverses. That's why they bought Minecraft. That's another kid-friendly

metaverse that I should have thrown in with Fortnite and Robox. Microsoft, it's just interesting because of their HoloLodd's contract, they're almost certainly

going to have the most pure AR, VR, VR revenue of any company. They control this video gaming platform. Almost all PC gaming happens on Windows PCs. And I think they're

slowly trying to bring that back away from steam. And then they have all these great first-party video games. So I think they have a very interesting collection of assets. All those companies, like, I just think of them, they're just levered royalties on global GDP. You could almost do a cohort analysis. And it's so bullish for all of those companies taking out Netflix. Netflix is for sure at some level, like a levered royalty on global GDP and consumer free time.

If you think about the internet advertising with cloud computing companies, it's like if you just bracket companies by the year that they were created, it's like I bet companies that were created 50 years ago, I bet they're spending, I don't know, I'm going to make this up, 2% of their total revenue on either advertiser or cloud computing with those companies. If you're a company that was created in the last three years, A good case is you're only spending 50% of your revenue with those companies. That's a great case.

Every year the world moves towards them. Some semiconductors grow at 3x GDP. They may collectively grow at a higher multiple of that. And they certainly have for the last 10 years, but that may continue as long as they could be broken up, TikTok, unless you have a real paradigm shift, a platform shift. that levered royalty on global GDP is going to continue supported by that cohort analysis that I just described. And that is why they're also focused on the metaverse. Everybody wants to own the next platform.

Everybody thinks the metaverse is the next platform. Everybody's working on it. And I go back to our first podcast. I think it's going to be Apple and Android, some pretty profound advantages because they control the platform that's in everybody's pocket. And ultimately, the metaverse were probably going to want it to be portable. and VR and AR are going to move in, fuse into XR extended reality. It's hard not to see how the dominant mobile operating systems aren't advantaged. And by the way, that is something exciting because I do think it means like, hey, you want to play in the Metaverse?

You probably need a mobile operating system. So I think you're going to see some of these companies start to collide. Like Apple's going to do search. They're eventually going to do it. I think you'll see more mobile OS competition. Some of these ecosystems will collide in ways that are interested. One of the things I don't think you and I have talked about is the impact of all of this on those companies that were founded 50 years ago and are spending the 2% or whatever it is on these

modern platforms. How do you think about that opportunity, both as an investor and for businesses, to bring the 2% to 20% or 30% or whatever? I think it's pivotal. When I was cautious on secular growth from summer of 2020 to spring in 2021, I was very focused on cheap consumer recyclals that I thought it really structurally and durably improved their business models. And I think there's a lot of retailers' brands that did that. And by the way, there's so many phases you go through. On a long enough timeline, every internet company sells ads. Well, all these retailers, they're going to start selling ads online.

Like, there's so much still in front of them from a becoming a modern internet business. I still think there's a lot of opportunity. And I would say for retailers that are on the right side of change, broadly speaking, I'm still very excited about a lot of those businesses, probably now much more excited about something like software than I am about those. But I don't think they're going back to being Herma Shorts that they were. And I think there's a lot of people who reflectively just want to short retailers, but a lot of these retailers, they are here to stay.

They do have big online businesses integrated the store network with their e-commerce operations in really cool ways. And by the way, this is what Bezos was worried about for 20 years. Buy online pickup and store. All the world's largest e-commerce companies, they're opening stores. Like, stores have value, but if they're really well integrated with the modern IT system. By the way, in the context of the software, I do think it's important to realize there is a crazy underlying private equity bid for these assets. It just, it will put a floor under.

Tomabrop, and they just raised a $20 billion fund. There is a lot of dry powder on the sidelines. By Patrick, another point, I just want to make about value versus growth that I think is so important. Every time growth starts to underperform, there are a lot of people who are like, oh, my God, this is amazing. It's the bubble crashing. We're going to go back to the way it was for value from 01 to 08. The glory days are here again. It's amazing.

By the way, like I said, I'm not always bullish of growth. I was tilted very, very value-heavy for nearly a year. But I think what's missing from that analysis? going back to the two components, what drives stock returns, multiples, and earnings. The reason value was so good after the tech bubble burst wasn't just that multiples expanded, but it was that earnings exploded. Why did earnings explode? Because you had Jim O'Neill, the bricks, the brickets, you had post-China entering the WTO, you had just this massive industrialization in China, it was a true step function in demand for oil, for iron ore, for every material

you could think of. They're building so many airports. They're buying so many airplanes, cars, everything. And that was really what drove it. And I think sometimes people miss that is there was a massive, massive, massive, fundamental upshift in demand that drove so many. of these value stocks in that period. I don't see that today.

So even when I think of a higher inflation world where you have wage inflation, it's like I just don't see any comparable demand impulse for a lot of these traditional smokestack industries like you had with the bricks during the 2000s. You'd meet with these Australian and South American giant companies, But it's like we're not sure there's enough iron ore in the world. Forget peak oil, which was a popular theory.

We were worried about peak everything. And it turns out the earth is a big place. And it really was a one-time build. I think maybe the first time we were on we discussed one reason value investing has been hard is that algorithms, they do have career risk. They just don't know it. They don't care. They don't feel emotion.

That career risk that people would talk about being with value investing, like that's gone. but also for sure this crazy demand impulse. I just don't see anything like that. There's two interesting points that that makes me think of, and I know we want to talk about this, so it's a great excuse to do so. One is the impact of private markets on all of this.

Demand is one thing on the side of the companies. It's another thing on the side of the equity for people that want to invest in these companies. And you've got just incredible $20 billion funds being raised. You've got this crazy disconnect, which is really what I'd like to hear your view on, between private market multiples, even late stage ones, and public market multiples, even recently IPOed ones. So it seems like this weird handoff where you go from private to public and your

valuation drops by a bunch. What's driving that? And like, how do you think all of this will affect the private equity, both private equity in the sense of later stage buyouts, but also early stage venture? What do you see unfolding here? Because it does seem to be this weird mismatch right now. So I think at a high level what is happening, so if you're an allocator, you want the highest sharp ratio asset you can have. What's been the highest sharp ratio asset for a long time now? Anything private. The reason is it's because they don't mark to market. Like I promise you, private equity funds and venture capital funds and everybody else mark to market. In other words, like if every venture capital firm sit down a thing, be like, here's your statement, because the multiples

of these mid-cap tech companies are down 60%, we're marking ourselves down 40%. I've changed a lot of things, that's not going to happen. And so what has happened is it used to be there was a liquidity premium. Now there is an illiquidity premium. This is even at individual fund level. If you're a mutual fund and you're in a big complex and you get access to privates and you have five percent of your assets and privates that are marked monthly or quarterly, you're going to have a higher sharp ratio than your competitors who all whom we do publics. There is for sure, and I'm not saying it's rational, there is an illiquidity premium. And that is just a fact. And I don't see it changing. It's what the entire system wants. The entire system wants less frequent marks. The entire system

savings in retirement needs bigger and bigger private markets, in which, to deploy capital so you can get these, they are smooth, 20, 30 percent IRAs. So I think this illiquidity premium is here to stay. I don't think the world is going back. Two things. One, illiquidity premium goes away when you become liquid, but you do have to eventually become liquid. So that is the ultimate governor on this. Public multiples are the ultimate reality. And at the end of the day, if public market weakness or strength persists for six to nine months, like I promise you, this weakness persists, private valuations will cool off. They just will. I've been doing venture for 20 years. This is a very consistent relationship. And by the way, and then when public start

to recover, it'll take the venture evaluations a while to recover. It's like there are all these great opportunities, even into the summer 2020, where you can make venture investments at the March 2020 low, just because the venture market is slower to adjust both up and down, but ultimately the public market does really lead and inform venture valuations. Because how could it not? One of the stats that is staggering is the percentage of exits for these venture funded firms that are strategic acquisitions versus IPOs, like it used to be all IPOs. Now it's dominated by strategic acquisitions, which puts yet more like opacity around it somehow. Tullio Buy's segment, you never really get to learn a lot about segment or maybe much later, you know, once it's a bigger

segment of Twilio, but it's this interesting lack of marks all the way up and down is what the system wants. Like I love how you put that. It makes me wonder how you think then the competitive landscape of venture will evolve since you and I both do a lot of private technology investing. Obviously, we're super interested parties here. What do you think will drive success or failure amongst those style of investors given this playing field? The world of venture is. The world of venture is being unbundled and re-architected at an incredible rate. It's happening in many different ways. So I would say to me there will be four market participants.

So there are angel investors. And these are really, really important because it used to be, if you were an entrepreneur or a founder, you'd really thoughtfully construct your board and you'd want to go to market expert from this firm. And then you'd want a technology expert from this firm. firm and then maybe an ops expert from this firm. Now you just get three angels. Do all that for you.

And you put them in at the very beginning. I had a stunning conversation with the Series A raising money. And I was like, hey, you know, I do think it makes sense. Like a lot of seed and A and Series B investors, they have magical skills that I will never have around helping you build your company. And wow, they add a lot of values. He's like, oh, but I can get that from angels. How much you get it.

In other words, his point was, I could take money from whoever I want. I do not need a value out investor because I give value from my angels. And I've thought, they thought about them very carefully. So that was really, really interesting. Angels are a big, big part of this in here to stay. And then I think there's the seed through B specialists. And these are, I think a lot of the great traditional firms. And here, man, to play here, you really do have to add value.

You must add value to have a franchise here. What those seed through B firms? In my mind, they're just credentializing agencies. They add value, but they also credentialize the company of the founder for later investors. They're like Harvard. And man, that's a great business. It's good to be Harvard. It's very good to be one of these really, really dominant early stage investors.

And then I think the rest of the world is going to be these really big multi-stage investors. I think ultimately everybody's going to be a crossover investor to compete with cross-staged. investors, you must be a crossover investor. Otherwise, they have a superior mousetrap. It's such a powerful value proposition to a founder to say, hey, we're ever going to sell, we're going to buy more on your IPO, and we can own you for 20 years. That's so powerful. And I think this competitive pressure is why Sequoia, arguably, whether they're the best, they're one of the three best venture investors. They convert it to effectively being a crossover investor. And then I think, think if you're not one of those three buckets, it's going to be very, very, very hard.

And I think this is cool because it is going to put, by the way, I think that this is a better setup for LPs too. And I should just say everything I'm about to say. Comes from my friend of mentor Antonio Gracia, so I really hope goes on the podcast sometime soon. We're scheduled. I think. Yes. But Antonio is one of my most important mentors.

I've learned so much from him. Nobody who has dealt with him would say that there is a. a venture investor in the world who's more value added than what he and his firm do for their companies. I've been involved in companies with them now and it's gotten to know him. It's true. Maybe people add as much value. No one adds more value. But his whole strategy, a lot of his strategy for venture, which I've ruthlessly copied, is around the idea of their profound advantages towards being multi-stage. One of my rules is I don't make a significant investment until I've known a company for six months. Why would you? I'm a crossover investment.

so I'm IRR focus, not Moik focused. And that's a really big distinction and advantage being able to R by R against Boiuk. And so I do think a lot of these multi-stage firms, the strategy they have and you're seeing in the market, which I think is imminently logical, is hey, you write these small checks early. And by the way, Patrick, it's a reason like we've co-invested with you several times. We watch the company. And if they execute, I do think a success metric for kind of a multi-state. H. Krassover firm becomes no company that is in your portfolio that is performing well should ever go out to the market once they come into your strike zone. You're getting their metrics.

You have perfect information on them. You're talking to the CEO. You're getting whatever metrics you want. And then it's like, oh, wow, we can tell they've got 12 to 15 months of cash left. Yeah, this is a good time to preempt. Boom. And I think that is the way the world is devolving. So angels, seed through B specialists who had a lot of value, some operational growth firms that add as much value as those early stage firms. And then these big, multi-stage, bulge bracket firms and some traditional venture firms are becoming those. Some hedge funds are becoming those. I hear to see some long only guys. It's all going to merge.

And the one thing I do want to say to all of the VCs, private equity guys, coming to public markets, it's like, welcome to the lovely world of daily marks and daily prices and crazy volatility. Welcome. It's a much more brutal quest for Alpha, Patrick. Anybody on Planet Earth now who has $2,000 or whatever, the Robin Hood minimums are probably lower, anybody can compete to price public equities. You're trying to generate alpha in public equities. You are literally competing with hundreds of millions of people, and a lot of them are brilliant. And they're out professional investors. And by the way, a lot of them have very unique information.

Peter Lynch, you know, if you love the stock and you love the store, some of them are industry participants. We're in the software industry, and they see which companies are winning. And those are the ones they buy. You go from competing with a pretty narrow competitive set of brilliant people to competing with hundreds of millions of people. I'll steal my friend Eric's term, the Terror Dome, which is a lot of people. the term I always think of for public markets. And if I count anything of the many things I'm lucky for, one of them in investing is like so happy that I spent 15 years only doing public equities first to live that pain and that hell. Now, I was doing quantitative. So totally different flavor.

There is no substitute for getting your face ripped off every couple of years in a very short period of time when nothing seems to have changed. Yeah, it keeps you humble. It's like, it keeps you humble. And the other reason the world will go crossover is for competitive reasons. There are profound advantages to both sides to being crossed over. So, you know, it's for sure an advantage if you're a public equity investor to see these companies for years before they become public, to kind of understand disruption, you know, whatever. When you first saw Uber, you kind of understood the impact on taxi medallion. So you're just, you're more sensitive to change. You're more sensitive to disruption. But I'll also say for a lot of times underwriting a growth equity round,

One of the most important risks to assess is the risk that one of these large Internet software companies focuses on you like a laser. Generally, these startups, they're not competing with the A team or even the B team at these big companies. These companies, they're really powerful, they can make their own weather, gravitational bodies. And so underwriting that risk, I think is an area where it's an advantage to look at both. My more successful venture investments was one where people were really, really worried about the internet giants coming in and competing with them and following those companies. I was very confident that it wasn't as higher priority, as the other BC's thought,

just wasn't as much of a risk. Got what, from my perspective, was a really, really, really tracked evaluation of this this six, seven, eight years ago. But I do think there are advantages to doing both once you get beyond that series BC. Yeah. This is kind of a shop talk question. and I'm just fascinated by it since you've now done it and had experience doing it, and I'm sort of in the process of doing it too.

What's the difference in recruiting, evaluating, and mentoring talent if they're focused on publics versus privates? If I could know one thing about a person to know whether or not they would be a good public equity investor, it would simply be, are you capable of being rational when you're wrong? Because all of us, all our lives were taught that when you're in third grade, you raise your hand and you have the wrong answer, people laugh at you, you feel. shame when you're wrong. Don't do well at a test, whatever it is. A lot of people, they can't even admit when they're wrong. Like, as a public equity investor, you're going to be wrong at least.

All the time. Right. Yes. Yeah. A lot of great public equity investors have a batting average well under 50%. They're wrong more than they're right, but because they make more money when they're right, they still have a great track record. And maybe some of the best batting averages you'll ever see in public equities are mid-50s. And those people often don't have great track records. just because they're kind of the heteroscadacistis or ketosis or whatever it is, the fat tails, almost to capture those big outcomes that drive great track records, you need to capture some of those fat tails, the 4% of stocks that account for all other excess return versus treasuries.

So if I was going to ask something, one question about public equities, is it's just can you be rational when you're wrong? And then part of that is just your own emotional makeup. And then the other part of it is finding like a philosophy and investment system that fits your own emotional makeup such that you can be rational when wrong. Mine is, we discussed our prior podcast, have a high knowledge level. Even when I have a really high knowledge level, I'm still wrong all the time. I just make higher quality, more rational decisions when I'm wrong.

That dynamic, it's just not his present in private markets. You don't feel like an idiot. I mean, you said over a few years, I'd say I feel like an idiot every few days. When you have it super dialed in as a public equity manager. Probably you're going to have one bad day a week. It's about as dialed in as it ever is. Just in private markets, for sure, you make mistakes. But, hey, there's this group decision-making dynamic that isn't present in most public equity firms. B, you can sell it. You have a preference. So I just think there are actually probably a lot of people who could never succeed as a public market

investor and vice versa. It's different. So another big difference is in privates. As a public market investor, if you're an activist, you don't need either access and you don't need to add value. You just buy it and sell in stocks. As a private market investor, A, you need access, you need to report with the founder, you need references, you need that founder to watch you on his cap table. And B, you do, even if you're a crossover firm, you do need to add some value. Even if your main value is going to be, hey, we're going to anchor your IPO, we're going to make going public a magic carpet ride, we're going to talk you through all of that, we're going to be there in tough times for you.

There's probably a lot of people who are really, really, really good at picking public stocks who aren't that good at building a rapport with founders, who can't communicate their ideas maybe in a way that is helpful. to a founder, even if they have got good ideas for that founder, just communication is in a strong suit. It's actually, even though at some level you're investing, the skill sets necessary to succeed, I think are pretty different. And there is, by the way, you know this, there is a big element to process in privates that is just not at all present in publics. Click a button to buy a stock. And you better get that process right, particularly right now.

my son, who's eight years old, was asking me all these questions about what I do. And so I was trying to explain some of the basics. Sometimes it's really helpful to explain something to an eight-year-old. And the way they put it back to you is so interesting. And when I described public versus private, he was like, oh, so in private, the other person has to say yes, too. I thought, yeah, I guess that's true. And he's like, so you have to like sell them.

You have to be convincing. I thought, yeah, that's definitely true. Like, you definitely very convincing. Maybe that's the answer, right? There's just much more of a sales job to the private investing. world than there is the public one, just like you just said. As I'm prone to ask you every time we talk, have you read any great sci-fi lately? So I will admit two things.

So one, I did recently reread Dude in advance of the movie coming out. It's the best book. God, it's awesome. The other book that I'm reading, this is 2021 was a tough, humbling year for me as an investor. And I do have a book that is kind of like a touchstone of sorts. And any time I go through a hard period, I read it, it's been really good because I have a period every, you know, let's go through five years, like a tough period of performance because this is a hard, humbling business. Hopefully the intervals between those periods get longer and longer as you learn and become a better and better investor. It's a book called The Wizard of Earth Sea, and it's by Ursula Le Guin, who's one of my favorite authors.

And I think the reason it's powerful for me has a touchstone is just at the end of the day, the book is all about how ego is at the root of most failures. But now it's a really powerful concept. I can remember, wow, I read this when I was 25. And that was the first time I'd really made a mistake as a investor. Then I read it again. It's almost like confidence building it of itself to be reading it. But it's called a Wizard of Versi. and I would highly recommend it.

I actually think in a lot of ways, it inspired Harry Potter. Wizard school, et cetera, et cetera. Have you read it? You recommended it to me, if you recall, for a similar reason, and I totally get it as one of those rereadable books. Actually, the second thing you did for me,

you were the first person that convinced me to go into their early stage investing business, too. I don't know if you remember that conversation, but Wizard of Versy and positive sum have your fingerprints all over them. Goodwill. I'm happy we get to collaborate in that business. Have you read the culture series now, Patrick? Not yet. The Ian Banks one. I have the first book. I just bought it. It's my next to my list. You must read it. You will not be able to put it out and read them all. I only have one left. I'm so sad. I don't let myself read more than one every two years. They're so good. They're right up there with dude. That in Hyperion are probably the only works of science fiction that I would compare to dude. But like, you,

must read them. They're so good. So, so, so good. I'll plug Hyperion like the Shrike. Is it Shrike? Is that how it's pronounced? Yeah, it's a Shrike at the time, too. It's one of the coolest episodic nature of that book is so cool. I can't say enough about reading these kinds of books. I think it's so fun. I know we're way over time. This was so much fun. So many interesting topics. What a weird wild market it's been. Love navigating it, talking to you about it. Thank you so much for your time. Yeah, thank you, Patrick. Always love our conversations. Love being friends. Love collaborating, adventure. And by the way, I do just want to say, like, I think you've done something really, really good for the world. It blows my mind when I interview these kids under 25. I was a super

investing nerd. I'd read every Ward Buffett Investment Partnership letter twice by the time I got to my first job. I'd read Peter Lidge. I'd read George Stroes. I'd read so many county textbooks. And I think largely because of your podcast, the kids who come in now, if they're motivated, because there is nothing better than investing to be kind of a self-starter. It blows my mind how good they are. And I think your podcast has a lot to do with it. So I think you've done something awesome for the world. I appreciate that.

You know, I'm obsessed with the open source concept in general. It takes time to compound, but it's convex when it does. Yes, it is. It's an amazing thing. Well said. I appreciate it. Stay tuned to hear more about Canalist's new quant product, Candice. Maybe judge is real quick just to get it on the record. It would be great to hear you just describe

Candice. We got to it organically here, but just literally if you were meeting a counterpart at an investing firm for the first time and just saying, let's assume familiarity as the audience has with Canalyst. What does Candice actually literally do? And then, Roger, I want to hear how you've engaged with the product and implemented it. There's a long tradition of puns and computer science. C++ is in the language C. If you want to increment an integer, you'll say integer or plus plus. So C++ was the next step from C, and that's a bit of a pun. Cantalyst itself is, I wouldn't say it's a pun, but it's a planned words. And when I was interviewing, I saw what they had done to the API and I realized they needed a panel data solution,

which is to say, serve the data like you would look at it in Excel, super easy. I said, you should call this thing Candace because it's a pun on the very popular Python Library Pandas, which stands for panel data, which was invented at AQR in 2007 by the great West McKenna. And it's the most popular open source library for data manipulation. So I named Candace in Ombuds, and to Wes, and to my surprise, Camel said, yeah, that's a great idea. I didn't really think that they would go for it, but they did. And what's good about it is when I talk to clients and I say, we have this data science library. We call it Candace.

If they laugh, I know that they know about somebody. It's like a bad signal. Absolutely. And I tell the sales staff this. If they don't laugh at Candace, then we probably have a lot more work to do with getting I'm on board with Python. So, Roger, I would love to hear how, back to that concept of rubber meeting the road, and using Candace as a part of that process, how you've engaged with this product and actually

made real the intersection between data science and fundamental investing. At Newberger, the role of the data science team is to work with the investing teams to deliver, I'd say, curated output from data analysis. While some of the teams here have people on them who actually are interested and want to work with some of these tools, most of them, I would say, are more interested in getting our read of the data, the interpretation of the output and how it's relevant for them. We typically engage with PM teams on single names. They'll come to us with a question. We're trying to figure out something that we're not finding an answer to anywhere else.

Or maybe it's more open-ended. What trends are you seeing in Nike? And we can then go back to our new analysis across our data sets, credit card data, web traffic, et cetera, and put together basically a presentation of the trends we're seeing. And the key there, though, and this is where I've spent a lot of time, is to tie it back into what matters for that company. So our job is to actually dig into the investment thesis of the company we're looking at, just like the fundamental analysts would.

So it's not just all about automation and data analytics, because we need to understand what's relevant because there's a lot of data we can look at. Some of it matters, some of it doesn't, or some of it might be relevant to a small 5% of the revenue. It's not going to move the needle. We want to focus on whether there's really insights that are worth sharing. Now, when it comes to the Candace product,

I'll actually give you an example. It was over a year ago. There was something was before Jet joined, And we were working with one of the teams here to look at some of the consumer names, probably basket of like 45 tickers. And I want to look at earnings sensitivity, basically operating leverage in the businesses, where you would see with a working Excel model, how much earnings or operating income would change?

Were they given change in revenue, right? So for a dollar or 1% change in revenue, how much of that falls in the bottom line. Different companies have different levels of fixed structures. That ratio is going to differ. So without the benefit of Candace at the time, we were using Canales. We downloaded these 45 models and basically manually had to go through and tinker with the inputs to make those revenue changes and then capture the earnings change and then manually copy and paste that into another sheet and basically build this up. Probably took close to three days to do that.

Since Jed came on board, and we talked about this use case of running sensitivity, he built functionality into Candice via Python now. we can basically throw a list of tickers in and get back earning sensitivity to a 1% change in revenue. And that, Jed, runs in probably a couple of minutes. Yeah, it's slower than I like. Three days, right? And we're working on it. And there's no mistakes either. The manual process had plenty of mistakes in it. We had to go back and do it twice to make sure we got it right. That's just to me a very, very clear example of the power. To hear the rest of our discussion on Candace, you can find the full interview.

at the end of my episode with Ricky Sandler. If you enjoy this episode, check out join colossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.