Invest Like the Best with Patrick O'Shaughnessy - Pat Dorsey Returns - The Moat Portfolio - [Invest Like the Best, EP.77]

Episode Date: February 20, 2018

My guest this week, back for a second conversation, is Pat Dorsey. Pat ran equity research at Morningstar before leaving to start his own asset management company: Dorsey Asset Management. His areas of deep interest are competitive advantage and capital allocation. He believes that capital allocation should be in service of competitive advantage and invests in a concentrated portfolio that he and his team feel embody these ideas.  If you have not already, I strongly recommend listening to our first conversation, which is a sort of crash course on moats. In this conversation, we cover different ground. We spend much more time on individual stocks like Facebook, Google, and Chegg, using them as examples to explore Pat’s investment philosophy and strategy.  Across a few conversations with Pat, I can tell he is in love with this stuff, and I always enjoy talking to investors like him who so passionately pursue and edge. Please enjoy round two with Pat Dorsey.   For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Links Referenced Pat Dorsey's first appearance on the podcast HQ - Live Trivia Game Show   Books Referenced World After Capital Principles: Life and Work   Show Notes 2:15 – (First Question) – Pat’s methods for valuing a business  4:17 – Is this process done after they would first identify potential targets for investment  5:11 – Pat’s take on how the market classifies stocks as growth vs value  6:40 – Qualitative insights and why the market can’t price them very accurately  9:57 – The business model behind zero marginal cost distribution business model  12:00 – Network effects and the potential downside to them down the road  13:54 – Valuing Facebook as a business heavily reliant on network effects 16:45 – What would have to change for Pat’s position on Facebook to radically change  18:58 – Most important lessons that a smaller/private business could learn from Facebook or Google’s business models  19:48 – Where is Amazon in Pat’s portfolio  22:06 – An example of where primary research led to a big surprise about a company  24:05 – The value of travel in this business, starting with recent travel to India  26:05 – Why are they targeting India and Japan  27:24 – How does he think about the risk of investing in foreign markets  29:52 – His thinking on relative vs absolute market share  31:26 – Exploring the SaaS business model  34:35 – The application of moats and pricing power with SaaS businesses 34:36 – Pat Dorsey's first appearance on the podcast  40:07 – Other models that Pat explores and how to screen for them  41:37 – How does he parse the difference between attention and demand  43:19 – How would Pat monetize something like HQ - Live Trivia Game Show that has aggregated massive amount of attention  45:19 – How does Pat react to the idea that attention is scarce and human capital is so crucial 45:14 – World After Capital  47:04 – How does Pat evaluate human capital in a business  48:09 – Experience in starting an asset management business  50:20 – What are the levers that are biggest value drivers in the asset management business  53:57 – Pat’s view on the strength of the relationship between risk and return        57:06 – The most risk Pat has taken in the face of uncertainty  59:23 – Favorite recent learning resource 59:43 – Principles: Life and Work Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

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The views expressed in this podcast do not necessarily represent the views of CFA Institute. 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, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaunacy 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 O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. My guest this week, back for a second conversation is Pat Dorsey. Pat ran equity research at Morningstar before leaving to start his own asset management company Dorsey Asset Management. his areas of deep interest are competitive advantage and capital allocation. He believes that capital allocation should be in service of a competitive advantage and invests in a concentrated portfolio that he and his team feel embody these ideas. If you have not already, I strongly recommend listening to our first conversation first, which is a sort of crash course on moats. In this conversation, we cover different ground.

We spend much more time on individual stocks like Facebook, Google, and Chegg, using them as examples to explore Pat's investment philosophy and strategy. across a few conversations with Pat, I can tell he is in love with this stuff. And I always enjoy talking to investors like him who so passionately pursue an edge. Please enjoy round two with Pat Dorsey. At the first time that we spoke, we did sort of a 45-minute crash course on all things, moats and capital allocation. We'll touch on some of those ideas as we talk about some businesses today. But we'll explore a couple other different topics first.

And I think a fun place to start would be your framework for valuation. So obviously you're looking for companies that have moats. hopefully run by people that are good capital allocators. But at the end of the day, even if you had those two things, there could be a price at which it didn't make any sense to buy the business. So in your third quarter letter this past year, you did sort of a deep write up on how you think about valuing a business. And so I would just open it up to you there to talk a little bit about the methods that you've used and found to be successful. So from a holistic perspective, we do not buy $0.60. And I think that if you view a business as a dynamic collection of

projects, which is what any business is, you cannot look at it as a 60 cent dollar. I think that makes sense if you're looking at more static enterprises, if you're looking at businesses that perhaps have a lot of hard assets to them, real estate, oil and gas. But if you're looking at a business that is growing and producing cash via different projects, I think you have to take a more dynamic view. And so what we do from a technical tool perspective is we use both a DCF, full three statement model, as well as an IRA framework. And those two do two very very different things. The DCF helps us unpack the cash economics of the business. DCFs are, as you know, very blunt tools. I mean, one change can swing it one way or the other. So we actually place very

little confidence in our point estimate. What it helps us do, however, is frame what are the value drivers here? What are the things that move the needle? And you can also run some scenario analysis with it. We marry that with a more less academic, more market-based framework, looking at our free cash flow and EBIT forecasts, three and five years out, and then applying a multiple to those, what we think is reasonable, either higher or lower than today based on kind of where we think the business should be. Again, it's subjective, but the idea is that's kind of a more market-based approach, and it should triangulate with the DCF model, and we use a minimum 15% IRA hurdle for the EBIT free cash flow. Is this process done after identifying some subset of companies that you feel has a sustainable,

competitive advantage? Yeah, that's a really great point. So I used to have an analyst some years ago who his first Intane instinct was always modeled the company before he really even knew much about it. And I had to sort of beat him up a little bit because if you try that, what's going to happen is you're going to put in just kind of, yeah, so what kind of inputs, but you're going to anchor on those. And so valuation is always the very last thing we do because no valuation output is worth squat unless the inputs are worthwhile.

And we spend way more time at my firm arguing about the inputs, arguing about sort of what should margins be, what should growth be, what is working capital efficiency going to be, than we do about the specific output. because at the end of the day, that's what we as analysts can have some confidence in. We can have some confidence in how fast will they take share. What is operating leverage? Should the discount rate be eight or ten? I mean, neither you nor I nor the good lord himself knows what the correct cost of equity is.

We didn't talk about this last time, but I'm curious what your take on this kind of market-accepted way of classifying stocks as either growth or value is. I think mode is something that sits maybe in between those two concepts. And in the write-up, you talked about how, well, obviously, DCF analysis is super-sensitive. to the inputs, and so can give you this kind of false precision problem. Exactly. And the terminal value, especially on growth-type stocks, can be such a big part of the equation, and then you're forecasting something that's so far out, and we just know that people are really bad at forecasting, you know, 10-year-type outcomes.

But how do you think about that differentiation? Do you feel like that's an appropriate way to classify stocks, and is it a model that you would all use as you think about valuing a business? So we don't find it useful at all, and that's perhaps because we don't typically look at what I would call classic value companies, low-pe, low-e, low-e, low pb, the things that would be, you know, kind of a Fama French framework. So it's not a framework that's valuable for us. But I think that as an investor, you know, widening the scope a little bit here, I think it is valuable because you need to analyze business in the context of what

you're analyzing. I mean, doing a DCF on a business that essentially has no terminal value because you're buying a cigar butt is asinine. And in the same vein, trying to say that, you know, Amazon is worthless because the PE is high when they're reimbursed. investing every cent of cash flow at a high return on capital against a massive market opportunity, that's equally insane. And so you just, I mean, you wouldn't use a, you wouldn't use a jackhammer to build a house. You'd use it to break up concrete, you know, so just using the right tool for the job, I guess. You mentioned one of the letters that one of your core beliefs is that quantitative information is fairly well priced in the market. So if there's data available, markets are

pretty good at arbitraising information in clean data, but that qualitative insight is likely often misprice, and that's a key kind of space that you play. Can you say a little bit more about how you arrived at that idea and kind of what that looks like in practice as we start to pick apart, like what these recurrent qualitative insights might look like? So it kind of goes back. There's an old quote from Bill Miller of Leg Mason fame, and now I think he has his own shop, that all the data's in the past and all the value is in the future. And that was kind of maybe the seed that got me thinking about this more. But especially as databases have become more robust over time, as you've had more data sets have gotten cleaner. I've seen this just in my

short investing career, how data sets have become cleaner and more reliable over time. As computing powers become cheaper, it just seems natural to me that that information should be more efficiently priced. And then that's what we find too. And so we rarely find that if we look at historical financials and they look really clean and neat and you can linearly project the past into the future, usually the equity is not that mispriced because most people project linearly. It's when you get into nonlinear things, whether it was like newspapers doing operating to leverage in the late 90s. They looked great until they didn't.

Or whether it's operating leverage from business with high fixed costs in the case of Facebook for us. Or the Chegg is a company we own right now where the historical data looks awful. And it's because they just sold a business. And the performance of this asset-intensive textbook rental, that's what's in the historical data. The performance of the asset-light super high incremental margin Chegg study business is kind of buried the segment results.

Let's use both those companies as ways to explore some of these ideas. So we'll start with Chegg. So for those unfamiliar with the business, maybe describe those two phases. So what the legacy business was, what it looks like today, and then we'll use it as a case study to sort of pick apart your process. So the legacy business for Chegg is textbook rental. They actually were kind of the end of the inventors and to some extent of renting textbooks versus buying them. Of course, this is a business that's fairly easily replicated. They're very low barriers to entry.

And so Amazon and Barnes & Noble essentially crushed them in the textbook rental business. The founders were fired by the venture capitalists who poured $220 million into the business. The new CEO was brought in. And he realized that essentially the only asset Chegg had at that point was a brand. That they have 70%, maybe 60%, unaided name recognition on college campuses. Well, that's an asset we could probably do something with. And so he did a little bit of kind of basically investing in different types of businesses. And the one that's worked out really well for them is essentially building a digital library of step-by-step answers to end of chapter

study questions. So if you took engineering or math or organic chemistry, there's going to be a series of questions at the end of the chapter so that you say, do you, did you understand what you just read? And if you didn't, you probably won't do so well on the test. What they've done is gotten exclusive licenses for 27,000 ISBNs and answered every single question and indexed it on Google. That being pretty important because the modal college student today copies and pastes. They copy the question and then they put it in Google and search on it. Chegg comes up as the first organic result, which is how their user base has gone up 2.5x in three years with marketing costs being the same as they were three years ago. I'm really interested by this kind of zero marginal cost

distribution business model. On the one hand, it's this amazing thing. If you have the brand and the distribution and it grows organically like that, low acquisition cost, it's like the most perfect business model in the world. But I wonder how that's balanced against, I can't remember who it was, like information wants to be free, that most things that, you know, maybe 10, 20, 30 years ago, maybe a by side firm would have paid amazing money for a certain sell-side research report. Often the times those things are just free now. And this kind of repository of answers to questions seems like something that could just end up being free.

So maybe describe in some detail how you think about these kind of zero marginal cost, distribution, I know Facebook and Google platform business models. I'm really interested by the business model behind these things with this concern that since it's free to produce, it could be free to consume. So, I mean, the best thing is you monetize content you don't pay to create. That would be Facebook. Now, Chegg has to pay good money, big money, for those licenses to get that content. And so to some extent, the publishers, Pearson McGraw-Hill, do have a bit of a lever over Chegg in that respect.

We think that those relationships are good. They recently renewed one of their licenses at a similar cost to what it was a few years ago, largely because the publishers themselves are struggling, and this is a very high-margin source of income for them. and most college students, they've never heard of Pearson. That name means nothing to them. So if Pearson were to take all their textbooks and try to do this themselves, we think the marketing costs would be enormous. But that's certainly a less attractive zero marginal cost business than, say, a Facebook one.

And you do have some crowdsourced competitors to check where students basically post their own answers. But here's the thing, when you think about the value to a student of getting a 3.5 instead of a 3 GPA, whatever it might be, or passing a certain class it's required for their major. The marginal benefit of paying $14.95 a month for Cheg and knowing it's the right answer because all your friends have used it and it's helped them versus just crowdsourcing it on Reddit. It's a good cost benefit. So this is a common theme in your portfolio, this kind of similar idea of zero marginal cost. Maybe talk a bit about Facebook as well.

We talked in some depth last time about network effects as one of the key drivers of sustainable competitive advantage, what everyone calls moat. We did not talk about the negative side of network effects or how they break down. So talk about Facebook, but also more generally about how you think about maybe the dark side of network effects that can be amazing when built but can maybe turn just as fast. The key that people don't realize is that a network effect has to be cared and fed, cared for, and fed. They don't just sort of exist and perpetuate without anything. Look at Open table.

Open tables, market share as a restaurant reservation platform, has really declined because price line didn't really invest in it very much. They did not innovate on tools that are used by like reserve and talk and other types of like ticketing platforms that you may have seen restaurants use. I mean, just anecdotally in Chicago, I'd say easily half the restaurants that I go to don't use Open Table. They use Reserve, and that's because it was not invested in. And they were extracting too many rents from the user.

But also, and this is a critical point, it's because for me as the user, it's a fungible experience. Reserving it through Open Table, Reserving it through, is exactly the same. Uber versus Lyft. It's a car. You don't care. And so when the headlines get ugly for Uber, and it turns out Travis is a pretty nasty dude,

people's... Don't know that. You know, Lyft's campaign is ride better. Very smart, right? And so this formerly unassailable business suddenly loses 15, 20 points of share in the U.S. because the founder does something dumb and because the products are fungible.

If MasterCard tomorrow had a massive data breach, you could go on using your visa card. You wouldn't care. It's to say that they're fungible. Facebook less so. I mean, if you decided I don't want to use Facebook, there's not at the moment, there could occur, but there's not at the moment an analogous platform for you to connect with people on. Let's use the valuation framework again to think about Facebook. So I think it's your largest position in the portfolio. By a long shot. By a long shot. So talk about that exercise.

How do you go about valuing something where the business model is so predicated on network effects and has just kind of continued to surprise people. Certainly me, just as a passive non-stock-picking observer, sort of has continued to surprise to the upside. How do you think about beginning to assign an estimate of value to something like that? So our starting point with Facebook was going to a bunch of digital ad conferences, frankly. And starting with not the user as in URI, but the user as in the person who actually generates their revenue. The URI are the product.

Exactly, exactly. We are monetized. the money that comes from the advertiser. So we went to a bunch of digital ad conferences, frankly, and just asked people and just said, you know, what value do you get out of Facebook that you can't get out of Google? What's your return on ad spent? Do you feel like the targeting has improved? By how much?

Just really trying to understand from granular perspective. And it's rare that you do primary research and the work comes back 95% positive, and that's kind of what we got. I mean, representative quote, if God invented an advertising platform, it would be called Facebook. All right. Well, that was rather strong. And that kind of makes you sit up and take notice because, you know, we know that advertising, digital advertising offers kind of the holy grail that's been sought for decades, which is measurement, measuring the return.

You know, it's the old quote of, I know half my ad budget is wasted. I don't know which half. And Facebook, because of its ability, it actually knows things about you. Google can intuit things about you based on where you have been or, a search term you put in, but it's intuiting that, right? It doesn't actually know things about you that you have told it, that you have voluntarily told it the case of Facebook. And so that information was resoundingly positive, and so we felt fairly comfortable thinking about the growth rate continuing out. The top line growth was pretty not easy to forecast, but I think that wasn't our real variant

perception. We've kind of been in line with consensus on revenue. We've been somewhat ahead, but not massively. It was really on the operating leverage front, because when in late 15, we'd be again looking at Facebook, they had bought WhatsApp not too long ago, and a lot of the purchase price for WhatsApp had been allocated to R&D. And so R&D spend as a percentage of revenue really jumped up. So if you were looking just linearly and just looking at the gap numbers, you said, wow, this business isn't scaling. There's no operating leverage here. But then if you pick it apart and just think, well, gee, the marginal cost of U or I contributing content is nothing, it really should scale. Hmm, why hasn't it? Hmm. Oh, it's the WhatsApp allocation. Hmm.

That means that number of 30% margin they printed in 2015 is probably not representative of what the future will be. That means we can forecast some operating leverage. Wow, that's a big number. You kind of go from there. What would cause your perception or your variant perception gap to close with Facebook? So is it merely a function of, I guess there's two ways, right? There's price. So the market catches up to your estimation of its underlying value.

That would be a happy thing. That would be good. And you could move on. And the second would be some sort of breakdown in the competitive advantage of the business. So, and maybe this is a good way to talk about negative network effects again. Like what would scare you about a position like that that would cause you to change your positioning? If user engagement went down, I mean, engagement is the sine qua non of a network effect business, right? And what you've seen with Facebook is management being willing to take actions that might be harmful in the short run but are beneficial in the long run, such as moderating ad load.

Most of Facebook's growth over the past year has come from increasing ad prices. they've actually brought ad load down, which is good for you or I, right? Because you don't want too many ads. That's what killed MySpace, just way too many ads. So if the user experience became spamier, for lack of a better word, if they weren't continuing to innovate the platform with tools like Facebook Live and other things that keep people coming back, if they weren't innovating on advertiser tools. You know, I mean, if the toolkit for advertisers was today the same as it was four or five years ago,

or if that slowed, that would be a concern because that's how it gets monetized. those would all be concerns. Capital misallocation. Zuckerberg is fairly young. The acquisition so far, Instagram was it that I've worked out really well, but it's a risk. It's a non-zero risk, right? So just doing Google X-type stuff. That would be a concern for us. Or if they actually spend as much as they say they're going to spend. Like they say they're going to spend $14 billion next year in CAPEX, which is double this last year's cap-ex. On what? Bingo. We can't figure out what they're going to spend it on. And we think it's basically political cover. because their last, you know, not this quarter's earnings called, but the one prior was right after they'd been halted in front of Congress. Well, what are you going to do? Say, hi, we're really profitable? No, no, no, we're going to spend all this money. I mean, they're projecting earnings growth, expense growth of 45 to 60%. Last year, headcount grew 45, and expenses only grew 34. We can't figure out how they will spend that. But maybe we're wrong. And if we're wrong, and expenses really do ramp up ahead of revenue and they de-leverage on the operating margin side.

we would be wrong. What do you think with the most important lessons that a smaller, say, private business could extract from Facebook's business model or even Google's business model? I'm just always interested in changes in prevailing business models. We're going to talk about the SaaS business model on a minute subscription business model. What do you think are the lessons that could be pulled out,

not so much from an investing standpoint, but from an undergoing business standpoint? I think one is take care of your customer and ignore Wall Street. I mean, a private business system is to deal with Wall Street, but they might deal with bankers. they might deal with other people. And because that's what Facebook's done. I mean, that's what I think Google is,

but they've both done for a long time. That's what Amazon's done. I mean, it's only recently then Amazon's become quite the darling there it is. I mean, for the longest time, I mean, it's a bankrupt business. So I really think that, I mean, if you, at the end of the day, the guy who pays your bills

is the guy who matters, and that's the customer. And so you do what's right for them, and things tend to work out well in the long run, regardless of what the banker says. Why don't you own Amazon? Oh, Patrick. I wish I had a good answer to that. I'm stubborn, maybe.

No, I mean, here's the real reason. I didn't appreciate the power of AWS until recently. That's the real reason. Because, I mean, you can make a credible argument that AWS is worth a very significant fraction of the share price right now. And we actually have a meeting at my firm later this week to basically go over people's takeaways from a recent, the reinvent conference in Vegas a month ago. I don't have a really good answer for why we don't because it checks every box. It checks every box. It fits your model.

It really does. And I don't have a really good answer. for you. I wish I had a thoughtful one, but I don't. You mentioned that conference. It's a good excuse to talk about your idea of primary research, I think it's what you call it. So you mentioned qualitative insight being often mispriced, and maybe that's a source of edge for more fundamental oriented investors versus quantitative ones going forward. And then you talked a little bit about going to conferences, doing primary research that maybe a lot of people don't do. Talk about that process and that sort of value that you've derived from it. At the end of the day, it's kind of like

what we mentioned a moment ago about, you know, the businesses should kind of ignore the bankers do what's right for the customer. You can't understand a business unless you sit in the customer's shoes. And the best way to sit in their shoes is go talk to them. So if it's vertical market software, go to the industry conference, find out why you can't switch to a different type of software. In the case of Chegg, you know, we did a survey. We did an online survey of 800 students across the country to understand name recognition,

where they're using it for other subjects besides science and technology. And that gave us some really valuable data points. You've got to get off your rear end and work the phone. The insights we get from just talking to people who are deep into the industry is phenomenal. You know, we own a landscape distribution company called Site 1, you know, and we've been to a couple landscaping conferences and basically trying to understand what's the motivation of someone to sell. What's the motivation of a landscaper? Because the intuition is that their time is valuable. Whether it isn't good every day, homeowners want to have the work done on a certain day of the week.

And so if you can save 15, 20 minutes by getting all of your stuff in one spot as opposed to driving to three or four others, you'll probably. to accept a higher price because your time is valuable. But you need to back up that intuition with talking to landscapers. And saying, well, is that true? You know, would you pay 3% higher for that brick if you didn't have to drive around? Oh, sure I would. What's been the most surprising finding where you went and did some sort of primary research and what you learned or the conclusion was very different from your expectation going in? Ooh, that's a good one. So it was probably about on the aerospace aftermarket. So yeah, sorry, I'm switching gears a little bit. You know, so a years back, we owned two actually companies that made aircraft parts, not trans dime, but

similar stuff. And we all know the story here, right? It has to be FAA certified, massive pricing power. The story's pretty familiar for lots of people. But even though global revenue passenger miles were going up at a very good clip, and so planes should be consuming spares if they are flying, like, the companies kept like good quarter, bad quarter, good. There was no kind of linear trend in like parts sales. And we're like, what is going on here? We couldn't figure it out. And so we dug and dug and dug and dug and finally found a couple guys who did consulting for the majors here in the U.S. in parting out old planes. And so parting out old planes has always been part of the business, but recently there had been two confluent, I think that's a word, events that made it much more common.

First of all, cheap capital. And like basically people giving money and just to say, hey, you go out and buy a bunch of plans and part them out and we'll share the proceeds, cheap money. The other is that you had, because of hugely ramped up production on new models by Boeing and Airbus, a lot of planes hitting the bonyard that were relatively new and still had a lot of life left on the parts, which meant that the amount of spare parts from basically dead planes on the market was way higher than it had ever been. Well, if you're an airline and you can buy it for X from a dead plane and you have to buy that same part brand new for 10x from the manufacturer, I think that manufacturer sales are going to be weak. And we just, we had no idea that this parting out part of the market had grown to be meaningful and material. And so that was like, I mean, a real wake-up call that basically our thesis was broken. Talk a little bit about the trips to India and Japan. So this is on that same primary research topic.

I know your strategy is a global one. I think the benchmark is ACWI. Yeah, that's right. I don't know how much of the portfolio is international, but you definitely have a global mindset. that. So talk about travel, not just event conferences, say domestically, but the value of traveling to different cultures and countries. Yeah. Well, I think part of it is that you don't know what you don't know until you go out and find out about it. And I think part of it also is once you're, and we didn't have the freedom to do this maybe our first couple of years because

you're kind of getting up and running as a business. But I think one thing you should do, always do as investors, think about when will this knowledge that I'm generating payoff? And there's some work that you do that needs to pay off for ideas and whatever. But you should be thinking about what will matter in five years town, what part of the world will be larger, more consequential, whatever, and start investing now, because then if you wait until five years from now, maybe it took you five years to figure it out. And so that was the reason for going to India, really, was that this is a large economy. Corporate governance is improving materially. It's actually a very vibrant stock market with a very vibrant investing culture in India.

And we didn't know, honestly, whether it was kind of diligent-sible, if that's a word, for us. not speaking the language and not being on the ground. And what I learned after, it was only a week there, was that we're probably never going to invest in businesses that are tied to consumer taste in India because we can't travel to 16 rural villages and figure out why they use this brand of hair oil versus a different one. That's out of our wheelhouse.

But there are plenty of good Indian export businesses that compete on a global scale. Well, gee, if you compete on a global scale and you just simply happen to be based in India, but the products are sold globally, the value change are global, that could be in our wheelhouse is something we could understand. And so it was really kind of understanding. So we'll go back once, twice a year, and it could be five years or never before we buy something in India.

But I think we would be doing a disservice to our clients if we just wrote it off as, well, it's too far on the food's bad. Before we get to Japan, which I'm really, it's a country that keeps coming up more recently as an interesting opportunity set, I'd like to hear about the process behind why it's India in Japan. So what about those places? You know, you're a relatively small team. You've got limited time in the day. What was it about those places relative to all the other places that caught your attention and made you focus there? So I wouldn't say we focused there.

It was simply our first trips there. Yeah, it's really our first trips there. I mean, you know, we went to Europe probably five, six times last year. Just didn't happen to make one of my letters. It was less interesting for in some ways. Although I did mention one of our letters that I ate moose for the first time. first time last year when I went to Norway. That was fun. It was good. It was good. So it was very opportunistic, just kind of the opportunity popped up for India and did it with Japan.

I had a friend in the industry going there, and we were able to kind of tag team on companies, and we found a really good translator who was easy to work with and who was not connected to a bank. So we didn't have to like do a whole bunch of trades with them. We just could pay this translator cash, and that worked out pretty well. Japan, A, corporate governance is improving their capital allocation is improving at the margin, and there are a lot of phenomenal global businesses there. But again, you really can't do calls with them. Japanese companies prefer visits, and especially to kind of break the ice. Okay. So that means you need to go fly over there and do the in-house visit to open that door for future conversation. We found it in our experience having run

strategies that are both pure domestic U.S. only companies and those that are global, that obviously I think a bigger universe is attractive in many ways. But in the world where you're benchmarked, right, and acquies your benchmark and it's 50-50 or something like that, U.S. international. How do you think about risk associated with relative exposures for regions or countries like Japan and trying to parse like the idiosyncratic risk, which is what you're after, with just regional risks. And you don't strike me as a macro guy. I'm not a macro guy at all.

But it does matter. Benchmarks matter. The guy I talked with this past week said, you know, anyone with the benchmark is benchmark afraid. And I love that phrase. So how do you think about, let's say you were to initiate positions in Japanese equities, like the bigger picture there that could just affect your results without really intending to. Exactly. And the thing that could affect us most in the short one is currency.

And the key for us in terms of risk is simply getting paid, getting paid for the risk we're taking. So to choose two countries with very volatile countries, Brazil and South Africa, both of which we've invested in in the past, our hurdle rate for investing in a Brazilian or South African equity is significantly higher than for a U.S. equity because over time, the Rial and the RAND will depreciate. I don't know what they'll do over two or three or five-year period, but the inflation. differential, just going back to the old Phillips equation, they will depreciate relative to the dollar. And so I need to get paid for that because my clients are in dollars. Now, Japan, obviously, the yen, I mean, people like to bet on the end doing whatever it does. We don't have a strong view on

that. But I think you have to be aware that if you're buying a business in a volatile currency, when the currency is at the top of the Big Mac index or, you know, is sort of hitting new highs, you're taking a risk. And you better get paid for that. Now, that's the, that's more, that's quantifiable in some ways. What's not quantifiable but it's just as much of a risk is what you don't know because you don't live there. You're not on the ground listening to the news every day. And that's why, I mentioned in the case of India, we will probably, our first foray into looking at businesses there will be global businesses, businesses that export on a global scale because we think those are more understandable for us.

A business that is very tied into local consumer behavior that could change without us knowing, I think for a country you might visit twice a year, that's going to be, it's a tall order for a concentrated firm like us. Now, if you're 120 stock EM fund, great. But a small position for us is 5 or 6%. So you need to be very aware of what you might not know. One of the things that stands out about when you look at Japan is just different objective functions. When it comes to corporate governance and shareholder value, they're just optimizing for different things, or at least half historically. I think that's very true.

Maybe improving. One of those things is market share. And this is an interesting segue into another kind of mental model or topic that you've talked about and some things that you've written about absolute versus relative market share. I'd love you to share kind of your thinking on that topic and whether or not those things are useful when thinking about identifying attractive opportunities. It's an interesting question. I think market share is often conflated with competitive advantage, which it's not. Generally speaking, you will have better economics as a business. This is speaking broadly.

If you have 6% share and the next biggest guy has 2, then if you have 40, but the other guy also has 40. I mean, look at Boeing and Airbus. The planes are functionally equivalent. The barriers to entry are high. And this is another way. The barriers to entry, there's another kind of misleading mental model. It's unlikely there's going to be another airplane manufacturer anytime soon. Barriers to entry are high. But Boeing and Airbus, their terms on capital are okay. They're not great. They're okay. Because at the end of the day, if you're American Airlines, you're at Japan Airlines, A320-737, what do you care? You don't. You're done. You're done. is to get butts in seats a certain distance.

You or I don't care, which kind of plan we sit in, right, for the most part. Whereas if you have a business that might only have 6% of a very fragmented market and they can achieve scale by buying other businesses and consolidating that market, and the next largest firm is only 2% and is way behind in terms of gaining scale, that flywheel will only accelerate. Talk about another business model that I think you and I both are really interested in, which is the SaaS model. We use Workiva.

You can describe that portfolio company, describe what it, does, and then we'll talk about why the kind of vertical SaaS segment of the market is so interesting to you. The SaaS model, I mean, it's interesting, it actually kind of ties back to the whole idea of things being mispriced because, you know, because you're getting paid over time, it's your lifetime value of the customer that matters. And you're stretching the value of that customer over many, many years, as opposed to the old software model, which is getting a big, juicy license payment today and then a little

bit of maintenance revenue going out, which pushes the value into the future, but also increases is the lifetime value. Companies that go from license and subscription often see a 1.5 to 2x increase in the lifetime value of the customer, but you don't get all the cake today. You have to wait for the cake. And the market doesn't always like that. I mean, look at when Adobe or Autodesk went through their subscription transitions and the stocks got hammered. But if you kind of look through that, there wound up being opportunities because the product was still very sticky. And so the metric we think matters most is sort of the ratio of lifetime value of the customer to customer acquisition cost. And there's 8,000.

different ways to calculate those. You just want to get a rough idea. But, you know, if you're getting, you know, three or four X delta between those two, you should be reinvesting every cent that you have, right? I mean, you shouldn't be generating free cash flow. So WERC, the business that we happen to own, which is kind of a very sassy business. They have about 96% client retention, 106 revenue retention. They keep upselling clients. And what they did is created a product that enables companies to do SEC filings much more efficiently than the old way, which was mark up a PDF and send it to Donnelly, and then Donnelly sends it back to you, and then you mark it up, and then you send it back to them. It was prehistoric. And so needless to say, they took,

went from zero to 50 percent share in about six years. In fact, the people who do external reporting, they've got about 80 percent share of the Fortune 500 right now. People actually won't go to work for another firm that doesn't use work if you do external reporting. Like, that's how strong the product. Why is that so defensible? It sounds like something that another software company could replicate. Like, why is there a mode around that business? It's a great question. So it's not an easy, product to create because essentially what they had to do is replicate Excel in the cloud and enable it for scores of simultaneous users. There's no check in, check out the worksheet. And also,

the data points get linked inside your enterprise. And so you might say, okay, we need to report this EBIT line. Well, that's the function of Bob here and Jane over there. And their numbers roll up into mine. I link that inside my enterprise. So if you had a new product, you'd have to break all those links and reintegrate it. So not impossible. But external reporting teams, even Walmarts it, you which is a huge company. Their external SEC reporting team is like 20 people. So, you know, it's feasible. It would be feasible to do a rip and replace.

But where things get interesting for this business and where the TAM gets much larger is internal reporting. Where basically you're rolling up data across the entire enterprise and then putting it together for the CFO, CEO, whatever. Because then your linkages become much greater. And the number of users become as much greater. And the more users you have in an entity whose workflow needs to get disrupted, if you got a new product, this took year the product becomes.

This is a little bit of a harken back to our first conversation, which I highly encourage people to listen to. It really is kind of an incredibly dense 50 minutes on MOTS and capital allocation. But when you're thinking about, I guess, the switching costs associated with these SaaS businesses, my understanding, like, I always hear the one about dentist's office software or something like that, that it's just once they're in there, it's a tremendous source of pricing power that you can kind of, You mentioned the 106% revenue retention because they're assuming that's because they're raising prices or cross-selling or something. Cross-selling.

So talk about the different aspects of moat and pricing power specifically. I think one thing that does happen sometimes in vertical market software, and I think any user of Bloomberg or Advent will appreciate this is what's called abusive pricing power. And yes, I'm talking to you, Bloomberg and Advent, where your share of the economics is becoming to some extent unfair. Advent looks like a DOS program from 1975. I mean, they haven't improved that thing in years. But we have no choice. I mean, no user has a choice in terms of using Advent. There's really no real substitute for it.

And so I think that's where these products that are very sticky can be, you can create a pricing umbrella that creates a profit pool for a competitor to come in and try and take it. But as long as you keep improving the platform and offering more functionality each year, more ease of use, whatever it might be, and you're taking prices up two, three, four percent, something modest. The path of least resistance is just keep using it, you know, especially if that piece of software is the plumbing that runs your business and is a relatively low cost relative to, you know, the revenue that you're generated.

Let's go back to that LTV to CAC ratio and describe these kind of levers in some detail. So when you're evaluating a SaaS business or any subscription business, I always like to think about Netflix. Talk about what each of those terms mean, maybe throw churn and retention in there. And then what like an LTV to CAC of one versus say five might mean and how a business should react to those things. Again, you can argue for years about how to calculate this. But conceptually, you know, lifetime value of the customers, how long does the average customers stick around? And it's like a discount of cash flow basically per customer.

Do you two months or whatever it might be. And what kind of margin are you making off of each of those customers? And that typically will include some assumptions around cross-selling or pricing power because that's kind of the revenue stream you're going to get. And the acquisition cost is basically sort of your marketing spend per customer over some time period, over six months, over trailing three years. You can pick different ways to do it. And I would say that, you know, so in Berkiva's example, their customer acquisition cost really spiked about a year and a half, two years ago because instead of going after the broader internal reporting market, they tried to pivot of going from the SEC market to the Sarban's, Soxley market. Sarban socks reporting, which didn't work very well because whereas with external reporting, you were just saying, hey, you should do use W-desk, which is their product, instead of

Donnelly or Merrill. You use that product, our product is superior. Customer goes, why, yes, it is. There is no socks product. There is no product for socks reporting. It's a whole bunch of clued together internal processes. So that's a much harder sale. Going in and saying, pay money for a product that is replacing an internal process that you're not actually spending money for, it's just sort of wasting people's time. Like that's harder to put a number on if you're a CFO or CEO. And so that really spiked up their customer acquisition cost. Once they kind of pivoted back to enterprise sales for internal reporting,

and frankly, just reorganize their sales force geographically as opposed to functionally, which means less travel because you're closer to your customer, customer acquisition costs came back down. So is it fair to classify this as where the LTV is basically like, a per user or per client discounted cash flow. Yeah, sure. And that acquisition costs is just how much is it cost to get one. And obviously you want the ratio to look good. But I've heard, for example, just as very simplified rules of thumb, I'd be curious to

hear if you agree with these ideas. Let's say that ratio is one. So your lifetime, you're basically, your lifetime value is the same as the cost to acquire the customer, kind of break in even on the customer. That probably means you're spending too much on acquisition. But conversely, you don't just want it to keep going higher because if it's like five, you actually should probably be spending, be willing to spend more on customer acquisition and explore new distribution channels.

So is that kind of roughly the right idea? Yeah, I mean, I don't know what the right number is, but you're correct that there is sort of an upper ceiling, at which point that sends a signal that the company is more interested in sort of milking the current client phase than growing clients. So some years back, we owned a company called diligent board books that basically made software to put together electronic boardbooks. So you think about like the big packet, a board member of a Fortune 500 company will get. Well, if you can do that online and do that in a PDF form so that when you have to change that page two hours before the meeting, which always happens, you don't have to reprint out all of them and it's more secure and everything. Great business. One thing that drove me, we don't own this anymore.

One thing that always drove me nuts is they're always like, yeah, we're so very proud to be profitable. You know, not like this is a New Zealand company, not like those money losing American companies. And it was like, yeah, but you're not growing. very fast and your customers never leave, that means you should be plowing every cent that you have into expanding your sales force. And like that, just never really clicked with them. It was very, very frustrating for us. So yeah, you're absolutely right. If that ratio gets too big, it means you're not acquiring customers. Besides that model, that sort of, that LTV to CAC model, which has become very popular, especially in the startup world, sort of maybe the de facto, one of the de facto models.

Are there other, I'm thinking back now to the DCF and IRR combination that you use when approaching valuation. Are there any other kind of valuation or business model type models that you think about or use as you screen for companies? So one, to think about is sort of a demand aggregator. So a company that aggregates demand in some ways. So sometimes this is a distributor. That's a classic example where you essentially pool variance. So let's say you're a distributor of widget parts for making widgets. And some types of widget parts are purchased very frequently.

Some are purchased very infrequently. The bigger you get, the more frequently your stock of infrequently used widgets will turn, which means it's more efficient for you to carry them as opposed to a smaller competitor who can't put with that product, that inventory just sits there for a longer time period. It's called pooling of variance, and then you can also think about it as aggregating demand. And, you know, you can think about, you know, one of the reasons Netflix can afford to invest in tons of content is that they have aggregated demand. You know, they have a large number of people to whom,

with whom they can monetize that spend on content. They've aggregated content demand. And so I think that when you have businesses that aggregate demand in some way, whether it's a distribution, like a classic distributor, like a dental distributor, or fast and all, or a platform company, which is a very overused word, things get very interesting very quickly. How would you parse the difference between the aggregation of attention and the aggregation of demand? It's kind of, well, in some ways, that's a cool question.

It's kind of the same thing in some ways, because there's only so many, hours in the day, and one of the beauties of both Facebook and Google, and as of mobile devices, is suddenly you actually have more attention because people do it will screen. 20 years ago, TV watching was a zero-sum game. If you were watching CBS, you were not watching NBC. And people just, you know, that's why it's such a cutthroat industry. But now people have a phone in front of them while they're watching TV. That has, in essence, created more ad time because the ad can be shown on TV, the ad can be shown on a mobile device, which is really an interesting dynamic. But it's still attention. You've still got, so in some ways, hours of attention have been created in some

ways with mobile devices, which is kind of a fascinating thing to think about, the time got created in a way. But it's still aggregating that attention onto one platform, be it Google, be it Facebook, be it Netflix, be it whatever. And then demand would be more for, I think, I guess I think of that more as a physical product. If you're aggregating demand, fastener for fasteners, or site one for landscape supply, or pool, which is for, you know, pool supply products, so forth. One of the guests I had on was talking about basically the business model being aggregating demand for a very specific cohort of people.

I think the idea was like Sephora, as was the end thing, that they could sell that attention to more or less, whereas a company like Google or really Facebook is probably the best example just seems to be aggregating attention. And then the back end like advertiser model, which sounds like you know very well and is extremely effective, you can measure your return on investment, is the way to just parse and basically create demand within that attention. It's really interesting. Yeah, I hadn't thought about it that way, but no, that's a good way of thinking about it.

Are you familiar with this kind of phenomenon right now, this HQ, the kind of countrywide quiz game? Oh, no, no, no. So there's this thing right now where it's an app on your phone, and I think it's twice a day. They are running a live quiz, like a quiz game. Like a quiz bowl. Okay, cool. A quiz bowl with prizes.

You know, there's video and the questions come up, kind of like who wants to be a millionaire or whatever, and you have very short period of time to answer it, so you can't be like Googling it. or whatever, and it's real cash prizes. It's like two grand. They did like a $20,000 cash prize at Super Bowl halftime. And so my question to you is, for a company like this, they just raised like $19 million of venture capital, mostly to fund those prizes.

So they're doing this incredible job of aggregating attention and engagement. Like people are obsessed with this game. There's like a million people playing twice a day. It's kind of very quickly. So if you were running that business, knowing everything that you do about advertising and sort of that business model. how would you go about monetizing something like that that has aggregated incredible engagement and attention? So one way, mobile gaming companies have really, it's become very common for mobile gaming companies to say,

okay, you can spend more time playing or you can level up by watching this ad. Right, that's a pretty common way. So what if they said, okay, if you, you know, we have one question, there's another question you can, you could try to answer. And no guarantee, same thing, you know, you may not be able to write, but you'll only get this new question. you only get a chance to play the lottery if you watch this ad. Right? Yeah, really interesting.

I'll bet you a lot of people would, especially because of the dopamine rush is going, right? Of course. What you would want to do is, you know, did they answer it? Oh, no, you didn't answer, but wait! If you watch this ad, you can try again with a different question. I don't know. I'll bet you you'd get some takers on that. I've learned a lot from reading your stuff and our couple conversations about this in general,

but it was really hit home yesterday. I read the introduction to a book that's coming. out. I think the book's called World Beyond Capital or Without Capital. It's by one of the partners here at Unscore Ventures in New York City. Okay. Interesting. And part of the core thesis is that what is scarce has just changed through time. And that in the industrial age, it was capital that's scarce, but we're now going to the knowledge age where attention is the scarce resource. So I'm just curious about your reaction to that kind of basic simple idea that I just thought was kind of elegant and neat. Yeah, well, both the tension and I think it also more, it's human

capital versus financial capital. And so attention may be the scarce resource now because people have more leisure time than they did 20, 30, 40 years ago when you're out on the south 40 plowing behind a mule or whatever. And so the competition to get a piece of that time is higher today. But I think more broadly speaking, and this is where I think is very applicable for a lot of investors and kind of harkens back to that 60 cent dollar point I made earlier, when the scarce resources human capital and not financial capital or physical capital, it becomes the output of human capital is poorly reflected on financial statements. It is the best way to put it.

If you build a rail or if you put a building up, that's on a balance sheet. I can look at that. Build a steel mail, that's right there, okay? But what's the value of Google's engineers? I don't know. I mean, the R&D is expensed. Price to engineer, we could create a series. Exactly, there you go, right?

It's not capitalized. And I mean, if you had to ask me, like, what is this scare? resource right now, it's human capital. It's a scarcest resource. And I mean, just as a brief pivot, it's one of the things that scares me most about the current immigration debate. Because for many decades, if you'd ask the best and brightest person in any given country, if you could live anywhere in the world, where would it be? Five out of ten, six out of ten, pick a number, would probably say the U.S. And if that goes down, then we, at the margin, lose, because that's the scarce resource as human capital. How do you evaluate that? So this is a nice, this pairs nicely with

this idea that what markets mispride is the kind of qualitative stuff versus the quantitative stuff. How do you evaluate that in a business, the value of human capital, say relative to peers or relative to pricing? It really kind of for us comes back to the competitive advantage analysis because competitive advantage is created via human capital. It's created via the construction and maintenance of a brand. It's created via the increased engagement of a network effect. It's created by making a product difficult to switch away from. That's all. That's not, you didn't just build a factory, you did something with the product, with the intelligence of the marketing guy and the product designing guy and woman who codes or whatever it might be, it makes that product

difficult to switch away from, whatever it might be. So that's kind of the, for us, that's the output, but we certainly don't do kind of like, because you have more engineers, you're more valuable. I mean, it's monetizing matters. I mean, look at Twitter and Snap. Need I say more? You know, I mean, lots of human capital and product that people love. Amazing products. People love Twitter. but just they've never figured out how to engage, how to monetize it. We both work in the asset management business. All of these same things, these concepts we've talked about are interesting to discuss in the context of what we do as operators versus as investors. So maybe talk a bit about the early experience now four years or so in to starting an asset management business, how you think about it as like this dichotomy of like an investing firm versus an asset gathering firm.

I think I know where you stand on that spectrum. but talk about the experience of actually starting an operating business and what has worked and what hasn't worked so far and I'll have some follow-up questions as well. So I would say that the first thing is know who you want to be when you grow up. Think about what should this firm look like in 10 years. And I actually don't think a lot of people who start asset management firms do that. They're thinking about what kind of carry am I going to get next year this year.

Sorry. But if you're an investor, you want to partner with someone who is going to be around in 10 years, especially if our clients are mainly endowments and foundations, which are perpetual entities. And so you need to be thinking on a perpetual time scale. So I think that's one thing we did okay at. We got right and sort of thinking about what should this business, designing it for durability. I think one thing, we got some operational stuff wrong at the outset, which isn't that important.

But I think one thing I got wrong personally is at the outset of the firm, I didn't do the best job being who I could be. I tried to be other people. I was too influenced by other investors I was close to, and some of the things we purchased were more things they would have purchased. Can you give a specific example? No, I'd rather not, actually. These are all smart people who have, you know, created value for investors in their own way. But if they're cooking Chinese, I'm cooking Italian, whatever it might be. And, you know, I was an Italian cook trying to serve fried rice, and it just doesn't taste very good, right?

It's a horrible analogy. But I think that was a mistake we made. And I think that was something that figuring out who you are, what you're good at, what your circle of competence is, and just sticking with that, which means really suppressing FOMO, really suppressing that, oh, that could be an interesting idea. Well, maybe it's an interesting idea, but it's not one that you have any competence at looking at. So four years in, you talked earlier about the DCF analysis as not trying to come up with some perfect forecast or value, but instead as a way of really identifying what the key couple levers are in a business. Like what are the value drivers good and bad? Turning that same idea on the asset management business, setting aside performance, or at least the high level of performance, which is obvious, better performance, better business. What are the levers that you found to be the biggest value drivers in your business and maybe in the asset management business?

and more generally speaking. First thing is remember that performance is an output. Performance is an output of people in process. And that if you don't get those two things right, you kind of lost the game before you even started to play. And so I think firms that are thoughtful about process, that are iterating on process, that are reflective about what works and what doesn't,

and that are willing to change things that don't work and that never say because we've always done it this way, I think that's a hallmark of good firms and that's something we try to do. On the people side, it's being willing to be open-minded, not just with the kinds of people you hire, but with how they behave inside the firm. I think that when you have one of the worst characteristics of some firms

is that analysts can weaponize information. And so if you know more, you know more detail about the semiconductor industry, the oil and gas industry, and you can throw out lots of jargon, you win the debate. But the person who knows more doesn't necessarily have the right answer. and that's a really hard thing to get around. And so I think that having humility and realizing that the best insight can come from the guy with a least information sometimes. And so that means making all voices equal that, you know, if you're looking at an oil and gas company, you know, somebody else may have somebody else's voice is just as valuable as the oil and gas guy who's frankly incentive to get more oil and gas into the portfolio.

That's not an issue for us because we're a smaller firm. We're generalists that we have a very. it's concerted portfolio. But I've certainly seen that breakdown at larger firms. Asset management's beautiful because it has enormous operating leverage done correctly. But it also, maybe the flip side of that coin is that they can be extremely fragile businesses. We saw we're sitting here. It's the 7th of February today. In the last couple of days, we've seen these enormous kind of ETF blowups literally overnight. So it tends to be a very fragile business, especially when it's a single strategy, a single fund, and in your case, very concentrated.

So how do you think about that kind of two-sided coin? Another way of asking the question would be, you know, you've got a fairly limited capacity strategy we were talking about before we started. What, if any, ambitions do you have beyond just the core approach of a concentrated, differentiated, differentiated portfolio? For us, we have none. I love it. Yeah, I mean, I want to be good at one thing, and we do one thing, and that's all we do. So we don't really have any ambition to manufacture product or, you know, do this or do that. And again, that's not to fault those who do and build a larger platform. It just needs to be done thoughtfully, and it needs to be done in a way that is leveraging intellectual capital you've built as a firm and not done as a way to capitalize on perhaps fleeting investor demand. That's where I think that that strategy can, in my view, run into trouble when people create product to meet demand. Because as we've seen, if you look at like the Morningstar data on like asset weighted versus time weighted returns, people tend to make pretty bad decisions about when, invest and when not to invest. And so if you're creating a product in response to investor demand, you're probably creating it at the exact right time and selling it to the exact wrong people. I missed something earlier when we were talking about Facebook that I want to circle back to because I meant to ask you, which is this idea of like embedded options that get mispriced by the market.

The reason I thought about that was I was going to ask about what your view on the relationship is between risk and return. So maybe we'll start there. What is your opinion on the strength of that relationship? And the reason I think of options is because, it seems like something that often gets mispriced within a big kind of complicated company. So maybe also talk about the options embedded in something like Facebook. With risk, it all just comes down to how you define it. And that kind of also comes back to who your clients are. If your clients are, frankly, maybe let's imagine a lot of your clients are funds of

funds who are getting evaluated on monthly performance. That means you're getting evaluated on monthly performance. And that means for you, risk is having a bad month. That is risk, which means volatility is. going to matter to you. You know, for us, risk is about permanent capital impairment because we are very fortunate that our investors have a long time horizon, and that's the same time horizon we take. We sort of underwrite businesses to a five-year-plus horizon. And so for us, risk is permanent capital impairment. But that's real. I mean, and so you have to

think about that, especially in a concentrated portfolio. You can't, I mean, a concentrated portfolio of biotech bets, where it's kind of like a completely binary upside and downside. I mean, I'm sure there's some PhDs out there who are doing this and doing it successfully. But, boy, you better know that science. You know, and your winner's better offset your losers. So for us, risk is permanent capital impairment. You know, on the option side of things, it's really tough. I mean, in Facebook's case, WhatsApp is not monetized yet.

We think it will be at some point how much we don't know. And the way I think you factor that into as an investor is you say, okay, so let's imagine, let's contrast to businesses, both which we know, like Dollar General and Facebook. You know, so if Dollar General were to trade kind of at our valuation estimate tomorrow, Okay, great. It is what it is. Dollar General is not going to suddenly open six times more stores than we suddenly expected. They're going to continue to kind of crank out what they do, which is basically server role America in a very intelligent way. If Facebook was trading kind of at our DCF fair value estimate, that estimate doesn't incorporate any value for WhatsApp. And then we have to make a qualitative judgment on is WhatsApp word zero or something above zero? And what's the likelihood that that something above zero will materialize in our lifetimes? Well, I said, well, then we probably shouldn't sell it. So it's just, again, I hate to say, but with so many things, it's a judgment call. A lot of art in this conversation.

I know. I hate to say it, but I mean, it's, you know, it's funny. I was actually talking to a friend of mine this morning who works at a firm that is both an investment management division and kind of a private banking division. And he contrasted kind of, that the one side of it was manufacturing, manufacturing product to meet demand. But then the investment management division was much more about kind of basically a giant HR function. Basically, it's about curating human capital. And it's almost like, you know, the craftsmanship versus manufacturing.

Neither is good or bad. And, again, it's in that pejorative. But I think if you're Franklin Templeton, you kind of have to be a manufacturer. But if you're a smaller asset manager, you're a craftsman or craftswoman. And those require different skills and different structures. The way you put it in the letter was you can often get paid for taking on uncertainty. Like uncertainty can have value. I think about that a lot personally, too.

One of the questions that I've started to ask more and more people in this context and privately is for periods where you've sort of taken the most risk in the face of uncertainty. So some sort of like personal leap of faith or where you just didn't know what the outcome was going to be, but you did something anyway. I'd love to hear that story and kind of what that felt like emotionally. Unfortunately, it's an obvious answer, which is starting my business. Starting my business. Because it was a leap of faith.

I'd never invest in anything with my own money. You know, I mean, I run a big team of analysts, but publishing research is not managing money. These are entirely different things. I mean, don't let anyone tell you different. I mean, it was a huge leap of faith. And I have to, I'm very grateful to some people in my life who are close to me who pushed me, you know, who said, you can probably do this. Your odds of success are maybe 20%, but that's better than the 2% that most people who start asking whatever the number is. And so I'm very grateful to those people. But that was certainly the big leap of faith. And, you know, in hindsight, I wish I'd done it 10 years ago. How did that percolate? Like, what was the process that kicked the whole thing off, the idea of going and hanging a shingle, so to speak?

It was really thinking, seeing a blank slate, thinking what to me is the most rational way to invest? And then saying, gee, is there a place where I can do that? And the answer is no. Well, then I guess you better do it yourself. Because I don't view things like, say, the Morningstar style box is frankly very useful. I'm sorry. It's certainly not how I think about investing. I wanted to be unconstrained.

I think concentration so you can invest a high amount of human capital on every idea gives me greater confidence in what I own, which means I'm going to be a better investor and a better fiduciary for my clients. But also for the specific types of clients I wanted to seek, large endowments and foundations, because if you're investing for a high net worth investor, they might only have two or three people managing their money. And so concentration is a little tougher, you know, being fully invested all the time. It's a little bit of a tougher ask.

But if you're investing on behalf of a large foundation or endowment, who is making asset allocation decisions a couple notches above you and wants concentration because you're going to be one of 5, 10, 15 managers, then the interests align. They align so well. And it just kind of made sense, I guess. My closing question for you since we've talked before, this time will be for your favorite kind of recent find in terms of a learning resource. So this could be anything. It could be a book that you've read. It could be a conference that you went to, really anything, something that really accelerated your understanding of some specific topic? Well,

it's a popular book, but it's definitely had an effect on me is Dahlio's principles. And that's maybe more specific than you were looking for. I read it over the holidays. And it's really interesting because our firms could not be more different. I mean, as a quant firm,

we are not. They're a little bit bigger than we are, I think. Couple orders, magnitude. Their fees are a little bit higher than ours. And, but, the central theme of let's get people together with diverse opinions and figure out how to get the best outcome from that conversation. That's exactly what I'm trying to do. And so that, you know, sort of, and this is somebody who's done it longer and probably thought more deeply about it. And so, you know, the insights from that book in terms of how do you tease out, as Dalio says, a discussion is about seeking the truth. I think of the phrase or something like that. That's immense. powerful. And I think it really helps focus like our team back on, look, this is not about you're wrong or you're wrong or I'm wrong or I miss this or he missed that or we should have done this.

It's about what's the right answer. That's the only thing we're trying to do because if we can on balance find righter answers, we'll do better for our clients. And that was despite the, I was really resistant to reading the book because I was just sort of like, what the heck? Brude water, man. Come on. But that's exactly what we're trying to do at my firm because I I'm a huge believer in the value of discussion, the value of conversation, the value of diverse viewpoints, testing each other, and then extracting hopefully better meaning from that than any individual could have arrived upon with their own more limited set of analytical under underpinning. So it's Dalia's principles was excellent.

Fantastic. Well, last time we were artificially cut short, so I'm glad we were able to fill in all the gaps this time. Thanks again for your time. No, thank you for the great questions. Hey everyone, Patrick here again. To find more episodes of InvestorField Guide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com

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