Protecting the Downside

“Thematic Investing” evokes feelings of “riding the wave” or “top-down investing” or “tailwind”. While all that is partially true, our main motivation is Risk Management.

We don’t like headwinds. Investing and beating the market is hard enough. We don’t need to make it harder by trying to game structural and cyclical headwinds. We want highly probable tailwinds because it significantly reduces the probability of facing headwinds. This allows us to spend our time and energy on the more “micro” stuff – like investing in individual companies. We like that because it has fewer moving parts – less chances of making expensive mistakes.

Ultimately, while we’re shooting for 10-15% Annualized Returns over the long-term, we are very loss averse. We hate losing money. Short-term dips due to myopic reactions by the market are OK. In fact, sometimes we like those bouts of market pessimism – it allows us to pounce on our favorite holdings on the cheap. But we hate permanent loss of capital. Our loss aversion mindset has forced us to think thematically even though our core competency is more bottom-up company-by-company valuation. As you no doubt have realized, it’s all connected.

Thematic Research is an integral part of our investment process. In fact, it’s the first cut. Our investment process, in a nutshell, is about answering the following questions: 

1. Is this company playing the right sport?
2. Does it have a durable competitive advantage?
3. Does the company have a good management team?
4. Is it trading at a comfortable price?

It is possible to answer “Yes” for question 2, 3 and 4 while answering “No” for Question 1. That would be a no-go. We don’t invest in such companies. The problem with ignoring Thematic Thinking is that it is impossible to predict when a slow and steady decline will suddenly accelerate into a sharp fall off the cliff to oblivion. If we were around 100-odd years ago, for example, we wouldn’t want to invest in the best buggy whips company when reasonably reliable automobiles were hitting the streets. Investing in a company that has a durable competitive advantage in a structurally declining industry would keep us up all night. It’s a game of musical chairs and we’d never know when the music stops. No thanks.

“…there's another model from microeconomics that I find very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon that I call competitive destruction. You know, you have the finest buggy whip factory, and, all of a sudden, in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you're dead - you're destroyed. It happens again and again and again.” - Charlie Munger

So, our motivation behind Thematic Research is not to ride the wave but to protect our downside by not getting caught up in the buggy whip business. But there’s more. 

Finding Positive Optionality

Once we’ve identified tailwinds, we can start dreaming about the potential upside. We’ve hopefully avoided the wrong sports. But how do we know what are the right sports? We keep this simple. We ask ourselves, “what would make lives better and/or easier for people around the world?” Common sense (and history) suggests that there will always be demand for products/services that significantly improve quality of life.

What is Progress? Anything that improves the quality of life of people around the world. Generally, that falls in these buckets: 

1. Faster way to do things
2. Easier way to do things
3. Cleaner way to do things
4. Healthier way to do things

Keeping this in mind, it didn’t take us too long to jot down and explore 11 forces of progress that will make life faster, easier, cleaner, and healthier. We didn’t need to collect a mountain of evidence before jotting down this list. But we sure did need to dig into each force of progress just to make sure we weren’t getting caught in the buggy whip factory. One of our first research pieces was on Renewable Energy. It presented the type of long-term payoff profile we love – high expected upside, low expected downside. Oil & Gas, in our opinion, has the opposite long-term payoff profile – low expected upside, high expected downside.

To many, maybe even to you, these forces may seem obvious and unimaginative. We think that’s a good thing. Forces of progress should be obvious. Remember that we’re not trying get creative with these forces. We’re not trying to uncover a diamond in the rough. We’re just trying to make sure we’re not playing the buggy whip game. And if we get massive tailwind behind us in the process, that’s gravy. 

Case in point: Even in 2018, when we started our portfolio, “AI & Big Data” was a rather “obvious” bet to some. And the connotation behind those dismissive judgements was this: “if it’s obvious, it must be played out, which means that market prices already reflect this obvious bet, so you won’t be able to generate high returns…” Well, in the case of AI & Big Data, this type of thinking was wrong then, and is wrong now. Most of our returns and outperformance (compared to the S&P 500) have come from AI & Big Data. And we expect this bet to pay off for years to come. 

There are 2 underlying behavioral tendencies behind that dismissive assessment (which we keep hearing almost every week): 

1. Short-termism
2. Linear Thinking

These 2 behavioral tendencies go hand in hand. Non-linear phenomena take time to materialize. In our experience, the market continually underestimates non-linear phenomena that take years to blossom. That’s where money is to be made.

We want to emphasize that these non-linear, exponential forces of progress are not guarantees. But we attach a high probability to them – high enough that we know we’re not playing the wrong sport. Investing is a game of probabilities, not certainties. The best we can hope for is Positive Optionality – the reasonable probability that reality will significantly surpass market expectations. But Positive Optionality (a term borrowed from Options Theory) inherently means that the downside is protected, at least partially. The probability attached to downside protection is high, while the probability attached to the (theoretically) massive upside is much lower. That’s OK.

Once we’ve cleared the threshold of “not playing the wrong sport”, we dream about “playing the right sport”. But we need to be humble about this. We simply can’t make precise predictions about huge, global phenomena that will shape our civilization for the next few decades. There’s an element of pie-in-the-sky thinking to this. However, we can look for cases of high non-linearity in a company’s thematic exposure, but where its stock price has short-termism and linearity built into it. That improves our chances of disagreeing with the broader market. That’s where money is made.

“You may take it as an axiom that you cannot profit in Wall Street by continuously doing the obvious or the popular thing.” – Benjamin Graham

Initially, our 9 forces of Progress or Positive Optionality were: 

1. AI & Big Data: Artificial Intelligence, Cloud Computing, and Analytics - Software and Hardware.
2. Autonomous & Electro Mobility: Autonomous cars, buses, or whatever, running on electricity. No air and noise pollution, please.
3. 5G & IoT: Data needs to flow, seamlessly and without latency. From the Cloud to the Edge and back.
4. Media & Entertainment: How people consume entertaining content is changing fast. And it will keep evolving.
5. Renewable Energy: Wind, Solar, Batteries. Any type of energy that's cheap and doesn't add to pollution.
6. India: Of all the emerging markets, The Buylyst has a better handle on this growth story.
7. Urbanization: Hundreds of millions more will move into cities over the next decade.
8. Retail: What people buy, and how they buy things, is changing. And it will keep changing.
9. Finance & Fintech: Modern Banking, Asset Management and Cryptocurrencies.

In time, we added 2 more: Industry 4.0 and Healthcare Equipment. We lumped in IoT with Industry 4.0, and in Healthcare our focus has been on technology and equipment rather than pharma and biotech (we won’t even pretend to have a nuanced understanding of them; we stick to what we know). 

As we zoom out and look through this list, we see 2 common threads of Positive Optionality. 

1. Data & Insights
2. Quality of Life

DaaM! Data as a Moat

Compounding of data and insights is our biggest bet. In fact, this bet runs through 8 out of our 11 themes:

1. AI & Big Data
2. Autonomous & Electro Mobility
3. 5G Networks
4. Finance & Fintech
5. Healthcare Equipment/Tech
6. Industry 4.0 & IoT
7. Media & Entertainment
8. Retail

Each of these themes stands to gain exponentially (literally and figuratively) from data and the insights embedded within data. But here’s the tricky part: it’s very hard to quantify the rate at which insights and (more importantly) profits from those insights compound. The good news is that the rate at which insights, and profits from those insights, will compound over the next decade (or two) is often severely underestimated by the market today. That’s the revenue growth angle of data. But there is also the more powerful angle: Data as a Moat. The more data companies have on user behavior, the better their products and services ought to be, which means customers are more likely to stick around, which means more data…and on and on goes the flywheel.

Let’s look at a couple of examples on the connection between insights and profits outside the namesake AI & Big Data theme.

Media & Entertainment: Our Spotify thesis was largely hinged on the inherent “stickiness” of the product. Users listen to songs based on their preference for a few months. This generates enough data for Spotify to recommend playlists or other artists who this particular user may like. Over time, Spotify becomes a personalized radio channel that (mostly) plays the type of music that this particular user loves. As long as Spotify keeps surprising – in an (ironically) familiar way – this user has no incentive to switch to Apple or Amazon. The algorithm that drives user experience on Spotify is a massive Economic Moat. 

Finance & Fintech: We recently sold Paypal because we were trimming the number of investments in our portfolio, and because the stock was, in our opinion, ludicrously overpriced. We had held on to it even after its stock price far surpassed our initial valuation of the company (done pre-Covid). That’s because one of the pillars of the thesis (apart from the now-obvious proliferation of cardless, contactless payments) was the role of data. A native mobile-app is constantly collecting data. This user behavior data is a gold mine of insights. Paypal’s big ambition is to be a one-stop-shop for all things called personal finance – payments, credit, trading, and maybe even mortgages someday. But Paypal has access to user data in a way that no traditional bank has. And in offering credit or other products to a user, Paypal can tailor it to a user’s specific needs and spending habits. Competition can’t. This data is a Moat.

Betting on data & insights has 2 inherent advantages: nonlinearity in revenue & free cash flow, and the possibility of data becoming a Moat – this combination is heaven for long-term investors like us.

The Quality-of-Life Bet

3 of our 11 investment themes can be categorized as a bet on humanity’s preference for a higher standard of living – cleaner, greener cities, bigger houses, more money to buy stuff etc. We all want this unless we’re enlightened monks in Tibet. Sadly, most of us are not. So, why not bet on this basic tendency.

The case for Renewable Energy is obvious to us. Vestas – one of the largest wind turbine manufacturers in the world – was one of our first bets. Only recently did we sell our position because it became hard for us to justify its stock price after a 300% plus run over the last 3 years. The bet on Renewable Energy is hinged on the indisputable fact that it is cleaner and greener. Most of us like that. But until recently – about 3 years ago – the economics didn’t make sense.
 Today, the overall cost of producing electricity from Wind or Solar farms is highly competitive compared to Coal or Natural Gas power plants – even after factoring in the initial high cost of installing wind turbines and solar farms. For companies like Vestas – they’re playing the right sport, they have a durable competitive advantage, they have a seasoned management team but they’re trading at an insane price. 

Our India bet is about harnessing the cliched demographic dividend. It’s one thing to know about this “dividend” – young population, reasonably well-educated, English-speaking etc. – but it’s another thing to invest in it. Our foray into India has been mostly via two of their largest private sector banks. This has been one of those rare cases in which our thesis on each of these banks played out almost perfectly. Betting on India is betting on the rising living standards of about 1/6^th of humanity. The country is still reeling from heavy-handed bureaucracy – a remnant of the pre-independence British Raj – but that’s where we see the opportunity of a non-linear trajectory. As regulations ease to bring the system in line with examples around the world that work reasonably efficiently – US, Singapore, Western Europe – history suggests that the spending power of India’s middle-class will increase exponentially. We’ve argued that India today is where China was 10-15 years ago. The trajectory of income and spending growth will be different compared to China, but it will probably be exponential, nonetheless. 

Our bet on Urbanization took a back seat with the pandemic. Our hypothesis was that the developing world will want/need to catch up with industrialized countries in the cities department. But our hypothesis now is that the chances of a revival in big government spending has increased significantly, which could transform cities in a big way. This goes back to the positive optionality point we made earlier – there’s a reasonable (if not high) chance that spending will be directed towards cities being more livable and more spread out. The need for commuting has decreased. But the need for community and convenience (outside pockets of American suburbia) remains steadfast. For a long time, there have been talks and design schematics of more livable cities. The pandemic may have just accelerated those plans. However, currently, we’re unable to see any lucrative investment ideas in this theme. According to our Watch List, all the Urbanization themed companies don’t rank well on our Investability Scale. Our only current bet on Urbanization is Xylem, an infrastructure-scale water purification company. Even Xylem is under review.

The common bet in these 3 themes is the universal desire to live cleaner, greener, richer lives. We could add our Healthcare bet into this “quality of life” group as well. Again, with all these themes, we’re looking for an almost 0% probability of headwinds and a reasonable probability of a massive upside. That’s Positive Optionality.

The link to SWAN Investing

All that “macro”, thematic thinking is not just rumination. It is directly connected to our “micro” appraisal of a company’s value. We’ve recently named our investment process SWAN Investing – stands for Sleep Well at Night. SWAN is about finding that elusive set of investments that: 

1. Promise high return…
2. …at low risk. 

Academic finance will tell you that’s impossible or too good to be true; with great return comes great risk etc. etc. Our experience has taught us that it depends on the definition of Risk. Their definition has been Standard Deviation of Returns or some derivative of it. Ours is much simpler – “not knowing what we’re doing”. Their definition is short-term and mathematically convenient. Ours is long-term and intuitive.

Based on our definition of Risk, not knowing what something is worth is risky. This is why we spend days ruminating over valuation of companies that look investable. But that involves multiple steps. We mentioned a little while ago that our investment process is about answering 4 key questions: 

1. Is this company playing the right sport?
2. Does it have a durable competitive advantage?
3. Does the company have a good management team?
4. Is it trading at a comfortable price?

Thematic thinking obviously plays right into the first question. But it doesn’t stop there. Our thematic worldview informs our answer to question 4. Ultimately, in investing, Valuation is what it all boils down to. 

SWAN Investing is built upon the principles of Expectations Investing. The core idea is to not take Valuation too seriously. This may sound like we’re contradicting ourselves but bear with us. Expectations Investing reverse-engineers the process of Valuation. It’s about backing out what expectations (like revenue growth) are baked into the current market price, and then asking, “is this believable?” The answer is subjective. And all that Thematic research informs this answer, apart from conclusions about a competitive advantage and management quality. 

Thematic Research provides the context for our bottom-up Valuation.

We’ve learned from experience that Valuation is, at best, a meditative exercise. It is by no means a science. The idea of an “intrinsic value” is a mirage. So, at best, we can home in on a valuation range – we call it the Range of Reason. It’s a rough marker that gives us an approximate indication of whether something’s significantly overpriced or underpriced. 

SWAN Investing – in a nutshell – is first and foremost about minimizing potential errors – errors of judgment and errors of valuation. The upside then, is gravy. Our investment process starts with Thematic Research to minimize the error of playing the wrong sport (like a buggy whip factory in an automobile world). Expectations Investing is about minimizing errors of Valuation. We don’t pretend to know the intrinsic value of a company or stock (anyone who does is disingenuous). We just make the best judgment we can about whether something is unreasonably underpriced or overpriced. Baked into this judgment is our on-going Thematic Research. 

Our Investment Themes of Progress are about positive optionality – minimal downside, massive potential upside. We do realize that we cannot precisely quantify these tailwinds into specific revenue growth targets. But we go ahead with the notion that even if we’re wrong about any particular theme being a massive tailwind, at least it’s not a headwind. That’s one less thing to worry about. And if we’re lucky, we harness that tailwind via the best companies playing that lucrative sport.

When we back into “revenue growth we need to believe to consider buying the stock at current prices”, we ask ourselves, “is this reasonable?” The answer depends heavily on the sport the company is playing. 

One of our foundational tenets of investing is this little quip from Warren Buffett (surprise, surprise):

“...ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.”

…to which we might add, “…and make sure the farm has the right type of crops.”

Many Happy Returns.