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All Models Are Wrong
Based on the number of responses I received, the idea that spreadsheets can be dangerous resonated. One of the more interesting takes came from Kyle, who described himself as having years of experience “on both sides of the spreadsheet argument.” He pointed out that “great people, great ideas, and great markets can overcome the worst spreadsheets.”
That context makes now a good time to point out that no financial model is ever correct. In fact, I’m pretty sure that it’s a law of the universe that once you forecast numbers in a spreadsheet those numbers will never ever come to be. So, to Kyle’s point, you want to make sure you are working with people, ideas, and markets that are likely to make your projections wrong about the upside, not the downside.
One of the first investments I ever made with my own money was buying stock in Whole Foods when I was in college. While I am loath to ever sell anything, I did eventually sell Whole Foods years later when the valuation got pretty crazy in late 2005.
For context, the chain at that time was growing quickly with tailwinds and had approximately $400M of operating cash flow against $4.7B of sales, for a pretty great (for a grocery store) cash flow margin of almost 9%. It was a good company! Investors thought so, too, because they had bid the value of the company up to over $10B, meaning shares could be bought or sold for 25x cash flow.
Now, I don’t know about you, but I invest to try to earn at least double-digit returns annually. For Whole Foods to deliver that on a cash flow basis on that valuation it would have to more than double in size while also maintaining best-in-class margins at the same time that copycats were emerging and competitors were catching up.
Was I able to make a spreadsheet at that time that made a case for Whole Foods doing just that? Of course I could. But as I stared at the numbers, it became clear that if that scenario were to come to pass, Whole Foods would have to sustain economics that no grocery store had ever achieved.
Reasoning through it I thought that might be difficult since Whole Foods was a grocery store.
Twelve years later Amazon acquired that grocery store for $13.7B. Whole Foods at that time had $16B of sales and $1B of operating cash flow. It had grown a lot and done great, but margins had contracted, not expanded (to look more like a grocery store’s) and its valuation multiples had compressed (to look more like a grocery store’s). In other words, holding Whole Foods would not have been a bad decision because it was a good grocery store but if I’d held from the point I sold to the point Amazon bought, I’d have earned about 3% annually. Not great!
This is an example where, to steal from Kyle’s framework, there was a spreadsheet and arguably great people and great ideas, but not a great market. And that’s the factor that ultimately carried the day.
I was talking to one of our operators recently and he pointed out that despite putting a lot of time, energy, and thought into his budget models, his projections had never been close, and we could laugh about that because reality had always been better. As I’ve reflected on why that is, and this is why I am shamelessly appropriating Kyle’s framework, it’s because the people, ideas, and market at that business have proved to create opportunities that didn’t fit in any spreadsheet, which is a fantastic problem to have.
– By Tim Hanson
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There Is No Medium Effort
One thing that I believe to be true about finance is that there is no medium risk. This is the idea that if you take any investment risk at all, what you are risking capital on can always go to zero, so you should either keep your money in safe assets or seek high returns that compensate you for taking risk. It’s anathema to the way a lot of asset pricing is structured, but I believe it to be true and conduct ourselves accordingly. For example, if you looked at Permanent Equity’s balance sheet you would see cash and illiquid long-dated investments.
I also spend a lot of time thinking about where else this barbell approach might apply.
That topic came up the other day when I was talking to someone who expressed frustration about certain tasks, like writing update emails, taking too long and therefore causing him to shortchange other meaningful tasks where he thought he should be spending more time. After talking it through we landed on a challenge: that he no longer spends 45 minutes on anything. Rather, he should divide his priorities into items that should take 5 minutes or less and others on which he wanted to spend a half day or more. In other words, there is no medium effort. Either do it fast or do it.
A seminal book that I read early in my career was Getting Things Done by David Allen. It’s full of lots of tips and tricks, but one that I’ve abided by ever since I read it is that if something comes across your desk that you can do in 5 minutes or less, do it right then and there. That approach has been a life-changer for me and is the reason why if you send me a short email, you’re likely to get a response in 5 minutes or less (please don’t all try that at once).
But as I was thinking about the challenge I talked through with my colleague, I wondered if it applied to me as well, but in the other direction. I, too, take 45 minutes to do a lot of things, but maybe these are things I should be spending more time on. Even if something seems settled, if it’s important enough, is it worth revisiting a few times over?
Suffice to say, I’m going to try it and see what happens. My productivity may suffer, but maybe that will be worth it if my product levels up.
– By Tim Hanson
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The Culture Beast
Where you work, who’s responsible for culture?
The most common answers we hear to this question are “Nobody” or “Everybody,” which is to say that no one is specifically accountable for sustaining one of the most valuable assets at any organization. Don’t think that’s true? Public companies with satisfied employees have been shown to outperform their peers and, for our own part, we’re much more excited to invest in (and will pay a higher price for) companies that have great culture. Why? They’re more likely to attract and retain top talent, which is probably the biggest challenge facing small businesses.
But those answers also make sense because one person can’t force culture on others. Culture is something that has to be built and shared across teams.
That’s also problematic, though, because it makes culture a fickle beast. We all know empirically that as businesses grow their cultures tend to get diluted. I’d never heard an elegant explanation for this phenomenon until I was recently sent a copy of the research paper “Corporate Culture and Organizational Fragility.”
The authors sum the problem up neatly:
Because a strong corporate culture relies on costly, voluntary investments by many workers, we model it as an organizational public good, subject to standard free-riding problems, which become severe in large organizations…workers’ incentives to make voluntary contributions to any genuinely corporate (as opposed to more local) culture vanish as an organization becomes large, because their marginal impact becomes negligible while their marginal cost does not.
So how can you grow a business without sacrificing culture? The specific tactics are likely to be unique to your organization, but using some fancy math the authors of that paper make two general recommendations. First, make lots of small, decentralized investments in culture. Second, promote from within.
Those make sense to me and I’ll add two more: (1) Measure it; (2) Don’t take it for granted.
– By Tim Hanson
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Follow Simple Rules
After I wrote about walking the fine line between knowing everything and knowing what matters, I got a nice response from @MikeBotkin who runs a holdco out of Florida. He said that he and his partner had spent hours that same day debating the same topic and reached a similar conclusion that “it depends.”
And whereas I had tackled the topic from a risk management perspective, he’d been focused on operations and specifically what does he need to know about how one of his businesses is being run versus what he trusts his CEOs to know. Then he added something profound:
“From our viewpoint, there has to be so much room for a CEO to a) lead b) perform c) grow…and most importantly…d) mess up.”
What’s interesting about those four factors is that I don’t think you can do one of them without also ending up doing the other three, yet three of them are celebrated as positives while messing up is typically not. But let me be clear, you need to mess up in order to lead, perform,and grow.
Quick aside, I was having dinner recently with a family that had a family office in which their recently graduated son was starting as an equity analyst. Mom found out what I do for a living and asked me what advice I had for her son. “Make a bad investment,” I said (Mom was not amused).
In the past I’ve expressed a pessimistic view of regulation. And it was after one such missive that my buddy Nate sent me “The dog and the frisbee.”
Published in 2012 after the Great Financial Crisis, the paper explores the idea that complexity is to blame for watchdogs’ failure to prevent crises. The entire thing is worth the read (particularly if you enjoy the minutia of financial regulation), but the two ideas that most resonated with me were “the more complex the environment, the greater the perils of complex control” and that simple strategies in sports, medicine, investing, and more tend to outperform complicated ones.
As for what these things have to do with one another, it’s the idea that no matter how much you know, you cannot prevent the realization of risk. To wit, banks have to submit tens of thousands of data points to PhDs on a regular basis and yet several more just failed.
The takeaway is that in a complex and overengineered world, whether it comes to managing investment risk, banking regulations, or people who work for you, try to follow a small number of simple rules. They won’t always work, but hopefully it will be obvious when they don’t apply, or more importantly, when you’re breaking them.
Have a great weekend.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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Wait Until Something Bad Happens
After I wrote about the importance of having fun at work I received a note from Ellen Twomey, Managing Director of Fugitive Labs in Atlanta. She said the Opinion really hit home and that fun was a great benchmark.
Intrigued, I looked up Fugitive Labs and it looks fun too!
But more interestingly I saw something on their website that I hadn’t seen before – a case study that featured a product of theirs that didn’t work…
I love that. No one bats one thousand and anyone who represents nothing but success is hiding something. Moreover, failing is important. Not only is it how we learn, but if you haven’t failed yet, failure is coming because you haven’t yet pushed the boundaries of what’s possible. And if you haven’t done that, it may mean that you don’t have enough experience.
For example, one of the common questions we got back when we were raising capital was “Can you tell me about an investment you made that hasn’t done well?” We all have those and we had one of those then as we do now and will in the future and so would tell people about what went wrong and what we were trying to do to make it right. Usually it would end then and we would move on to another topic.
But one of the more interesting reactions to our answer to that question was someone who said “Huh, that’s not that bad. Good for you. But we only invest in managers who have had something really, really, really bad happen to them.”
That struck me. On the one hand it was preposterous. Isn’t avoiding catastrophe a sign that you might be good at something? But on the other, there was logic to it. Perhaps the only way to avoid a catastrophe is to have already had one and therefore know what it looks like when one’s coming.
Either way, everyone fails at something eventually and I think the world would be a more interesting place if we were able to follow the lead of Fugitive Labs and put our failures front and center on our websites, resumes, and LinkedIn profiles.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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People Who Worked For Me
There are inside jokes and there are inside jokes by which I mean jokes that are only funny to the person telling them and my relentless trolling of Morgan Housel for a retweet certainly falls into the latter category. (But it did make me laugh.)
If you don’t know Morgan, he is today a best-selling author, partner at the Collaborative Fund, and an in-demand speaker on behavioral finance (who we just happen to have a podcast conversation with out today). Plus, he’s a great dude. What’s also true is that at one point in a past life he worked for me.
Morgan’s always been a great writer, but he’s never been strong on change and he and I had a lot of conversations before he decided to move on to something next. That probably seemed like a net negative for the organization we both worked for at the time, but it turned out to be a great move for everyone involved. No one doesn’t benefit from others achieving great things. And now instead of managing him, I get to free ride on his 450 thousand followers.
Lesser-known than Morgan, but still great, is Michele Hansen (who has fewer Twitter followers than Morgan, but still more than me). She, too, worked for me in a past life while also founding and bootstrapping her own software company, Geocodio. She’s since gone on to run that company full-time while also finding time to write a book and host a podcast (Morgan has a new podcast too).
I’m plugging my friends and former direct reports here because I’m proud. I think the best measure of anyone is what the people you might be helpful to go on to do next. And while it’s insanely egotistical of me to believe I had anything to do with any of this, Morgan did send me an inscribed copy of The Psychology of Money that I keep on my desk and Michele did send me a Geocodio sticker that I put on my laptop because both inspire me and remind me when I see them of what matters when it comes to people.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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Apple Watch Psychopaths
Luckily, I live out in the country because otherwise I would be embarrassed by my neighbors seeing me sprint down my driveway at 9pm risking life and limb because my Apple Watch told me I could still do it and burn the 40 calories left to hit my Move goal.
Yes, I’m a psychopath. Does anyone else have this kind of dysfunctional relationship with their Apple Watch?
The answer has to be “Yes,” right? Because everybody has them. I look around now and see so many square faces on wrists despite the fact that it was viewed as a failed product upon its release. And it should have been, if it didn’t become so darn useful. Absent its judginess, it’s a no-brainer. That said, everyday I think about going back to the Timex Ironman I keep in my bedside table.
But I digress…
Which brings us to metrics, which are both the most important and most dangerous concept to introduce to any business…or really any group of people. If you have them and you understand them and you work towards them, metrics can be unlocking and important. But if you try to achieve them at any cost without regard to nuance, they can be your undoing…fast. To bring this all full circle, yes, it’s frustrating to come up short of an arbitrary but well-intentioned goal, but do those last 40 calories really matter in the scheme of things and should I be out in the pitch black with a headlamp instead of helping put my kids to bed?
But I digress again…
When it comes to metrics, three things matter: (1) What; (2) When; and (3) How.
What is the variable you are measuring. Make sure these are items that matter and that are leading indicators i.e., predictive and not lagging indicators i.e., reactive.
When is the time period over which you are measuring your What. Does an hour matter? A day? A week? A month? A quarter? A year? Make sure what you are measuring is calibrated with when you are measuring it and that the two together provide meaningful information.
And finally How are you achieving the What over the When? As Mark notes, if you’re measuring a rate, make sure you’re also measuring a volume of throughput. And if you’re measuring volume, make sure you’re almost measuring a rate of quality. Moreover, ask if what you’re doing makes you proud? And is it sustainable or does it carry hidden costs i.e., does it make you want to go back to your Timex Ironman?
These are also important questions even if your What and your When are spot on.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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Where Did the Money Come From?
Emily (our MD) sent me this cautionary tale about a guy who won an auction for the famous (because it’s a triangle!) Flatiron Building in New York City and then couldn’t even produce his $19 million deposit. You would have thought somebody would have asked for proof of funds from any potential bidder beforehand because now a lot of work has been done and no one is any closer to closing a deal.
If you remember your risks, this is counterparty risk, or “the risk that the other side of the trade will fail to perform.” The obvious lesson is that before doing a deal, make sure the other side has the money.
But I also think counterparty risk is more than just black or white. You not only want to know if your counterparty has the money, but also where he/she/they got the money from. Because while the source of capital may not be what determines whether it’s there or not, it absolutely will determine how it behaves. And if you’re going to be stuck with your counterparty for any length of time after a transaction closes, that matters.
Here’s a hypothetical…
Let’s say you were Twitter. Would you have rather taken an investment from Warren Buffett or Elon Musk? If you don’t know what you know now about how Musk has run Twitter since his investment, I actually think the answer to this question is a pretty close call. Despite Buffett’s reputation, it’s unlikely he could have helped the company. He is typically hands-off and doesn’t cop to having much knowledge about technology whereas Musk is (was?) one of the foremost technologists on the planet.
And – hot take – I actually think Musk could have been (and may turn out to be) a pretty great owner of Twitter. What tripped him up was the fact that he overpaid for the company using high interest rate debt and personal wealth tied to leveraged, highly volatile stock. This is not high quality capital. Instead, it’s expensive and short-term and what has happened at Twitter since Musk’s investment – the cost cutting, aggressive monetization, etc. – is always what happens when a deal is closed using expensive, short-term capital. In other words, the root problem isn’t necessarily who provided the money but where the money came from.
We teach kids that it’s rude to ask anyone where they got their money from, but (1) it’s a really important question and (2) anyone who actually has high quality capital should be proud to tell you about it.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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And More CIMple Truths
As always, we have empathy for the analysts at investment banks tasked with putting together lengthy decks about small private businesses (aka Confidential Information Memorandums or CIMs). Information is often incomplete or missing altogether, there are skeletons in the closet, and the people approving your work probably don’t appreciate how difficult it is to make a color pop.
That said, we occasionally see some things that make us scratch our heads. In no particular order…
Fake numbers and made-up words
Tremendous synergy.
Announcements that say nothing
Congratulations to someone for something!
Needless hedging
We didn’t do that already?
Numbers that don’t quite add up
Wait, what?
Have a great weekend and shoutout to Danny Coffeepot for his help on today’s Opinion.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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Who Holds the Float?
It turns out that David (our creative director) is passionate not only about high quality content, but also March Madness. This was probably helped by the fact that his alma mater Mizzou made the tournament as a frisky 7 seed (although the high variance team flamed out in the second round), but motives aside it was good for the office vibe. We made tee shirts, ordered wings, had contests, and watched the games. Of course, he also administered a bracket challenge. It was $10 to enter and he required that you pay upfront (the Challenge, I might add, was won by my daughter who picked San Diego State to win it all).
Ever the imp, I poked him on Slack. “Why do you get to hold the float,” I asked?
“Because it’s not my first rodeo,” he replied. “Coordinating who owes what to who at the end is a mess. Pay to play is the way.”
Which is completely a fair point, but I can never leave well enough alone. Now, for the rest of this exchange to make sense, you have to know two details:
David briefly way back when dabbled in speculating on obscure cryptocurrencies, including Polkadot.
When I think something is funny, I never let it die.
Two observations. First, it’s amazing to me that “pulling out to fiat” is part of our vernacular now. Second, even in this small example, when you pay or when you get paid and what happens to the money in between those events matters.
The term for this is “float,” and it’s how Warren Buffett built his empire. Here he is writing in his 2009 letter to Berkshire Hathaway shareholders:
He estimated that year that Berkshire’s insurance operations provided him with $62 billion of other people’s money to play with. Not bad work if you can get it, particularly if you have the investing acumen of Warren Buffett and can put that money to work making more money.
What’s the takeaway?
If you run anything from a small NCAA office pool to a multinational conglomerate, think carefully about when money moves and who gets to hold the float. If it’s not you, why not? If you’re floating other people, why? And how might you stop?
But if you do get the float, crucially don’t do something stupid with it because you’ll have to give it back eventually. Or “pull it out to fiat” as I guess the kids say.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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Perform, Don’t Perform, But Also Perform
After I wrote about Permanent Equity’s secret formula, I received an email reply (which I love…if you reply to this email it goes directly to me) from someone who said “I’ve been involved with companies for more than 25 years and keep getting caught up in the ‘what people think you need to do or want to see’ perspective.”
I think this was mostly a reaction to the idea that we don’t require our portfolio company leadership to be good at PowerPoint animations and that one shouldn’t spend time on activities that don’t actually move the needle. But it’s also true that it doesn’t hurt to be good at PowerPoint animations.
What am I talking about?
I made the observation on Twitter that back when I ran an investment team, the ideas from extroverts were overrepresented in our portfolio vis a vis the ideas from introverts. The reason was we had a process that required analysts to present their ideas to a group and introverts were not as good at that as extroverts. And that wasn’t fair to the introverts or a very good process, which I think is a point that stands.
But SuperMugatu aka Dan McMurtrie (a very smart investor we know) responded “I agree with the virtue of what you’re saying but have been seriously burned by people with poor communication skills.” And he’s got a point too.
When I was first starting out as an investment analyst I was taken aside and told “Look, you’re not going to be judged by all of your ideas. You’re going to be judged by the ideas clients actually take action on. So, you have to always be selling.”
That’s why it can pay to be good at PowerPoint animations. They’re a means to convincing others that your ideas have merit. Yet it’s also true that if you’re always performing for others, you won’t have time to spend on efforts that actually generate good objective performance.
This can be thought of through the product/packaging paradigm. In order to be successful, you need a good product, but you also need to put that product in attractive packaging that is enticing to consumers. In other words objective performance and performative performance go hand in hand, but striking the right balance can be an ongoing challenge. If you tilt too far to the former without the latter, you’re the proverbial tree falling in the forest that no one hears. But if you’re the latter without the former, you’re, as they say in Texas, all hat, no cattle.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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The Cause of and Solution to Life’s Problems
After I wrote about Growth, and Other People’s Money, I received a thoughtful note from @michaelnewt. He wrote:
OPM can be addictive. It changes behaviors and incentives…Mathematically it makes sense to go with the cheapest capital, but your write ups on OPM and Debt vs Equity are the reminders I needed to think deeper on the issue. There is more to choosing the best partner than simply what Excel tells us to do.
I joke that Excel is the cause of and solution to all of life’s problems. That joke is a riff on an old Simpsons episode that said the same thing about alcohol. And I’d argue that they are not dissimilar. In moderation, both are great, but if you let your life be run by spreadsheets or booze, well, you have a problem.
Keep in mind that I say this as someone who has a spreadsheet for everything.
Household budget? Spreadsheet. Son’s swim times? Spreadsheet. Distribution of wildflowers in a native Missouri wildflower meadow? Spreadsheet. But I have to remember that as much as I love a numerical safety net, data is a way to help you make decisions, not to make decisions for you.
In fact, I’d argue that one of the most dangerous situations you can find yourself in is one where “the numbers make sense.” If you’re falling back on the fact that the numbers make sense, then it may be the case that the sense doesn’t make sense. This, I think, is how people got lured by low interest rates to buy too much house in the mid-aughts or how a financial institution like Silicon Valley Bank got lured to buy long-dated slightly-higher interest rates treasuries more recently.
In both cases the numbers made sense, but the decisions turned out to be bad ones.
There’s a saying that numbers don’t lie, and that’s true. The learning, though, is that people can and do lie, both to themselves and to others, and often use numbers to do it.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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How to Become a Good Investor
We recently launched a new program at Permanent Equity with the goal of hiring investment analysts for a predetermined period to help us increase our deal flow and help them become better investors. Here are the details of the program, but what I hope is most interesting is the idea that we intentionally didn’t overengineer the details and are interested in candidates with a broad range of backgrounds and experiences.
Not a CFA? Not a problem.
Never built a DCF model? We can teach you how to do that.
Don’t know what an Iron Condor is? I wish I didn’t either.
The reason for that is there is no clear cut expertise that makes someone a good investor. Math matters, sure, but so does temperament, curiosity, communication, salesmanship, confidence, humility, and so much more. Moreover, the way we do it, investing is a team sport, so it’s also important that you fit but also don’t in such ways that it makes our team stronger and more resilient.
Finally, I’d add that I don’t even know that I’m wedded to some of the preferred qualities we listed. Are they preferred? Sure. But these two right here would have meant that a version of Past Me would not have been qualified for the job.
The point is that I think anyone can become a good investor regardless of where they’re starting from. The key is getting real reps and transparent feedback to find the approach that works for you. Those things are each easier said than done, of course, but I think we can offer both.
– By Tim Hanson
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Read Your Own Emails
We were in a meeting the other day when I said something colossally stupid. The table called me on it, and I agreed.
What I’d proposed was an idea that would net a small gain for one of our portfolio companies at the risk of exposing our entire portfolio to loss. While it might have worked, that’s not ring-fencing, it’s inviting contagion. “It’s like I don’t even read my own emails,” I muttered later to myself.
And yet…
There’s a reason why “Do as I say, not as I do” is an aphorism. It’s often much easier to say something than actually do it. One example in sports is the football coach who punts when the entire team and the television commentators and all of the fans in the stadium know they should go for it.
There are a lot of cognitive biases at work for why this can be the case, particularly in stressful situations. To combat them it’s important to have objective procedures in place such as checklists or manuals or reference guides to know when you are deviating from the standard you set when weren’t stressed. But even more important, particularly if you’re in a position in leadership, is to make sure you empower everyone around you to call this out when it happens.
After all, one of the most important things someone can do for you is tell you you’re wrong and be right.
Have a great weekend.
P.S. Permanent Equity’s investing team is hiring. Click here for the details.
– By Tim Hanson
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Pistachios, Six Flags, and Assumptions
My daughter and I were getting set to make the 90 minute drive home from St. Louis after one of her soccer games when we decided to stop at a convenience store to get a road snack. She picked out chips and I, trying to be slightly healthier, grabbed pistachios. We got back in the car and on the road and it was then that I noticed my mistake: the pistachios weren’t shelled. Since there’s no way to shell pistachios and drive (responsibly) on the interstate simultaneously, my road snack was worthless.
“I was wondering how you thought you were going to do that,” she smiled.
Thankfully she shelled my pistachios for me after she finished her chips, so all was not lost.
Now this is admittedly smaller stakes stuff (though never underestimate h-anger), but it’s illustrative of the fact that game-changing mistakes can be made when you take small things for granted (leaving aside what me assuming all pistachios are shelled says about my own moral degradation).
Here’s a related example…
Mark (our COO) told me about a time when he was a kid and visited Six Flags with his family. When they arrived, the computers were down, so the park couldn’t accept credit cards. Thankfully, Mark’s dad Paul is old school and carries cash. He was able to pay for everyone’s tickets out of pocket even as those trying to pay with plastic were out of luck, so the family got to enjoy the park crowd-free for a few hours until the computers came back online.
That’s not an example of how taking something for granted led to a mistake, but rather of how not taking something for granted can create a massive advantage if everyone else takes it for granted. No one except Mark’s dad Paul thought they might need cash at Six Flags and 99.9% of the time you don’t. But the 0.1% of the time you do, well, that’s World’s Best Dad stuff.
So a very interesting question to ask is “What do I take for granted and what might it look like if I didn’t?”
Back when I worked in public equities I took it for granted that given the liquidity of public markets, I would always be able to buy and sell investments. Now that I don’t, my behavior as an investor is different, particularly when it comes to underwriting risk and spending time on relationship building and origination. This is not to say that Current Me would have done Past Me’s job better, but rather that Past Me might have benefited from thinking a little bit more like Current Me on this topic.
Businesses can take things for granted as well, such as employees staying healthy, customers abiding by payment terms, and so on. Yet the real world inevitably intervenes. Now, in order to be efficient it’s not necessarily to always be examining all of your underlying assumptions, but it is worthwhile to list them from time to time and ask what you might do differently if you didn’t take them for granted.
– By Tim Hanson
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There’s a Small Chicken Shortage
I did not expect to open The Wall Street Journal the other day and see the headline “KFC, Other Chains Hunt for Elusive 4-Pound Chicken,” but there it was. Apparently due to the skyrocketing popularity of spicy chicken sandwiches (and they are delicious; shoutout Hattie B’s) small-breast meat is in high demand while chicken farmers prefer to produce larger, meatier, more profitable birds.
The market should correct for some of this but among smaller businesses there’s a concern that “in a few years the large fast-food chicken chains will hog the tight supply.” And it’s a valid concern. In fact, one of the biggest risks for any small business is that a larger, better resourced competitor changes the rules of the game because any changes will have a disproportionate impact on the small business.
A good summary of this reality comes from a 1981 Harvard Business Review article that I discovered back before I took a job at Permanent Equity when I was reading around trying to get a lay of the small business landscape. “A Small Business Is Not a Little Big Business” makes the compelling case (and I’ve found it to be largely true) that small businesses, through no fault of their own, suffer from resource poverty and therefore “external forces tend to have more impact on small businesses than on large businesses” The authors warn further that “small businesses can seldom survive mistakes or misjudgments” (also true), which is why when you meet small business owners liquidity, and not ROI, is paramount.
This is where higher prices for small chickens, or a lack of supply, could be devastating for the not Chick-fil-As of the world. That’s because direct costs, such as chicken prices, are likely to be a greater percentage of total expenses for a small business than a large one. Moreover, a higher percentage of operating expenses at a small business are likely to be fixed or difficult to cut because they have fewer employees, smaller marketing budgets, etc. Finally, if a small business has to do something like borrow to buy its raw materials, rising input costs and rising interest rates can combine to wipe out any remaining profits pretty fast and there is likely less ballast on the balance sheet to sustain them.
Or as HBR put it, the short-term variances during the year at a big business are relatively small compared to the overall result so their financial statements describe a system in approximate equilibrium. Small businesses, on the other hand, are “seldom in equilibrium, or even near it.”
When you don’t have a steady state, any adversity can be major adversity if you’re not prepared for it with a lot of room for error.
– By Tim Hanson
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How the Muppets Ended Up Singing Nirvana
At the risk of dating myself, “Smells Like Teen Spirit" is one of the great songs ever. If I owned the rights to it, I’d consider it closer to the irreplaceable end of the asset spectrum and not cheapen it by letting anyone else use it for anything other than rocking out.
And yet here on the internet are the The Muppets doing a pretty horrendous barbershop quartet version of it…
And here’s another (not as bad but not as good as the original) version at the opening of Disney + Marvel’s Black Widow film…
What happened was that Nirvana frontman Kurt Cobain’s estate sold some of its voting rights in matters like these for a tidy sum of money to an entity that’s more than happy to license rights for cash flow and the other original members of Nirvana voted along with that because they had diminished economic rights anyway (don’t fact check me, I read it on the internet). But at the end of the day, the asset was commercialized in a way that impaired the underlying value of the asset…maybe…
Irish playwright Samuel Beckett (he of Waiting for Godot fame) catches flack in some quarters for being notoriously strict from beyond the grave in his demands for how his plays are produced:
But I’m good with it even while acknowledging that other interpretations might also be valuable:
And yet ownership matters:
If you own something of incredible, irreplaceable value, commercializing it to be marginalized in a Muppets movie (and I love the Muppets) seems shortsighted. So, too, however, does thinking that your way will always be the right way and that something you created can never be improved upon.
There’s a world where “Smells Like Teen Spirit” should have never been sold to be sung by The Muppets. But there’s another where a new take on Waiting for Godot is a global blockbuster that enhances the value of the original.
– By Tim Hanson
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When You Should Know Everything
This recent piece (“Ignorance Really is Bliss When It Comes to Investing”) in The Wall Street Journal is mostly spot on. Its conclusion? That knowing more doesn’t help you make better investing decisions.
Back when I ran a team of public equity analysts, we had a rule that no financial model could run longer than 20 rows in Excel. The reason? Limiting your inputs forced you to boil down your thesis to the metrics that really mattered.
But there’s nuance here in that ignoring the fine print is really only something you should do when you have asymmetric upside i.e., your potential gains are uncapped but your losses stop at zero. Because if you have losses that could generate additional liability, then you should absolutely read the fine print. The reason is that if you don’t dig into everything you could inadvertently wander into uncapped pain.
Here’s a real life example. We were recently looking at a company where the core business looked strong. But we discovered in the course of asking a lot of questions that its warehouse abutted a property that was a contamination site. Moreover, they’d never had a phase 1 let alone a phase 2 environmental assessment done on the property yet the lease held the tenant liable for remediating any issues caused by said tenant. So if we took on that lease without knowing what was already in the ground on that property we could end up on the hook for a multiyear multimillion-dollar clean-up.
Was any of this germane to the core investment thesis? Of course not. But could it turn a promising potential investment into a massive loss. Of course it could.
This is among the reasons we have Taylor (our CLO) on staff and why his diligence request spreadsheets run way longer than 20 rows.
See, when you’re in charge of upside, you need to focus on what matters. But if you’re accountable for the downside, you need to know everything. So who carries the day? We should all always be in charge of and accountable for everything but still, we come from where we come from and so that’s always the subject for debate.
– By Tim Hanson
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Why More Banks Will Fail
A lot has been written about Silicon Valley Bank, Signature Bank, and the other financial institutions that failed or almost failed recently. People understandably want to know why that happened and who was responsible. And as I said on a recent podcast with Nikki (our CFO) and David (our creative director), there is a lot of culpability to go around.
My intent is not to rehash any of that here as better explainers have already been written. Instead it’s to build on an exchange that Emily and I had on Slack and that I tweeted about:
One of my favorite memos is the Lin Wells memo that Donald Rumsfeld shared with then President Bush in April 2001 ahead of the Quadrennial Defense Review. The point of the memo is that it’s hard to predict the future and that big changes can happen in short periods of time, so plans should be adaptable and not assume that anything will stay the same. The timing of the memo is evidence of that as well as five months later September 11th happened and the world changed again.
What does this have to do with banks failing?
A common thread across the banks that failed is that they assumed (1) that interest rates would stay low and (2) that depositors wouldn’t all ask for their money back at the same time. Assumption (1) was naive on its face, but to be fair rates until recently had hovered near zero for almost 15 years. And if you can’t assume (2), well, you can’t reasonably operate as a bank. So I understand why mistakes were made.
Regulators won’t want to read this but regulation is inherently narcissistic. It means that you think you reasonably know what might happen before it does and can write rules to prevent it. But as the Wells memo demonstrates, we often don’t know anything about even really big things before they happen. But to Emily’s point, rulemakers can’t also be constantly reactionary, deciding what’s allowed and what’s not ex post facto. That’s the Calvinball approach (shoutout Bill Watterson) and it wouldn’t work either!
How can these ideas hang together? The answer is they don’t. And that’s why, whether now or in the future, more banks will fail and other bad things will happen because we didn’t know what to prepare for.
Have a great weekend.
– By Tim Hanson
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The Circle of Sadness
One thing that a lot of people don’t know about me is that I cry during pretty much every Pixar film. In fact, I made the mistake of watching Up for the first time on a flight to Germany and was such a weepy mess just a few minutes in that the stoic Lufthansa flight attendants felt compelled to come check on me. I’m not sure why I’m sharing this other than this is the background you need to understand why one of the best ways to think about risk management comes from Inside Out.
If you don’t know the film, the premise is that all of us are run by competing emotions with distinct personalities inside our head with each of them “driving” at different times. When Joy’s in charge, for example, we’re happy. When Anger is, we’re mad.
The plot of the movie is that an 11-year-old girl moves from Minnesota to California and in doing so starts to be driven more and more by Sadness (which is what happens when one leaves the Midwest). Joy, however, doesn’t want to see that happen and does everything she can to stop Sadness from taking over, but in doing so sows chaos. It’s great entertainment.
One iconic scene is when Joy draws a circle around Sadness and says that her job is to make sure all of the sadness stays inside of it. And that’s precisely how to think about risk.
See, when you’re taking risk, whether business or operating or investment or duration or whatever, you’re not going to walk away unscathed 100% of the time. What’s more, that arguably shouldn’t even be a goal because if you’re always right, it probably means that you are not taking enough risk. But if you know that you are going to be wrong or unlucky, then what’s critical is to make sure when you are, the consequences don’t overwhelm you.
For example, if you have a portfolio of real estate, it probably all shouldn’t be on the beach in Miami because if you’re wrong about hurricane risk, then you’re going to have a real problem. Or if you have a handful of businesses, they probably shouldn’t be guaranteeing one another’s loans because if one goes down it’s going to take the rest of them with it. Or if you have operating funds and emergency funds, you might not keep them in the same account at the same bank, just in case. Because if that bank fails, you’d lose access to your emergency funds at exactly the time you need them.
The term for this in high finance is ring-fencing, but ring-fencing applies everywhere. It’s the deliberate practice of acknowledging that bad things happen and therefore organizing yourself in such a way that when they do, it’s not game over.
– By Tim Hanson