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James Joyce and Joey Ramone
I like to recommend Dublin as a travel destination because unlike other European capitals there is nothing there you have to see or do so you never end up paying through the nose to stand on some unbearably long line. That said, even though there is nothing you have to see or do there is still lots to see and do and one fun stop is the James Joyce Centre on North Great George’s Street. It was there that I first encountered one of Joyce’s famous notebooks.
Joyce, you may know, is the author of Ulysses, which is generally considered one of if not the greatest novel of all time. It’s a wonderful, albeit dense, book, and if you do the work to understand the references and inside jokes, it is in spots wildly entertaining. Part of that work can be reading The Most Dangerous Book, a more recent nonfiction publication that delves into great detail about how Joyce came to write Ulysses and handled its many censorship battles. The reason that book is interesting is because the story of how someone comes to create a masterpiece is often more interesting than the masterpiece itself!
So what of Joyce’s notebooks?
Joyce was an inveterate notetaker, filling notebooks with one-liners, short anecdotes, and references that he later wanted to use in his work. What he then did was methodically deploy those in his drafts, crossing them out in crayon as he did so so he could tell that he had used that note already in something. What the exhibit I saw at the Joyce Centre did was connect the crossout to the usage and the reason that stuck with me is because I didn’t expect a creative genius to use such a simple, rote, and structured process.
Speaking of, I was at the Rock & Roll Hall of Fame in Cleveland, Ohio, and had the chance to see a Ramones setlist. What was similarly interesting about that was not only did the setlist include the songs that the seminal punk band would play in the order they would play them, but it also included how long each would last and what Joey Ramone, the lead singer, would say in between songs including their trademark “1-2-3-4s!” (be sure to click that link). Here I thought all of that energy was improvised (isn’t that the ethos of punk rock?), but it was, in fact, scripted.
People and organizations tend to resist structure and process and have lots of good explanations for doing so. But I would argue that structure and process are necessary for a person or organization to achieve greatness. The reason is that greatness requires being able to do something well over and over again and the only way to reliably do that is to have a sustainable process to fall back on. This is why Joyce had his notebooks and the Ramones their setlists. Those resources are what enabled them to go out into the world everyday and try to do something amazing without having to start over each day from zero.
Because if someone had to do that daily, achieving greatness would be at the very least exhausting and potentially impossible.
– By Tim Hanson
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My Worst Opinion
One way I quality control the content of these missives is by sending them out to the Permanent Equity team before they ever get published. And so I did that with a short piece that riffed on a joke we have here in the office that we should just reorg into two teams: Numbers and Feelings. Because those are usually what our challenges boil down to: Numbers and Feelings.
Despite it being a decent joke, was the piece a little light? Sure… So I wasn’t surprised when I received an email back from Emily that read “Not your best.”
But what was surprising was that she had inadvertently cc’d the entire rest of the company (good times!).
I think Emily felt a little sheepish that her publicly-delivered feedback wasn’t more constructive, but ultimately it’s all good. I wrote previously that one of the most valuable things someone can do for you is tell you you’re wrong and be right. A variant on that is one of the most valuable things you can do for yourself is do something poorly, realize it, and make it better. That’s because my experience is that iteration makes things exponentially better. But in order for this to happen you need to do something poorly – and not good enough that you never iterate – the first time.
In other words, I’m glad I wrote a bad piece and that Emily told me it was bad and that I agreed with her because it gave me the chance to write a better one.
Somewhat related is a post Johnny shared that Jason Fried (the “Co-founder & (sometimes) CEO of 37signals”) published on LinkedIn. In it Jason wrote that he’d come to believe that Founder & CEO is an “impossible title” because a founder’s job is to “injecting risk” into a business whereas a CEO’s job is reducing risk.
Just like numbers and feelings, that's an interesting people paradigm! In your role as a professional or parent or spouse or coach are you someone who injects risk into situations or reduces it? Because the thing is, situations need both.
I’ve talked a lot about risk in this space. About how it can be high risk to be low risk, about what different risks look and feel like, and about how to (maybe) win the game Risk by creating optionality and getting rapid payback or waiting for a big payday.
The reason that risk is on my mind so much is that everything is risk because nothing is for certain. For example, it’s risky to send out an email to the world because people might not like it. But it’s even riskier not to because then you’ll never make new friends.
Or it’s risky to make long-dated illiquid investments but it’s even riskier not to because then it’s guaranteed that inflation will erode the purchasing power of your life’s savings.
And it’s risky to tell the President and CIO of the place you work that something wasn’t his best, but it’s even riskier not to because if you don’t maybe no one else will!
It’s fairly well-accepted that if a situation feels risky, it’s important to try to make it more comfortable. What’s less accepted is that if a situation feels comfortable, you should work to risk it up. But that’s absolutely what you should do, if anything is ever going to get better.
– By Tim Hanson
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Budget for It!
Since I’ve already copped to the fact that the biggest risk facing Permanent Equity is cholesterol, then you probably won’t be surprised to learn that we like to eat while we talk about stuff. This is why we’ve started a tradition of hosting semi-regular Lunch & Learns at the office for the team on topics that might be important or interesting. Taylor, for example, led a fantastic Lunch & Learn on compliance and James on what to do and not do and drink and not drink if we end up at Harpo’s for Late Night Rooftop at Capital Camp this week.
But I’m pretty sure the best received Lunch & Learn so far was the one where I led a discussion on personal finance…
Kidding aside, the reason we did it is that we want everyone at Permanent Equity to be making good and confident decisions about their money. After all, if people are stressed about their finances, they probably won’t be able to keep a clear head about work.
So we kept it general, but hit on things like savings and withdrawal rates for retirement, expected costs of college, the ease of low cost indexing, and how to craft a household budget. It ended with me getting several requests to share my own household budget framework, which is a spreadsheet I built a long time ago now when my wife and I started a family.
But it’s funny, I had a lot of anxiety about sharing that document and edited it heavily before doing so. The reason is that, and you wouldn’t necessarily know this on its face, budgets are really personal documents. Even leaving aside numbers and amounts, the things you budget for say a lot about you. “Oh wait,” I thought a few times, “do I want everyone to know I am saving for that? Or that I value that enough to put in my budget?”
Yet even after making the Hanson budget framework more anodyne, I got some really interesting questions.
“Why isn’t there a line for charitable giving?” someone asked (I consider this a more discretionary item and handle it that way but absolutely take the question).
“Do you never eat out?” wondered another (because I had “Groceries” listed as a category but not “Eating Out,” but in my defense do have the catchall “Fun and Travel”).
Just don’t judge me. Like I said, this is personal stuff! Your budget says a lot about you and that’s why you, your family, and your business should have one.
Because here’s the thing, budgets get a bad rap for being a tool only fun-sucking penny pinchers use. But they don’t have to be that. Used correctly, they aren’t something you create to spend less. Instead, budgets are a tool you can use to make sure you are able to allocate meaningful capital to the things in your life or business that are the most important to you.
The alternative (and my experience) is that if you don’t have one, more money than you know ends up being spent without a purpose. The reason that’s sad is because having capital is a privilege and an opportunity. And if you have a privilege and an opportunity, why not have a plan?
– By Tim Hanson
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Connect 4 Eyes on the Ball
"There's your dad's next newsletter.”
That’s what my wife said after our kids beat me at Connect 4. I’d been so focused on how many potential connect 4s I was creating i.e., variance that I lost sight of the very obvious connect 4 that my kids played that defeated me. This is why we have Occam’s razor and the KISS principle. Because sometimes it is that straightforward.
My kids have not a care in the world for variance but they do care about beating their dad and while the former is often a precondition of the latter, it’s not always and if you lose sight of the goal in front of you, well, that’s a false good to paraphrase Plato, and that can bite you as it did me.
We tell people that Permanent Equity’s competitive advantage is that we show up and do what we said we would do when we said we would do it. And I’ll add to that if we don’t or we can’t, we will explain why and show our work.
For this to be a competitive advantage it means that others aren’t doing it. If you agree with my premise, then the question is why is something so simple and straightforward so rare.
I think it comes down to what people consider ends and what they consider means. For us doing what we say we are going to do is an end and it’s made possible by the fact that we have an investing track record. For others, and if this is a strawman argument I apologize, I believe that generating an investing track record is an end and so sometimes you won’t do what you said you were going to do because doing so might hurt your returns.
There’s always, as we say in our office, a “next best step.” But if you’re always taking the next best step, you might end up far afield from where you wanted to go. That was me creating loads of variance and thinking I was winning at Connect 4 up until the moment I lost at Connect 4. Because it wasn’t the point of the game.
This is a lighthearted example of where losing felt like winning and it’s because in trying to create the conditions for success, I set the stage for failure. We had this happen with one of our construction companies where we helped it get a bigger line of credit and better bonding so it could take on bigger projects and substantially increase profits. The problem was it took its eye off the ball and didn’t execute those projects well, creating substantial losses that were enabled by those same conditions for success.
This is what makes things complicated. Keep your eye on the ball but also keep a lot of balls in the air. It’s not the most helpful/actionable advice, but it is how I am finding the world works.
Have a great weekend.
– By Tim Hanson
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Roald Dahl and Dave Portnoy Sold Out
When I was a kid, I read every Roald Dahl book. And with the exception of Charlie and the Great Glass Elevator (which is up there with Godfather III on the list of sequels that never should have been), his books remain among my very favorites today. So it made me sad that some people who are probably less than half the writer he was could change his work without his permission.
When I read the news I thought, I can’t believe his estate signed off on that. But then I remembered that his estate sold the rights to his work to Netflix who said at the time “As we bring these timeless tales to more audiences in new formats, we’re committed to maintaining their unique spirit…”
Yeah but, Netflix doesn’t really care about Dahl’s legacy. Rather, the company wants to make popular content with other people’s intellectual property (because it's quicker to buy than build) that attracts and retains large audiences and then amortize the cost of that content over a far-too-long period of time in order to appear more profitable than it really is.
I digress…
Based on what I’ve read about Dahl’s heirs who sold out to Netflix, I don’t know that they care much about what happens to the author’s stories. Or maybe they do and in that case I apologize for judging. But the lesson is that when you sell, what you sold is sold and it’s not yours anymore.
To wit…
Barstool Sports is a thing, described on Wikipedia as “an American blog website…that produces content on sports and pop culture.” (Let’s ignore the fact that “blog website” is redundant. After all, this is from Wikipedia, a website that once tried to block me for trying to add crudites to its canonical list of hors d'oeuvres despite the fact that crudites is absolutely an hors d’oeuvres.)
Anyhow…
Barstool Sports is never without controversy and after its most recent controversy founder Dave Portnoy said he had to reluctantly fire someone at the request of PENN Entertainment, the publicly traded gambling company that acquired Barstool. Subsequently responding (with frequent use of the eff word) to people who accused him of “selling out,” Portnoy said he absolutely did sell out because selling out, he said, is “what you do when you’re an entrepreneur.”
There’s a lot to unpack here.
Is the point of starting a business to eventually sell out? Sure, it’s great to get bigger and take on partners, but I don’t know that doing so should require compromising one’s values (let’s also leave aside the merits of the “values” related to either of these specific controversies).
But should you pick your partners wisely? If you sell out and money is your only consideration, then you likely will end up in business with people who may decide to do things differently from how you might do them on your own or at the very least are optimizing for something else.
Is that problematic? Not if you’re at peace with your decision and understand what you are doing and why. Portnoy, for example, seems to understand what he signed up for.
Yet if all you care about is controlling your own destiny, then the answer is never sell anything. That’s because the only person who will always act like you would is you and ownership is ultimately what enables someone to call the shots.
Or if you do decide to take the money, recognize that things will be different. How different, of course, depends on who you take the money from.
– By Tim Hanson
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Decide Before It’s Too Late
Back when I worked at The Motley Fool cofounder David Gardner taught a strategy class to employees that centered around playing strategy board games (and if you ever have the chance to take a class on strategy board games taught by David Gardner, I highly recommend it). A central tenet of the class was the OODA loop, a framework developed by a military strategist to help fighter pilots win dog fights.
OODA is an acronym that stands for Observe/Orient/Decide/Act. The idea is that if you find yourself in an intense competition you need to see things for how they are, put that in context, figure out what to do to improve your position, and then do it. David’s point in teaching it was whether in dog fights or strategy games or business, when challenging circumstances present themselves, it’s not the side that makes the best decisions that necessarily wins, because there is arguably no one best decision, but the one that cycles through the most OODA loops.
This is because that side will cycle through the most iterations and therefore adapt to changing reality the fastest.
The idea is applicable to small businesses because they are inherently fragile due to their size. They need to be nimble and adaptable, constantly cycling through OODA loops, because the margin for error is slim. It’s with this as background that we strongly prefer to invest in small businesses with fast feedback loops rather than slow ones, even if the slow ones have meaningfully better economics. The reason is that if you’re trying to protect against downside, you need to know when risk starts turning against you so you can OODA.
If, on the other hand, you operate in a world when you might not know if you’re off the rails until you’re really off the rails (i.e., you have to order seasonal inventory 9 months ahead of time before demand is known), you can find yourself in a situation where the die is cast and your business has no agency. And even if you would have made a great decision back when you had time to course correct or know then what you know now, there’s often nothing you can do.
Yet the OODA loop can still apply, provided you are able to identify more frequent observable inputs to inform many small actions. This can be difficult, but worth it, to ensure it’s never too late.
– By Tim Hanson
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Thank You for Thank Yous
Our Ops Team (Mark, Nikki, Johnny, Ryan, Sarah, Lori, Caroline, Kelie, and Danny) hosted an Ops Summit recently with all of the leaders from our operating companies (it was a lot of Ops). We played cornhole (or Bags as they call it in Duluth…shoutout Joe and Matt), ate, shared best practices, ate some more, did some personality testing (I think…I wasn’t there for that…I’m afraid of what I might learn), ate additionally, and then headed home. The very thoughtful Ops team (again, Mark’s team is “hoppin’”) even sent flowers to significant others for letting us borrow the others’ others for a few days.
We thought good times were had by all.
We didn’t know for sure though until Ryan got a thank you. And not just any thank you, but a thank you from Dan.
If you don’t know Dan, well, I’m not surprised. He’s not famous, but he runs a pretty great commercial waterproofing subcontractor down in Texas. Dan’s also opinionated and doesn’t shy away from letting you know if he thinks you wasted his time or money. But here’s what he said!
Thank you for hosting the Operator’s Summit in Columbia, MO, last week. It was great to be in an environment of top notch business leaders. It is so beneficial to bounce ideas and actions off other folks that have been successful outside of my organization. Being so immersed in the propagation of our own business sometimes makes me “snow blind” to other forces in the world. Being surrounded by other business leaders that don’t work for me is refreshing and humbling. There are some very talented and dedicated people in that group. I hope my strong, if not caustic, personality was not too overwhelming. Maybe next time I’ll be more of a wallflower…
Thanks to whoever sent the flowers to my wife. That was such a nice touch. She thoroughly appreciated it (and needed it). By virtue of our company being associated with Permanent Equity, I got some credit for it. Go figure. Feel free to let me know if there is anything I can do for you.
A couple of points (leaving aside the fact that Dan is a double spacer)…
(1) We should all be routinely getting outside views. They are scary, but helpful, and whether you’re on the right or wrong track, ultimately invigorating.
(2) Small gestures go a long way. If you think you should do something, do it. Thoughtfulness is a valuable currency.
(3) Gratitude is a superpower. We literally didn’t know if we should call the event a success or not and Dan’s email means it is now an annual doing.
(4) People you love and who love you care about who you work with. Business can seem cold and unfeeling sometimes, but it doesn’t have to be. And even though it’s risky, it’s exponentially empowering when your reputation is tied up with someone else’s and they do a good job too.
See you next year in Columbia, MO?
– By Tim Hanson
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It’s High Risk to Be Low Risk
Risk is fascinating because there is no standard way to measure it. I’ve said before that in a world where everything can go to zero, there is no medium risk, and I believe that.
But I also acknowledge that risk is a perception and a concept that is related to ability, resources, goals, and objectives. What’s risky to you might not be risky to someone else and vice versa.
For example, audiences marveled at performer Harry Houdini when he had himself thrown into the East River… handcuffed… and in a crate. That seemed insanely risky. But Houdini knew how to escape and did so in 57 seconds, which made it a relatively low-risk walk in the park for him.
A financial equivalent of this is how younger people are told to buy stocks for more return and older people to keep bonds and cash for more stability, as if age explains all needs. If you have years until you need the money, it makes sense to risk volatility to make more money. If you need the money now, it makes sense to risk lower returns to have more predictability.
Yet just as Houdini’s line of work eventually contributed to his death, the universal truth about risk is that the amount of risk you are or are not taking will eventually catch up to you.
One observation about risk is what I call the OPM problem. OPM stands for “other people’s money,” and the problem with it is that people tend to take more risk with other people’s money than they would with their own and that this creates massive and systemic problems.
The dot-com bust was an OPM problem (venture capitalists were allocating other people’s money) and so too was the mortgage crisis (banks were lending other people’s money). More recently, the blow-ups in crypto were also OPM problems.
But just because someone is willing to give you money at low cost, doesn’t mean you should use it to chase returns. That sounds obvious when one says it, but the temptation to use OPM to make money is tantalizing. After all, what’s nauseating about the financial crises mentioned above is that for the most part the people who originated the mess didn’t end up suffering the consequences.
But doesn’t Permanent Equity invest OPM?
Yes, we do, but we’ve tried to structure our partnerships in ways to avoid the OPM problem. We charge no fees for our work until we’ve generated performance (so we’re not incented to do anything stupid) and if our performance ultimately implodes our partners can claw back any fees we did take (so we’re not incented to do anything unsustainable).
On the flip side, because a small business owner’s wealth is mostly tied up in their business, we’ve seen many inadvertently take on massive risk by trying to take a lower-risk approach. This manifests itself in older owners making less reinvestment in their business in order to keep it stable and cash-flowing under the auspices that they don’t want to upset the apple cart so late in their careers.
This sounds like it could make sense, but when you consider your business as an asset, it exists in a competitive ecosystem and isn’t guaranteed to hold its value. If you stop investing in yours and others keep investing in theirs, yours will start to lose. Or as the writer William S. Burroughs put it, “When you stop growing you start dying.”
The insidious thing about this fact is that it’s not immediately visible. The effects of people competing against you are a lot like potential energy. They get stored up until there is an event – like a major customer deciding who to award the next big contract to – that releases them. Then all of a sudden your stable enterprise finds itself in a crisis because you thought you were making low-risk decisions about growth and capital allocation.
The key is to remember that risk has negative space. Every risk you take, has a risk you’re not taking and every risk you don’t take, means you are taking another risk. If you’re aware of that fact and can identify what you’re not seeing in addition to what you are seeing, it makes it possible to manage toward better and more reliable outcomes.
– By Tim Hanson
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Don’t Forget to Celebrate
When we close a deal, we have a champagne toast in the office with everyone on the Permanent Equity team. That’s to recognize that making a new investment is an event that doesn’t happen all the time, an achievement to which everyone in the office contributed, and an opportunity to talk about what went right and how we got there.
But that was a tradition we implemented in 2022. Before then, we’d close a deal and move on to the next one. After all, it was our job to make investments, so making one was what we were doing in the normal and ordinary course. There was no reason to celebrate.
Further, when we had a business doing well, we often took it for granted. When you’re working with well-compensated professionals, shouldn’t moderate success be the base state?
Yet, when we thought about it, that felt wrong.
It felt particularly wrong when we took stock of how much time we spent beating ourselves up for our mistakes compared to how much time we spent celebrating together. Sure we had team outings and trips, but looking back at our Google calendars there were probably 10 meetings set up to talk about problems for every one where we talked about or celebrated something that went right.
An ongoing challenge we have in our portfolio is communicating with our company leaders and making sure that important details don’t slip through the cracks. After all, our investments are located all across the country, in different time zones, and doing different things involving very different types of personalities. It can be exhausting and time consuming for them and for us to maintain open and effective lines of communication, and even when we did, we would often discover that items were falling through the cracks.
Organically at one of our portfolio companies, one of our CEOs developed in tandem with our team a weekly written reporting framework that he could share with his stakeholders. It’s broken into four sections:
Progress last week
Focus next week
What I learned
What I need
When he started sending these in, we quickly discovered that (1) everyone read them; (2) everyone enjoyed them; and most importantly (3) that everyone who could be helpful responded to them.
It was a few years ago when we discovered this simple best practice and what did we do? At first, nothing. Even though it was obvious that this was something to celebrate, we didn’t tell any of our other companies about it and we didn’t shower the CEO with recognition.
In hindsight, we should have done both. Because if we had, we would have quickly spread this best practice across our portfolio and immediately solved for an acute pain point.
Instead, it took a few years for this to happen.
The fact of the matter is success is not a base state. Business is messy, people are messy, and at times it seems that the world conspires against your best ideas.
That’s why when something works, it isn't a given. If something goes according to plan, that’s a success. And if you have a big win, everyone probably contributed. So when something like that happens, don’t forget to celebrate.
Have a great weekend.
– By Tim Hanson
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Care to Be Curious
I’ll be honest: I didn’t know who Claire Hughes Johnson was until Brent and David interviewed her, but she got David’s Spinal Tap reference so now I’m hooked. Moreover, she recently published a useful book called Scaling People (to 11?) about what she learned running large organizations at Google and Stripe.
One of the most clarifying discussions they had for me was about the interplay between transparency and trust.
I think the two go hand in hand. An organization can’t build trust without transparency, but also can’t afford to be transparent unless there’s already trust. Claire’s wrinkle is that there is such a thing as too much transparency and that that level of disclosure can actually erode trust. One example she gave in this regard was about a manager she called Eli who was oversharing with his reports in real time about potential changes in structure and compensation that hadn’t been decided yet. This not only made those people anxious, but also forced them to try to reconcile the logic behind not yet fully formed thoughts.
Another was about a program at Stripe where every email that got sent in the company was copied to an email list so anyone could read them. While this program had some benefits, it was probably also the case that it resulted in people not sending genuine emails since everyone knew that everyone else could read them!
The learning is not everyone needs to – or even should – know everything all of the time. That seems self-evident, but it’s also the case that it can seem bad not to clue people in on changes that might affect them. Where Claire lands is that you need to be transparent that you won’t always be transparent and also demonstrate empathy so people will trust you that you will clue them in when the time is right.
My personal policy on transparency and trust has long been that I will answer any question anyone asks me or if I can’t or won’t, admit that and explain why that’s the case (usually because I don’t have enough information). I also don’t write emails thinking everyone will read them, but try to make sure before I send any email that I’d be okay forwarding that email to anyone in the future. The standard here is not that everything I write in an email will be popular, but rather that I’d be able to at least explain why I thought what I did at the time and have it be defensible.
Does every email age well? Of course not. But they age a lot better without trust destroyers like cynicism and sarcasm (which should always be edited out before you hit send on anything).
Brent ended the interview by asking Claire about kindness and feedback and how an organization can have both. Her answer, I thought, was a good one. She basically said that people should be genuinely curious before beginning any dialogue or inquiry. This may also seem self-evident, but it’s also the case that people ask questions for lots of reasons other than wanting to know the answer to them and frequently ask questions (like those that start with “Don’t you think…”) they already know the answer to.
The difference — and it’s an important one and the reason Claire’s answer is a good one — is that curiosity inherently comes from a place of caring about the best right answer and when starting any conversation, there’s no better place to start from than that.
– By Tim Hanson
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The Long Term is the Short Term
Back in 2018 Warren Buffett and Jamie Dimon, the CEOs of Berkshire Hathaway and JPMorgan, respectively, declared in The Wall Street Journal that “Short-Termism is Harming the Economy.” Their gist was that public companies should stop providing quarterly earnings guidance because optimizing for near-term profits was causing companies to hold back on investments in technology, hiring, and R&D that would deliver more robust growth over a longer time horizon.
Similarly, there’s a rich vein of thought in the investing industry that even the best long-term investing strategies will endure lengthy periods of underperformance. Our good friend and value investor Chris Bloomstran, for example, said that “It must be expected that long-term outperformance will come with durations of underperformance, perhaps as much as half of the time over short-term intervals.”
But it’s also true that the future is unknown and unknowable and mathematically the case that a dollar today is worth more than a dollar in the future. Moreover, believing things will work out long-term can be a convenient way to sweep near-term challenges under the rug or explain away underperformance.
The cold reality is that now matters. Most things don’t just get better over time. In fact, due to entropy, absent consistent involvement, everything is gradually declining into disorder.
But what of those public companies that Buffett and Dimon spoke of that are hitting their quarterly earnings targets and not creating sustainable value? The issue there is not that they are short-term oriented, but rather that they are GAAP EPS oriented (see yesterday’s Opinion). In other words, yes, if your goal is to generate fake numbers, no, you won’t create real value.
See, if you’re focused on the wrong things, it doesn’t really matter how often you focus on them, but if you’re focused on the right ones, you should be ruthlessly short-term about focusing on them all the time. The reason for that is that every moment you don’t meet your standard, it becomes harder and harder to keep pace with it over time.
– By Tim Hanson
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Who Generally Accepted GAAP?
Generally accepted accounting principles (GAAP) are the financial equivalent of democracy. If you’re using it, know that it’s the least worst way of tracking the financial performance of your business – except for all others. If you’re not using it, well, it’s the uncredible way to gain credibility, and eventually, you probably will.
If you’re running a business, the fact of the matter is that you have to keep track of how you’re doing. It’s also true that there are lots of subjective ways to count how much money you are (or are not) making. And while GAAP can be helpful in that regard, it can also be useless – or worse, misleading.
Take the case of Netflix. If you look at its income statement, it made $4.5B in 2022. But if you look at its cash flow statement, operations burned through $50M. How could a company make $4.5B and end up with less in the bank?
The answer lies in a line item called “Additions to Content Assets” and how it compares to another line item called “Amortization of Content Assets.” See, Netflix spends lots of money each year – $16.8B in 2022 – to produce and acquire content to put on its platform. But it estimates that that content will be consumed by subscribers for many years to come. So rather than recognize all of that cost on its income statement, it amortizes it (i.e., only expenses a portion of it each year). Here’s the magnitude of that. While Netflix spent $46.3B from 2020 to 2022 adding to its content assets, it only expensed $37B. That leaves an $9.3B gap. Over the same three-year period, Netflix’s cumulative profits were $12.4B. In other words, the question of whether Netflix makes $4B per year or $1B per year (a big difference!) is a subjective one and depends on whether or not you believe the company’s own estimates about the residual value of its content.
Here’s what the company’s auditors say about that: Auditing the amortization of the Company’s Content is complex and subjective due to the judgmental nature of amortization which is based on an estimate of future viewing patterns.
Translation: They have no idea either. Presumably there’s a spreadsheet somewhere (that’s definitely wrong!) where if you change the value of one cell (the one that calculates estimated future viewing patterns), you could double the company’s profit or cut it in half. Let that sink in.
That said, I’d hate to be the CFO of Netflix. I don’t know that I can top this methodology, but I certainly wouldn’t sleep well greenlighting content development that led to the company burning through billions of dollars with an uncertain and arbitrary return profile.
This is why every business owner needs to think hard about what they watch and how they want to run their business. If you’re investing in software development, under GAAP you may capitalize that as an “Intangible Asset” on your balance sheet instead of expensing it. But what if you had to call it “Ephemeral Property” or “Non-Existent Stuff” or “Touchy-Feelies” instead?
Would you be as excited about investing?
– By Tim Hanson
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Warren Buffett Dance Off
One reason I switched from public to private equity investing was my observation that technology was making investing in public stocks less fun. Thanks to algorithms, arbitrage, and automated trading, it was becoming more and more difficult to find an edge and generate excess return. After all, when you buy a stock, you can only take or leave the listed price. You can’t negotiate favorable terms or, absent being an enormous activist investor, influence management. So if the price is fairly efficient, that’s that. You should earn the market return.
When I met Brent (our CEO), I became fascinated by what he was doing because it seemed like private equity investing in the lower middle market was the better opportunity set. Not only might you find opportunities that were attractively priced, but you could also generate return through how you structured the investment and how you helped operate the business post-close.
And based on everything I know now, I think that point still stands to reason.
Yet here is Warren Buffett, the Oracle of Omaha, in his most recent annual letter expressing the exact opposite opinion:
Far be it from me to start a dance off with one of the most successful investors of all time (no one showed up to my annual meeting this past weekend), but while the stock market has certainly been volatile many times in the last 25 years, it probably hasn’t objectively achieved “panic-type” valuations since 1982, when it traded for less than eight times earnings.
Now, before you @ me, know that I recognize that there are all sorts of ways to measure stock market valuations, that individual stocks often trade well outside of average valuation bands, and that value investing has on average achieved very attractive long-term returns. But let’s just replace the phrase “selling at a panic-type valuation” with the phrase “selling at a valuation attractive to a buyer.” If we do that, then I think it is more common to find that among the universe of private businesses, particularly small ones.
See, it’s easy to find public stocks for sale. Just look up the price on your phone. Finding private businesses for sale is immeasurably harder. I was reminded of this at a conference I attended recently where potential buyers scheduled 20 minute slots of time with bankers representing handfuls of small business sellers. As a buyer, you didn’t know beforehand what the banker might have for sale. And as the banker, you had no idea ahead of time what the seller might be looking for. Some meetings were duds; others led to epiphanies. Yet there was no consistency, and if there’s no consistency, there can be no price discovery.
But back to Buffett’s statement. One could argue that if a seller does not receive an attractive offer from a buyer then that seller just won’t take it. This argument ignores the fact that there are lots of reasons beyond price that a seller might sell. They might want to retire or diversify or need help or be subject to a divorce settlement that requires liquidity. In that world, where there is limited price discovery and ample need, a private business might absolutely transact at a price attractive to a buyer.
Whenever you transact it can be worth asking who’s your counterparty and if that counterparty has more information than you do. In the public markets, whether you’re buying or selling, your counterparty likely absolutely has more information than you do and the price of the transaction is non-negotiable. In the private markets, your counterparty may still have more information than you, but it may not matter and you may be able to close the value of that knowledge gap by negotiating on details other than price.
I’m not saying Buffett is wrong, but that you should always think about where you want to take your chances and why.
– By Tim Hanson
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What’s Your Cost of Capital?
Cost of capital is a concept that (1) is near and dear to my heart and (2) gets a bad rap for being abstract when in fact it’s probably the foundation for every disagreement people have with one another. For example, if you and your significant other want to leave at different times to drive somewhere because one of you expects traffic and the other doesn’t and would prefer more time to pack, that's cost of capital.
Don’t believe me? Your time is your capital and your opportunity cost and traffic are your risks, so you are both backing into different fair values of departure times based on different acceptable margins for error. And God help you if you end up being the wrong one...
Or let’s say you bought a lottery ticket with a billion dollar jackpot picking the numbers that are your grandkids’ birthdays because you had a feeling that there was a really good chance you would win. Then let’s say a stranger came up to you and offered to buy your ticket for less than you paid for it, but more than zero. Mathematically, it would be a no-brainer for you to take that offer because lottery tickets have negative expected value. Once you bought one, getting anything more than zero would be a win!
But the reason you bought it is because you had a feeling, and if it’s a billion-dollar jackpot, think about what you might sell that ticket for. $100? $100k? $1M?
This is the reason game shows like Let’s Make a Deal, Who Wants to Be a Millionaire, and Deal or No Deal work. Because there’s tension when counterparties assess odds and values differently. Again, that’s the cost of capital.
See, we’re all fair-valuing everything all of the time and transacting when we think it suits us. This means we mostly try to buy things that we think are undervalued and sell things that we think are overvalued, except when we find ourselves in times of distress, i.e. there’s a need for immediate action. But leaving aside those times when we put ourselves in a pickle, there is an academic definition of this. Cost of capital equals the risk-free rate plus volatility times the return one expects to get for taking risk in excess of no risk.
But here’s how I’d put it in layman's terms…
Your “cost of capital” is what you can do by just getting out of bed plus your probability of doing something great times the magnitude of that greatness.
Knowing that, if you struggle to reach agreements with people, it should prompt consideration of all of those variables…and also of what you decide to do this weekend. Have a great one.
– By Tim Hanson
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Should AI Run HR?
A paper called “Hiring, Algorithms, and Choice” crossed my desk recently, and I found it interesting enough to pass along to Kelie (our Director of Talent Acquisition) and Mark (our COO who also has strong opinions about people). The paper asks very fairly “Why do organizations still conduct job interviews?”
The basis for the question is that people are bad at predicting future performance and fit and that algorithms and AI are better at it and also more efficient. Given that, why aren’t organizations turning over their hiring processes to technology? Now, many have to some degree, and even though we’re not running a business that employs thousands of people or more, even Kelie utilizes automated tools to do screening.
Yet interviews persist. Is there a good reason or is it just theater?
One thing that’s true about Permanent Equity is that we’ve never regretted having dinner with anyone. Even if we show up without an agenda and unsure of our purpose, breaking bread is never without benefit. You build trust, rapport, and loyalty and probably have some fun, which ideally is what happens on both sides of an interview, as Kelie pointed out to me.
To put that in the language of transactions, these experiences generate credits in the relationship bank, credits that are hugely valuable when times get tough and hard decisions have to be made.
The authors of the aforementioned paper reach a similar conclusion about interviews, citing the work of American philosopher T.M. Scanlon. By bringing other employees into the choice of who to hire through the interview process, it validates those employees and also likely makes the hire more successful than it otherwise would be (given equal measurable “fit”) since everyone who was involved in the choice has an interest in seeing their choice validated.
If this is true, then hiring is not an objective process, but rather a cultural one in which the means may be as important as the end. Thinking that through kind of blew my mind and reframed the entire hiring process for me. Maybe there is more to it than filling the role with the most qualified person as quickly as possible.
And if that’s the case then the two rules of culture apply (1) Decentralize it and (2) Promote from within. Or as they may pertain to hiring: (1) Let teams hire their own and (2) Only hire externally for entry level roles.
I might have ended this piece right there, but as Mark pointed out to me, there is more nuance to hiring than that. “If you only hire leadership from inside, your organization’s self-awareness and innovation can stagnate,” he says. “As with most things, it’s a balance.”
He’s right, of course. After all, I wouldn’t be here at Permanent Equity if Brent had only promoted from within.
– By Tim Hanson
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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