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Danny Didn’t Get a Glass
Our friendly (not fiercely) independent local brewery did a holiday glass giveaway on each of the four Tuesdays leading up to Christmas. I learned this serendipitously on Tuesday, November 28 (the first glass giveaway), when I stopped by the brewery at the not unreasonable time of 5 pm to have a beer in between dropping my son off for and then picking him up from swim practice. I ordered my beer and got a glass. Fun! And Molly the bartender said there would be a different glass available the next week and the week after that and the week after that.
So the next Tuesday I recruited James and Danny to meet me at the brewery for a beer and to get the next glass. But instead of 5 pm, I suggested the slightly less reasonable time (to start drinking on a Tuesday) of 4:15 pm (the brewery opens at 3). That would still give me time to drop off my son at swim practice, but I also wanted to make certain we got glasses.
The first sign of trouble when I got to the brewery a little before 4:15 pm was that there was nowhere to park. This is Columbia, Missouri. There is always somewhere to park. That’s sort of one of the points of living in Columbia, Missouri.
And so it went. As we were walking up to the brewery, others were leaving and saying that there were no more glasses. They’d run out before 4 pm! (Apparently a lesser-known corollary to Moore’s Law is that when a brewery has weekly glass giveaways, supplies last half as long as they did the week before).
So fast forward to the following Tuesday, which also happened to be James’s birthday. At 2:30 pm I said, “Reasonableness be damned, are we walking over?” And James said, “Yes.” And Danny said, “Hold on. I need to finish something.” And Garrett, overhearing all of this, said, “I’m coming too!”
I warned Danny that he might miss out, but he said he just needed five minutes. As CIO, I probably shouldn’t tell team members not to do their jobs in order to go day-drinking on a Tuesday and so I said, “Ok, we’ll see you there.”
We got there at 2:37 pm and we were the only ones there, so we took a walk around the block (risky in hindsight!) to get our steps in. We got back to the entrance at 2:44 pm and just as we did, 10 cars pulled into the lot. Thankfully, we were still first in line when they opened at 3 pm, but the line was around the block.
With no sign of Danny…
When Danny finally did show (nothing takes just five minutes unless you are ruthless), I said to James and Garrett, as we were sipping from our holiday giveaway glasses, that while I was no card counter, I thought Danny’s chances of getting a glass were slim. And so it went. Ten minutes later a dejected Danny came down the stairs with a beer in a non-holiday giveaway glass. It was 3:30 pm (Moore’s Law!).
So we made a plan for the next week to be out in front of the brewery (or at least check to make sure no line had developed) by 2 pm. The lesson, of course, is a well worn one around these parts, which is that certainty has a cost and that it’s typically expensive. In this example, in order to ensure that we would get a $5 glass (admittedly, a limited edition $5 glass), we were prepared to spend an hour of our time. And when we did the math in our heads, the trade was worth it (though not everyone in our office agreed).
Funny enough, the same week, one of our businesses was given the opportunity to lease warehouse space across the street from its current facility. This was a good opportunity because space in that area didn’t often come open and new space would be needed to accommodate our 5-10-year growth goals. The thing was though (1) we didn’t need new space yet and couldn’t know for sure exactly when we would and (2) it would be really expensive to lease it now and carry it just to know for certain that we had nearby space in the future if we needed it.
In that case when we ran the numbers, the trade wasn’t worth it, so now we still have stress about future space needs, but more money in our pocket. Will a day come when we regret that decision? Potentially. And as Danny learned well, there are few worse feelings than missing an opportunity you know you had the opportunity not to miss.
Have a great weekend.
-Tim
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FSU’s Bonus, Alabama’s Raise
I probably don’t (and shouldn’t) need to be the one to point out that the concept of complex adaptive systems is increasingly lost on politicians, but I did do just that after Florida senator Rick Scott continued his saber rattling after (admittedly then undefeated) Florida State was left out of the recent College Football Playoff. Because after that happened, Senator Scott wrote a letter to the CFP committee in which, after throwing some shade at the committee (just five (38%) members have “relevant experience in coaching of playing football”), he demanded “total transparency” with regards to how this decision was reached.
Responding in due course, the committee, after throwing some shade at the senator (“Knowing how busy you are, thank you very much for taking the time to write about college football”), noted that Florida State was not as good now that its star quarterback was injured and would miss any CFP game.
This wasn’t good enough for Scott. “FSU football was #4 before beating #14 Louisville without Jordan Travis [the QB]...but then after that win, the Committee thinks FSU is a weaker team? It makes no sense,” he responded.
But it makes perfect sense. Complex adaptive systems are what it’s called when “the behavior of the ensemble may not be predictable according to the behavior of the components.” And they are what you need to take into account in any situation (business tie-in coming below) you need to be forward-, rather than backward-, looking.
In this case, yes, FSU did defeat Louisville, but the score was only 16-6, and Louisville had just lost 38-31 to Kentucky, a team that lost 49-21 to Alabama and 51-13 to Georgia (both teams also under consideration by the Committee). Further, Alabama had just edged Georgia 27-24, so if Kentucky was a little better than Louisville and Florida State a little better than Louisville, then Florida State (without its QB) was about as good as Kentucky. Based on the behavior of the other components in this system, Florida State (without its QB), despite winning, was now a lot worse than Alabama and Georgia. And since Alabama beat Georgia, it deserved the spot it was given.
But don’t take my word for that. Responding to my post before any of the games took place, venture capitalist and Santa Fe Institute trustee Bill Gurley pointed out that Vegas, the people who put capital at risk on things like this, had Florida State as a 14-point underdog in the game they did get awarded, which was the Orange Bowl against Georgia. Were Senator Scott correct about the injustice done to FSU by the Committee and FSU was, in fact, better than both Alabama and Georgia, then here was an opportunity to make a big profit betting the money line.
Of course, we all know what happened next. Florida State lost by a historically large 63-3 margin to Georgia in the Orange Bowl (acknowledging they had additional players not participate, but the point stands), while Alabama showed it more or less belonged in the CFP by taking #1 (and eventual national champion) Michigan to overtime.
The point is if the CFP Committee’s process were backward-looking, then undefeated Florida State deserved a spot. But the CFP Committee is explicitly forward-looking and they predicted, rightly as it turned out, that Alabama would provide better competition.
If you own or operate a business (and here’s a business tie-in), similar consideration should be given when deciding whether to give an employee a bonus or a raise. That’s because a bonus is a capped payout awarded for outstanding achievement in the past, while a raise is an uncapped payout for continued excellent performance in the future. Put this way, it may seem like it is always better to give and receive a raise than a bonus, but the thing about raises is that they increase performance expectations and if increased expectations are not met, that can cause a situation to turn sour quickly (whereas a bonus rewards good work but leaves expectations the same).
In this case, the CFP committee essentially gave FSU a bonus and Alabama a raise. Not only did that turn out to be the right call, but given how FSU performed in the Orange Bowl, the last thing that team would have benefited from was higher expectations.
-Tim
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The High Interest Rate Glitch
Back in June when one of our funds was planning to make its mid-year distribution, we went hat in hand to our portfolio companies to see what they could pony up. One of the businesses, which works in construction, had had a great year to that point, earning almost $2.5M. But when they looked at their bank account, there was only about $500K there they could reasonably distribute. That’s because the earnings were not yet beer money and had piled up in IOUs.
“Pick up the phone and kick those loose,” we said. And after doing an analysis of which customers it would be most impactful to call most aggressively about their non- and late-payments, they did.
One of the calls they made was to a customer who was a pretty big offender who said, “Hey, sorry about that. Let me look into it.”
Before I get to the punchline here, I should note that commercial construction, generally speaking, is a low margin business. That’s because it’s not only hard work, but also because there is a lot of competition.
Further, commercial contractors usually have to agree to 10% to 20% retainage, which is payment that is withheld by the customer until a project is substantially complete. Because that 10% to 20% retainage also happens to be roughly the profit margin of your average construction business and because construction projects always take longer than expected to complete and because the definition of “complete” can be squishy, a consequence for construction businesses is that they can’t predict when they are going to get paid their profits. This means that most of the time these businesses are cash flow breakeven at best. To solve for this and smooth cash flow, many draw on lines of credit from banks.
Now, unless you’ve been living under a rock, you know that interest rates are up and therefore the cost of these lines of credit has in some cases more than doubled. And with many construction businesses borrowing at prime or prime-plus, they can expect to pay 8.5% to 10.5% or so on that borrowed money. If you’re already only netting 10% to 20%, paying that expense to finance your customer will take a big bite out of profits.
So we were hardly surprised when our customer called back a week later and said they had found the problem. There was a glitch (a glitch!?) in their payment software that was preventing them from transmitting money to us. It would take a little time to fix, they said, but then they’d make us whole.
We were not amused.
“Weird,” we said, “that after years of working together, this glitch is only popping up now, when borrowing costs have spiked.”
“Yeah, weird,” they agreed.
“Well, you’re pretty late on some pretty big amounts,” we politely told them, “so we’re about to get pretty aggressive with liens if you’re not able to just cut us a check.”
We got our beer money.
There has been a lot written about the impact of higher interest rates on the U.S. economy. Add to that list a proliferation of payment software glitches. Weird.
-Tim
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The Point is Constraints
It’s not officially a new season of Unqualified Opinions until I tell a story about helping coach u12 girls soccer, so I figured I’d get it out of the way sooner rather than later…
There we all were at the field the other night (yes, the team practices through the winter) playing 7v7 where each side had to complete five consecutive passes before they could shoot on goal. I noticed, though, that the head coach hadn’t set up any boundaries and offered to do so.
“No,” she replied. “I’d like to see what they do with all the space.”
After about 15 minutes you could barely see the girls off by the parking lot, our goalie was bored to death, and I was frowning. The coach looked at me.
“You think there should be boundaries,” she observed.
“I mean, it’s not even mowed over there” I answered.
And so we set up boundaries.
The point here isn’t to impugn the drill; it turned out to be a good one once we established a finite, but still large, field of play. Rather, it’s to note that there is an interesting relationship between freedom, constraints, and achievement. Given unlimited space in which to operate, the u12 girls literally lost sight of the goal.
Our COO Mark spins this a little differently. Talking to a group at last year’s Main Street Summit, he said that creating boundaries for employees is paradoxically what gives them the freedom to succeed. The reason that’s so is because knowing where one can’t go instills the confidence to fully explore where one can.
Morgan Housel provides another take on this topic in his new book Same as Ever. He observes that “the most important innovations don’t happen when everyone is happy…[but] when the consequences of not acting quickly are too painful to bear,” citing among other things improvements factories had to make during The Great Depression in order to increase efficiency to survive the downturn. Morgan further points out that those gains in efficiency, necessitated by operational constraints, are ultimately what helped the U.S. later win World War II.
This is interesting to me because a question we’ve historically liked to ask operators is “What’s one thing you would do if you had access to unlimited capital?” The point of asking it is to try to suss out strategic opportunities that would be no-brainers absent constraints.
But I’m starting to wonder if that’s not the only question. Maybe we also need to know about what they would do if there were more constraints.
For example, what if you lost access to capital? Or if your biggest supplier went bust? Or couldn’t hire anyone for a decade and then had to fight and win a world war?
Those questions would yield some pretty interesting answers too. Because whether you’re removing them or succeeding despite them, the point is constraints.
-Tim
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Two Things I Regret
This is a sad story to start off season 3 with, but it’s worth telling so here it goes…
Our CEO Brent called me into his office a while back to talk about something. He’d been out of town for a few days and was opening his mail, including a good sized box. “What’d you get?” I asked.
“Oh,” he sighed and pushed it aside.
I looked inside and saw some peanut brittle and a copy of the new edition of Poor Charlie’s Almanack. It was a care package sent to get him excited about an upcoming lunch he’d been invited to have with Charlie Munger, but Mr. Munger had passed away a few days before.
People way more qualified than me have written about the life and impact of investing luminary and business philosopher Charlie Munger, so I won’t do that here. Instead, I’ll just add (instead of “nothing”) “Thank you” and “What a run” and admit something that made me tear up when I learned of his death: I never met him.
You’d think that having worked in the investing space for 20 years and been a Berkshire Hathaway shareholder for longer that I’d have run into him or bothered to attend an annual meeting of either Berkshire or Daily Journal Corporation. But I didn’t.
I had opportunities, sure, but getting to Omaha or L.A. seemed hard, something else would always come up, and it was easier to read a recap or watch the webcast. I regret that reasoning.
What’s more, you’d think I would have learned. See, one of my other big regrets is passing on the chance to see Joe Strummer (I loved The Clash) perform at the Olympia Theater in Dublin, Ireland, in November 2001. I was in college at the time and the ticket seemed expensive, the concert was on a weeknight, and I had an exam to study for. Strummer died a year later.
The learning I haven’t learned? The only thing you can’t make more of is time. Use it wisely, and thank you for being here.
-Tim
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Now You’ll Get All the Jokes
We survived the holidays and are getting set to end our hiatus here at Permanent Equity’s Unqualified Opinions and kick off season three (“S3, huh?” indeed!) next week. To prepare for that, and in recognition of the fact that Brent’s shoutout in his annual letter garnered this humble daily email dozens of new subscribers who might not get the running jokes, here’s everything anyone needs to know to get up to speed:
First, as we were getting going, Emily made sure to tell me which ones of these were “not my best.”
Then we started referring to free cash flow as “beer money.”
Only to have the fiercely independent bakery here in town refuse to sell Brent all the biscuits.
But cholesterol may still be the biggest risk to our investment approach.
And I learn a lot from helping coach a u12 girls soccer team.
Now you’re in the know. So happy New Year, have a great weekend, and see you Monday!
-Tim
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Write Love Letters
When people ask, I tell them that I started Unqualified Opinions to challenge myself to say something interesting every day. And that’s still a true statement, and I hope I am achieving that objective. That said, meeting that challenge on a daily basis is difficult and sometimes stressful, so another question to ask is: Why?
Back in 2021, singer Billie Eilish released a film on Disney+ called Happier Than Ever: A Love Letter to Los Angeles. I thought that was an interesting title so I looked up why she called it that. The reason, she told Good Morning America, is because it “made me who I am…I owed Los Angeles some love.”
Of course, the thing about love letters is that while they are emotionally charged, they are not universally positive. They are also born out of anguish, conflict, fear, and all of the other feelings that might lead someone to do something out of the ordinary. And so it goes in the film, with some of Los Angeles’ shortcomings causing Eilish to change over time as a person.
It sounds funny to say it, but I feel the same way about the subjects of business and investing. Business and investing have framed how I think about the world, been the source of my best friendships, and even been why I moved my family to Missouri. But my experience in these areas has also not always been positive. I’ve lost money, fired people, failed and been wrong, and experienced shortcomings that have caused me to change over time as a person.
In other words, I owe the subjects of business and investing some love.
So these are my love letters. I'm energized to contribute to the discourse, and I hope that when it’s all said and done they form an interesting and coherent complete thought. Further, and generally speaking, I am going to bind these and hand them to my kids so they understand why I am such a weirdo.
But it’s not all said and done yet, and I know that’s the case because Sarah(!) already designed the logo for Season 3. That said, I've got a Turkey Trot to run and then will definitely need a break to recharge.
Have a joyous holiday season, see you in 2024, and write some love letters of your own.
-Tim
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The Person-to-Problem Ratio
One way to look at capital allocation is through fancy math such as return on invested capital (ROIC). This has you figure out how much money you spent on something and how much money you made as a result. It’s calculated in dollars and expressed as a percentage, and useful in evaluating and prioritizing work based on expected outcomes and also in thinking through how to get better outcomes by lowering the cost of achieving them.
A lesser-known framework (because maybe I’m the only one that uses it) is the person-to-problem ratio (P/P), which counts how many people are working on a problem. It’s useful in evaluating and prioritizing work based on the effort required to do it and also in thinking through how to get better outcomes by raising the cost of achieving them.
But why would anyone want to raise the cost of achievement?
Let’s say you make a New Year’s resolution to exercise more. Then the first week goes great and the second week ok, but by the third week you are back to your pre-resolution, couch potato self. If you tried to calculate a ROIC to justify investment to solve your problem, you’d get nowhere because it’s nearly impossible in this scenario to quantify an expected return in dollars. Further, a ROIC lens wouldn’t help you gain any insight into what or how much of an investment to make. You could buy weights, for example, but would that make you more likely to lift them?
Now apply the P/P ratio. Your problem (the fact that you’ve stopped exercising) exists because your P/P was 1, but what if you double it?
First, doubling anything is significant, so a forcing function here is that people are whole numbers and can’t be gradually allocated, so anytime you think about increasing your P/P ratio on something, you have to really consider whether doing so is worth it. Second, people are less faceless than money, so increasing the P/P ratio on something also forces you to consider specifically what that looks like. Going back to the exercise example, one way might be to hire a trainer. Another might be to get a running partner.
Or you could even push the P/P ratio to 10 by doing something like join a running club.
Of course, none of us have infinite resources, so another interesting aspect of the P/P ratio is thinking about how to increase it when warranted using lower-cost labor. After all, that’s exactly what the running group is.
Now, this is easier when it comes to personal rather than business problems due to networks of friends and relatives who are often willing to help on something, but it’s not impossible. Indeed, if you run a small business, it’s worth thinking about. After all, an unfortunate reality of small business is that the P/P ratio on many SMB problems is often less than one. In other words, there are lots of problems and limited resources.
But how might that work?
If you’re challenged for sales growth, for example, rather than bring on a salesperson, you might start a referral program that effectively turns customers into salespeople, increasing the P/P ratio without adding headcount. Or if you’re consistently out of stock, what might you do to delight a supplier to make sure they are focused on your access to raw materials as much as you are? Then there’s the idea of crowdsourcing, which was all the rage for a while, but seems to have fallen back down to earth aside from Wikipedia being near canonical.
At the end of the day, people solve problems, so it stands to reason that problems will get solved as the P/P ratio goes up. That said, the risk is that as P/P goes up, your ROIC goes down, which is bad news for running a profitable business. Further, there is risk in throwing too many people at a problem or assuming that if you overstaff a problem it will get solved well. This is the origin of Amazon’s Two-Pizza rule, which states that no team should ever be larger than can be fed by two pizzas because at some point you reach a point where the value of collaboration is diluted by having too many collaborators.
So the P/P ratio is not a panacea, but nothing is. Rather, it’s a different and – I think – interesting lens through which to analyze things, and I offer it up in that spirit.
– By Tim Hanson
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You Will Get Sued
The title of this Unqualified Opinion is what Brent told me when I signed up for this nutty gig (which I wouldn’t miss for the world). The reason is that while he used to think legal conflict was avoidable (“Just treat people well and everything will work out.”), the thing is that people get funny about money. Since it’s a way to keep score, sprinkle on top some ego, some “advisors” with strong opinions, and an attorney (who is probably looking for more work), it’s not hard to see how situations get volatile.
Said differently, you will get sued. And now I’ll turn it over to B…
“The first time I had legitimate legal action threatened against me was right after my first acquisition in 2009 and it involved an employee issue that was black-and-white. An at-will employee was let go for beyond good reasons after repeated attempts to salvage the relationship and many opportunities to make things right. The decision to end the relationship wasn’t a difficult one and the person knew it. But as I found out, this person had a history of being litigious with former employers and openly talked about getting “an exit bonus” based on getting lawyers involved, on contingency of course. This person looked at legal action as a game and knew how to play it.
So having just put all my chips on the line and borrowing a big sum from the SBA, I was faced with a lawsuit for about a third of the total purchase price. That got my attention. And, it kept my attention for months. I couldn’t sleep and struggled with depression. I obsessed about possible outcomes. I worried about affording a settlement or even the on-going legal costs of defending the claim. I stressed about what people would think and fretted about my reputation. I had little margin financially or emotionally and it showed.
Thankfully, the company I acquired had insurance that stepped in to cover the defense of the claim and they settled the claim for a fraction of the claimed damages. The process was brutal, but not because of what actually happened. My attitude and fear made it so. I learned never to meet a problem halfway, especially a legal problem. People will allege all kinds of things for all kinds of reasons. Almost always, very little comes from allegations where there’s little or no wrongdoing. And anyone who has been in business for very long doesn’t pay much attention to allegations, even ones that look bad.”
What’s the guidance?
Find a great lawyer.
Build trust when you don’t need it.
Do the right thing.
Government regulation is such that even if you desperately try to comply, you can’t operate successfully without inevitably running afoul of some rules, some of which conflict with other rules.
You will get sued.
Have a great weekend.
– By Tim Hanson
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Safe Ball, Make a Run
One paradigm that’s gained in popularity at Permanent Equity HQ is the barbell. This is the idea that there is no medium risk, so in investing you should either keep your money in safe assets or seek high returns that compensate you for taking any risk at all.
Yet the barbell can be elsewhere. When it comes to time management, for example, we’ve experimented with never spending 45 minutes on anything. Instead do something in 5 minutes or less if it’s that type of task or do it for as long as it takes to get it done right if it’s that type of task instead.
And at the risk of talking too much about my daughter’s soccer team in this space, the barbell is there as well. Here’s a recent example…
I was coaching a small group in a 3v3 tournament where when the ball goes out of bounds, you get a kick-in and not a throw-in. These kick-ins are real opportunities because it’s a small field and if you make a good pass, it can really break down a defense and lead to a scoring opportunity.
But the girls were getting frustrated by their kick-ins. First, you have limited time to kick the ball in and the ref is counting down that time, which is stressful. Second, as I said it’s a small field, so as the other two players moved around to get open, they’d often run into the same space, which makes it easy on the defense. Third, if the kick-in is not executed well and the other team intercepts it, well, it’s a small field, so now they have a scoring opportunity from what should have been your tremendous advantage.
So we huddled up to talk tactics and I said, “Hey, let’s try something. What if during a kick-in one player gives the kick taker a super safe ball and the other makes a really dangerous run? If the run is not there, play the safe ball. And if it is there, take the risk.”
They liked that because it was clarifying, solved for the time pressure, and also put us in a better position in case we turned it over. Moreover, it gave them a repeatable framework. Every time a ball went out of bounds one of our players would place the ball down to take the kick then point at one teammate and say “Safe ball” and point at the other teammate and say “Make a run!”
The point was to take a lot of risk if success meant making a material improvement to the status quo and to take no risk at all if it didn’t. And to do that over and over and over again. The reason that’s a recipe for success (they won the tournament, by the way) is because as you do it, your upside is increasing asymmetrically relative to your downside and if you can do that, do it all day everyday.
– By Tim Hanson
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What Can You Optimize
One of the reasons Permanent Equity invests in existing businesses that already have customers, suppliers, earnings, and employees is because we know that efforts to help optimize something that’s working are far more likely to be successful than those starting something from scratch. And there’s data to back that up. For example, of the 632 thousand businesses that started in the year ended March 2012, 132 thousand of them (20%) failed in their first year. But fast forward 10 years and of the 234 thousand survivors, just 13 thousand (5%) failed last year, their tenth year of operations. In other words, the Lindy effect is real.
What’s more, we believe this lesson to be true at the project level when it comes to working on a business as well. Yet instead of spending time optimizing strategies that are working reasonably well, we often see leaders get either bogged down in fixing something that’s broken or distracted by the glamor of inventing what to do next. Don’t get me wrong, there is a time, place, and circumstance to engage in both of these activities, but – and it’s a big but – our experience has taught us that the most significant returns come from leveling up parts of a business that are working well.
Here’s how that thinking can apply to several different areas of a business:
Now, I recognize that business and operations are hard and that things don’t always go your way or according to plan. When that happens, everyone needs to spend time fixing things. But know ahead of time that this work is a grind and it will be breakeven, at best. Many times, the best outcome from these efforts will be the status quo, i.e., the preservation of your reputation.
That’s nothing to sneeze at, of course, nor is a new idea that works brilliantly. But if you want to be able to consistently and sustainably level up, regularly ask and answer, “What can I optimize?”
– By Tim Hanson
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Insanity and Inflection Points
I went to a college that didn’t play FBS football, so when we moved to Missouri we logically thought we’d adopt Mizzou as a rooting interest. But don’t do it, I was told by the locals, because the program is doomed and nothing good ever happens to us.
The track record to date is that mostly that’s true except that this year has captured most everyone’s interest. What’s more, ahead of the game at number one ranked Georgia in early November (which the Tigers ended up almost pulling out), pretty much everything was on the table.
As for why that was, you could trace it back to Coach Eli Drinkwitz’s decision to fake a punt against Kentucky down 14-0 and facing fourth and 10 in week 7. See, Mizzou had lost to LSU the previous week and was on the verge of getting blown out. But instead Missouri scored, changed the momentum, and went on to win 38-21. And then the team carried that momentum into homecoming against South Carolina and blew the Gamecocks off the field. In other words, the fake punt was an inflection point in the sense that it leveled up the baseline of what was possible and the team took full advantage.
Author Malcolm Gladwell is famous for calling these “tipping points” and his so-titled first book is full of case studies of small, niche products that had a few things go right and “tipped” into becoming cultural phenomenons, leveling up the baseline of what was possible. And it seems correct that if you do something in football or business that creates a massive opportunity, you go ahead and take it. But is it?
Now that I’ve broken the seal on talking about the foibles of mid-Missouri dining establishments, I have no shortage of stories and this one is about the fiercely independent local juice bar (if you know, you know) that decided to expand its breakfast menu. On its face, this was a sound strategic decision. Breakfast is a logical complement to juice and capturing more wallet-share from a customer is good business. What’s more, we heard that the addition to the menu, some blueberry wheatcakes, were delicious. So delicious, in fact, that Mizzou students camped out to get them and customers came from as far away as St. Louis and Kansas City with lines out the door.
When we went to try them, however, we were told they were no longer being served. They’d gotten too popular and the lines were disruptive, stressful to the staff, and inconvenient for the cold-pressed-juice-drinking regulars. (Befuddled, Brent offered to buy the recipe, but the juice bar demurred.)
Faced with an inflection point that could level up the baseline of what was possible, the fiercely independent local juice bar walked back. So a fair question to ask is: Is that insane?
Whether you agree with the decision to stop selling delicious blueberry wheatcakes or not, the juice bar in making it was practicing risk management. See, the thing about inflection points is that they create variance, and the thing about variance is that while it’s great, it also makes a lot of people uncomfortable. Facing an onslaught of new customers demanding blueberry wheatcakes, the juice bar might need to hire more employees, upgrade its kitchen, lease new space, or maybe even stop selling cold-pressed juice to cold-pressed-juice-drinking regulars in order to take advantage of the opportunity. There’s reward to be had from this, sure, but it could also not work out and maybe it’s not why the juice bar got into business in the first place.
To me, creating an advantage with significant upside and then not pressing it is, yes, insane, but you could also argue insanity is doing something you don’t want to do because someone else thinks it’s insane not to. Still, they should have sold Brent the recipe.
– By Tim Hanson
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Why Small Business
Our COO Mark and I both moved to mid-Missouri from the Washington, DC area to join the Permanent Equity team. Before doing so, we both worked for a company that invested in large public companies, so making the move was a big change both personally and professionally. The east coast to the midwest; big companies with audited financials to small companies that in some cases are lucky to have financials. You might ask why we did it?
The simple answer is our shared observation that one’s opportunity for growth is directly correlated with the number of problems one has the opportunity to solve. It’s a strange epiphany, but if you have an infinite number of problems, you can achieve exponential growth. That’s because each problem, once solved, now means something is being done better/faster/cheaper, with those gains dropping straight to the bottom line and compounding over time.
By those measures, there is no higher growth opportunity than operating small businesses. So while it’s frustrating to get punched in the proverbial face over and over again, it’s a first-class problem to have so many problems.
The other aspect is agency. It’s a cold truth that the ability to influence something is inversely related to its size. If you were an investor in Amazon, is there a website optimization you could think of that they haven’t thought of yet? And if you could, how long might it take you to get Amazon to test it, let alone implement it? And if it did get implemented, would the benefits have a noticeable impact on the company’s bottom line?
Yes, breakthrough, trajectory-changing improvements can happen at large companies, but the odds don’t tilt that way. The introduction of something like a lead-scoring system to focus limited resources on the best prospects for a small business, on the other hand, can lead to exponential improvement almost overnight.
Of course, it doesn’t always feel that way with what can often feel like an unending parade of problems and new challenges constantly emerging alongside solved issues unsolving themselves. But when you take a step back to appreciate the chaos, you see that when it comes to having chances to solve problems to great results, there is no better opportunity set in the world.
– By Tim Hanson
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They Blew Up the Bridge…Again
Of all of the lessons we learned from blowing up the bridge, the one I keep thinking about is Robbie’s observation that the rebuilt thing is also not forever. Not only is he right, but God willing, you’ll get a note from me 60 years from now titled “They Blew Up the Bridge…Again” and it will really be about that (and not about the fact that they accidentally did blow up a part of the new bridge already). Because that’s the hard thing about growth. Not only does it create new problems, it also causes solved problems to become unsolved.
Take, for example, the problem of keeping track of the financial performance of Permanent Equity’s companies. When I arrived in 2018, there were basically seven businesses to keep an eye on. So I made a spreadsheet that listed the expected performance of the different metrics we wanted to track at each company and asked our financial partners to input the actual performance when they received it, and we went on our merry way. The system worked...for a while.
Now we have 17 or so businesses to keep an eye on and that spreadsheet and process have gotten unwieldy and inefficient, so Mark and Nikki are thinking about investing in some software to replace it. Am I sad to see my spreadsheet go? Yes. Am I sad I spent time building a solution that ultimately didn’t work? Absolutely not; I’m pumped that we outgrew it.
I wrote previously that one thing that’s undefeated is the ability to raise unlimited capital. Another is entropy.
If you're a homeowner, you know entropy well. It’s the thing that causes you to say “Didn’t we just pay for that?”
Like risk of loss and risk of gain, entropy and growth are kind of the same thing just reversed. Except growth causes entropy and entropy causes growth. In other words, by trying to grow, you will create problems, but solving problems will also cause you to grow. And if you think about it that way, acknowledging nothing is forever, then all of those problems unsolving themselves all of the time will become a source of delight rather than frustration.
Or not. But have a great weekend and the next time they nuke the Rocheport Bridge (not by accident, great job guys), you are all invited on the boat.
– By Tim Hanson
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Now That’s Pessimistic
When we last saw my friend with the not sufficiently pessimistic financial model, he was going to go back to forecast higher levels of volatility in the commodity business he was thinking about buying in order to determine if the deal he had on the table made sense. He did that, and the answer was that if revenue declined by 20%, he wouldn’t be able to service the debt he proposed to put on the balance sheet.
Could that happen?
Well, since the relative standard deviation of the commodity price that drove sales at this business was 26%, the potential for a 20% decline in sales was very much on the table. He could hedge, of course, but that didn’t seem practical for a business of this size, so the question was “What next?”
If you’re ever in a position where you need to predict how a business will behave, the thing to look at is its capital structure. In other words, is it funded by debt or equity, how much of each, who are the actors, and what are the terms? In this case, my friend wanted to buy a business and reinvest in capabilities in order to grow, but his cap table with far more debt than equity would never enable him to do that even after leaving aside the potential for top line volatility.
So I said, “You’re already raising money from investors to do this deal. Can you raise more and swap out some of the debt with equity?”
“I could,” he responded, “but then the returns will be lower.”
And that’s a true fact. Equity capital is more expensive than debt with its cost borne directly by other equity holders. Yet what selling equity won’t do is bankrupt you.
Or here’s how Stripe cofounder John Collison phrased it on Patrick O’Shaughnessy’s Invest Like the Best podcast recently: “Credit financing is fixed cost to the borrower…[but] has the unbounded risk of destroying your business. Equity capital has unbounded costs, but does not come with the embedded risk of possibly blowing up your business.”
That’s a great way to look at it. So a question to ask of your cap table is what is the risk of it blowing up my business and how much is it worth to me not to?
Given that my friend was personally guaranteeing this loan, relocating his family, and staking his savings and employment in the deal, when he thought about it, not blowing up turned out to be really valuable to him. Further, when he went out to raise additional equity and explained why, he found that his investors now wanted to give him more money despite the lower return profile because lowering the risk of their losing their investment was valuable to them as well.
In other words, it can pay to be pessimistic, particularly if your pessimism is realistic, and helps you align the funding of your business with the funding it needs.
– By Tim Hanson
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Risk of Gain
Not all of Permanent Equity’s employees have finance or investing backgrounds, so we do what we can from time to time to help everyone gain a shared understanding of how this sick, sad world works. A little while back, it was a Lunch & Learn about personal finance and investing. More recently, it was a note explaining how our investors might react to news of a loss in our portfolio.
In that note, I said this: “Our partners are sophisticated investors who know that equity investing involves the risk of loss. The reason they, or anyone, take this risk is because equity investing also involves the risk of gain.”
“Risk of gain,” I heard back, was a curious term. What did I mean by that?
Volatility, variance, beta…whatever jargon you want to use (and among professional investors there is a lot), one way to think about gains is they are the same as losses, just reversed. In other words, both are what happens when an asset you purchase changes in value or price…just don’t get a professional investor started on the difference between the meaning of “price” and “value.”
But if you think this way about gains and losses, then a key to investing successfully is to only traffic in transactions where the risk of gain is greater than the risk of loss i.e., if your thesis is correct, you stand to make more than you stand to lose if you’re wrong.
Provided you don’t use leverage, since the most you can lose is all of your money, this is why making a portfolio of equity investments and holding them for a long period of time mathematically makes sense. Some will go to zero, but that’s a bounded loss, while others will increase exponentially in value, creating boundless upside. So if you own a group of them and you’re only, or more than, or even less than coin-flip talented, your risk of gain is more than your risk of loss.
The same reasoning helps explain why if you own a home, you should absolutely have homeowner’s insurance. You only have one home, it’s only going to appreciate in value (on average) a few percentage points per year, but one catastrophic event such as a fire could zero it out in a blink, leaving you without shelter and owing a bank a lot of money. That's an unbounded downside in my view, so pay to insure against it.
The point is when a party and a counterparty are transacting, both are assuming a risk of gain and a risk of loss. If that’s you and your risk of gain is greater than your risk of loss, that’s a good investment. If they are equal, then hopefully the transaction makes sense for some other reason. And if your risk of gain is less than your risk of loss, then hopefully the transaction makes sense for some other reason, but also buy insurance.
– By Tim Hanson
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In Defense of Micromanagement
Here’s what Jerry Seinfeld had to say to the Harvard Business Review about why Seinfeld was such a success:
“If you’re efficient, you’re doing it the wrong way. The right way is the hard way. The show was successful because I micromanaged it – every word, every line, every take, every edit.”
This very well may have offended the HBR professionals (or at least made them cringe), as they have published a deep catalog of content writing against micromanagement as a viable business philosophy:
February 2008: Micromanage at Your Peril
September 2011: Stop Being Micromanaged
November 2014: Signs That You’re a Micromanager
August 2015: How to Stop Micromanaging Your Team
August 2017: To Get Your Boss to Stop Micromanaging, Clarify Expectations
December 2019: 3 Ways to Kick Your Micromanaging Habit for Good
December 2020: Stop Micromanaging and Give People the Help They Really Need
January 2021: How to Help (Without Micromanaging)
September 2022: How to Stop Micromanaging and Start Empowering
You get the point. Conventional wisdom doesn’t have a lot of nice things to say about micromanagement. And yet, we see it happening – and often working – all the time
The reason is that small businesses tend to struggle to hire talent and not have time or resources to invest in building training programs. Absent those factors it’s almost impossible to run a business without micromanaging.
What’s more, micromanagement is an effective way to manage risk. If nothing can happen without an owner’s approval, it’s nearly impossible to stumble into a problem that might destroy your business.
There is, however, a cost to micromanaging, which is that a micromanaged business can’t grow sustainably and its equity is worthless to anyone but the micromanager. This is why Seinfeld stopped running after nine years even though NBC would have loved to keep it on the air. You couldn’t just bring in John Goodman or Nathan Lane and keep rolling.
But that’s also one way to do it. Not every enterprise needs to have a plan to grow for decades and go public. It’s okay for something to exist successfully for a period of time and then stop existing. That’s not nihilism, it’s reality, and it happens all the time.
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You Can’t Buy All the Biscuits
Our founder and CEO Brent can be a magnanimous guy and so he stopped into a local bakery the other morning (which will remain nameless, but any denizen of Columbia, Missouri, will know the one I am talking about) to buy breakfast sandwiches for everyone in the office. When he got his turn at the register, the following dialogue ensued:
Brent: 15 breakfast biscuits, please.
Fiercely Independent Bakery Employee: 15 biscuits?
Brent: Please.
F.I.B.E.: That’s all of them.
Brent: Is it?
F.I.B.E.: You can’t buy all the biscuits.
Brent: There are 15 people at my office.
F.I.B.E.: What if someone else wants a biscuit?
Brent: What if someone doesn’t?
F.I.B.E.: You can’t buy all the biscuits.
Brent: How many biscuits can I buy?
F.I.B.E.: Not all of them.
Brent: 14?
F.I.B.E.: Probably not.
Brent: 13?
F.I.B.E: Uh.
Brent: I can’t not bring biscuits for everyone.
F.I.B.E.: Sorry.
And I don’t think he has been back since. But why couldn’t Brent buy all the biscuits? Let’s apply stakeholder theory…
Brent here was a Customer, and while the Customer is not always right, he was right to try to buy 15 biscuits. The F.I.B.E. here needs to sell 15 biscuits, so it would seem like the interests of the Customer and Employee are aligned. It’s also obviously good for the Capital behind the bakery to sell all of its biscuits.
Ergo it seems like a no-brainer to let Brent buy all the biscuits.
Unless you think the world is losing out by the bakery not having any more biscuits to sell that day. Or perhaps the F.I.B.E. did some math in her head on behalf of the Capital and realized that the incremental increase in earnings would be negative to the equity value of the bakery due to an increase to its cost of capital given risks associated with customer concentration.
While I can’t say for certain exactly what reasoning took place, to me it is not good business to not sell your biscuits to a customer you’ve already acquired. We have a saying around the office that small businesses don’t stay small on purpose, but sometimes I guess they do.
– By Tim Hanson
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What Blowing Up the Bridge Taught Us
Back when I shared the video of the Rocheport Bridge blowing up (and here it is again), I said that if you were able to find a business, finance, or investing lesson in the carnage to let me know what it is. And you didn’t let me down! So here’s all of the wisdom watching the bridge blow up imparted:
“If something isn’t working out, a vendor, customer, employee, or investment, sometimes it’s better to just blow it up.”
–Casey
“You have to be willing to destroy things you work hard to build if they stand in the way of something new and better, because if you don’t, your competitors will.”
–Mark
“It’s fun to watch things blow up because it teaches you how to build it better.”
–Augusto
“That rebuilt thing is also not forever.”
–Robbie
“The explosion happened before anyone heard it. If you’re not actively looking for risk, you may be in for quite the surprise.”
“The synchronicity of the explosions stood out to me. As leaders, we focus on being aligned when we are building, but we also need to be aligned when it’s time to break things down (or blow them up).”
–Joe
“Reputations are like bridges. Years to build, but seconds to blow up.”
–Russell
“Any year that passes in which you don’t destroy one of your best-loved ideas is a wasted year.”
“When you blow up a bridge, which you need to do sometimes, do so in an artfully controlled manner so you don’t get collateral damage.”
–Kieran
“Economic progress, in capitalist society, means turmoil.”
Not bad learnings from a 13-second video. Have a great weekend.
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Negotiate No-Brainers
The Investing team had a pleasant conversation at lunch the other day about how much we enjoy investing and our jobs, but then turned to the topic of how many of our fellow investors seem stressed out by and even adversarial with their chosen profession. We wondered how anyone can not enjoy doing this for a living?
Now, I don’t think any investor starts off hating his or her job. After all, it’s a white collar affair with upside and glamor if you do it well. But it can become challenging if there’s underperformance as self-doubt creeps in and customers start asking hard questions or even for their money back. But every investor will experience periods of underperformance, so how might that happen without that person hating it or calling it quits?
I think the secret comes down to two factors: 1) Who do you invest with and (2) How do you define success?
As we’ve talked about in the past, other people’s money (OPM) can come with lots of baggage that can make life less fun. So choose partners wisely and only be in business with people whose names you’ll be excited to see pop up on your cell phone when things aren’t going well (which is a great litmus test).
As for success, defining it needs to happen along several vectors: magnitude, frequency, timeline, and measurability. Further, you need to be on the same page with your customers about that definition before ever deploying a dollar.
That said, a wrinkle here is that good partners aren’t people who don’t hold you accountable and success isn’t something that can only be measured after a 30-year period. As I’ve said before, one of the best things someone can do for you is tell you you’re wrong and be right and also that the long-term is a series of short-terms. In other words, to love investing you need to be able to have hard conversations about things that aren’t working right now.
But then what?
This is where terms come into play i.e., the rules of engagement between an investor and his or her capital. For example, if you manage a typical public company mutual fund or ETF and you have a bad day, all of your investors could ask for their money back. That’s stressful! And it’s also why that industry suffers from sleights of hand like window dressing and closet indexing.
Yet while the best investing strategies should only get better with time, an investor also can’t lock up capital forever because if you’re doing a bad job, there needs to be redress. But it’s also true that investing outcomes aren’t always controllable. So the question is how can you be held accountable for results that aren’t linear or predictable?
One approach to negotiation is that a good agreement has been reached when both sides feel a little aggrieved. In other words, no one got exactly what they wanted, so the compromise was probably fair. That doesn’t work in investing because being able to take back some of your money when performance is meh really isn’t great for anyone.
So this is where a different approach to negotiation comes into play: to only agree to no-brainers. In other words, terms that are so obvious that if the other side exercises one, it’s exactly what you would have done had you been in their shoes.
At Permanent Equity, one way that takes shape is that if our performance isn’t good, our investors pay no fees. Another is that if we take fees we end up not being entitled to, we give them back.
If either one of those scenarios happens (and we hope it doesn’t), the consequences are both predictable and reasonable. And that, I think, is among the reasons why we love our jobs. We have great partners, understand what success looks like, and know that no matter what happens, we will be treated fairly and treat others fairly along the way.