What makes investment management a super interesting profession is that there doesn’t have to be one right way of investing. If Lindsell Train’s newsletter was all about finding Anti-Fragile businesses which can not only withstand the test of time and technological disruption but emerge stronger, this speech from another fund manager is a little more humble in that it helps acknowledge the risk of disruption and prepare for it. Christopher Tsai, the son of Gerald Tsai Jr, instrumental in taking Fidelity to the top of the mutual fund industry, even before Peter Lynch, with stellar performances of his aggressive growth fund through the 60’s. Chris Tsai, founder of Tsai Capital, in this speech at the Yale Club of New York, makes three key points:
1 – Investors continuously underestimate the speed at which disruption transforms business and society.
2 – In an age of rapid technological change, we need to approach valuation, not with heuristics, but with new eyes.
3 – We should use diversification, not only to play defense, but also to play offense. We don’t need a bad-ass, 3 stock portfolio to outperform the market
He says the reason disruption transforms faster than most of us can anticipate is among other things – feedback loops. “As a long-term investor, feedback loops are so important because they can drive exponential growth by providing the fuel for a business to compound earnings in a durable manner. Today, the volume-cost feedback loop is helping to accelerate the adoption of battery electric vehicles (BEV) and renewables, including solar. Think about it this way. When volumes rise for new technologies, costs fall. This in turn spurs more consumer adoption and greater volumes. Conversely, falling volumes for the incumbent businesses means lower utilization rates, collapsing profits, more stranded assets, higher costs, less consumer usage and lower volumes. A technology feedback loop adds momentum to this flywheel, or virtuous cycle
…McKinsey found that the average life span of a company listed in the Standard & Poor’s 500 is about 18-years. That compares with a life span of 61-years back in 1958. Put differently, in just six decades, a company’s lifespan has fallen by 70%! And would it surprise you to know that since 2000, half of the companies on the Fortune 500 list have either gone bankrupt or have been acquired? Why did this happen, you might ask?”
He explains using concepts of entropy and how it is hard for us humans who naturally think in linear terms to appreciate S-curves.
On the aspect of valuation, his views are similar yet applied differently to Lindsell Train – whilst Lindsell Train says the market undervalues the anti-fragile franchise by underestimating its longevity, Tsai says the market undervalues the disruptor by underestimating the pace and extent of disruption (and as a corollary overvalue the disrupted).
Much like Lindsell Train, he argues PE multiples can be misleading when it comes to valuing disruptors or the disrupted. He elaborates using GEICO and Apple as examples.
“It’s so convincing when someone says that a company’s market value does not make sense because it exceeds the market value of all its competitors combined. That sounds so rational, right? But if you look at history, that argument is often misguided. Logically, whoever makes this argument is in effect saying that the market value of A, as stated in the numerator, should not exceed the market value of the competition B plus C plus D plus E, as stated in the denominator. But why not? We know that a company’s market value should approximate the present value of future cash flows. Well, if a business is being disrupted, its future cash flows are likely to decrease while the cash flows of the disruptor are likely to increase. And if you think about it this way, that means as the cash flows of the disruptor continue to grow, and the market value reflects that growth, the disruptor will be worth not just 1X the denominator but 2X, 3X and so forth as the incumbent players go out of business. After all, fractions increase exponentially as the denominator trends toward zero. Indeed, Apple was cheap in 2007 when its market value was just 1X its competitors combined.”
The third point about portfolio diversification. Tsai, much like us at Marcellus, is from the Charlie Munger cult of owning concentrated portfolios. However, he reckons in the age of disruption a little more diversification can help play defence as well as offense. He still owns only 20 businesses (compared to the dozen a few years ago) in his portfolio.
“Today, there are about 4,000 publicly traded companies in America alone. And there are so many new companies that are born each year that are disrupting the incumbents. I prefer businesses that are benefiting from one or more positive feedback loops, require little capital, and can reinvest at high rates of return in a durable manner. And when they have pricing power too, they can be wonderful investments to own in an inflationary world. If there is a silver lining in bear markets like today, it’s this: bear markets provide us with the opportunity to diversify and provide added protection against unknown variables without necessarily having to sacrifice upside. That’s because in bear markets, there are usually lots of attractive opportunities in which to deploy capital”
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