October 12, 2020
Great ideas are only as good as the investment process to see them through
A tipping-point in technological adoption across nearly every sector simultaneously is unleashing a financial opportunity greater than the upside created by financial crisis. We are living in an incredible time to be investing, but the path forward will not always be this obvious.
Today stock investors have access to the widest selection of companies with sustainable growth runways across market caps and geographies that I have seen in my career. There is a lot to do.
But because stocks are liquid and drive a perpetual fear of decline as they appreciate, great ideas are only as good as the investment process that protects against selling for the wrong reasons.
Identifying great ideas is only the first stage of a giant obstacle course to earning outsized returns. The most challenging part is building and maintaining a framework that allows you to think in terms of the evolving optionality of a business compared to its price today.
Investors notoriously underperform their best ideas because of a robotic investment processes that prioritize generating new ideas at the expense of old ideas as prices move around.
This hamster wheel approach works against the outsized benefit that a few extraordinary ideas will have on performance over time. Warren Buffett has regularly given credit to a handful of best ideas like GEICO, See’s Candy and MidAmerica Energy as the foundation for Berkshire’s success.
If I were evaluating an outside manager for my family’s assets, I would prioritize a manager with a strong investment process to support holding great ideas based on improving optionality during the periods when others are tempted to sell (including bull markets) or hold back on a great idea because the price has gone up since you discovered it.
The Investment Process Supports Strategy which Supports Investment Process
JDP’s strategy is to make long-term investments in a handful of businesses with significant unrealized earnings potential. The strategy has a twofold goal of: (1) maintaining and growing an attractive track record, and (2) beating the S&P 500 net of fees on an unleveraged, tax-efficient basis.
JDP has built a research process that supports this strategy by focusing the majority of our time and attention on the businesses within our portfolio, their adjacent sectors, and competition.
In practice, this means working within a framework to digest incremental business progress and related future optionality not priced in the stock.
The benefit to our investors is that we are not continuously distracted by the need to find new ideas, trade around sentiment, or take new risk in all market conditions.
Tomorrow’s Survivors & Thrivers: The game doesn’t change but the players do
Looking back at JDP’s history, far more performance leakage has come from selling the winners versus holding on to the losers. In 2016 Seth and I recognized the need to develop a more strategy-driven mindset in order to evaluate, understand and hold companies facing a future that will look very different from the past.
It seemed ridiculous to watch value investors that we admired consistently miss the very best investments the world had ever seen simply because they did not have a framework to underwrite optionality. The optionality generated by great companies in leadership positions often compounds much faster than their valuation which creates inefficiency and opportunity.
In 2017 we adopted the Survivor & Thriver company criteria into our investment process as a checklist and mental model. Survivor & Thriver is a term we use for companies with a specific combination of attributes which our research links to companies that have outperformed the S&P by the widest margin over 10+ year periods when purchased at peak points of historical market cycles.
Example past Survivors & Thrivers include Microsoft purchased at the dot.com peak of 2000 and held continuously (MSFT +600% vs. S&P +260%); and Domino’s Pizza purchased at the pre-financial crisis peak of 2007 and held continuously (DPZ +2,900% vs. S&P +181%).
Tomorrow’s Survivors & Thrivers will benefit disproportionately from productivity enabled by the internet and the scalability that it brings. The financial result is the ability to accelerate profitability in a non-linear way, by adding products and services to the existing customer base with little to zero outside capital. This flywheel also feeds optionality in the business, often in directions never imagined (Amazon).
Strategic partnerships that are more valuable than being acquired
An area of growing optionality for our portfolio companies is the potential for strategic partnerships with their Big Tech rivals.
Buying and integrating companies in adjacent verticals a has been an important part of Google and Facebook’s growth in particular (Facebook: WhatsApp, Instagram, Oculus VR, LifeRail, Atlas, Google: YouTube, Waze, DoubleClick, Nest).
Google has purchased at least 238 companies since 2001 or more than one company per month for the last 19 years to sustain its growth. Amazon has acquired around 90 companies in the last 20 years plus taken stakes in several dozen others.
Anti-trust regulatory pressure is making it difficult for Google, Amazon, Apple and Facebook to keep the M&A machine going especially for deals large enough to move the needle.
Once believed “inevitable” mergers like Instagram and Spotify, YouTube and Roku, or Amazon and XPO are might not be possible for years, absent a breakup. Even Google’s $2.1 billion acquisition of Fitbit in August 2019 (2% of Google’s market cap) was still not approved by EU regulators as of September 2020.
There is also a growing distrust for Big Tech as a single-source IT infrastructure provider within organizations.
As an example, we are seeing sustained growth in third-party software such as DevOps products that operate within AWS or Google Cloud as an alternative to the OEM version. Historically many of these “bells and whistles” companies in Big Tech’s growth path were acquired and tucked in.
As long as the regulatory scrutiny runs this hot, we see the use of strategic partnerships as a placeholder or alternative to needed acquisitions. This is a win especially for shareholders of the smaller partner companies because it means reduced business risk, certainty of growth, and a higher valuation.
Recent Big Tech partnership examples include Fastly (FSLY) + Google Cloud for edge computing, Datadog (DDOG) + Azure for application monitoring and security (not regulatory driven), Amazon + Slack (WORK) to compete with Microsoft Teams, and Amazon + Cerner (CERN) to build a healthcare platform.
Within our own portfolio today we see similar partnership opportunities. For example, last week Roku announced that The Roku Channel is now available on Amazon Fire. Although a deal with Amazon was not part of our Roku thesis it is an example of the optionality that Survivor & Thriver companies offer.