Introduction

Patrick: [00:01:24] My guest this week back for a second conversation is Pat Dorsey. Pat ran equity research at Morningstar before leaving to start his own asset management company, Dorsey Asset Management. His areas of deep interest are competitive advantage and capital allocation. He believes that capital allocation should be in service of a competitive advantage and invest in a concentrated portfolio that he and his team feel embodied these ideas. If you've not already, I strongly recommend listening to our first conversation first, which is a crash course on moats. In this conversation, we cover different ground. We spend much more time on individual stocks like Facebook, Google, and Chegg, using them as examples to explore Pat's investment philosophy and strategy. Across a few conversations with Pat, I can tell he is in love with this stuff. And I always enjoy talking to investors like him, who's so passionately pursue an edge. Please enjoy round two with Pat Dorsey.

Framework for Valuation

At the first time that we spoke, we did a 45 minute crash course on all things, moats and capital allocation. We'll touch on some of those ideas as we talk about some businesses today, but we'll explore a couple of other different topics first. And I think a fun place to start would be your framework for valuation. So obviously you're looking for companies that have moats, hopefully run by people that are good capital allocators, but at the end of the day, even if you had those two things or it could be a price at which it didn't make any sense to buy the business. So in your third-quarter letter, this past year, you did a deep write-up on how you think about valuing a business. And so I would just open it up to you there to talk a little bit about the methods that you've used and found to be successful.

Pat: [00:02:54] So from a holistic perspective, we do not buy 60 cent dollars. And think that if you view a business as a dynamic collection of projects, which is what any business is, you cannot look at it as a 60 cent dollar. I think that makes sense if you're looking at more static enterprises, if you're looking at businesses that perhaps have a lot of hard assets to them, real estate, oil and gas, but if you're looking at a business that is growing and producing cash via different projects, I think you have to take a more dynamic view. And so what we do from a technical tool perspective, is we use the DCF, full three statement model, as well as an IRR framework. And those two do two very different things. The DCF helps us unpack the cash economics of the business. DCFs are, as you know, very blunt tools. I mean, one change can swing it one way or the other.

So we actually place very little confidence in our point estimate. What it helps us do, however, is frame what are the value drivers here? What are the things that move the needle? And you can also run some scenario analysis with it. We marry that with a more less academic, more market-based framework, looking at our free cashflow and EBIT forecasts, three and five years out, and then applying a multiple to those, what we think is reasonable, either higher or lower than today, based on where we think the business should be. Again, it's subjective, but the idea is that's a more market-based approach and it should triangulate with the DCF model. And we use a minimum 15% IRR hurdle for the EBIT free cashflow.

Patrick: [00:04:18] Is this process done after identifying some subset of companies that you feel has a sustainable competitive advantage?

Pat: [00:04:24] Yeah, that's a really great point. So I used to have an analyst some years ago who his first instinct was to always model the company, before he really even knew much about it. And I had to beat him up a little bit because if you try that, what's going to happen is you're going to put in just, yeah, so what kind of inputs you're going to anchor on those? And so evaluation is always the very last thing we do, because no valuation output is worth squat, unless the inputs are worthwhile. And then we spend way more time at my firm arguing about the inputs, arguing about what should margins be, what should growth be, what is working capital efficiency going to be and then we do about the specific output. Because at the end of the day, that's what we as analysts going to have some confidence, that we can have some confidence in. How fast will they take share? What is operating leverage? Should the discount rate be eight or 10? I mean, neither you nor I, nor the good Lord himself, knows what the current cost of equity is.

Patrick: [00:05:11] We didn't talk about this last time, but I'm curious what your take on this market-accepted way of classifying stocks as either growth or value is. I think mode is something that sits maybe in between those two concepts and in the write-up you talked about how well, obviously, DCF analysis is super sensitive to the inputs and so can give you this false precision problem and the terminal value, especially on growth type stocks can be such a big part of the equation and then you're forecasting something that's so far out. And we just know that people are really bad at forecasting tenure type outcomes. But how do you think about that differentiation? Do you feel like that's an appropriate way to classify stocks and it isn't a model that you would all use as you think about valuing a business?

Pat: [00:05:50] So we don't find it useful at all. And that's perhaps because we don't typically look at what I would call classic value companies, low P/E, low P/B, the things that would be a Fama-French framework. So it's not a framework that's valuable for us, but I think that as an investor, widening the scope a little bit here, I think it is valuable because you need to analyze business in the context of what you're analyzing. I mean, doing a DCF on a business that essentially has no terminal value because you're buying a cigar butt, it's asinine. And in the same vein, trying to say that Amazon is worthless because the P/E is high, when they're reinvesting every cent of cashflow at a high return on capital against a massive market opportunity, that's equally insane. And so you just ... I mean, you wouldn't use a jackhammer to build a house, you'd use it to break up concrete. So just using the right tool for the job, I guess.

Patrick: [00:06:41] You mentioned in one of the letters that one of your core beliefs is that quantitative information is fairly well-priced in the market. So if there's data available, markets are pretty good at arbitraging information in clean data, but that qualitative insight is likely often mispriced and that's a key space that you play. Can you say a little bit more about how you arrived at that idea and what that looks like in practice as we start to pick apart? Like what these recurrent qualitative insights might look like?

Pat: [00:07:07] So it goes back to, there's an old quote from Bill Miller of Legg Mason fame. And now I think he has his own shop, that, "All the data's in the past, but all the value is in the future." And that was maybe the seed that got me thinking about this more. But especially as databases have become more robust over time, as you've had more data sets have gotten cleaner, I've seen this just in my short investing career, how data sets have become cleaner and more reliable over time. As computing power has become cheaper, it just seems natural to me that that information should be more efficiently priced. And then that's what we find too.

And so we rarely find that if we look at historical financials and they look really clean and neat, and you can linearly project the passion of the future, linearly the equity is not that mispriced, because most people predict linearly. It's when you get into non-linear things, whether it was like newspapers doing operating the leverage in the late '90s, they looked great until they didn't, or whether it's operating leverage from business with high fixed costs. In the case of Facebook for us, or the Chegg is a company we own right now where the historical data looks awful and it's because they just sold the business. And the performance of this asset intensive textbook rental, that's what's in the historical data. The performance of the asset light, super high incremental margin Chegg study business, it's buried the segment results.

Patrick: [00:08:23] Let's use both those companies as ways to explore some of these ideas. So we'll start with Chegg. So for those unfamiliar with the business, maybe describe those two phases. So what the legacy business was, what it looks like today, and then we'll use it as a case study to pick apart your process.

Pat: [00:08:36] So the legacy business for Chegg is textbook rental. They actually were the interview the first, the inventors to some extent of renting textbooks versus buying them. Of course, this is a business that's fairly easily replicated. They're very low barriers to entry. And so Amazon and Barnes & Noble essentially crushed them in textbook rental business. The founders were fired by the venture capitalists who had poured 220 million bucks into the business. A new CEO was brought in and he realized that essentially the only asset Chegg had at that point was a brand. That they were not ... I mean, they have 70%, maybe 60% unaided name recognition on college campuses. Well, that's an asset. We could probably do something with. And so he had a little bit of basically investing in different types of businesses. And the one that's worked out really well for them is essentially building a digital library of step-by-step answers to end of chapter study questions.

So if you took engineering or math or organic chemistry, there's going to be a series of questions at the end of the chapter. So that you say, did you understand what you just read? And if you didn't, you'd probably want to as well on the test. What they've done is gotten exclusive licenses for 27,000 ISBNs and answered every single question and indexed it on Google. That being pretty important because the modal college student today copies and pastes. If they copy the question and then they put it in Google and search on it, Chegg comes up as the first organic result, which is how their user-base has gone up 2.5X in three years with marketing costs being the same as they were three years ago.

Zero Marginal Cost of Distribution Business Model

Patrick: [00:09:58] I'm really interested by this zero marginal costs, distribution business model. On the one hand, it's this amazing thing. If you have the brand and the distribution, and it grows organically like that, low acquisition costs, it's like the most perfect business model in the world, but I wonder how that's balanced against, I can't remember who it was, information wants to be free. That most things that maybe 10, 20, 30 years ago, maybe a buy-side firm would have paid amazing money for a certain sell-side research report. Often times those things are just free now. And this kind of repository of answers to questions seems like something that could just end up being free. So maybe describe in some detail how you think about these zero marginal costs, distribution, I know Facebook and Google platform, business models. I'm really interested by the business model behind these things, with this concern that since it's free to produce, it could be free to consume.

Pat: [00:10:49] So, I mean, the best thing is you monetize content, you don't pay to create. That would be Facebook. Now Chegg has to pay money, good money, big money for those licenses to get that content. And so to some extent, the publishers, Pearson, McGraw-Hill, do have a bit of a lever over Chegg in that respect. We think that those relationships are good. They recently renewed one of their licenses at a similar cost to what it was a few years ago, largely because the publishers themselves are struggling. And this is a very high margin source of income for them. And most college students, they've never heard of Pearson. That name means nothing to them.

So if Pearson were to take all their textbooks and try to do this themselves, we think the marketing cost would be enormous, but that's certainly a less attractive zero marginal cost business than say a Facebook one. And they're in, we do have some crowdsourced competitors to Chegg, where students basically post their own answers, but here's the thing, when you think about the value to a student of getting a 3.5 instead of a three, GPA, whatever it might be, passing a certain class it's required for their major, the marginal benefit of paying 14.95 a month for Chegg and knowing it's the right answer because all your friends have used it and it's helped them versus just crowdsourcing it on Reddit, it's a good cost benefit.

Patrick: [00:12:00] So this is a common theme in your portfolio. This similar idea of zero marginal costs. Maybe talk a bit about Facebook as well. We talked in some depth last time about network effects as one of the key drivers of sustainable competitive advantage, what everyone calls moat. We did not talk about the negative side of network effects or how they break down. So talk about Facebook, but also more generally about how you think about maybe the dark side of network effects that can be amazing when built, but can maybe turn just as fast?

Pat: [00:12:28] The key that people don't realize is that a network effect has to be cared and fed. Cared for and fed. They don't just exist and perpetuate without anything. Look at OpenTable. OpenTable's market share as a restaurant reservation platform has really declined, because Priceline didn't really invest in it very much. They did not innovate on tools that are used by like reserve and talk and other types of like ticketing platforms that you may have seen restaurants use. I mean, just anecdotally in Chicago, I'd say easily half the restaurants that I go to don't use OpenTable. They use reserve and that's because it was not invested in. And they're extracting too many rents from the user. But also, and this is a critical point, it's because for me as the user, it's a fungible experience. Reserving it through OpenTable was they're going through exactly the same. Uber versus Lyft. It's a car, you don't care. And so when the headlines get ugly for Uber and it turns out Travis is a pretty nasty dude, peoples-

Patrick: [00:13:21] Download an app and switch.

Pat: [00:13:22] Lyft's campaign is ride better, very smart. And so this will formerly unassailable business suddenly loses 15, 20 points of share in the U.S. because the founder does something dumb and because the products are fungible. If MasterCard tomorrow had a massive data breach, you could go on using your a Visa Card. You wouldn't care. Just say they're fungible. Facebook less so. I mean, if you decided I don't want to use Facebook, there's not at the moment, there could be, it could occur, but there's not at the moment a analogous platform for you to connect with people.

Patrick: [00:13:55] Let's use the evaluation framework again, to think about Facebook. So I think it's your largest position in the portfolio.

Pat: [00:14:00] By a long shot. Yes.

Patrick: [00:14:01] By a long shot. So talk about that exercise. How do you go about valuing something where the business model is so predicated on network effects and has just continued to surprise people? I've certainly made just as a passive non-stock looking observer, has continued to surprise to the upside. How do you think about beginning to assign an estimate of value to something like that?

Pat: [00:14:21] So, our starting point with Facebook was going to a bunch of digital ad conferences, frankly. And starting with the, not the user as in URI, but the user as in the person who actually generates their revenue-

Patrick: [00:14:33] Well, you and I are the product.

Pat: [00:14:33] We are the product. Exactly, exactly. We are monetized the money that comes from the advertiser. So we went to a bunch of digital ad conferences, frankly, and just asked people. And just said, "What value do you get out of Facebook that you can't get out of Google? What's your return on ad spend? Do you feel like their targeting has improved, by how much?" Just really trying to understand from granular perspective. And it's rare that you do primary research and the work comes back 95% positive, and that's what we got. I mean, representative quote, "If God invented an advertising platform, it would be called Facebook."

All right. Then let's rush. That was rather strong. And that makes you sit up and take notice because we know that digital advertising offers the Holy Grail that's been sought for decades, which is measurement. Measuring the return. As the old quote of, "I know half my ad budget is wasted, I don't know which half." And Facebook, because of its ability, it actually knows things about you. Google can intuit things about you based on where you have been or a search term you put in, but it's intuiting that, right? It doesn't actually know things about you that you have voluntarily told when you use a Facebook. And so that information was resoundingly positive. And so we felt fairly comfortable thinking about the growth rate, continuing out. The top line growth was pretty not easy to forecast, but I think that wasn't a real variant perception. We've been in line with consensus on revenue. We've been somewhat ahead, but not massively.

It was really on the operating leverage front because when, in late 15, we began looking at Facebook. They had bought WhatsApp not too long ago. And a lot of the purchase price for WhatsApp had been allocated to R&D. And so R&D spend as a percentage of revenue really jumped up. So if you were looking just linearly and just looking at the gap numbers, you said, "Wow, this business isn't scaling. There's no operating leverage here." But then if you pick it apart and just think, "Well, Gee, the marginal cost of URI contributing content is nothing. It really should scale. Hmm, why hasn't? Hmm. Oh, it's the WhatsApp allocation. Hmm. That means that number of 30% margin they printed in 2015 is probably not representative of what the future will be. Hmm. That means we can forecast some operating leverage. Wow. That's a big number." And then you go from there.

Patrick: [00:16:46] What would cause your perception or your very own perception gap to close with Facebook? So is it merely a function of, I guess, there's two ways, right? There's price, so the market catches up to your estimation of its underlying value.

Pat: [00:16:57] That would be a happy thing.

Patrick: [00:16:59] That would be good and you could move on. And the second would be some sort of breakdown in the competitive advantage of the business. So, and maybe this is a good way to talk about negative network effects again. What would scare you about a position like that that would cause you to change your positioning?

Pat: [00:17:12] If user engagement went down, I mean, engagement is the cynic one-on of a network effect business, right? And what you've seen with Facebook is management being willing to take actions that might be harmful in the short run, but are beneficial in the long run, such as moderating ad load. Most of Facebook's growth over the past year has come from increasing ad prices. They've actually brought ad load down, which is good for your ad, because you don't want too many ads. That's what killed my space, just way too many ads. So if the experience, user experience became spammier, for lack of a better word, if they weren't continuing to innovate the platform with tools like Facebook live and other things that keep people coming back, if they weren't innovating on advertiser tools.

I mean, if the toolkit for advertisers was today the same as it was four or five years ago, or if that slowed, that would be a concern, because that's how it gets monetized. Those would all be concerns. Capital misallocation, Zuckerberg is fairly young, the acquisition so far, Instagram has worked out really well, but it's a risk. It's a non-zero risk. So just doing Google X type stuff, that would be a concern for us. Or if they actually spend as much as they say they're going to spend. Like they say they're going to spend $14 billion next year in CapEx, which is double this last year's CapEx.

Patrick: [00:18:22] On what?

Pat: [00:18:23] Bingo. We can't figure out what they're going to spend it on. And we think it's basically political cover, because their last, not this quarter and it's called but the one prior was right after they'd been holding in front of Congress. Well, what are you going to do? Say, "Hi, we're really profitable." No, no. We're going to spend all this money. I mean, they're projecting expense growth of 45 to 60%. Last year head count grew 45 and expenses only grew 34. We can't figure out how they will spend that, but maybe we're wrong. And if we're wrong and expenses really do mat(erially) ramp-up ahead of revenue and they deleverage on the operating margin side, we would be wrong.

Patrick: [00:18:59] What do you think were the most lessons that a smaller say private business could extract from Facebook's business model or even Google's business model? I'm just always interested in changes in prevailing business models. We're going to talk about the SaaS business model in the minute subscription business model. What do you think are the lessons that could be pulled out? Not so much from an investing standpoint, but from an underlying business standpoint?

Pat: [00:19:20] I think one is take care of your customer and ignore Wall Street. I mean, the private businesses deal with Wall Street, but they might deal with bankers as they might deal with other people. And because that's what Facebook's done. I mean, that's what I think Google has, but they've both done for a long time. That's what Amazon's done. I mean, it's only recently that Amazon's become quite the darling it is. I mean, for the longest time, I would say a bankrupt business. So I really think, I mean, at the end of the day, the guy who pays your bills is the guy who matters and that's the customer. And so you do what's right for them and things tend to work out well in the long run, regardless of what the banker says.

Patrick: [00:19:49] Why don't you own Amazon?

Pat: [00:19:50] Oh, Patrick, I wish I had a good answer to that. I'm stubborn maybe. No. I mean, here's the real reason. I didn't appreciate the power of AWS until recently. That's the real reason. Because it, I mean, you can make a credible argument that AWS has worth a very significant fraction of the share price right now. And we actually have a meeting at my firm later this week to basically go over people's takeaways from a recent, the reinvent conference in Vegas about a month ago. I don't have a really good answer for why we don't, because it checks every box.

Patrick: [00:20:21] Seems to fit your model.

Pat: [00:20:21] It checks every box. It really does. And I don't have a really good answer for you. I wish I had a thoughtful one but I don't.

The Importance of Primary Research

Patrick: [00:20:28] You mentioned that conference. It's a good excuse to talk about your idea of primary research, I think is what you call it. So you mentioned qualitative insight being often mispriced and maybe that's a source of edge for more fundamental oriented investors versus quantitative ones going forward. And then you talked a little bit about going to conferences, doing primary research that maybe a lot of people don't do. Talk about that process and that value that you've derived from it?

Pat: [00:20:51] At the end of the day, it's about, it's like what we mentioned a moment ago, about the businesses should ignore the bankers, do what's right for the customer. You can't understand the business unless you sit in the customer's shoes, and the best way to sit in their shoes is go talk to them. So if it's vertical market software, go to the industry conference, find out why you can't switch to a different type of software. In the case of Chegg, we did a survey. We did an online survey of 800 students across the country to understand name recognition where they're using it for other subjects besides science and technology. And that gave us some really valuable data points. You've got to get off your rear end and work the phone. The insights we get from just talking to people who are deep into the industry is phenomenal.

We own a landscape distribution company called SiteOne. And we've been to a couple of landscaping conferences and basically trying to understand what's the motivation of someone to sell. What's the motivation of a landscaper, because the intuition is that their time is valuable, weather isn't good every day, homeowners want to have the work done on a certain day of the week. And so if you can save 15, 20 minutes by getting all of your stuff in one spot, as opposed to driving to three or four others, you'll probably takes up the higher price because your time is valuable. But you need to backup that intuition with talking to landscapers. And saying, "Well, is that true? Would you pay 3% higher for that brick if you didn't have to drive around?" Oh, sure. I would

Patrick: [00:22:06] What's been the most surprising finding where you went and did some primary research and what you learned or the conclusion was very different from your expectation going in?

Pat: [00:22:16] That's a good one. So it was probably about on the aerospace aftermarket. So, yeah, sorry, I'm switching gears a little bit.

Patrick: [00:22:23] Love it.

Pat: [00:22:24] So, a few years back we owned a, two actually companies that made aircraft parts, not TransDigm, but similar stuff. And we all know the story here, right? Has to be FAA certified, massive pricing power. The story is pretty familiar for lots of people. But, even though global revenue, passenger miles were going up at a very good clip, and so planes should be consuming spares if they are flying. The companies kept good quarter, bad quarter. And there was no linear trend in parts sales. And we're like, "What is going on here?" We couldn't figure it out. And so we dug and dug and dug and finally found a couple of guys who did consulting for the majors here in the U.S., in partying out old planes. And so partying out old planes has always been part of the business, but recently, there had been two confluent, I think that's a word, events that made it a much more common.

First of all, cheap capital and basically people giving money and just saying, "Hey, you go out and buy a bunch of plans and put them out and we'll share the proceeds. Cheap money. The other is that you had, because of hugely ramped up production on new models by Boeing and Airbus, a lot of planes hitting the boneyard that were relatively new and still had a lot of life left on the parts, which meant that the amount of spare parts from basically dead planes on the market was way higher than it had ever been. Well, if you're an airline and you can buy it for X from a dead plane and you have to buy that same part brand new for 10X from the manufacturer, I think that manufacturer sales are going to be weak. And we just, we had no idea that this partying out part of the market had grown to be meaningful material. And so that was like, I mean, a real wake up call that basically our thesis was broken.

Patrick: [00:24:06] Talk a little bit about the trips to India and Japan. So this is on that same primary research topic. I know your strategy is a global one. I think the benchmark is Acquia.

Pat: [00:24:14] Yeah. That's right.

Value of Travel

Patrick: [00:24:15] I don't know how much of the portfolio is international, but you definitely have a global mindset. So talk about travel, not just event conferences say domestically, but the value of traveling to different cultures and countries.

Pat: [00:24:25] Yeah. Well, I think part of it is that you don't know what you don't know until you go out and find out about it. And I think part of it also is once you're, and we didn't have the freedom to do this maybe our first couple of years, because you're getting up and running as a business, but I think one thing you should do always as investors, think about when will this knowledge that I'm generating payoff? And there's some work that you do that needs to pay off ideas and whatever. They need to be thinking about what will matter in five years down? What part of the world will be larger and more consequential, whatever? And start investing now, because then if you wait until five years from now, maybe it took you five years to figure it out. And so that was the reason for going to India, really was that this is a large economy, corporate governance is improving materially. It's actually a very vibrant stock market with a very vibrant investing culture in India.

And we didn't know, honestly, whether it was diligent supple, if that's a word for us, not speaking the language and not being on the ground. And what I learned after, it was only a week there, was that we're probably never going to invest in businesses that are tied to consumer taste in India, because we can't travel to 16 rural villages and figure out why they use this brand of hair oil versus a different one. That's out of our wheelhouse. But, there are plenty of good Indian export businesses that compete on a global scale. Well, Gee, if you compete on a global scale and you just simply happen to be based in India, but the products are sold globally, the value chains are global, that could be in our wheelhouse, is something we could understand. And so it was really understanding. So we'll go back once, twice a year and it could be five years or never, before we buy something in India. But I think we would be doing a disservice to our clients if we just wrote out or if we just wrote it off as well. It's too far in the food's bad.

Patrick: [00:26:05] Before we get to Japan, which I'm really, it's a country that keeps coming up more recently as an interesting opportunity set. I'd like to hear about the process behind why it's India and Japan. So what about those places? You're a relatively small team, you've got limited time in the day. What was it about those places relative to all the other places that caught your attention and made you focus there?

Pat: [00:26:26] So, I wouldn't say we focus there. It was simply our first trips there.

Patrick: [00:26:29] Your time there. You can talk about-

Pat: [00:26:30] Yeah, it's really our first trips there. I mean, we went to Europe probably five, six times last year. Just didn't happen to make one of my letters because there was no nothing really. It was less interesting for, in some ways. Although I did mention in one of our letters that I moved for the first time last year when I went to Norway. That was fun. It was good. It was good. So it was really, it was very opportunistic, just the opportunity popped up for India and did it with Japan. I had a friend in the industry going there and we were able to tag-team on companies and we found a really good translator who was easy to work with and who was not connected to a bank.

So we didn't have to do a whole bunch of trades with them. We just could pay this translator cash. And that worked out pretty well. Japan, a corporate governance is improving their capital allocation, is improving the margin. And there are a lot of phenomenal global businesses there. But again, you really can't do calls with them. Japanese companies prefer visits and especially to break the ice. Okay. So that means you need to go fly over there and do the in-house visit to open that door for future conversation.

Patrick: [00:27:24] We find on our experience having run strategies that are both pure domestic U.S. only companies and those that are global, that obviously I think a bigger universe is attractive in many ways, but in the world where you're benchmarked, and Acquia is your benchmark and it's 50-50 or something like that, U.S. international, how do you think about risk associated with relative exposures for regions or countries like Japan and trying to parse like the idiosyncratic risks, which is what you're after, with just regional risks? And you don't strike me as a macro guy. I'm not a macro guy at all, but it does matter. Benchmarks matter. Like the guy I talked with this past week said, "Do you know anyone with the benchmark is benchmark afraid?" And I love that phrase. So how do you think about, let's say you were to initiate positions in Japanese equities, the bigger picture there that could just affect your results without really intending to?

Pat: [00:28:13] Exactly. And the thing that could affect us most in the short run is currency. And we are just, the key for us in terms of risk is simply getting paid. Getting paid for the risk we're taking. So to choose two countries with very vulnerable countries, Brazil and South Africa, both of which we've invested in, in the past. Our hurdle rate for investing in a Brazilian or South African equity is significantly higher than for a U.S. equity because over time the real and the rand will depreciate. I don't know, but they'll do over two or three or five-year period, but the inflation differential, just going back to the Old Phillips equation, they will depreciate relative the dollar. And so I need to get paid for that because my clients are in dollars. Now Japan, obviously the yen, I mean, people like to bet on the yen doing whatever it does. We don't have a strong view on that.

But I think you have to be aware that if you're buying a business in a volatile currency, when the currency is at the top of the Big Mac Index or is hitting new highs, you're taking a risk and you better get paid for that. Now that's quantifiable in some ways. What's not quantifiable, but it's just as much of a risk is what you don't know, because you don't live there. You're not on the ground listening to the news every day. And that's why I mentioned the case of India. We will probably, our first foray into looking at businesses, there will be global businesses, businesses that export on a global scale because we think those are more understandable for us. A business that is very tied into local consumer behavior, that could change without us knowing, I think for a country you might visit twice a year, that's going to be, it's a tall order for a concentrated front like us. Now, if you're 120 stock EM fund, great, but a small position for us is five or 6%. So you need to be very aware of what you might not know.

Patrick: [00:29:53] One of the things that stands out about when you look at Japan is just different objective functions. When it comes to corporate governance and shareholder value, they're just optimizing for different things or at least have historically-

Pat: [00:30:02] Yeah, that I think is very true.

Patrick: [00:30:03] Maybe improving. One of those things is market share. And this is an interesting segue into another mental model or topic that you've talked about and some things that you've written about absolute versus relative market share. I'd love you to share your thinking on that topic and whether or not those things are useful when thinking about identifying attractive opportunities.

Pat: [00:30:21] It's an interesting question, is I think market share is often conflated with competitive advantage, which it's not. Generally speaking, you will have better economics as a business, this is speaking broadly, if you have 6% share and the next biggest guy has two, then if you have 40, but the other guy also has 40. I mean, look at Boeing and Airbus. The planes are functionally equivalent. The barriers to entry are, and there's another barriers to entry. There's another not misleading mental model. It's unlikely there's going to be another airplane manufacturer anytime soon. Barriers to entry are high.

But the only Airbus returns on capital are okay. They're not great. They're okay. Because at the end of the day, if you're American Airlines or Japan Airlines, A327, 737? What do you care? You don't. Your job is to get butts in seats a certain distance. You are, "I don't care which kind of plane we sit in," for the most part. Whereas if you have a business that might only have 6% of a very fragmented market and they can achieve scale by buying other businesses and consolidating that market, and the next largest firm is only 2% and is way behind in terms of gaining scale, that flywheel will only accelerate.

SaaS Business Model

Patrick: [00:31:27] Talk about another business model that I think you and I both are really interested in, which is the SaaS model. Then we use Workiva. You can describe that portfolio company. Describe what it does and then we'll talk about why the vertical SaaS segment of the market is so interesting to you?

Pat: [00:31:41] The SaaS model, I mean, it's interesting, and this actually ties back to the whole idea of things being mispriced, because you're getting paid over time. It's the lifetime value of the customer that matters. And you're stretching the value of that customer over many, many years, as opposed to the old software model, which is getting a big juicy license payment today, and then a little bit of maintenance revenue going out, which pushes the value into the future, but also increases the lifetime value. Companies that go from licenses subscription often see a 1.5 to 2X increase in the lifetime value of the customer, but you don't get all the cake today. You have to wait for the cake and the market doesn't always like that.

I mean, look at when Adobe or Autodesk went through their subscription transition, some of the stocks got hammered. But if you look through that, those wound up being opportunities because the product was still very sticky. And so the metric we think matters most is the ratio of lifetime value of the customer to customer acquisition cost, which and there's 8,000 different ways to calculate those. So you just want to get a rough idea. But if you're getting three or 4X delta between those two, you should be reinvesting every cent that you have. I mean, you shouldn't be generating free cashflow. So Workiva, the business that we have known, just a very SaaSy business, they have about 96% client retention, 106 revenue retention. They keep upselling clients.

And what they did is created a product that enables companies to do SEC filings much more efficiently than the old way, which was mark up a PDF and send it to Donnelley and then Donnelly sends it back to you and then you mark it up and then you send it back to them and it was prehistoric. And so needless to say, they took and went from zero to 50% share in about six years. And in fact, the people who do external reporting, they've got about 80% share of the fortune 500 right now. People actually won't go to work for another firm who doesn't use Workiva. If you do external reporting, that's how strong the product is.

Patrick: [00:33:24] Why is that so defensible? It sounds like something that another software company could replicate. Why is there a moat around that business?

Pat: [00:33:30] That's great question. So it's really not an easy product to create because essentially what they had to do is replicate Excel in the cloud and enable it for scores of simultaneous users. So there's no check-in, check out the worksheet. And then also the data points get linked inside your enterprise. And so you might say, "Okay, we need to report this EBIT line." Well, that's the function of Bob here and Jane over there. And their numbers roll up into mine. I'd link that inside my enterprise so if you had a new product, you'd have to break all those links and re-integrate it.

So not impossible, but external reporting teams, even Walmarts, huge company, their external SEC reporting teams is like 20 people. So, this feasible. It would be feasible to do a rip and replace, but where things get interesting for this business and where the TAM gets much larger is internal reporting, where basically you're rolling up data across the entire enterprise and then putting it together for the CFO, CEO, whatever, because then your linkage has become much greater and the number of users become less much greater. And the more users you have in an entity that whose workflow needs to get disrupted, if you've got a new product, this trickier the product becomes.

Patrick: [00:34:35] This is a little bit of a harken back to our first conversation, which I highly encourage people to listen to. It's really is an incredibly dense 50 minutes on moats and capital allocation. But when you're thinking about, I guess, the switching costs associated with these SaaS businesses, my understanding, I was here, the one about dentist's office software or something like that, that it's just once they're in there, that it's a tremendous source of pricing power that you can, you mentioned the 106% revenue retention because they're assuming that's because they're raising prices or cross selling-

Pat: [00:35:05] Cross selling. Yeah.

Patrick: [00:35:07] So, talk about the different aspects of moat and pricing power specifically?

Pat: [00:35:12] I think one thing that does happen sometimes in vertical market software, and I think any user of Bloomberg or Advent will appreciate this, is what's called abusive pricing power. And yes, I'm talking to you Bloomberg and Advent, where your share of the economics is becoming to some extent unfair. Advent looks like a DOS program from 1975. I mean, they haven't improved that thing in years, but we have no choice. I mean, no user has a choice in terms of using Advent. There's really no real substitute for it. And so I think that's where these products that are very sticky can be, you can create a pricing umbrella that creates a profit pool for your competitor to come in and try and take it. But as long as you keep improving the platform and offering more functionality each year, more ease of use, whatever it might be, and you're taking prices up two, three, 4%, something modest, the path of least resistance is just keep using it, especially if that piece of software is the plumbing that runs your business and is a relatively low cost relative to the revenue that you're generating.

Patrick: [00:36:18] Let's go back to that LTV to CAC ratio and describe these kind of levers in some detail. So when you're evaluating a SaaS business or any subscription business, I always like to think about Netflix. Talk about what each of those terms mean, maybe throw churn and retention in there. And then what, like an LTV to CAC of one versus a five might mean and how a business should react to those things?

Pat: [00:36:40] Again, there's, you argued for years about how to calculate this, but conceptually, lifetime value of the customer is how long does the average customer stick around?

Patrick: [00:36:49] And it's like a discounted cashflow basically per customer.

Pat: [00:36:51] Yeah, yeah. Exactly. Two months or whatever it might be. And what kind of margin are you making off of each of those customers? And then that typically will include some assumptions around cross selling or pricing power because that's the revenue stream you're going to get. And the acquisition cost is basically your marketing spend per customer over some time period, over six months or a trailing three years. You can pick different ways to do it. And I would say that, so in Workiva's example, their customer acquisition costs really spiked about a year and a half, two years ago, because instead of going after the broader internal reporting market, they tried to pivot of going from the [SCC] market to the Sarbanes-Oxley market, Sarbanes and SOX reporting, which didn't work very well because whereas with external reporting, you were just saying, "Hey, you should do use Wdesk," which is their product, instead of Donnelley or Merrill. "You use that product. Our product is superior." Customer goes, "Why? Yes it is."

There is no SOX product. There is no product for SOX reporting. It's a whole bunch of kluged together, internal processes. So that's a much harder sale going in and saying, "Pay money for a product that is replacing an internal process that you're not actually spending money for." It's just wasting people's time. That's harder to put a number on if you're a CFO or CEO. And so that really spiked up their customer acquisition cost. Once they pivoted back to enterprise sales for internal reporting and frankly just reorganize their Salesforce geographically, as opposed to functionally, which means less travel, but you're closer to your customer, customer acquisition costs came back down.

Patrick: [00:38:17] So is it fair to classify this as where the LTV is basically like a per user or per client this kind of cashflow?

Pat: [00:38:23] Yeah, sure.

Patrick: [00:38:24] And that obviously acquisition costs is just how much does it cost to get one? And obviously you want the ratio to look good, but I've heard, for example, just as very simplified rules of thumb. I'm curious to hear, if you agree with these ideas. Let's say that ratio is one. So basically your lifetime value is the same as the cost to acquire the customer, breaking even on the customer. That probably means you're spending too much on acquisition, but conversely, you don't just want it to keep going higher because if it's like five, you actually should probably be willing to spend more on customer acquisition.

Pat: [00:38:54] Exactly right.

Patrick: [00:38:55] And explore new distribution channels. So is that roughly the right idea?

Pat: [00:38:59] Yeah. I mean, I don't know what the right number is, but you're correct that there is an upper ceiling at which point that sends a signal that the company is more interested in milking the current client base than growing clients. So some years back we owned a company called Diligent Board Books that basically made software to put together electronic board books. So you think about the big packet a board member of this fortune 500 company will get. Well, if you can do that online and do that in a PDF form so that when you have to change that page two hours before the meeting, which always happens, you don't have to reprint out all of them and it's more secure and everything, great business.

One thing that drove me, we don't own this anymore. One thing that always drove me nuts is they're always like, "Yeah, we're so very proud to be profitable." They're not like, this is a New Zealand company, not like those money losing American companies. And it was like, "Yeah, but you're not growing very fast and your customers never leave. That means you should be plowing every cent that you have into expanding your Salesforce." And that just never really clicked with them. It was very, very frustrating for us. So, yeah, you're absolutely right. If that ratio gets too big, it means you're not acquiring a customer.

Power of Demand Aggregators

Patrick: [00:40:08] Besides that model, that LTV to CAC model, which has become very popular especially in the startup world, maybe the defacto, one of the defacto models, are there other, I'm thinking back now to the DCF and IRR combination that you use when approaching valuation, are there any other kind of valuation or business model, type models that you think about or use as you screen for companies?

Pat: [00:40:29] So one to think about is a demand aggregator. So a company that aggregates demand in some way. So sometimes this is a distributor, that's a classic example where you essentially pool variants. So let's say you're a distributor of parts for making widgets. And some types of widget parts are purchased very frequently. Some are purchased very infrequently. The bigger you get, the more frequently your stock of infrequently used widgets will turn, which means it's more efficient for you to carry them as opposed to a smaller competitor who can't put with that product.

That inventory just sits there for a longer time period. It's called pooling of variants and then you can also think about it as aggregating demand. And you can think about one of the reasons Netflix can afford to invest in tons of content is that they have aggregated demand. They have a large number of people with whom they can monetize that spend on content. They've aggregated content demand. And so I think that when you have businesses that aggregate demand in some way, whether it's distribution, like a classic distributor, like dental distributor, veterinary, Fastenal or platform company, which is a very overused word, things get very interesting very quickly.

Patrick: [00:41:38] How would you parse the difference between the aggregation of attention and the aggregation of demand?

Pat: [00:41:43] Well, in some ways that's a cool question. It's the same thing in some ways, because there's only so many hours in the day. And one of the beauties of both Facebook and Google and mobile devices is suddenly you actually have more attention because people do all screen. 20 years ago, TV watching was a zero sum game. If you were watching CBS, you were not watching NBC and people just, that's why it's such a cutthroat industry. But now, people have a phone in front of them while they're watching TV, that has in essence created more ad time, because the ad can be shown on TV, the ad can be shown on a mobile device, which is really an interesting dynamic, but it's still attention.

You've still got, so in some ways, hours of attention had been created in some ways with mobile devices, which is a fascinating thing to think about, the time got created in a way, but it's still aggregating that attention onto one platform. Be it Google, be it Facebook, be it Netflix, be it whatever. And then demand would be more for, I guess I think of that more as a physical product, if you're aggregating demand Fastenal for fasteners or SiteOne for landscape supply or a pool, which is for pool supply products. Self work.

Patrick: [00:42:46] One of the guests I had on was talking about basically the business model being aggregating demand for a very specific cohort of people. I think the idea was like Sephora as was then the end thing that they could sell that attention to more or less, whereas a company like Google or Facebook is probably the best example just seems to be aggregating attention. And then the backend like advertiser model, which sounds like you know very well and is extremely effective. You can measure your return on investment, is the way to just parse and basically create demand within that attention. It's really interesting.

Pat: [00:43:16] Yeah. I hadn't thought about it that way, but no, that's a good way of thinking about it.

Patrick: [00:43:19] Are you familiar with this kind of phenomenon right now? This HQ, the countrywide quiz games?

Pat: [00:43:24] Oh, HQ. No, no, no.

Patrick: [00:43:27] So there's this thing right now where it's an app on your phone. And I think it's twice a day, they are running a live quiz, like a quiz game.

Pat: [00:43:35] Like a quiz bowl. Okay, cool.

Patrick: [00:43:36] Like a quiz bowl with prizes. There's video and the questions come up like who wants to be a millionaire or whatever. And you have very short period of time to answer it. So you can't be like Googling it or whatever. And it's real cash prices. It's like two grand. They did like a $20,000 cash prize at Super Bowl halftime. And so my question to you is for a company like this, they just raised $19 million of venture capital, mostly to fund those prizes. So they're doing this incredible job of aggregating attention and engagement. People are obsessed with this game and there's a million people playing twice a day. It's very quickly. So if you were running that business, knowing everything that you do about advertising and that business model, how would you go about monetizing something like that, that has aggregated incredible engagement and attention?

Pat: [00:44:22] So one way, mobile gaming companies have really, it's become very common for mobile gaming companies to say, "Okay, you can spend more time playing or you can level up by watching this ad." That's a pretty common way. So what if they said, "Okay, we have one question. There's another question you could try to answer. And you don't guarantee same thing. You may not pick it right, but we'll only get this a new question, you only get a chance to play the lottery if you watch this ad." Right?

Patrick: [00:44:49] Yeah. Really interesting.

Pat: [00:44:50] I'll bet you a lot of people would, especially because of the dopamine rush is going, right?

Patrick: [00:44:54] Of course.

Pat: [00:44:54] What you would want to do is they answer it. "Oh, no, you didn't answer. But wait, if you watch this ad, you can try again with a different question." I don't know. I'll bet you you'll get some takers on that.

Patrick: [00:45:06] I've learned a lot from reading your stuff and our couple of conversations about this in general, but it was really hit home yesterday. I read the introduction to a book that's coming out. I think the book's called the World Beyond Capital or Without Capital. It's by one of the partners here at Union Square Ventures in New York City.

Pat: [00:45:20] Okay, interesting.

Patrick: [00:45:21] And part of the core thesis is that what is scarce has just changed through time and that in the industrial age it was capital that's scarce, but we're now going to the knowledge age where attention is the scarce resource. So I'm just curious about your reaction to that kind of basic simple idea that I just thought it was elegant and neat?

Pat: [00:45:38] Yeah. Both attention and I think it also more, it's human capital versus financial capital. And so attention maybe the scarce resource now, because people have more leisure time than they did 20, 30, 40 years ago, when you're out on the South 40 plow, behind the mule or whatever. And so the competition to get a piece of that time is higher today. But I think more broadly speaking, and this is where I think is very applicable for a lot of investors and hearkens back to that 60 cent dollar point I made earlier, when the scarce resource is human capital and not financial capital or physical capital, it becomes, the output of human capital is poorly reflected on financial statements. Maybe this is the best way to put it. If you build a rail or if you put a building up, that's not a balance sheet. I can look at that and build a steel mill less right there. Okay. But what's the value of Google's engineers? Well, I mean, the R&D is expensed. R&D is-

Patrick: [00:46:32] Price to engineer. Okay, cool.

Pat: [00:46:32] Exactly, right? It's not capitalized. And I mean, if you had to ask me, "What is the scarce resource right now?" It's human capital. It's the scarcest resource. And I mean, just as a brief pivot, it's one of the things that scares me most about the current immigration debate. Because for many decades, if you'd ask the best and brightest person in any given country, if you could live anywhere in the world where would it be? Five out of 10, six out of 10, pick a number, would probably say the U.S. And if that goes down, then we at the margin loops because that's the scarce resources, is human capital.

Patrick: [00:47:05] How do you evaluate that? So this pairs nicely with this idea that what markets mispriced is that qualitative stuff versus the quantitative stuff. How do you evaluate that in a business? The value of human capital say relative to peers or relative to pricing?

Pat: [00:47:19] It really, for us, comes back to the competitive advantage analysis, because competitive advantage is created via human capital, is created via the construction and maintenance of a brand. It's created via the increase engagement of a network effect. It's been created by making a product difficult to switch away from. That's all. It's not, you didn't just build a factory. You did something with the product, with the intelligence of the marketing guy and the product designing guy and woman who codes or whatever it might be that makes that product difficult to switch away from. Whatever it might be. So that's the, for us, that's the output, but we certainly don't do like, because you have more engineers, you're more valuable. I mean, it's monetizing matters. I mean, look at Twitter and Snap. Need I say more? I mean, lots of human capital product that people love. People love Twitter, but just they've never figured out how to engage, how to monetize.

Thoughts on the Asset Management Business

Patrick: [00:48:10] We both work in the asset management business, all of these same things, these concepts we've talked about are interesting to discuss in the context of what we do as operators versus as investors. So maybe talk a bit about the early experience now, four years or so in, to starting an asset management business. How you think about it as, I like this dichotomy of an investing firm versus an asset gathering firm. I think I know where you stand on that spectrum, but talk about the experience of actually starting an operating business and what has worked and what hasn't worked so far? And I'll have some follow-up question.

Pat: [00:48:42] Yeah. So I would say that the first thing is know who you want to be when you grow up. Think about what should this firm look like in 10 years? I actually don't think a lot of people who start asset management firms do that. They're thinking about what kind of career am I going to get next year or this year? I'm sorry. But if you're an investor, you want to partner with someone who is going to be around in 10 years, especially if you know our clients are mainly endowments and foundations, which are perpetual entities. And so you need to be thinking on a perpetual timescale.

So I think that's one thing we did okay. That we got right. And so thinking about what should this be, designing it for durability? And I think one thing, we got some operational stuff wrong at the outset, which isn't that important. But I think one thing I got wrong personally, is at the outset of the firm, I didn't do the best job being who I could be. I tried to be other people. I was too influenced by other investors I was close to. And some of the things we purchased were more things they would have purchased.

Patrick: [00:49:38] Can you give a specific example of that?

Pat: [00:49:42] I'd rather not, actually.

Patrick: [00:49:43] No problem.

Pat: [00:49:43] These are all smart people who have created value for investors in their own way, but if they're cooking Chinese, I'm cooking Italian, whatever it might be. And I was an Italian cook trying to serve fried rice and it just doesn't taste very good. Right? It's a horrible analogy. But I think that was a mistake we made. And then I think that was something that figuring out who you are, what you're good at, what your circle of competence is and just sticking with that, which means really suppressing FOMO, really suppressing that fear of missing out, that, "Oh, that could be an interesting idea." Well, maybe it's an interesting idea, but it's not one that you have any competence at looking at.

Patrick: [00:50:21] So four years in, you talked earlier about the DCF analysis has not trying to come up with some perfect forecast or value, but instead as a way of really identifying what the key couple levers are in a business, like what are the value drivers, good and bad, turning that same idea on the asset management business, setting aside performance, or at least the high level of performance, which is obvious, better performance, better business, what are the levers that you found to be the biggest value drivers in your business and maybe in the asset management business, more generally speaking?

Pat: [00:50:52] First thing to know, the performance is an output. Performance is an output of people in process and that if you don't get those two things right, you lost the game before you even started to play. And so I think firms that are thoughtful about process, that are iterating on process, that are reflective about what works and what doesn't, and that are willing to change things that don't work, and that never say because we've always done it this way, I think that's a hallmark of good firms and that's something we try to do. On the people side, it's being willing to be open-minded. Not just with the kinds of people you hire, but with how they behave inside the firm. I think that when you have one of the worst characteristics of some firms is that analysts can weaponize information. And so if you know more, you know more detail about the semiconductor industry, the oil and gas industry, and you can throw out lots of jargon, you win the debate.

But the person who knows more, doesn't necessarily have the right answer. And that's a really hard thing to get around. And so I think that having humility and realizing that the best insight can come from the guy with the least information sometimes. And so that means making all voices equal, that if you're looking at an oil and gas company, somebody else's voice is just as valuable as the oil and gas guy, who's frankly incentive is to get more oil and gas into the portfolio. If that's not an issue for us, because we're a smaller firm, we're generalists that we have a very conservative portfolio, but I've certainly seen that breakdown at larger firms.

Patrick: [00:52:22] Asset management is beautiful because it has enormous operating leverage done correctly, but it also, maybe the flip side of that coin is that they can be extremely fragile businesses research. We're sitting here, it's the 7th of February today and the last couple of days we've seen these enormous ETF blowups literally overnight. So it tends to be a very fragile business, especially when it's a single strategy, a single fund, and in your case, very concentrated. So how do you think about that kind of two-sided coin? Another way of asking the question would be, you've got a fairly limited capacity strategy we were talking about before we started, what, if any ambitions do you have beyond just the core approach of a concentrated, differentiated portfolio?

Pat: [00:53:01] For us, we have none.

Patrick: [00:53:02] I love it.

Pat: [00:53:02] Yeah. I mean, I want to be good at one thing and we do one thing and that's what we do. So we don't really have any ambition to manufacture product or do this or do that. And again, that's not to fault those who do and build a larger platform. It just needs to be done thoughtfully and it needs to be done in a way that is leveraging intellectual capital you've built as a firm and not done as a way to capitalize on perhaps fleeting investor demand. That's where I think that strategy can, in my view, run into trouble, when people create product to meet demand, because as we've seen, if you look at the Morningstar data on asset weighted versus time-weighted returns, people tend to make pretty bad decisions about when to invest and when not to invest. And so if you're creating a product in response to investor demand, you're probably creating it at the exact right time and selling it to the exact wrong people.

Patrick: [00:53:56] I missed something earlier when we were talking about Facebook that I want to circle back to, because I meant to ask you, which is this idea of embedded options that get mispriced by the market. The reason I thought about that was I was going to ask about what your view on the relationship is between risk and return? So maybe we'll start there. What is your opinion on the strength of that relationship? And the reason I think of options is because it seems like something that often gets mispriced within a big complicated company. So maybe you also talk about the options embedded in something like Facebook?

Pat: [00:54:24] Risk, it all just comes down to how you define it. I mean, and that also comes back to who your clients are. If your clients are people who are frankly, maybe let's imagine a lot of your clients were funds of funds, who are getting evaluated on monthly performance. That means you're getting evaluated on monthly performance. And that means for you, risk is having a bad month. That is risk, which means volatility is really going to matter to you. For us, risk is about permanent capital impairment because we are very fortunate that our investors have a long time horizon and that's the same time horizon we take. We underwrite businesses to a five-year plus horizon. And so for us risk is permanent capital impairment. But that's real. I mean, and so you have to think about that. What is, especially in a concentrated portfolio, you can't, I mean, a concentrated portfolio of biotech bets, where it's like a completely binary upside and downside.

I mean, I'm sure there's some PhDs out there who are doing this and doing it successfully, but well, you better know that science and your winners better offset your losers. So for us, risk is permanent capital impairment. On the options side of things, it's really tough. I mean, in Facebook's case, WhatsApp is not monetized yet. We think it will be at some point how much we don't know. And the way I think you factor that into as an investor is you say, okay, so let's contrast two businesses to both which be on the Dollar General and Facebook. So if Dollar General were to trade at our valuation estimate tomorrow, okay, great. It is what it is. Dollar General is not going to suddenly open six times more stores than we suddenly expected.

They're going to continue to crank out what they do, which is basically serve rural America in a very intelligent way. If Facebook was trading at our DCF fair value estimate, that estimate doesn't incorporate any value for WhatsApp. And then we have to make a qualitative judgment on is WhatsApp board zero or something above zero? And what's the likelihood that that something above zero will materialize in our lifetimes. Well, if it will, then we probably shouldn't sell it. So it's just, again, I hate to say, but with so many things, it's a judgement call.

Patrick: [00:56:20] A lot of ash in this conversation. I hate to say this.

Pat: [00:56:23] Yeah, I know. I hate to say it, but I mean, it's funny. I was actually talking to a friend of mine this morning who works at a firm that is both an investment management division and a private banking division. And he contrasts that, the one side of it was manufacturing product to meet demand, within the investment management division was much more about basically a giant HR function. Basically it's about curating human capital. And it's almost like the craftsmanship versus manufacturing. Neither is good or bad. And again, there's enough pejorative, but I think if you're Franklin Templeton, you have to be a manufacturer, but if you're a smaller asset manager, you're craftsman or craftswoman. And those require different skills and different structures.

How Uncertainty Can Have Value

Patrick: [00:57:07] The way you put it in the letter was you can often get paid for taking on uncertainty, like uncertainty can have value. And I think about that a lot personally, too. One of the questions that I've started to ask more and more people in this context and privately, is for periods where you've taken the most risk in the face of uncertainty. So some personal leap of faith or where you just didn't know what the outcome was going to be, but you did something anyway, that would love to hear that story and what that felt like emotionally?

Pat: [00:57:34] Unfortunately, it's an obvious answer which is starting.

Patrick: [00:57:37] Starting the business.

Pat: [00:57:39] Starting my business, because it wasn't a leap of faith. I'd never invested anything with my own money. I mean, I run a big team of analysts, but publishing research is not managing money. These are entirely different things. I mean, don't let anyone tell you different. I mean, it was a huge leap of faith and I have to, I'm very grateful to some people in my life who are close to me, who pushed me. Who said, "You can probably do this. Your odds of success are maybe 20%, but that's better than 2% that most people who start estimating," or whatever the number is. And so I'm very grateful to those people, but that was certainly the biggest leap of faith. And in hindsight, I wish I'd done it 10 years ago.

Patrick: [00:58:12] How did that percolate? What was the process that kicked the whole thing off? The idea of going, hanging a shingle, so to speak?

Pat: [00:58:19] I was really thinking, seeing a blank slate thinking, what to me is the most rational ladle invest? And then saying, "Gee, is there a place where I can do that?" And the answer is no. Well, then I guess you better do it yourself, because I don't view things like say the Morningstar style box is frankly very useful. Sorry. Yeah. It's certainly not how I think about investing. I want it to be unconstrained. I think concentration, so you can invest a high amount of human capital. And every idea gives me greater confidence in what I own, which means I'm going to be a better investor and a better fiduciary for my clients.

But also for the specific types of clients, I wanted to seek large endowments and foundations, because if you're investing for high net worth investor, they might only have two or three people managing their money. And so concentration is a little tougher. Being fully invested all the time it's a little bit of a tougher ask. But if you're investing on behalf of a large foundation or endowment who is making asset allocation decisions a couple notches above you, and once concentration, because you're going to be one of five, 10, 15 managers, then the interests align. They align so well. And it just made sense, I guess.

Patrick: [00:59:24] My closing question for you since we've talked before, this time will be for your favorite recent find in terms of a learning resource, so this could be anything, it could be a book that you've read, it could be a conference that you went to, really anything, something that really accelerated your understanding of some specific topic.

Pat: [00:59:41] Well, it's a popular book, but it's definitely had an effect on me, is Dalio's Principles. And that's more specific than you were looking for. I read it over the holidays and it's really interesting because our firms could not be more different. I mean, a quant firm, we are not, they're a little bit bigger than we are, I think.

Patrick: [00:59:59] A couple orders.

Pat: [01:00:01] Their fees are a little bit higher than ours. But, the central theme of let's get people together with diverse opinions and figure out how to get the best outcome from that conversation, that's exactly what I'm trying to do. And so that view, and this is somebody who's done it longer and probably thought more deeply about it. And so the insights from that book in terms of how do you tease out, as Dalio says, "A discussion is about seeking the truth." I think it was the phrase or something like that. That's immensely powerful. And I think it really helps focus our team back on. Look, this is not about you're wrong or you're wrong or I'm wrong, or I miss this or he missed that or we should have done this. It's about what's the right answer.

That's the only thing we're trying to do because if we can on balance find right or answers, we'll do better for our clients. And that was, despite the, I was really resistant to reading the book, because I was just like, "What the hell is Bridgewater man?" Come on. But that's exactly what we're trying to do at my firm, because I'm a huge believer in the value of discussion, the value of conversation, the value of diverse viewpoints, testing each other, and then extracting hopefully better meaning from that than any individual could have arrived upon with their own more limited set of analytical underpinning. So, Dalio's Principles looks excellent.

Patrick: [01:01:26] Fantastic. Well, last time we were artificially cut short, so I'm glad we were able to fill in all the gaps this time. Thanks again for your time.

Pat: [01:01:32] No. Thank you for the great questions.

Transcript by @ScarrottKalani