John Harris - Resilience and Imagination - [Invest Like the Best, EP. 230]

My guest today is John Harris, Managing Partner of Ruane, Cunniff & Goldfarb, where the flagship Sequoia Fund has an incredible 50-year track record running a highly concentrated portfolio of equities. In our conversation, we cover John’s approach to finding businesses that can be owned for the long-term, what goes into their diligence process, and the importance of resilience for investors. I think many of the stock pickers will enjoy many of the points on good management, good businesses, and using imagination. I hope you enjoy my conversation with John. For the full show notes, transcript, and links to the best content to learn more, check out the episode page here. ------ This episode is brought to you by Tegus. Tegus has built the most extensive primary information platform available for investors. With Tegus, you can learn everything you’d want to know about a company in an on-demand digital platform. Investors share their expert calls, allowing others to instantly access more than 10,000 calls on Affirm, Teladoc, Roblox, or almost any company of interest. All you have to do is log in. Visit tegus.co/patrick to learn more. ------ This episode is brought to you by Paxos. Paxos offers your customers crypto buying, selling, transferring, and more with easy to integrate APIs. Whether you’re a small fintech or a large financial institution, Paxos takes care of everything in the backend – from licensing and compliance to custody and exchange. You can start offering crypto to your customers within months. To learn more, visit paxos.com/patrick. ------ Invest Like the Best is a property of Colossus, Inc. For more episodes of Invest Like the Best, visit joincolossus.com/episodes. Stay up to date on all our podcasts by signing up to Colossus Weekly, our quick dive every Sunday highlighting the top business and investing concepts from our podcasts and the best of what we read that week. Sign up here. Follow us on Twitter: @patrick_oshag | @JoinColossus Show Notes [00:03:48] - [First question] - How markets undervalue long-duration growth of companies [00:07:21] - Why should one even do DCFs at all [00:10:01] - Defining homework when studying a business and what getting better as you do your homework tends to look like [00:12:24] - How the market still underestimates how the quality of a company reduces risk [00:15:09] - Reinvestment opportunity and risk and why they’re important for long term returns [00:17:14] - Lessons learned owning Google stock options for over a decade [00:22:02] - Skill versus luck when it comes to investing psychology [00:24:32] - Perspectives on big market cap companies in a portfolio when success often comes from smaller-cap non-linear growth [00:26:47] - Features of the current market landscape that he finds interesting [00:31:24] - What buying behavior looks like in the demand side of the business equation [00:34:10] - Discovering a company that served the customer and was a delight to discover [00:37:58] - Analysing getting one's hands dirty to get a competitive advantage in serving the customer [00:39:24] - The hardest episode of his investing career and what he learned from it [00:43:03] - Reasons why a company succeeded after doing a deep dive but not buying in [00:43:54] - One of the CEOs he finds most remarkable [00:47:20] - Examples of businesses where scale isn’t the driver of competitive advantage [00:49:50] - A company they owned that did well but didn’t have the strongest company culture [00:50:56] - His view on the investment industry today writ large [00:52:16] - Ways investors could expand their imagination when analyzing businesses [00:53:07] - The kindest thing anyone has ever done for him

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

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• 0:43Patrick O'Shaughnessy?

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• 1:26Patrick O'Shaughnessy?

  just $300 per call, not the $1,000 or more that others charge. If you're curious about Teegus, call the top performing investment manager you can think of. They're probably already a Teegus customer and they'll point you in the right direction because customers, myself included, love Teegus. Visit tegus.co/patrick to learn more. To hear more about how investors use Teegus, stay tuned at the end of the episode where I talk to Elliot Turner of RGA Investment Advisors, a longtime Teegus customer. This episode of Invest Like the Best is brought to you by Paxos. I have personally interviewed Paxos's CEO Chad Cascarilla on this podcast before and I'm excited about how they're changing the crypto landscape. Whether you're a small fintech or a large financial institution, with Paxos crypto

• 2:09Patrick O'Shaughnessy?

  brokerage, you can offer your customers crypto buying, selling, transferring and more, all with Paxos's easy to integrate APIs. Paxos takes care of everything in the backend from licensing and compliance to custody and exchange. You can start offering crypto to your customers within months. I've gotten to know Paxos over the years and have been personally impressed with their track record. With clients that include PayPal, Venmo, Revolut, and Bank of America, they're the most trusted infrastructure provider for crypto and blockchain. I'm excited that more fintechs and banks are starting to offer crypto features and Paxos Crypto Brokerage is the best way to get to market quickly and safely. To learn more, visit Paxos.com/Patrick. That's P-A-X-O-S.com/Patrick.

• 2:55Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at joincolossus.com.

• 3:22Speaker 01

  Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast.

• 3:47Patrick O'Shaughnessy?

  My guest today is John Harris, managing partner of Ruane, Cunith, and Goldfarb, where the flagship Sequoia Fund has an incredible 50-year track record running a highly concentrated portfolio of equities. In our conversation, we cover John's approach to finding businesses that can be owned for the long term, what goes into their diligence process, and the importance of resilience for investors. I think many of the stock pickers out there will enjoy many of the points on good management, good businesses, and using imagination. I hope you enjoy my conversation with John Harris.

• 4:21Patrick O'Shaughnessy?

  So John, I was toying with where to start our conversation. Something your team sent over stood out in all the materials that I reviewed prepping for our chat today. And there are these three interesting things that you say markets tend to do. I'm going to list them and I'd love to spend some time on each of them because I think they're unique and interesting. First is undervalue long duration growth potential. Second is underestimate how quality reduces investment risk. And then I really like the third one, ignore how growth and quality reduce reinvestment risk. These are three views of fault lines in markets in terms of how they price things. And could be a great jump off point for our discussion about all things business and investing. So we'll start with that first one. What do you mean by markets tend to undervalue long duration growth potential of companies?

• 5:02Speaker 02

  Well, I think it just has a lot to do with the fact that it's hard to stare into the future and know what you're looking at. We're basically in the business of predicting the future and predicting the future is not easy. And the further you go out into the future, the harder it is to predict. And I think the natural, and I think to some extent understandable, human bias is to apply some basic heuristics as you look further and further out into the future to simplify what is inherently incredibly complex picture. So the most common heuristic that I think people apply when they start trying to estimate the way a business will perform over the long term is they assume some kind of asymptotically declining rate of growth.

• 5:44Speaker 02

  If the business is growing at 15% a year today, then it'll probably grow at 12% next year and then 11, 10, 9, 8, 7, 6, 5, 4, 3. That's how typical like DCF looks. And then maybe the profit margins of business, maybe sometimes you just make a default assumption that they stay flat. Maybe you assume like slight rises over time, but it all tends to be very linear. And it's interesting that people make these simplifying assumptions because pretty much anybody who's invested capital for a significant period of time will tell you they've, they've learned from experience that the world is nonlinear. It never works the way you draw it up in a DCF. Everybody knows that. And yet, nobody seems to assume it because it's just scary. You don't know what the future is going to hold.

• 6:28Speaker 02

  And there are some businesses where I think our experience has shown us and that we believe.

• 6:37Speaker 02

  If you do enough homework and you get to understand the business well enough every once in a while, and you know, not always by any stretch, but every once in a while, you can find a business where you can have confidence that actually the growth is not going to follow that asymptotically declining curve and it's going to sustain at a high rate for a long period of time. There are some businesses also that accelerate for one reason or another. That's a very bold prediction to make, and I think it's very hard for the human psyche to sort of wrap a brain around the idea of making that bold bet. But there are a lot of fortunes in our business that I think have been made by people who've been open minded enough to appreciate scenarios or situations where at least that's

• 7:22Speaker 02

  possible. And I think have understood that, hey, I won't always be right. But if I can find situations where the possibility of accelerating or sustained high growth exists, and I can make investments in those businesses in an asymmetric way where if I'm wrong, I won't be too wrong. But if I'm right about that potential for accelerating growth, I can be really, really right. You assemble a portfolio of those, you can do pretty well.

• 7:54Patrick O'Shaughnessy?

  So if, as you point out, and as the data shows, returns are nonlinear, like most of the return in any equity distribution are explained by the absolute top winners, and none of those scenarios that drive those returns would ever show up in a DCF. It stands to ask the question, why do DCFs at all? Are they useful at all? Or are they a giant waste of time?

• 8:13Speaker 02

  We don't do them. You know, I think to each their own, right? I mean, for some people, I think that's a very useful construct, and probably the people who use them well would say, look, I appreciate while I'm doing the exercise that this is not what the future is going to look like, but it helps me to conceptualize the business or understand this or that or the other thing. And I'm super, super respectful of that because I'm a big believer that investing is way more about the heart than the mind. And you need to find a way of doing what we do and looking at the world that is comfortable for you and works for you. And I think it's different for every person. There is no right way. And if that's part of your right way, then great. But at least for me, and I think for a lot of them, speaking for a lot of people on our team, we just don't do that.

• 8:58Speaker 02

  I mean, I very rarely build a model, frankly. The extent of the Excel work that I do personally as an investor and have done for a long time is, I tend to like to spread out historical numbers. It's just helpful for me to understand sort of how a business works, what's driving the profits, what are the key financial drivers of a business or a business model. But I very rarely make forward-looking models. And if I do, they're super simple. Never do DCFs, don't do screens. Because I think one thing I've learned, and I think as a firm we've learned, is that the numerical part of what we do is the easy part. Looking at a bunch of numbers on a sheet of paper and sussing out what might be an interesting investment,

• 9:43Speaker 02

  that's easy. A lot of people can do that. What's really hard is to figure out through exhaustive qualitative research, is to figure out whether what looks so good on paper is really as good as it looks. And a lot of time, the closer you look, the less attractive the picture gets. It's like in one of the people, like the mosaic rule. I'd say one big pattern match for us for successful investments is when you look closer and closer and the picture actually looks better. That's very rare. The overwhelming majority of the cases, we start to really dig in and do our homework. And the situation that you are so excited about starts to look less and less appealing. Every once in a while, the closer you look, the better the picture gets.

• 10:28Speaker 02

  And that's typically, I'd say, our batting average in those situations tends to be super high.

• 10:34Patrick O'Shaughnessy?

  Let's talk through that process. What does homework mean and look like on average? And what does getting better as you do your homework tend to feel like or look like?

• 10:42Speaker 02

  It means trying to understand a business from every angle, thinking about it the way a long-term business owner would think, rather than a holder of a stock. Those are two very different mindsets. I mean, when we talk to executives at companies that we own or invest in, We typically describe our work as the kind of work they would do if they were making an acquisition, where you're not approaching whatever you're thinking about from a standpoint of going on dates, you're thinking about getting married. And so, we try to talk to everybody we can talk to who understands that business, that industry, how it competes with other businesses, why it's grown in the past, who are the people

• 11:24Speaker 02

  running the business, what has to happen for it to thrive in the future, what are the risks, what should we be worried about. We'll talk to people, we'll go to trade shows, we'll read whatever we can read. And eventually, you tend to reach a point of diminishing returns where you keep hearing the same things over and over and over again, and then you pretty much know you've done all your homework, or as much as you can do. I think that's a process that our industry has gotten better and better at over time. And that's the nature of the world, right? We live in a competitive market, in a competitive capitalist economy, where everybody gets better at everything every year. And it's frankly, not just in business, it's in life, it's in sports, it's in whatever.

• 12:07Speaker 02

  And so, if you want to keep competing in that world at a high level, you have to get better and better and better every year at doing that basic process of understanding businesses and sussing out whether those numbers you see on the page are as good as they look. And that means finding new sources of information, finding different ways of approaching people, and cultivating human sources. It means using different alternative data sets. It means expanding your circle of competence, and your ability to look at different types of businesses and business models. It means broadening your aperture to encompass different geographies.

• 12:49Speaker 02

  It can mean all kinds of things, but in a competitive world, the one thing I'm certain of is you need to get better every year, because somebody else is.

• 12:56Patrick O'Shaughnessy?

  The second great feature of what you think markets maybe are fault tolerant on is the idea of underestimating how quality reduces investment risk. So I'd love to focus, if we can, on whatever unique angles you have on this idea. Every investor, like you never see a pitch deck that says, "We buy junk companies." Maybe some momentum investors do that inherently. So everyone says quality matters, but I think what you're saying here is even then, the market still underestimates how that reduces risk. Talk us through this concept in some detail.

• 13:25Speaker 02

  So I heard someone say this recently, and I really like the way they put it. Assuming qualitative equivalence in investing is a dangerous thing. I think that's really true. You can look at, you know, two businesses on paper by the numbers, and they can look very similar. Depending on what they do and who's in charge, they can be extremely different enterprises with extremely different future trajectories. So again, the numbers are the easy part. What's behind the numbers is where all the nuance is. And, you know, I think 30, 40, 50 years ago in our business, you could do paint by numbers and get a very good result. But people are observant. And if simple constructs for success work, they get copied.

• 14:09Speaker 02

  And eventually, paint by numbers doesn't work anymore. And you have to appreciate the nuance behind the numbers if you want to keep getting that successful result as you evaluate those numbers. So quality matters. Why does quality reduce risk? Well, first of all, the one thing you know when you're in the business of predicting the long-term future, what's going to happen three, four, five, seven, 10 years into the future? And those are just incredibly hard questions to answer. And I would say experience is definitely helpful in this business. But at the same time, with each passing year, the longer I do this, the less confident I get in my own ability to predict what the future holds. 10 years is just a really long time.

• 14:53Speaker 02

  And no matter how much homework you do upfront, the one thing you know for sure is there are going to be surprises. And I think one thing we've found repeatedly over 50 years of experience is that Ultimately, people run and build businesses. And if you're with the right people and the right teams and the right cultures, the surprises, the inevitable surprises tend to be good ones. And if you're with the wrong people, they tend to be bad ones. So I think a lot of what we perceive as business quality and a lot of the, a lot of what goes into our judgments of what is or is not a quality business boils down to people and culture.

• 15:33Speaker 02

  And we get way more comfortable making those assumptions about what the future holds when we're backing people who we like and trust.

• 15:42Patrick O'Shaughnessy?

  Obviously, people are the drivers of capital allocation in the business and therefore of reinvestment, which brings us to the third thing, that markets tend to ignore how growth and quality reduce reinvestment risk. So reinvestment risk, I'm not sure is a topic I've specifically drilled in on, on the show before. Talk about reinvestment opportunity and risk and why that's so important to long-term returns.

• 16:03Speaker 02

  I think it just goes back to the whole idea that this is really hard to do. And it just gets harder every year. It's really hard to be right. One way to make the game of trying to make correct predictions about the future a little easier is just to not have to make so many of them. A lot of what we do is effort in the service of trying to minimize the number of questions that we have to answer. Try to focus on the easier questions rather than the hard ones. And one way to minimize the number of predictions that you have to make, and frankly, minimize your number of opportunities to be wrong,

• 16:46Speaker 02

  is to own businesses that you can own for a really long time. Because if you own businesses that have long-duration opportunities, run by people who you can trust to run them for you over long periods of time, with really dominant competitive positions that you can trust to stay dominant over long stretches, you just don't have to make so many decisions, right? Instead of buying 15 stocks every year, maybe you only have to buy one or two or three. And it's a lot easier, I think, we think, to be right. One or two or three times a year than to have to be right 15 or 20 or 30 times a year. You know, when we say that quality and duration reduce investment risk and reinvestment risk,

• 17:29Speaker 02

  I think that's what we mean because when you have a successful investment, you sell it, you got to find something else to do with the money. And I hate to say it because, you know, it doesn't sound terribly confident, I guess, alluring in a client presentation, but every time you sell something and have to make a new investment is just another opportunity to be wrong.

• 17:47Patrick O'Shaughnessy?

  One of the cool things about the nature of your portfolios is how long you've actually owned stocks. So some of them you've owned 10 plus years, some well-known names in there, some lesser known names in there, but the firm walks the talk of long-term ownership, unlike almost any other firm out there of its size. And so I'd love to dig in on some examples of lessons learned from owning some of these businesses for such a long time. I think, for example, you've owned Google for 11 or 12, forever, right? But like basically the entirety of the company's public history. With a company like that, it's up to you to pick some of the companies and the lessons that they've taught you. I'm as interested in the lessons you've learned owning something like that for so long as the particular business, if that makes sense.

• 18:28Patrick O'Shaughnessy?

  So owning an asset like Google across a lot of change and volatility in the world for 11, 12 years, what has something like that taught you?

• 18:37Speaker 02

  Uh, I think to have a healthier appreciation for how right things can go when they sometimes go right. It's very common in our business to talk prudence. Rule number one, don't lose money. Rule number two, don't forget rule number one. Those are great rules because as an investor, I have a list of regrets that is literally a mile long and it just gets longer every year. And I have to tell you, there's not a single thing on that list, I don't know, anywhere in the top 20, 30, 40 regrets that involves something we actually did where we lost money.

• 19:16Speaker 02

  All of them are the things we either didn't do or the businesses that we sold too soon. And it sort of stands to reason because that's the way, I mean mathematically, that's the way the stock market is set up. You can only lose what you put in and that hardly ever happens. I've done that a couple of times too, but much more likely is if you're wrong, you're going to lose 10, 20, 30, 40. We've had embarrassing situations where it's been more like 50, 60, 70%. As painful as that is, it's way, way worse to miss the situation where you made five, six, seven, 10, 12 times your money. I guess emotionally, in some cases, they don't

• 19:59Speaker 02

  seem as painful because you didn't actually lose money. But opportunity cost is real, and it can be enormous in this business. I mean, again, just mathematically, your ability to lose money in opportunity cost terms is way, way greater than your ability to lose money in actual, you know, I made the investment and it went down. Owning businesses like a TJX for, I think we owned TJX from beginning to end for 20 years. Fastenal is a business, a wonderful business. We own for probably like something on the order of 15 years. Google, as you pointed out, 10 years. Mastercard, we have made at Ruwanki Nif over, well, you know, one thing 50 years gives you the opportunity to do is to screw everything up every which

• 20:43Speaker 02

  way you can do it and then do it multiple times over and over again. And we, we've done it all. And I would say it's probably indisputable that the single biggest mistake we ever made as a firm was not buying more Mastercard on the day we bought it after the IPO. I think if you took a poll of our clients, very few of them would point to that. They, they would all have their episode of where we actually bought something and it went down and it was an embarrassing result. And that was my mistake. It was me in the office with the person who managed Sequoia Fund at the time, and I was the analyst on Mastercard. And we had tried to get an allocation in the IPO and we didn't get it. We're like

• 21:27Speaker 02

  the world's worst Wall Street clients and we never get allocations in IPOs. But it was sort of a failed IPO and the day the, the company went public, it basically traded for the offer price. And so we were buying it in the aftermarket. And we had all these things we were worried about and I was worried about. And I, I, I can't remember what they were because I've tried to purge the whole episode from my mind. Basically, we put 1% of Sequoia Fund into Mastercard. And I think we probably made over 100 times our money on that investment. If we had just put a single percentage point more and held it as we did for, I don't know, well, over a decade. The amount of money we would have made is almost hard for me to contemplate.

• 22:08Speaker 02

  So I guess what long-term ownership of great businesses teaches you over time is that every so often, things can go right and sometimes they can go really, really, really right. And capturing a few of those situations over your career as an investor is just way more important than the ones that, you know, the mistakes, the overt mistakes that you make where it goes down 20 or 30%.

• 22:34Patrick O'Shaughnessy?

  What is the skill there? We've already talked about some of these funny features like hold for a long time, things are nonlinear, things can go more right than you think. Is the skill re-underwriting the business well? Is it just patience? What is skillful versus luck in letting that strategy work?

• 22:52Speaker 02

  Well, I think you said a lot of things. Patience is definitely part of it. A big part of it is the ability to keep an open mind and the ability to maintain your imagination as an investor. It's way easier for people to think about what can go wrong than what can go right. And I think it's very hard to conceptualize not just what can go right, but how right can it go? We do a better job of guessing at what could go wrong than what could go right. I think that's true of the vast majority of investors. There definitely have been some fortunes in our business made by people who are just very, very diligent about thinking about what can go wrong and protecting themselves from it.

• 23:37Speaker 02

  There's money to be made from that mindset and discipline in our business pays. There's no doubt about that. I've never seen a study done on this or hard numbers, but I'd bet you reasonably good money that there have been more investing fortunes made from imagination than there have from discipline. You need a basic level of discipline to do what we do well. You have to operate with common sense. You just can't do patently stupid things. But I think, once you clear that bar, you can be incredibly well compensated for

• 24:13Speaker 02

  Having an open mind and a healthy sense of imagination. If you look at our 50-year experience, there are probably 10 investments that have driven the vast majority of the returns, where we found a really great business run by really great people. We paid a sensible price for it. In some cases, it was a great price. In some cases, it was not demonstrably great when we did it. But the business just really performed. And not only were we right, but right meant really, really, really right. And we made five, seven, 10, 20, 100 times our money. And those investments are really the story of Ruwan Kniff.

• 24:56Speaker 02

  And all the stupid stuff we did along the way, where we bought it, went down, and we sold it, you know, and the fullness of time is not terribly consequential.

• 25:04Patrick O'Shaughnessy?

  It's a fascinating observation that all the mistakes or all the regrets are things you didn't do. And as I look through the portfolio today, like I said, there's the Facebooks and Googles of the world and something interesting, maybe we could talk about like Taiwan Semiconductor, which is a fascinating company. I'm curious, as you think about some of these well-known names, especially ones that are very big in market cap, and mapping it back to the observation that it's the big multiples of capital that have driven the success, how do you square those two things? So you've got some of the biggest companies in the world in the portfolio, and then you've got much smaller companies. If the success comes from these big nonlinear outcomes, how do you think about the trillion-dollar companies that might be in the portfolio today?

• 25:45Speaker 02

  Look, I think it's probably unlikely that the Facebooks or the Taiwan semiconductors are the next, you know, 25 times your money, open-ended success. But I think what's true of small businesses can also be true of big businesses, is the market can still underestimate the

• 26:09Speaker 02

  Quality, growth potential, and ultimately, you know, profit potential of a big business, just like it can a small business. And I think one thing we've all learned over the last decade is that in an economy that's based increasingly on human capital rather than physical capital, it's possible to build these massive businesses that can ultimately turn out to be just way bigger and more profitable. Businesses in this digital world just have the ability to get bigger, scale faster, and be more profitable than the leaders of, you know, the prior generation.

• 26:51Speaker 02

  And so I think that's part of what you've seen with the Facebooks and the TSMCs and the Googles and so forth. And trees don't grow to the sky. I think we're very cognizant of that fact, but I think in spots, if you pick your spots very carefully and you do your homework very, very carefully, you can find situations, even with these huge businesses, where the market just doesn't fully appreciate how great grade is and how long, long duration growth can extend.

• 27:19Patrick O'Shaughnessy?

  The state of the world today is fascinating. I like the idea that physical is like a dampener on nonlinearity and that in the absence of the physical constraints, you could get even more nonlinear outcomes in purely digital. That's, I guess that's definitely been the case. What is most interesting to you in terms of features like that one of the current market environment? And that could be not just prices, but just like sorts of businesses that are being built, major trends or frontiers in technology or anything else, business models. What about the current landscape has you most curious and reading on a Saturday morning?

• 27:54Speaker 02

  One thing that's on my mind increasingly is that a lot of what you just talked about, I think, has become the conventional wisdom. And there's a generation today that is driving markets and allocating capital and that is basically behind what you see on your screen every day today, that has watched a certain type of business flourish repeatedly, has seen a certain type of investment work repeatedly, have seen certain industries drive success both in business and investing.

• 28:37Speaker 02

  And that has operated from beginning to end against a backdrop of essentially free money. And one thing I know is that the world changes. And the conditions that you've seen over the last 10 or 15 years, they could very well extend for another 10 or 15 years, or they might not. And so, one thing that we think a lot about as a firm, and I think increasingly, you know, as we've watched the landscape unfold over the last few years is, we really try to be diligent about not playing one note. It's just such an unpredictable world. It's so easy to be wrong. Things can change in such surprising and nonlinear ways

• 29:23Speaker 02

  that I think one way to protect yourself is to just own a lot of different businesses that do a lot of different things in a lot of different places. And not be all in a single type, a single business model, a single industry, a single geography. We just like to play a lot of different notes. Now, the one big implication of that preference, and we say this to clients all the time, is we are very unlikely to be your best single money manager in any given year. Because there's always going to be the firm or the person that's all in whatever that thing is that's working. And we all know what those things have been. I wish, you know, we had just filled the fund with cloud software five years ago, right?

• 30:04Speaker 02

  We would look like complete geniuses, just like if you went back to 2004 and you had filled your portfolio with Phelps Dodge and Cleveland Cliffs and Mattel Steel. And nobody remembers that stuff anymore. But those were the drivers of the go-go portfolios of the mid 2000s. It was anything that was exposed to the emerging market super cycle. Trends come and go. The world changes. And so, we may not be your best manager in any given year because we're not going to be all in those businesses, trends, geographies, whatever, that are leading the market. But what we want to do is make a lot of really well-informed and thoughtful decisions.

• 30:48Speaker 02

  Every year, within a framework of basic common sense. And we want to apply that process and that framework to a lot of different businesses in a lot of different places, doing a lot of different things. Hopefully with a really healthy dose of creativity around the ideas that we generate. And we know that if we do that well enough for long enough, we're going to get a good result. And what's really important is we're going to get a resilient result. Whatever happens in the world, whether what's happening today keeps happening or whether it changes. Whether there's a huge curve ball like we saw last year. If you own a concentrated group of high quality businesses run by high quality people

• 31:33Speaker 02

  that you've evaluated really carefully, that you know really well, and that you've bought pursuant to some kind of just commonsensical framework around valuation. You do that year in, year out, rinse, repeat, rinse, repeat, and a little better every year than you did the last year. The odds of getting a good result are really, really high, come what may.

• 31:56Patrick O'Shaughnessy?

  Can you describe what you've learned, especially through this period, about how, what I'll call buyers, or the demand side of any business equation? So consumers and/or businesses that are buying the products of the companies you own? How their behavior looks similar or different to your entire history as a career as an investor? I look at the portfolio, I see things like, you already mentioned some of the technology firms, but Disney and Netflix have been companies you've talked about in the past, that sort of modern streaming entertainment companies. It seems like it's well tuned to how people buy things, whether that's consumers or businesses. What have you learned there more recently? What's interesting to you about the demand side of the business equation in the last couple of years?

• 32:36Speaker 02

  One thing we're really attuned to, and I think- We're a little bit ahead of our time as a firm being attuned to was how important it is to own businesses that really do right by their user. People talk about sustainability in business. That is just a key element of building a sustainable business that can thrive over long periods of time and where you as an investor can have that confidence to make a truly long-term investment. You were asking earlier, where do you get the confidence to own a business over the inevitable ups and downs of a 10-year holding period or a 15-year holding period? One thing is definitely people. I would say another thing is it's just a lot easier to live with businesses that delight their user.

• 33:19Speaker 02

  That's a lot more rare than it sounds, but a business that delights its user, especially in a way that's really hard to replicate, that's an easy thing for us to get behind. And those typically tend to be businesses that inspire the confidence that you need to make a bold assumption about what the future holds that might be at odds with the market's assumptions. And ultimately, as an investor, if you want to earn a premium return, I think it was Michael Steinhardt coined the phrase, you have to have a variant perception. The market is really smart. Most of the time, the market is pretty good at sussing out what the future prospects of a business are. And I think the market probably gets better and better and better at it over time.

• 34:04Speaker 02

  And so it's no small thing to stick a stake in the ground and say, I have a different point of view about what the future of that business holds. Maybe I agree with the market about what it's going to do for the next couple of years, but I think that high rate of growth that you're going to see for the next couple of years actually is going to sustain way longer than the market thinks. That's a bold bet to make, and you need something you can hang on to and hang your hat on and believe in that gives you the confidence to make that bet. I think. In a lot of cases for us, it's management, it's culture, and then it's a product or a service that is really hard to do or imitate that delights a user.

• 34:42Patrick O'Shaughnessy?

  Can you give an example of a discovery experience of yours personally where you found that delight? I'd love to just put a story around this concept where you were digging into some business or service and you found not just a good service or product, but something truly great and what that felt like to discover?

• 35:00Speaker 02

  Wayfair is an interesting example of a business where a lot of the best businesses, there's a flywheel effect that happens where you delight your user. As a result, you're able to earn a premium return on your interaction with that user, a high profit margin, a repeat sale, whatever it is, that allows you to reinvest in making that proposition for the user even better. And as a result, more sales, more profits, more investment, and the business and the user proposition just gets better and better and better over time. That's a really tough thing to compete with them. And that's the story of Walmart over 40 years, basically.

• 35:39Speaker 02

  More scale, more efficiency, lower prices, more customers, more scale, more efficiency, lower prices, again, again, again. That's the recipe for a business that just gets better and better over time and that creates more and more distance between it and its competition. We love situations like that. Wayfair is, you know, I think a classic example of that, where they were early to a very big market. They built a user proposition that was attractive. And then as it got traction with their user, they just were relentless about reinvesting whatever contribution they got

• 36:20Speaker 02

  from their existing business to make their future business even better. It was more selection. It was more investment into logistics. The early insight at Wayfair was that they were really insightful Google marketers and they realized that if you were thoughtful about the way you advertised on Google, basically you could acquire customers at low cost. And then if you showed them a really wide selection, they were likely to convert at attractive rates relative to what you were investing in advertising. And you know, you got more customers and more customers enabled you to invest more in scale

• 37:02Speaker 02

  and selection. And eventually, they got to a point where they realized they could also start investing in helping their marketplace to function better. They started with a market where the seller interacted directly with the user and everything was drop shipped. And then they realized, well, that was sort of a suboptimal logistics experience. And if we take it upon ourselves to play a role in the movement of goods around the marketplace, we'll create a better customer experience. It's a very expensive thing to do. A lot of people who run a marketplace don't want to do that. They just want to sit back and collect the capital light profit and let the users and the sellers transact between themselves. They realized if they got their hands dirty and made

• 37:46Speaker 02

  big investments in the backend of their marketplace, they could create a much more attractive proposition for both buyer and seller. And as they did that, they basically just made the business better and more attractive to both sides of the market. And as you do that, you get more sellers, you get more buyers, and then you're off to the races. So I think that was a situation where investing really aggressively in a more attractive user proposition brought more users, buyers, sellers to a marketplace, made it more attractive, and got a flywheel starting that ultimately allowed them to achieve escape velocity and just create a ton of distance between them and their competitors.

• 38:30Patrick O'Shaughnessy?

  Do you think this idea of getting one's hands dirty pervades the portfolio? Like, is that something that you see most of the time in these great long duration businesses that they're willing to do that kind of behind the scenes dirty work to make the user proposition better?

• 38:46Speaker 02

  Well, I think as a business, if you want a different result than your competitors, you need to do something different. There are a lot of different sources of competitive advantage, but I think one interesting one that we've had success backing over time is, we like businesses that are hard, that require a lot of capital or a lot of expertise in order to provide a differentiated user experience, because hard is hard to copy, right? You know, I think of something like a UnitedHealth. The network and the scale and the data and the systems and the experience that goes into

• 39:30Speaker 02

  building the engine that they've built there, it's incredibly hard to replicate. I mean, it would take you billions and billions and billions of dollars and many, many years to replicate what they've built there. When you build an edifice like that, you earn the right to succeed. And so we like businesses like that. We like things that are hard.

• 39:56Patrick O'Shaughnessy?

  What in your experience has been the hardest episode of your investing career? Like what period or individual episode stands out as the most brutal? And what did you learn from that most brutal period?

• 40:07Speaker 02

  We run a few different pools of capital. Like Romaine and I, we're best known for Sequoia Fund or Mutual Fund. We also run a couple of private partnerships that are basically structured as hedge funds. And I run one of those. And the way our documents were written, we always had the ability to sell short. And while that was never a core part of what we did, there was a period a long time ago where we found what we thought was really interesting investment. So this is going back to 2007, 2008. It was a period where Porsche had made investment in Volkswagen. And we really liked Porsche's business.

• 40:46Speaker 02

  And if you were able to hedge out that investment that Porsche had made in Volkswagen, the stub that you owned in Porsche was trading at what we thought was a really attractive price. So we sort of made an exception to our rule where we bought shares in Porsche and then we shorted shares in Volkswagen in proportion to the investment that they had. And it seemed like a really sensible thing to do. And then, as often happens in markets, something you'd never expected to happen. And there was a very weird sort of battle for corporate control at Volkswagen that actually has echoes in history. If you go back a hundred years to a sort of similar episode that happened in the railroad industry in the United States.

• 41:29Speaker 02

  But anyway, the result, without going into a lot of detail, of that battle for control of Volkswagen is that those shares that we shorted went up 10 times in one week.

• 41:41Patrick O'Shaughnessy?

  I remember it well.

• 41:43Speaker 02

  Yeah. And in the span of five days, I lost a third of my investors' capital.

• 41:49Patrick O'Shaughnessy?

  Wow.

• 41:50Speaker 02

  And we were just starting out. We had not really earned the right to take that kind of loss. You don't ever earn the right to take that kind of loss as an investor, but that was incredibly painful episode. We ended up in 2008, down 53%, I think. It was our first full year of operating the fund. Those were dark days. What's interesting is here we are, a bunch of years later, fund has done well. I don't think I'll ever completely forget that episode, but it's definitely receded into the background. And if I go back to that list of regrets we talked about earlier, I never, ever thought I would say this,

• 42:34Speaker 02

  but that's not even on the list. There have been so many profound money-making opportunities that we've come across from then to now, couple of which we've done, way too many we haven't done. Those are all higher on the regrets list than Volkswagen. Because it's interesting, we took that big loss during what turned out to be an incredibly opportunity-rich environment. And as painful as it is to be down 53% in a year, if you're down 53% in an environment that's incredibly opportunity-rich, where everywhere you look, there are chances to make three, five, seven, 10 times your money

• 43:18Speaker 02

  over the ensuing two or three years. You need to just mentally compartmentalize the fact that you were down, whatever you were down, forget about it and just focus on making the best of the opportunities that are in front of you. Because if you do that, the down 53 will be a distant memory in a few years and you'll do just fine.

• 43:35Patrick O'Shaughnessy?

  You've mentioned so many times now, the list of regrets that really are mistakes of omission. What do those most share in common? Like, what was typically the reason why you did a deep dive, you ultimately didn't buy, and then the thing did really well? Is it price? Is it something else?

• 43:51Speaker 02

  Always a failure of imagination, or almost always a failure of imagination, and an inability to fully appreciate how good good can be.

• 44:02Speaker 02

  I think a lot of people tend to conceptualize that in a different way, which is to say, I should have been willing to pay more. I was penny wise, pound foolish. I got hung up on valuation, whatever it is. Typically, that's just code for a failure of imagination. You didn't appreciate how long that business could grow at that rate, how profitable it could get, how much market share it could take. The way we like to say it is just how right right can be sometimes.

• 44:27Patrick O'Shaughnessy?

  When I say remarkable CEO, who pops most immediately to mind?

• 44:31Speaker 02

  One for sure is Mark Leonard at Constellation Software. What Mark has accomplished is just remarkable. And not just what he's accomplished, but the way he's accomplished it. Mark had a really profound insight, which, you know, again, gets back to this whole idea of having an open enough mind to appreciate just how good good can be sometimes. Mark was not the only person to have this insight, but there are a few people, most of them actually, interestingly enough, in private equity as opposed to the public markets in this case. But there was a small community of people who figured out, call it 15, 20 years ago, just how great a business software was.

• 45:16Speaker 02

  I think the market writ large understood that it was a good business, better than average, maybe way better than average. But there was this very small community of people. Mark would be one of them. The people at Vista Equity, Toma Bravo, a couple of other firms. They all came to realize that these businesses weren't just good. They were incredible and that you could buy a portfolio of them and pay more than people thought was probably reasonable. And if you ran them a certain way, you weren't buying them well. You were just stealing them. And I think a lot of the realization and the insight was around pricing power and profit potential

• 45:58Speaker 02

  of businesses that are just super, super sticky, especially niche software businesses where not only is the software inherently sticky, but there's just not a lot of competition. And you're, and you're doing something really important for your user. Mark just understood that at a really early stage before a lot of other people did and capitalized on that insight in a really brilliant way. You know, we have another CEO in the portfolio who I think where it's a similar story, Gilles Martin. At Eurofin Scientific, she all understood probably earlier than anybody in the world just how good testing and measurement businesses could be.

• 46:40Speaker 02

  You know, again, like Mark Leonard just went around and bottom hand over fist before anybody else really realized what he had figured out.

• 46:48Patrick O'Shaughnessy?

  Why are those businesses so good? I don't know that I know that one.

• 46:51Speaker 02

  Testing is a sort of scale and route density business. The way people know it in the U.S. is typically like LabCorp and Quest, where you have a facility that is mostly fixed costs. And if you layer enough volume onto your facility, it just becomes advantage from a unit cost perspective relative to the competition. And it's a great business because you're providing a service that your customer needs. They don't pay a lot for it. The cost of testing your typical product, especially a pharmaceutical product relative to the cost of the actual product is very low, but the importance of the test is very high.

• 47:35Speaker 02

  So you have pricing power and also reputation matters, right? By definition, especially the more important your product is, you want to have it tested by someone who's reputable. So if you have a brand and a reputation and a scaled cost structure, testing can be a really, really, really good business.

• 47:52Patrick O'Shaughnessy?

  Are there any good examples where there's not a lot of operating leverages, where scale isn't the primary driver of great competitive advantage in one way or another and in sort of the mature state of a business? It seems like it always comes back to supplier-demand side scale effects. What are examples that that's not true that you think are really interesting, if there are any?

• 48:13Speaker 02

  We used to own Fastenal. That's one of the most successful investments our firm ever made. And Fastenal is not so much a scale business as it's just a culture and a hustle business. It's an industrial distribution business, but it's branch-based, built around individual, personal selling relationships and just good old fashioned service, customer service.

• 48:39Speaker 02

  And that was a business where the value proposition always resonated, I think particularly for me, because I grew up in a business family where you had a family business and it was sort of a conglomerate. And one thing I appreciated, I think, from an early age about their business was it wasn't really doing anything special. You know, it wasn't like they had unique patents or some product somebody else didn't have, or some unique scale advantage. It was just impossible to copy. They were making bottle caps and alarm systems and building control systems that, you know, were not, I don't think hugely unique, but they just did what

• 49:22Speaker 02

  they did better than everybody else did. And it really tied back to the people who were running and building the business and the culture that attracted really great people to the business and brought them together and turned one plus one plus one into way more than three and allowed a talented group of people to realize their talent to the fullest. And that really is the story of Fastenal. It's just a business that is a result of a really special culture that the founder, Bob Kirland, built, was able to attract people who just hustled a little harder than the next guy and to retain them

• 50:06Speaker 02

  and to push them to do what they did just a little bit better every year than their competitors did. That's a powerful advantage in business. It's very hard to quantify. It's very qualitative in nature, but it's very hard to copy.

• 50:23Patrick O'Shaughnessy?

  Is there any example of a business that you did really well in and owned for a long time that had a mediocre culture?

• 50:29Speaker 02

  I'd say we have a definite bias toward really excellent management teams because they just reduce the uncertainty involved in making inherently deeply uncertain decisions.

• 50:41Speaker 02

  But I think you can develop enough confidence to make those long-term bets about the future without truly special people and a special culture, so long as you have a really special business. And I think there are some businesses that are so good, you don't need really special people. I mean, the A number one example in our portfolio in history would be Mastercard. It had different generations of leadership over the period that we owned it, and I think some were definitely better than others. But I wouldn't say that there was a special culture or a really awesome management team there. But it's just one of the best businesses the world's ever invented, and you didn't need great people.

• 51:19Patrick O'Shaughnessy?

  You mentioned that Ruane kind of has been around for 50 years. That's a long time for an investment firm that's specialized and focused and runs concentrated portfolios. What is your view on the investment industry? So if you just turn all of what you've learned about business and apply it to our own industry, what do you think about it today?

• 51:35Speaker 02

  I guess one thing that we feel strongly about is that there still is and always will be a place for active management in the equity markets. And the idea that the market just becomes more and more efficient and it's harder for active managers to earn a fee, earn their right to clients' money, we just don't see that. I think the world changes and the cadence of opportunity can change. I think we've definitely noticed that over time, opportunity has become a little more episodic and a little bit less idiosyncratic than it used to be. It's changing a little bit back now. I'd say that trend

• 52:20Speaker 02

  feels like it reached its apex a few years ago, and it's a more idiosyncratic market and a less correlated market today than it was, I'd say, two or three years ago. But if I think of the quantum of opportunity that's available to firms like ours, the alpha that's out there in the markets, there's still More than enough of it for people like us to continue doing what we've done in the past.

• 52:48Patrick O'Shaughnessy?

  You've mentioned several times how important imagination is for investors. What do you think the best way is for would be your existing investors to expand their imaginations?

• 52:58Speaker 02

  Investing is way more about the heart than the mind. It's just a fact that there are so many super smart people and so many super impressive resumes in our business. And there are just not that many great investment in investing records. So what we do is about way more than IQ points, but there are a few temperamental traits that can really take you a long way in markets. And I think you can definitely train for them, accentuate them, improve them. But I think at some level, it's just got to be there. And if it's not, it's it's hard to teach just from scratch.

• 53:40Patrick O'Shaughnessy?

  I think maybe we'll call the episode resilience and imagination. I like that combination of characteristics. I've really enjoyed our conversation. I ask everyone the same closing question. What is the kindest thing that anyone's ever done for you?

• 53:52Speaker 02

  It's probably not one person. It's probably my parents and my wife. They've given me what I think is the greatest gift any person can get, which is just truly unconditional love. And the knowledge that no matter what happens in the big, brutal world, you can walk through that door every day and somebody's going to love you no matter what. It's a gift that, you know, my wife and I have really tried hard to give to our kids. Cause I just, you know, it's a tough world. Stuff just goes wrong all the time. You make mistakes. Fate can be brutal.

• 54:35Speaker 02

  And to have a place you can go and people you can go to where you know, no matter what happens, they love you. It's like a warm blanket. When I was early in my career, I was looking for some career advice. And I was lucky through another family member to get a meeting with Michael Steinhardt. A long, long time ago, when he was still in business. At the end of the conversation, I sort of asked him for some just general advice. And he said, just marry the right girl. He said, "You can pretty much screw everything else up in life if you get that

• 55:15Speaker 02

  one decision right." And he was on to something there. I might broaden it a little bit to if you have the right wife and the right parents. But I think if you can just find that bedrock of family support and love, you're sort of ready for anything.

• 55:33Patrick O'Shaughnessy?

  Wonderful place to close. Couldn't agree more with the sentiment. This has been so much fun today. John, thank you so much for your time.

• 55:39Speaker 02

  Really enjoyed it. Thanks, Patrick.

• 55:42Patrick O'Shaughnessy?

  This episode was brought to you by Tegus. In this five-part mini-series, I sit down with Elliot Turner, the managing partner at RGA Investment Advisors, to talk about how he discovered Tegus, how Tegus helps him with his investing process, and how Tegus has made him a better investor. In this week's episode, Elliot and I discuss how Tegus' platform helps him build a deep understanding of a business and why he values former employee and customer opinions the most. So, give me an example of the sorts of things you might find reviewing Tegus transcripts that's valuable, because obviously you've mentioned the phrase differentiated view. If you're going to do well in investing, you do need to have that. You can't believe the same thing is everyone, even if that thing is great. Usually that means it's priced

• 56:24Patrick O'Shaughnessy?

  into the stock, you're not going to outperform. So, let's assume the villain test here, like everyone has access to Tegus. Talk me through how even in that scenario, it would still be valuable in a differentiated research process, or in a process focused on differentiated view.

• 56:38Speaker 03

  Yeah, so that's one of the important things. Everyone has access to it, but not everyone could process and synthesize the information the exact same way. And I think one of the areas a lot of people go wrong in looking at expert networks, I know some people who will start their idea research process in Tegus, in doing expert calls, and I think that's doing the process backwards. You want to come at it and do your calls and do your reading, once you've done deep research and deep background work and gotten yourself intimately familiar with the business and understand its key drivers. Have a sense of what you're looking for and what you're not looking for, what you want to disprove or what you want to confirm along the way. And so it's really just one piece in building out a much broader mosaic,

• 57:22Speaker 03

  but it's an instrumental piece at that. And depending on which angle you want to isolate on, you're not getting the complete picture from any one call. It takes many calls and not all of them will necessarily flow through to you. Some of them might be from people that are in your network or building that mosaic with company conference calls and everything else that we have at our disposal freely available.

• 57:42Patrick O'Shaughnessy?

  In a given company, there's lots of people whose opinions may be interesting or useful in your process. Are there major categories of people that you find especially interesting reviewing transcripts, whether that be former employees as a category or a supplier as a category? Talk us through the different styles or types that you find useful or interesting.

• 58:02Speaker 03

  My personal favorites are former employees and customers in particular. My research, my process, I'm very focused on trying to understand the value proposition for a customer to engage with the business, why they want to use it. And I'm also trying to figure out how a company divides its pool of resources and who they care for first and foremost. So I want to truly understand what the customer is getting and if they'll keep coming back. And the talks with formers are really important too, because I want to understand how the company thinks about their customers, how they strategize and how they think about as they scale up. Because again, I'm dealing mainly with smaller SMID caps. I want to understand what the company will do with its benefits of scale, who those benefits will accrue to.

• 58:47Speaker 03

  Are they customer centric or are they going to try to squeeze customers? Are they going to try to squeeze suppliers for every last penny? And then I also want to understand how the company treats its stakeholders. So talking to formers gives you a pretty good sense of whether the company is treating one of their most important stakeholders fairly. If a company is not treating their employees too fairly, that's going to be a red flag to me. So those are the two most important directions I've gone. Most of the calls I've underwritten myself are with customers in particular, especially in areas where in many consumer facing tech products, I could sample the product myself, develop my own opinion. But there are certain areas where I don't have a natural intimacy with the product. And when that's the case, I want to speak to a handful of people

• 59:30Speaker 03

  who have that sort of intimacy and who make the decision every day to engage with that business. So those are the most important.

• 59:38Patrick O'Shaughnessy?

  If you enjoyed this episode, check out joincolossus.com. There you'll find every episode of this podcast, complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.