Pod Insights Invest Like the Best with Patrick O'Shaughnessy Gavin Baker – Investing Through a Bear Market - [Invest Like the Best, EP.167] About this episode My guest today is with past guest Gavin Baker, the founder and CIO of Atreides Management, LP. We discuss investing during a bear market and the major ways in which the COVID19 outbreak has dramatically altered the investment landscape. Please enjoy my second conversation with Gavin Baker.
This episode is brought to by Koyfin.
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Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub.
Follow Patrick on Twitter at @patrick_oshag
Show Notes
(1:40) – How he sees the markets right now
(3:06) – How he handles information uncertainty and the value spreads
(5:53) – Trading in today’s market and the volatility
(9:45) – How the economic activity squares with the amount of stimulus being pumped into the market
(13:11) – Market Wizards: Interviews with Top Traders
(13:56) – Asset tests for individual companies in this environment
(19:09) – This Time Is Different: Eight Centuries of Financial Folly
(20:45) – His take on software companies during the crisis
(28:57) – Fast pace of change during extreme times of duress
(35:14) – Space as a service
(39:52) – Attention and time inside digital universes and how investors can take advantage
(46:17) – Why chaos is a ladder
(50:42) – It Was a Very Good Year: Extraordinary Moments in Stock Market History
Learn More
For more episodes go to InvestorFieldGuide.com/podcast.
Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub
Follow Patrick on Twitter at @patrick_oshag
Transcript Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.
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1:08 Patrick O'Shaughnessy? Hello and welcome, everyone. I'm Patrick O'Neal and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.
1:29 Speaker 01 Patrick O'Neal is the CEO of O'Neal Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Neal Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Neal Asset Management may maintain positions in the securities discussed in this podcast.
1:54 Patrick O'Shaughnessy? My guest today is with past guest Gavin Baker, the founder and CIO of Atreides Management LP. We discuss investing during a bear market and the major ways in which the COVID-19 outbreak has dramatically altered the investment landscape. Please enjoy my second conversation with Gavin Baker.
2:12 Speaker 02 You said this is absolutely unprecedented market. Nothing other than 08, 09 really compares in my experience. And I did live through 00, 01, 02. And while that obviously had a much greater peaked trough decline, particularly for tech, the volatility was not what we saw in 08, 09, and you can see that in the VIX. So why is this kind of game seven of the NBA Finals, the Super Bowl, the deciding match in a esports tournament? Valuation spreads within a sector between individual stocks are at all time highs. It was a four and a half standard deviation relative to the norm only a few days ago. I think today it's three and a half standard deviations. So it's swinging around wildly.
2:57 Speaker 02 You have peak volatility, peak valuation spreads, and then very high correlations, which means when you put all those together, this is the biggest opportunity if you're focused on alpha, are you a long-short investor? If you're an absolute return investor, it's a little bit of a different environment because you don't care as much about valuation spreads. You care about absolute valuations. But if you were focused on alpha as a long only, or you were a long-short manager, this is statistically as rich of an opportunity set as we have seen in the last 100 years.
3:33 Patrick O'Shaughnessy? One of the most interesting things about those spreads, which is something we in the quant world monitor extremely closely, and like you said, it's just, there's no other word for it than historic. No matter how you measure the spread in sectors between market cap, anywhere, it's really crazy. The interesting thing about spreads in this environment, though, is that we're operating on a lot of uncertain information because we haven't seen the first round of quarterly financial statements that reflect exactly how coronavirus is impacting firms. So I'm curious, with that crazy spread environment, but understanding we don't have the official numbers yet and companies are just withdrawing guidance, they're not just changing it, they're withdrawing guidance, how you as an active, concentrated active manager, deal with that problem of information uncertainty?
4:17 Speaker 02 Well, I would say broadly speaking, I think there are two choices if you're an active investor in a market like this. Either you can do nothing, believe in your companies, hopefully your companies have good balance sheets, they have strong competitive advantages, and they were well positioned for this.
4:36 Speaker 02 Or you can trade really actively. And if you're going to trade actively, I wrote on Medium that it's like being in a knife fight when you're blindfolded and covered in grease. And part of that is it's just risk versus uncertainty. This is a time of really high uncertainty. This is the fog of war. And the only information you can rely upon is information that is wildly stale, and that is trailing numbers. That is the best information. But at least trailing numbers are actual. They happened. They mean something. No forward number means anything. Every company is going to miss. They're all going to guide down.
5:17 Speaker 02 So I think for, for me, I'm kind of using a couple of filters. It is really, really critical. Again, in some ways, this is the most critical thing for if you're going to actively change your portfolio and try and take advantage of dislocations and try and make volatility for you rather than against you in a bear market like this, is you cannot anchor. I believe it's from golf. But I don't golf. I think I've swung a club once in my life. In golf, it is critical. And it's actually the same thing in video games. I imagine it's the same thing in all competitive pursuits. You have to play in the present. You cannot let the mistake that you just made impair your thinking. That's always important as
5:57 Speaker 02 an investor, but playing in the present and not anchoring either on anything that you thought you knew, anything in the past, other than broad principles. And more importantly, not letting the mistakes you're making because you're inevitably going to make mistakes in an environment like this, and they just cannot influence your thinking. That would be number one. Just play in the present.
6:21 Patrick O'Shaughnessy? How are you thinking about that trade off of, we've talked in our first conversation about linchpin ideas for individual companies that will guide long term tremendous results. And I think oftentimes those things last. You can be a pretty low turnover in some of those stocks, or have to be, to realize the benefit of those insights. But now you're talking about, do you stay the course or do you actively trade? In which camp do you fall? Or is it a blend?
6:46 Speaker 02 For me, I am.
6:49 Speaker 02 Actively trading, I am trying to take advantage of volatility. Some of the dislocations are so wild and it's amazing how big some of the inefficiencies have been. For instance, for a while, there was a big inefficiency, and this was maybe two weeks ago, where companies that had done a financing in January or February or had sold a big division, their financials were obviously incorrect. Some cases, you had companies that had a $2 billion asset disposal, which meant that their balance sheet had $2 billion more of cash on it than was being reflected. And this is the context of a company that maybe had a billion dollars on their balance sheet.
7:32 Speaker 02 And yet it was trading, you could look at it, relative to other stocks in the group, as if it didn't have that $2 billion in cash. How do you not try and take advantage of that? And I would say, for me, and this is the fourth bear market I've lived through, oh, oh, oh, two, then a bear market when I ran the pharmaceutical fund, then obviously oh, eight, oh, nine, and now this. I just said I was going to play the president, but inevitably, in an environment like this, people have regrets. As an investor, you're trained to almost never do this. It is very rare that doing really obvious things generates alpha.
8:10 Speaker 02 At the beginning of almost every bear market, doing the most obvious things works. So who crushed it for the first three to four weeks of this bear market? It is people who sold all of their airlines, all of their travel-related names, all of their cruise lines, and went out and they bought Target, Walmart, Costco, Kroger, Amazon, Netflix. I'm sure most people thought about doing those things three weeks ago. But you never could have imagined that doing something that seems so obvious would pay off to the extent that it did. And yet that happens on the front end of every bear market. This is
8:55 Speaker 02 happening with unprecedented speed. So I think we're through that phase. But that was one thing that I think was hard for me was in terms of trying to play in the present, was just wow, there were so many things that you thought about doing and you thought, no, it's too obvious. You know, that stock's already up or down five or 10%. And that goes to a little bit, you cannot anchor. You have to be open to a very wide range of outcomes from both scenarios and individual names. And then with the VIX where it is, a five to 10% move, it's immaterial. I guess another thing for if you're trying to trade actively in this is just, this has been said a lot recently, but volume is not liquidity. Even has, I think for a while, on the futures,
9:38 Speaker 02 the bid ask spread, it was one future bid and one future ask. And normally, I don't know if it's hundreds or thousands or tens of thousands, I'm not a futures trading expert, but it was an incredible difference. So although there's a lot of volume, there is minimal liquidity. So it is critical in this environment to use limit orders. What is happening with the high frequency traders in this environment, and probably a pullback from a lot of real market participants, has led to where even you're probably influencing the market more than you think.
10:13 Patrick O'Shaughnessy? I'd love to turn now to what for me is kind of the most confusing aspect of all of this, which is now really getting into potential investment returns and the relative attractiveness of public markets, which is this obvious horrible outcome right now in the actual economy, specifically in the small business sector, where listen, everyone I talk to is either laying everybody off or knows 10 businesses where 90% of the workforce has been laid off. It is a disaster, really like nothing we've ever seen, certainly in our lifetimes. I'm struggling with that on one hand, and then the incredible obvious signaling and action and behavior from the government fiscally and monetarily to support.
10:54 Patrick O'Shaughnessy? The system with liquidity, with bids, with seemingly anything. And what seems like an unlimited appetite, everyone uses that term bazooka. It seems like the right term. An unlimited bazooka to keep firing shots at this thing. That seems like a very hard problem to square. A fundamentally bad story on one hand. I mean, trillions and trillions of dollars is hard to even comprehend what that might do to asset prices. So how do you square these two concepts of kind of monetary and fiscal support with a really nasty small business and business situation?
11:25 Speaker 02 This is the irresistible force meeting the immovable object. We have the biggest, sharpest GDP decline in history. This is absolutely unprecedented. This is not a financial crisis where credit issues are transmitted to the real economy. The economy just stopped. There is no model, there is no precedent, there's nothing you can look to for what has just happened. So it is inherently unpredictable. On the flip side, we have significantly more fiscal and monetary stimulus than at any other point in history, any other recession. In every measurable way, this is the most aggressive Fed we've ever seen.
12:10 Speaker 02 I can't speak to the New Deal, but this is certainly the most aggressive fiscal stimulus in the last 50 years. And more importantly, it is happening fast. And it is happening in what seems like a relatively intelligent way. This is not 2008 when the president was out up for reelection and there was a tremendous delay and amount of infighting about the bailouts and about the stimulus. You have a president who's up for election. And what I think is more interesting, he has embraced the idea of sending checks to people. This is something that economists always advocate. It's a pretty radical policy and we're doing it. But every day counts, every week counts.
12:54 Speaker 02 Those checks need to hit quickly. All these loans to small businesses, can they really flow through the Small Business Administration? Which I think processed only 58,000 loans last year and only employs a few thousand people. The situation is fluid and the one thing we know, and they've made this very clear. Is the stimulus will be increased until the recession stops. I think that is the one thing that the government on both sides of the aisle has made very clear. And ultimately, the government can and will do anything to stop this. So I think it's important to keep that in mind. The political willingness and understanding of the problem is very, very high.
13:39 Speaker 02 Market Wizards, I think, is one of the best books written about investing. And I believe it's in the Bruce Covner chapter. He says he always tries to imagine himself as a boulder at the top of a mountain. And then he tries to imagine all the different scenarios of the boulder traveling a different path down the mountain. There is a lot of path dependence and sensitivity to initial conditions. And that way, whichever way the boulder started to go, he had it visualized. He planned for it and he kept an open mind. We're now in kind of the alphabet soup phase of recessions where we're talking about, is it an L, a U, a V, or a W shaped recovery? You want to have a wide range of scenarios in mind.
14:24 Patrick O'Shaughnessy? Let's spend the rest of our time talking about companies. This is the thing that you spend most of your mind share on, the actual companies in the portfolio, the reasons they're there. Those reasons changing very, very quickly. I'd love to get into as much detail as possible, maybe beginning with the sorts of acid tests that you're thinking about for extremely bad outcomes. So insolvency, liquidity problems inside company, liquidity ratios, maybe that need to be modified for this kind of environment that we're seeing today. Starting with sort of ensuring safety inside of a business. How do you think about that in the environment of coronavirus?
14:59 Speaker 02 I do think this goes to that. Are you trying to actively trade and invest during this or not? Because the beginning of a bear market is very different than the end of a bear market from an investing perspective. So at the beginning of the market, at some level, everybody doing the same exercise, but it is good exercise. You start with the balance sheet. You want to have a bias towards companies that you can value on GAAP price to earnings. The new liquidity test that I think probably every investment firm in the world is doing, and I'm fascinated to see what it's going to be called. It's not the Altman Z score. It's not the debt to EBITDA ratio. It's not interest coverage. It is days of solvency with a zero revenue. That
15:43 Speaker 02 is the equation that is being run everywhere. I don't know that that equation had actually ever been run. And this goes to that point about investing. The outcomes are always very wide. We've been through a lot of bear markets, a lot of recessions, but no one had run an analysis of zero revenue, yet that is the analysis that every investment firm is running. And I would imagine just about every company because you want to have a standardized metric. It's asked, well, how many companies could exist forever? And the answer is none. Even if you have $100 billion in cash and no debt, if you have zero revenue forever, even if you ultimately get down to just one employee, you will eventually
16:24 Speaker 02 run out of cash with no revenue if you have expenses. Days of liquidity with zero revenue has been the acid liquidity test that I think a lot of investors have been working through. And then from a broader perspective, I think a couple of insights. My dad is a bankruptcy attorney, so I've been talking about bankruptcy literally as long as I can remember. And everybody's very focused on covenants. And I think that that may be a little bit of a mistake because I think lesson number one is that covenants don't really matter. Cash dominates covenants. The debt holders actually don't want to put companies into bankruptcy,
17:05 Speaker 02 particularly at a time like this. So what really matters is cash on hand, liquidity. And then you can extend that to the revolver, and that is the only place where covenants do matter. The covenants on revolvers really, really matter. But I do say this bear market has happened with incredible speed. And I think we're through
17:31 Speaker 02 That first phase and now I think we're in different phase of investing. When I say phase, like everybody, I have checklist for bear markets and things that I think about. But something I really believe in bear markets in the same way that all companies are going to miss. All companies are going to guide down, even the safest companies. Everything gets shot, everything gets sold. More defensive names with great balance sheets, they just get shot last. Bear markets, they work on a FIFO principle, not a LIFO principle. The first companies to kind of be sold by the market are the first ones to be bought. And that's why I think how you invest in a bear market is very different.
18:14 Speaker 02 Now I think we're in a treacherous part of the bear market. All of the obvious actions has been taken. The market has kind of sorted itself out. Names that are kind of the tip of the spear from the coronavirus have been really hurt. Names that are going to benefit from it have helped. Good balance sheets, bad balance sheets, all of that sorting has been done. And what's going to lead the market out of this recession? And what's going to lead great companies for the next five to seven years? Aren't actually those safe companies with great balance sheets. One thing that really helped me in oh nine is I was managing a portfolio.
18:54 Speaker 02 And I had some large positions in relatively illiquid names that had a high degree of financial leverage. And they got absolutely destroyed at the beginning of the bear market. I was getting redeemed, getting redeemed daily. And what I chose to fund those redemptions with, I'd done the exercise that I described on the balance sheet. I mean, not the days of liquidity with zero revenue, but I'd gone through covenants on the revolvers, got myself very comfortable with liquidity, where they can take CapEx down to what a disaster scenario really looked like. I had really convinced myself that these companies with bad balance sheets were going to be able to make it through even the worst scenarios in that Carmen Reinhardt book.
19:37 Speaker 02 And so I decided, hey, I am going to fund these redemptions with the safer, more liquid names. So I sold those, which effectively increased the weighting of these more aggressive names. And that really saved me because people talk a lot about market internals being on checklist for bear markets.
19:56 Speaker 02 And what that basically boils down to is the aggressive names start to outperform the defensive names. And that happens generally before the market bottoms. So long before the market bottomed, I was beginning to generate much more positive alpha and then your portfolio is kind of ready to really benefit from the recovery, which will inevitably come, as hard as it is to imagine. And go back to what were the best stocks coming out of June of 2009? Netflix, Booking.com, Ulta Beauty, Domino's Pizza. Domino's was a name that was incredibly levered. It had come out of a PE buyout. It had a huge amount of debt and the stock
20:37 Speaker 02 had really been sold hard. So I do think we are getting close to the phase, and this is, again, only if you are an alpha-driven investor. It's a more uncomfortable phase. It feels really good at the beginning to, okay, my portfolio is safe. Okay, I've done this liquidity analysis. If you want to generate alpha in the later stages of a bear market, and particularly in a recovery, you now do need to begin taking some risks that are not obvious. We're past that first stage of the bear market where you get paid for doing obvious things.
21:13 Patrick O'Shaughnessy? I'd love to talk about some very specific areas that I know you pay close attention to. One that I was reading about that I've been so interested in is software. So software businesses have been handed down from on high, perfect business model, insanely high gross margins, incredible revenue growth, asset light. I mean, you can't draw businesses better than sort of the index of public software companies. And as a result, they've traded at incredible multiples of their sales in a way that make any value investor cringe. I'm curious if and in what way your view of software companies has changed or evolved in this short, kind of, four-week correction.
21:53 Speaker 02 Software is something that I have been thinking a lot about. And I think the conclusion I've come to is just, there is no such thing as truly recurring revenue. Some revenue is just more recurring than others. A lot of people are baselining off what happened in 08, 09. And I think that is dangerous because... In 2009, software was 7% to 10% of IT spend. And today, it's roughly 30%, excluding spending on the big cloud hyperscale infrastructures and service companies like Azure, Amazon Web Services, and Google GCP. If you put those together, software plus cloud, it's almost 50% of IT spending.
22:37 Speaker 02 So in 2009, it makes perfect sense that software did not get hurt. If you were a CIO, you could stop buying servers. You could stop buying storage. You could stop buying new PCs. There are a lot of levers you could pull to cut your budget. Today, with software at 30% and software plus cloud at 50%, if budgets are going to get cut, software is going to get hurt. And I don't see any way around that. Robert Smith is the CEO of Vista Equity Partnership, brilliant man, and he famously said software is better than first lien debt. And I'm just not sure that that is going to be proven true. And I say that with all humility because it has been better than first lien debt.
23:22 Speaker 02 But in a world where first lien debt holders aren't being paid, not sure that software bills are going to be paid on time and on full. If you're an airline and you're looking at potentially having negative revenue in the second quarter, if you're a hotel company and you effectively have zero revenue, if you're a cheesecake factory and you're not paying rent, are you actually going to pay all your software bills? Or are you going to say both to your landlord and your debt holder, hey, I'm not going to pay you guys, but I'm not going to pay anyone else either? And then when they tell that to the software company, are they really going to say, actually you have to pay us, we're going to shut you down, we're going to bankrupt you?
24:04 Speaker 02 I don't think that they will because I think the software industry and sub-CEOs are probably beginning to realize that if they do that, the government can and will do anything. They can just say, you know what, we're going to have a holiday on software expenses. You don't want to be the company that drives a major industry into bankruptcy. Push comes to shove, the software companies are going to blink. And already hearing from friends who run private equity firms that they are suggesting to their companies, don't pay any expenses. Conserve cash, focus on your employees first and foremost. But other than that, no cash out the door. And software is going to be caught in that. One of my good friends who runs a private equity firm knows that I have been thinking about
24:49 Speaker 02 this and intrigued with this idea. He called me a few nights ago with his sister. He said, tell Gavin exactly what you just told me. And his sister is a dentist and obviously she's grappling with how to run her practice. And she said, listen, I was on a big webinar that was put on by some trade industry group on what you should do to manage your practice. And the number two or number three recommendation had been to call up all of your software vendors and either ask for an extension of payment terms or a reduction in monthly rate and threaten to switch if they didn't do it. In one hour, she cut her software bill in half. One hour. She said there was zero pushback.
25:34 Speaker 02 And I've been telling people this story. We all have friends who run small businesses and it is amazing to me. I mean, that happened two nights ago. In the last two days, lots of friends have come to me and said, hey, I told my brother, my sister, my mom, my dad, my uncle, my aunt, my friend who has a small business that story. They did the same thing and they cut their software bill 30 to 50% in an hour. And I think that that is indicative and means something. Anecdotes are very dangerous just because they play into so many biases that we all have, but I think it is interesting to hear that that is happening. On the flip side of it is, there are software companies that are going to benefit immensely from this.
26:16 Speaker 02 Any software company that enables work from home is struggling to keep up with demand. Now, obviously, when the world goes back to work, they're going to be in a very different situation, but for now they're struggling to keep up with demand and benefiting immensely. In some ways, the most intellectually interesting stock in the market might be Zoom. It has become a verb. Companies that become verbs generally do well for a long period of time. Google, Xerox. Xerox obviously did well for decades and then eventually imploded. Nothing is forever. Capitalism does work. But Zoom has become a verb.
26:56 Speaker 02 And I should say, we are not involved with Zoom, but I'm highly intellectually interested in it. And I think there are things that they could do around messaging and almost make themselves into a more privacy-friendly social network. And I'm sure they're thinking along those lines. Recession are always an accelerant of change. They always change the vector of change, both the speed and direction. It's just incredible what's happened with Zoom. Four-year-olds having birthday parties on Zoom. Families having reunions on Zoom. Above and beyond just people working on Zoom every day. It is being woven into the social fabric of the country
27:40 Speaker 02 in a way that I don't think anyone could have imagined even two weeks ago. I often think some of the largest internet companies are just kind of gold mines of missed opportunities. And I can only imagine what it feels like to be at, whether it's Apple with FaceTime, Google with Hangouts, Facebook with whatever their video chat is. And just what could have been. Because something that matters immensely in technology that I believe 100%, and I think we spoke about on the last podcast, is that very small differences in UI and UX, user interface and user experience, matter immensely.
28:21 Speaker 02 At some level, iOS today, it's probably, I don't know, 50 basis points better than Android. At most. I would argue personally, they're at parity. But 50 bips is huge. If you're 50 bips better, that can be the foundation of hundreds of billions of dollars in market value. Google found that milliseconds of latency mattered to search. That if you could take two milliseconds out of search latency, that it had a huge impact on search volumes. And Zoom's UI and UX, for all sorts of reasons, is just better than Hangouts, FaceTime, or whatever the comparable Facebook product is.
29:03 Speaker 02 And wow, if one of those companies, if one of those particularly, either Google or Apple, had FaceTime or Hangouts, been as good as Zoom. From a UI UX perspective, think of the value that they would have come out of this with. Instead, I think they've already missed one of the biggest changes to come out of this recession.
29:25 Patrick O'Shaughnessy? I'd love to talk about that concept now of fast pace of change in behavior and company formation and all these interesting things during extreme times of duress, during recessions. Everyone knows the stats about some of the biggest companies being born during recessions. Obviously, from an investing standpoint, this is a critical model to think about the world with because you want to position yourself in those trends. So as you look on the long side of your portfolio, what sorts of things are you starting to pay attention to? I want to talk about metaverse type stuff here. I'm just really curious what things you are watching for fast rates of change in ways that may benefit companies coming out of this recession.
30:03 Speaker 02 Sometimes what you don't do that is as important as what you do. So we just got software, but e-commerce is an area that is obviously changing rapidly in real time. And I think there's a temptation to say, oh, e-commerce is going to be a huge beneficiary of this. Let me go buy e-commerce stocks. I've thought long and hard about that. And for sure, e-commerce is going to structurally shift upwards as a percentage of retail sales. I don't know, though, that after this structural shift up, it will continue to take share at anything different than the rate it's been taking share for the last five to six years, which has been very consistent. E-commerce has been on a very consistent growth trend for a while.
30:42 Speaker 02 What I am beginning to think about is for these omnichannel retailers like Walmart, Target, Costco, maybe even Kroger, are they actually going to be the biggest beneficiaries of this? Because they are building years of kind of e-commerce experience.
31:04 Speaker 02 Muscle know-how in months because I'm sure they're going to do 12 to 18 months of e-commerce CapEx in months, if not quarters. Not only that, but every physical retailer, there is a debate going on about how much to invest in e-commerce. People who run the stores say, invest less. We're driving e-commerce with buy online, pick up at store. People who run e-commerce want more. That debate has been settled, I would imagine. And all the omnichannel retailers who are really benefiting from this, they're going all in on e-commerce. And so I think that may work to the disadvantage of some of the incumbent, more pure-play e-commerce companies. And also, we talked about the Facebook and Google auctions in
31:49 Speaker 02 the last podcast, but the way that Facebook and Google auctions work, it really advantages strong incumbent players in a strong economy, but it actually disadvantages them in a weaker economy and advantages some of these smaller e-commerce operations that are part of a big physical retailer. So I think there's huge cross-currents in e-commerce. It's for sure going to benefit its category, but I think it may be dramatically more competitive in 2021 than it was even in 2019, which was super competitive. I think the companies that are going to benefit the most from this are the companies where their competitors
32:33 Speaker 02 go bankrupt. And I think where I have been focusing is actually on both physical omnichannel retailers and quick service restaurants. The reason for that is, I think it is very clear that tragically, a lot of small businesses and retail and restaurants are going to go bankrupt. A lot of owner operators are going to go out of business, and there's probably going to be a reasonably high mortality rate. And then I put that back together with thinking through the sequencing of what happens when the world begins to restart. And by the way, the world beginning to restart does not mean that the recession is over. It just means that Americans slowly begin
33:15 Speaker 02 to return to a more normal pattern of daily life. Where you eat out, you go to stores. I think the first thing that people are going to do when this current coronavirus quarantine ends is go to quick service restaurants that have a drive through. Who couldn't use a good fast food hamburger or some good fried chicken or good taco right now? At the end of this, everybody is going to be tired of eating only at home. People have got out and bought literally a historic amount of groceries. And as soon as the world begins to restart, I think people are going to go back to these restaurants. And these restaurants
33:56 Speaker 02 are going to face a significantly less competitive environment because so many of their owner operator SMB competitors will have ceased to exist. It's amazing the density of family owned restaurants around big chain restaurants. So for sure, they are going to come back to a world that is less competitive. I think the same thing for physical retailers. If you are a large physical omnichannel retailer, you're benefiting right now because you're being able to do years of e-commerce brand building and expertise building in months. When you turn your physical store footprint back on, there's going to be less competition. And then I'm beginning to think about, hey, who are technology companies that have customer
34:41 Speaker 02 bases that are going to be advantaged in this way? I guess that's on the long side. In addition to Zoom, I think watching TikTok over the last month has also been really eye opening to me. Let's touch on the metaverse a little bit, but TikTok has begun to have an impact on incumbent social networks for the first time ever. That began in February and it has really accelerated so far in March in every way.
35:14 Speaker 02 That we can imagine. Look, TikTok, it doesn't speak to me. I'm beginning to wonder if every generation is going to have its own social network. With Snapchat, they used to say that, hey, the fact that it's hard to use for people over 30, it's not a bug, it's a feature. Nobody who's a kid wants their parents or grandparents or aunts or uncles or family friends on their social network. Maybe TikTok is going to further prove that out. But I do think TikTok, it's very interesting to watch what is happening there.
35:42 Patrick O'Shaughnessy? I'm curious what you think about this notion of space as a service, something that you jotted down ahead of this conversation. Really interesting concept. Everyone's familiar with sort of what went wrong with WeWork. We're in this bizarre environment where we're not using commercial space all that much right now. What are your thoughts here?
35:57 Speaker 02 I mean, I'm excited because there have been all these hotly debated topics around different business models, most of them tech-enabled, whether it's space as a service, iBuying, are fintechs better at lending the traditional financial institutions? And they're all going to be resolved. We're going to know the answer to some of the most hotly debated topics within the world of technology investing over the last 10 years. We're going to know those answers quickly. Space as a service, I think WeWork has probably been unfairly maligned. I can tell you that the heads of real estate of the world's largest companies were super excited about WeWork and this whole concept of space as a service. And basically, the belief was, hey, there's this notion of core competencies. All businesses have embraced, what's our core competence?
36:43 Speaker 02 Headquarters real estate, that's a core competence for us. We can do that. That's generally in our hometown. We know the right architects, the right builders, the right real estate lawyers, the right brokers. We will have a good headquarters. But for branch offices, is that really a core competence? And broadly speaking, you don't have as much local knowledge, you don't have the local connections. And more to the point, you can never size it appropriately. Branch offices were always too small or too big. So this notion that outside of your headquarters, it made sense to put significant chunk of your workforce in a more flexible co-working environment, I think is something that I could say with absolute certainty made sense.
37:24 Speaker 02 To the head of real estate at a huge number of the world's largest corporate buyers of real estate. And that space as a service provider would have buying efficiencies, the same way that corporations began to outsource their kitchens to Aramark and Compass Group. And Aramark and Compass Group could generally run a corporate cafeteria cheaper and provide a higher quality than any individual corporation. But the same way Aramark and Compass could do that and earn a margin, hey, these spaces as a service companies would be able to do the same thing. So they'd be able to give you cheaper, more flexible space, and that was their core competence.
38:05 Speaker 02 I think the virus is going to really change the shape of that because now being able to control health and carefully think about population density in environments is going to be super important. And the way broadly speaking, most of those firms created value is they brought the Ian Schreger Hotel model to spaces of service where you pack way more people into much smaller offices, then you have these glorious common spaces. And so you can actually get more guests into a hotel, charge them more money, and drive a lot more revenue per square foot, which is ultimately what any real estate game is all about. That's what they're all doing.
38:45 Speaker 02 That model is going to have to really change in a world where containment of the virus is a priority, where health is probably even more a priority than it ever was for corporations, where everybody may want to have a different protocol as far as temperature sensors and what's going to happen. So I think that is a space where this recession is going to have a huge impact on it, one way or another. And you can always make lemonade out of lemons. Maybe they get temperature sensors installed first, maybe they become thought leaders. But I do think that of all the debates, that one has much in the crosshairs of this recession as any. I buy, I guess, another debate.
39:29 Speaker 02 I kind of conceptualize eye buying as just they're just making a spread. They're just a market maker between buyers and sellers. And if that's the case, you just widen your spreads in a time of financial stress. It should be immaterial to you. The same way if you're a market maker on the New York Stock Exchange, going up, going down, you're not that sensitive to it. Obviously, you hold inventory for longer as an eye buyer than you do as a market maker on the New York Stock Exchange, even back in the 1920s. But still, I think that was one mental model. The other mental model was, hey, these guys are taking huge inventory risk. They don't understand it and they're not going to be able to just widen their spreads in a recession. That's going to be resolved. Another thing much debated is sports really the anchor of the linear TV bundle?
40:14 Speaker 02 Well, we are actually going to find out this month and next. Full stop.
40:20 Patrick O'Shaughnessy? Starting with metaverse, I think the insight that you shared with me that I just think is true is it just seems as though people are going to spend more of their time in digital universes. So if you think about the metaverse just as, like you said, maybe TikTok is a digital universe. It's this thing that you kind of has standards, has a style. You have ways of participating in it or not, or just observing it. But we're just spending a huge amount of time there. So talk to me about this concept of sort of the tailwind behind attention and time inside digital universes. And from an investing standpoint, who might benefit from that trend?
40:53 Speaker 02 The metaverse is, to me, the most exciting trend in the world today. And I think of the metaverse as being the culmination of the internet in the same way that mass production was the culmination of the industrial revolution. So I think it's helpful to define the metaverse because I think you and I are both familiar with it. By the way, I hope you're getting to play some video games with your kids during this downtime, Patrick.
41:19 Patrick O'Shaughnessy? Just starting to, yeah.
41:22 Speaker 02 Awesome. Don't be discouraged and don't forget that age and treachery can overcome use and scale. Positioning, breadth, knowledge and discipline can take you far, my friend. The metaverse is simply a series of connected virtual worlds.
41:37 Speaker 02 That I firmly believe a majority of people will spend a majority of their waking hours in within my lifetime. Today, most of those virtual worlds are called video games. And I would say the metaverse being the culmination of the internet is a relatively accepted opinion amongst early-stage venture investors and large technology companies. When you hear Mark Zuckerberg say he wants to own the next platform, and that's going to be augmented reality or virtual reality, that is the metaverse. The metaverse is the next platform. And then what is the strategic point of control in the metaverse? What is the abstraction layer?
42:19 Speaker 02 What layer in the metaverse actually becomes a platform? This is why Facebook bought Oculus. This is because the thought is, hey, if you can own the company that powers these virtual realities, you'll be able to own identity, you'll be able to own avatars, you'll own payments, and that will create a lot of value. I'm not sure that that is true, and I think that there is a very real world in which some of these video games emerge as platforms unto themselves. This has already happened with Roblox. It is happening to a degree with Fortnite. We spoke last time about how it's a place, not a game, Fortnite.
43:03 Speaker 02 And I do think broadly speaking, talked about how video games are social networks, they're places. And parents everywhere, they understand this now. I'm sure they did not two weeks ago. Kids and people under the age of 30, when they want to hang out with their friends, often, rather than calling them, they will play a game with them. And I do think there's a lot of FUD in society about video games. I do wonder if one thing that comes out of this and helps pull the metaverse forward is parents realizing that relative to having your child's ego destroyed on Instagram, relative to having them sit in front of the TV passively for hours, that playing a goal-oriented video game with a group of their friends and socializing is actually a relatively
43:48 Speaker 02 healthy activity. Coming back to the metaverse and kind of video games as being foundational for them. I just think Occam's razor is powerful philosophically and logically. The simplest explanation is most likely to be correct. I think it's also very powerful for forecasting. So if the metaverse is going to be kind of the culmination of the internet and foundational to the future. I think that that metaverse, video games are going to be super important to us. And the social networking parts are going to be ever more important. And so I think as you see, a DJ called Marshmallow had a concert in Fortnite that 40 million people watched. There's a special Star Wars premiere within Fortnite. They're already events regularly in every video game.
44:33 Speaker 02 I am becoming more and more convinced that video games are going to be foundational to the metaverse. And one kind of signpost there is we have a lot of data on internet traffic. Everybody does. Verizon just published some stats this morning. Video game traffic is up 100% as people are working from home and kids are spending more time at home. I think the last stat I saw, and this was a Telecom Italia stat, so we should not mix and match. But Telecom Italia saw video game traffic up 75% and social media traffic up 0%. And that is because people are connecting within video games. And so I would not underestimate the importance of video games, the ability of them to become platforms.
45:17 Speaker 02 And then within platforms, Xbox, PlayStation, Steam, any video game platform that has an identity and a payments layer is fairly well positioned. I think an asset that is very interesting is Discord. You're very friendly with the benchmark guys. They're investors in Discord and this has been fantastic for Discord. So I think Discord is something that could easily come out of this as a platform, foundational to the metaverse. And Discord is something like Zoom that can, I think, potentially go between work and play. But yeah, I think all of this really pulls the metaverse forward. We've talked about video games, we've talked about social networks. What's the infrastructure that's going to power the metaverse?
46:01 Speaker 02 I think all of that is going to get pulled forward. That for sure is, I think, one of the more obvious. Changes in vector as a result of this recession and the coronavirus. And then I also think it's really important to be humble and when you think about changes and speed and direction, how much path dependence matters. PayPal would not be the company it is today if they had not raised money right before the market imploded in 2000 or 2001. So the timing of fundraising is going to kind of rule the fate of many industries and many companies, particularly within venture. So path dependence is going to matter a lot and randomness, path dependence, even probability, they rule the world.
46:46 Patrick O'Shaughnessy? I'd love to close with this great concept that everyone knows the phrase because they all watch the show, this, this idea that chaos is a ladder. Can you describe why you invoke that as a closing thought for listeners?
46:57 Speaker 02 Yeah, so chaos is a ladder. To me, Game of Thrones, it's so great. Littlefinger is one of the best characters. Love him or hate him, he inspires powerful emotions. That is his signature phrase. Chaos is a ladder. Chaos creates opportunities, but chaos is also a slippery slope. Certainly did not work out well for Littlefinger. Chaos is a ladder. It's going to drive a lot of change. We've spoken a lot about that. But on the slippery slope side, I think it is important. On the positive side, you want to express this thought in your portfolio. We've spoken about that. You also want to be, really be cognizant of risk and that is something I always think about. To me, risk and valuation, they're both the parable of the blind man and the elephant. You want to look at risk evaluation from as many perspectives as possible.
47:42 Speaker 02 So chaos is a ladder. Chaos is a slippery slope. The range of outcomes is really wild. Littlefinger did not conceive of a world in which his former wife Sansa's little sister murdered him. But that's what happened. You want to be aware of wide range of outcomes. So you want to have a wide aperture and look at it as many ways as possible. I try to cut it quantitatively. We don't need to go through that. But something that I think a lot about as a growth investor, the biggest single risk to me is a regime shift in valuations. And it's actually not as easy as one might think to capture this quantitatively. And this is just a regime shift where companies go from being valued on EV to sales to being valued on GAAP price to earnings.
48:28 Speaker 02 And this is something that I think about all the time and really try and mitigate this risk in as many ways as I can. Two more good things that I think of when it comes to risk control. The first is Augustus versus Julius Caesar. Julius Caesar was a brilliant ruthless politician in general. So he was brilliant and ruthless, but he was also a risk taker. So he was magnanimous, he pardoned his opponents, he took a lot of risks, he didn't take his bodyguard into the senate with him. So Julius Caesar, he died before the age of 50. Augustus was probably not as brilliant as Julius Caesar was, but he learned from what
49:12 Speaker 02 happened to his uncle and he managed risks carefully. He was so cold-blooded. If you are suspected of being a traitor or a threat to him, you are invited to kill yourself with the understanding your family would be taken care of. When you come to managing risk, you want to be Augustus, not Julius Caesar. You want to be super cold-blooded, super ruthless, super dispassionate. And this summer versus winter, Game of Thrones made me think of it, always through the books, there's summer king, there's the knights of summer.
49:52 Speaker 02 And if you are going through one of the winters, the long winters, the long nights, society was very different. As a leader, you had to be very different. As a knight, you had to be very different. Everything was different. And I just think, we're no longer in a summer, we're in the winter now. As an investor, that means you need to think and act differently. As a CEO, you need to think and act differently. You're gonna have to make really hard decisions. And so I think about that a lot. Augustus versus Julius Caesar. Winter versus summer. I do want to kind of end on a note of optimism. There are so many ways in the 20th century that the world could have ended and it never ended. World wars, Spanish flu, Great Depression, the threat of nuclear annihilation.
50:36 Speaker 02 It always pays to bet on humanity. And something I like to do at times like this, and the reason I find this important to do at a time like this, is because optimism never sounds smart. It never sounds smart to be optimistic. Pessimism always sounds smarter than optimism. But the history of the last 200 to 300 years of the human race tells you that optimism has paid consistently. It is good to bet on humanity. And so the way I like to kind of translate that to markets is there's a book written by Martin Frithzen called It Was A Very Good Year. And I think it's called A History Of Exceptional Years In The Stock Market.
51:17 Speaker 02 And he goes through the 10 most exceptional years of stock market returns in the 20th century. They all come after a truly terrible period. It's strange to me, and I think it's so many human behavioral biases, but nobody could have imagined what we were living through two weeks ago, two months ago. Nobody really could have imagined this. Nobody could have imagined that a virus would really kind of shut down the world. And obviously, loads of people had written about pandemics, but I don't think people really could have imagined this. Obviously, Bill Gates, all these people have warned about pandemics. But there are so many analogies about how the world has come back from worse situations. And I think it's important to have those in mind.
52:00 Speaker 02 We are going to get through this. Unfortunately, 1919 was not one of the most exceptional years of stock market history following the Spanish flu of 1918. But a lot of the exceptional years came after years that were at least as hard as what we're going to go through in 2020. So I think it's important to be imaginative, to be optimistic, and to recognize that this too shall pass, the market will bottom, the economy will bottom, we will find a cure for the virus, humanity will prevail, and there will be better days.
52:33 Patrick O'Shaughnessy? I love it. Great place to close. Thanks, Kevin.
52:36 Speaker 02 Awesome. Thanks, Patrick. This was great. Thanks a lot.
52:42 Speaker 03 Hey everyone, Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter @Patrick_OShag, O-S-H-A-G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.
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