Gavin Baker – Tech and Consumer Growth Investing - [Invest Like the Best, EP.149]

My guest this week is Gavin Baker, the founder, and manager of Atreides Management. I met Gavin in the same way I meet many of the most interesting people, on twitter. His focus is on consumer and technology growth investing, which is the topic of our conversation. We discuss many of the largest trends in these sectors, several fascinating investment cases, and also explore the videogame industry in detail—which I found especially interesting. Please enjoy my conversation with Gavin Baker. 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 Show Notes 1:16 – (first question) – His unique view on the markets 4:00 – Distilling Apple as a growth investment 6:44 – What is the most important lever for Apple looking forward 9:01 – His view on Intel 11:03 – Most important technological changes that may dictate his investing strategy 16:20 – How do you look at a big idea, like AR, and then apply to an individual business 18:21 – Fortnite isn't a game, it's a place 18:26– Fortnite Is the Future, but Probably Not for the Reasons You Think 18:56 – His insight into video games and their ability to control attention 28:36 – How do you invest in the gaming sector 40:06 – Favorite video games 32:07 – Why gaming and customer sector allows him to find Alpha richness 34:17 – Being in the top 1% of knowledge before investing in a company 36:24 – His view on value investing today and, in the future, 41:15 – Increase of regulatory capture 42:01 – Headwinds to the tech companies today 43:50 – Thoughts on the Chinese internet market and how it impacts US markets 45:36 – How often companies look at China for ideas 46:21 – Role of alternative data in his process 49:36 – Big trends today we should be paying attention to 54:20 – the most interesting company he does not own 58:48 – Advice for new investors 1:00:17 – Non-obvious tech resources - TechMeme 1:00:50 – Favorite sci-fi character 1:01:19 – Kindest thing anyone has done for him 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 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. Clients of the podcast guest’s firm may also maintain positions in the securities discussed in this podcast.

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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• 0:36Patrick 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.

• 0:57Speaker 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.

• 1:22Patrick O'Shaughnessy?

  My guest this week is Gavin Baker, the founder and manager of Atreides Management. I met Gavin in the same way I meet many of the most interesting people on Twitter. His focus is on consumer and technology growth investing, which is the topic of our conversation. We discussed many of the largest trends in these sectors, several fascinating investment cases, and also explored the video game industry in detail, which I found especially interesting. Please enjoy my conversation with Gavin Baker.

• 1:48Patrick O'Shaughnessy?

  So Gavin, this is going to be really fun. The way that you invest, I think, is one of the last interesting ways to do public market investing. So I'd love you to begin by describing what is unique about the way that you view markets, maybe growth, tech and consumers specifically, and why you do it this way.

• 2:04Speaker 02

  I'm a student of history and I think we are living through a period of accelerated change. The only comparable period in history, I think, is the Industrial Revolution. You and I both like Carlotta Perez, and I would argue her work and kind of history suggests that we have another 30 to 40 years of rapid and powerful disruption ahead of us. And in some ways, I think of the invention of the microchip in 1959 as being, or the integrated circuit, as being analogous to James Watt's invention of the rotary steam engine in 1761. But I would argue, peak economic, political, social change as a result of that invention was 70 to 100 years later, during the peak of the Industrial Revolution, 1820

• 2:47Speaker 02

  to 1850. So I think in some ways, we may be just entering peak disruption. And with that lens, I try to invest at the edge of disruption, just before it. I approach public equity markets, I think a lot of people say this, but like a private equity investor, like a business owner, always looking out five to seven years and trying to own very high ROIC companies with growing competitive advantages, owner-oriented management teams who are on the right side of disruption. And what I try to do, sometimes successfully, sometimes unsuccessfully, is looking out five to seven years, buy these businesses at what I think is a 20 or 30% free cash flow yield to the EV. It's critical in growth

• 3:32Speaker 02

  investing to assume multiple compression. It doesn't always happen, but you want to be paid based on business outcomes and assume valuation is not part of the outcome.

• 3:41Patrick O'Shaughnessy?

  That seems like a key part here is that over some long enough time scale, I'm curious why specifically five to seven years, I'm sure there's thought behind that. Over some minimum time scale, the only thing that matters is the business growth, not valuation changes. That gets muted as time goes on. I think that's part of the reason, but why specifically five to seven years?

• 3:59Speaker 02

  Five to seven years, I think, is as far as I can convince myself that I can look out and have a differential view on a future state, something that I can have conviction in. And yeah, for sure, in the short term, valuation dominates price movement. But the longer you go out, the less important valuation is. And I would always modify, it's absolutely true that the price you pay that determines the return you get, but I would modify that statement by saying the price you pay determines the return you get for a given business outcome. No matter how cheap it is, if it goes bankrupt, you're at a zero.

• 4:32Patrick O'Shaughnessy?

  Yep. So we're going to use tons of individual company examples here because I think when you're thinking about that five to seven year period, you've often honed in on it. I'll call it like most important question or single variable, which really is going to drive that cash flow growth for an underlying business. So maybe we'll start with one I've seen you talk about publicly, which is more current, which is Apple. So if you're thinking about Apple as a growth investor, what is that sort of distillation and how did you arrive at it?

• 4:57Speaker 02

  Apple was actually kind of foundational, I think, to the way I evolved as an investor. I think a lot of people, when they start as fundamental investors, they're looking for earnings or free cash flow estimates can be revised up and the multiple can grow. And then you can convince yourself-

• 5:11Patrick O'Shaughnessy?

  Get paid twice.

• 5:11Speaker 02

  You get paid twice, yeah. And that's exciting because you feel like, hey, there's 100% upside over the next 12 to 18 months. I realized a couple of things over the years. One, that's a very efficient and competitive time horizon. Two, almost certainly any company where you can convince yourself that it can double in a 12 to 18 month time horizon has a lot of risk to it as well. There is some sort of efficient frontier, full stop. Return and risk are related. So if you can intellectually convince yourself that it could double in 12 to 18 months, it's probably a very significant risk. And over the years, I gravitated towards looking for companies where I could bet on multiple compression, look out several years and get paid on the business outcome. Apple, I think, was pivotal

• 5:54Speaker 02

  to that. I'll never forget, this was in 2007, maybe early 08. I was at lunch with a group of former colleagues and my friend Sunu Kalra, we were debating the Apple quarter and they were going to report in two weeks. And it was something like, were they going to sell 850,000 iPods or 900,000 iPods? Everybody had a very nuanced view based on the Asian supply chain data points and how things had been trending and the product cycle. And Sono just said, you know what? I don't care about any of this. Sony sold 400 million Walkmans and I think Apple's going to sell way more iPods than Sony ever sold Walkmans. And as soon as I heard that, it's like, wow, it really doesn't matter. Apple went on to be 7X, 10X, 15X from there.

• 6:38Speaker 02

  I actually don't know that they actually ever ended up selling 400 million because it got subsumed into the iPhone, but it was directionally accurate. And that kind of set me on this path of finding a mental model or a framework that would let me look out a long time and have confidence in forecasting, looking out a long time. Occam's razor, it's very powerful for science, but it's also powerful for forecasting. Simple is beautiful. If you can find a simple framework like that, that gives you the conviction to A, look out and B, hold through the periods of volatility that a lot of growth companies go through.

• 7:11Patrick O'Shaughnessy?

  Apple's a much different business today than when you guys were having that conversation back then. As a much more mature business, one that seems hyper efficient, you know, Tim Cook, famously a supply chain guy by background, what now is, do you think, that most important level or Occam's razor model for Apple and its business looking out five to seven years?

• 7:29Speaker 02

  There are three. One is, I think the price of used iPhones is critically important to Apple's business model.

• 7:35Patrick O'Shaughnessy?

  Why is that?

• 7:36Speaker 02

  Used iPhones retain their value much better than used Android phones. When you trade in your phone, you capture that. That lets the used iPhones retain their value better, supports a dramatic price premium for Apple. Because when you're paying $1,000 for an Apple phone, if you're trading in an 18-month-old phone, chances are you're getting $400, which means you're really only paying $600. That comparable Android phone is being traded in for probably $150, which means you're paying $850. So, Apple can charge the consumer more than its competitors, but actually have a lower effective price to the consumer.

• 8:14Speaker 02

  The second thing that's happened is the iPhone is becoming an edge server of sorts for wearable devices. You know, to go back to 1990s client server, I think we're all going to have this constellation of wearables. We have the phone now, we have the AirPods, and we are eventually going to have augmented reality glasses. And so, the attach of those wearables, I think, is an important variable. And then the third thing that I think is critically important, there were two really important things that happened in 2018, only two in technology. The first, which doesn't pertain to this, is Intel losing its manufacturing lead. The second was Apple hiring John Giandrea, who is the head of search at Google. And this meant to me that Apple had a chance.

• 8:58Speaker 02

  Apple is one of arguably two companies, Apple and Facebook, that could be a competitor to Google over some period of time. To compete with Google in search, you need a differentiated data set. Facebook and Apple both have that. And Apple, they had a series of beliefs about privacy that made it unlikely, in my judgment, that they were going to succeed. And hiring John Giandrea, A, I don't think he would have gone there unless there had been a tectonic shift beneath the surface in Apple's views on privacy, and B, it meant that they had a chance.

• 9:32Patrick O'Shaughnessy?

  What about the story behind Intel? I can't let that one go.

• 9:36Speaker 02

  Intel, for the last, I don't know, 50 years, 60 years, always got to the next node in semiconductor manufacturing first. And this is Moore's Law, price performance, you know, doubles every, you know, it's slowing down, so who knows? The rate at which Moore's Law is improving is very controversial right now, but nonetheless, being to the next node first is a big advantage because you can choose, you can have a faster chip, you can have a more power-efficient chip, or you can have a smaller chip that costs less money. Intel always got there first. And let's just say if they got there six to nine months on average before their competitors, if you do the math on what that means, it meant they had a 15 to 20% embedded advantage. And in 2018, and it's important that the Taiwan Semi seven nanometer node is equivalent

• 10:21Speaker 02

  to the Intel 10 nanometer node. There is a terminology difference for marketing purposes, but Taiwan Semi got to the node before Intel, which meant that Taiwan Semi, who supplies most semiconductor companies that you can think of, the semiconductors that go into Apple, you know, the world has really gone fabulous, with the exception of Intel and memory companies, it meant that that universe of companies had that 10 to 15% advantage. So that's, call it a 20 to 30% swing in competitiveness. In modern semiconductor manufacturing, it is the closest thing to magic in the real world. We are manipulating atomic particles.

• 11:05Speaker 02

  It is amazing what is happening. It has much art, has science. And the reason that Intel had that lead so consistently is it's almost like cooking, where you come up with a recipe for the new node and you have to test it and iterate. And it depends on what you did before. And just like a cook needs to see what the brownies taste like or the cake tastes like and hone in on the exact right recipe. That is modern semiconductor manufacturing. There is an element of art in making bets and trial and error.

• 11:35Patrick O'Shaughnessy?

  What are, do you think, the most important of these major technological changes? So you've written a little bit about, obviously, the one that started in 1959. But I'm curious whether or not you would classify something like mobile or artificial intelligence or crypto or fill in the blank as like the next important platforms? Because those then become, I assume, sort of the waves that you want to ride as a growth investor in individual businesses. Are those kind of the big three?

• 12:00Speaker 02

  Yeah. And it's one reason, we went back and forth a little bit on Twitter over the Carlotta Perez framework, and I would argue that it's not just the semiconductor, but you've had the semiconductor, the internet, and then mobile, and now artificial intelligence. And each one was kind of requisite for the next. And they happened in a very unusually fast timeframe. If you look at the spread between the rotary steam engine, canals, railroads, steel mills, and then you go all the way into mass manufacturing, it happened over a dramatically longer period of time. But you know, you obviously needed the microchip for the internet. And then you needed the internet, mobile phones, truly useful because being able to access the data centers where all the content is stored is a big part of what made them useful.

• 12:44Speaker 02

  And then you needed the mobile phones to be foundational for artificial intelligence because they generated the data that is needed for AI.

• 12:50Patrick O'Shaughnessy?

  The training set, yeah.

• 12:50Speaker 02

  Yeah, there's been almost no advances in technology or algorithms. The only thing that has enabled the AI revolution that we're living through, which I think we're at the bottom of the first inning in. Is one, we had the ability to do cloud computing. So just apply significantly more computational power to old algorithms. And then B, we had dramatically more data. And that data actually generally came from mobile phones. Within that, there's a lot of things that are exciting. I think augmented reality and virtual reality are going to be very important. I think virtual reality, you may need brain computer interfaces to really unlock it. Cause it's very difficult to solve the nausea problem.

• 13:31Speaker 02

  So if you're in a virtual reality and you're walking in that reality and your body isn't walking, a lot of people feel nauseous. This is why I think the great VR experiences today are either games where you're in a spaceship, a pilot piloting an airplane, or you're in a car. Or they're in, you know, one of these new startups, Sandbox VR, where you actually can walk. AR, I think, will happen sooner. I think autonomous vehicles, this is kind of, I think, going to be the first applied application of AI that's going to have a dramatic impact on the world. It's always important to think laterally. AVs may have a bigger impact and create more value or redistribute more value in the worlds of retail, real estate than they do within the core automotive industry.

• 14:15Speaker 02

  Cause they're going to have seismic impacts on those industries. Based just on ease of access? So you've had this huge trend towards people moving back into the cities. Cause they want to be able to walk around. People don't like long commutes. But if you can get in your car, leave whenever you want, go to sleep, mess around on your phone. The idea of living an hour away from a big city in a beautiful suburb with a big lawn might seem very different. Retail, it's going to have the balance between e-commerce and physical retail. The efficiency of distributing goods between AVs and drones is, I think, going to really change the relative economics of both of those businesses. And then I'm also excited within the virtual world, virtual reality, which I've written a lot about is the metaverse.

• 14:58Speaker 02

  I think it is inevitable that a majority of people will spend a majority of their waking hours in virtual worlds within our lifetimes.

• 15:08Speaker 02

  And I think that's semi inevitable. It's a linear extrapolation of current trends.

• 15:12Patrick O'Shaughnessy?

  Yeah. What's the average phone time? I mean, just the phone time alone today, like you could argue that kind of is that just a crappy version of it?

• 15:18Speaker 02

  A crappy version of it, although you're looking at a real world events. Maybe you're watching sports, you're reading news, you're communicating with your friends. You know, I would say a subset of that is kind of my definition of a virtual world. And when I think people spend a majority of their time in virtual worlds, that is the metaverse. And why video games and virtual worlds have been taking share of consumer time and engagement for a long time. Why is that? To put numbers on that, and these are in the John Maynard Keynes, I'd rather be vaguely right than precisely wrong spirit. The UK government authority keeps pretty good stats on the sales of video games, music and movies in the United Kingdom. And I think 20 years ago, video games were sub 5% of that combined bucket. Today, they're a majority.

• 16:02Speaker 02

  Reason for that is, I would argue, you can't make a movie that is better than Empire Strikes Back, Godfather II, Deer Hunter. Those are all movies that were made 35, 40 years ago. I love classical music. I would argue, nobody's ever going to make better music than Bach, Beethoven and Mozart, Tchaikovsky 300 years ago ish on average. Whereas a video game today is incomparably better than a video game from even 15 years ago. It's the only form of engagement that's writing Moore's Law. So that's why they've been taking share. And then if you just extrapolate that linearly, that's going to continue until

• 16:40Speaker 02

  virtual worlds are indistinguishable from real life. Why go watch the HBO series Rome when you can go be in ancient Rome?

• 16:49Patrick O'Shaughnessy?

  Yes, absolutely. So how do you take this general extrapolation or trend that's likely to happen in your view? And think about it through the lens of individual businesses. So maybe we could take AR. I know Apple has come out and said that by 2022, they'll have glasses or something like this. How do you then take the big idea and shrink it down to the portfolio size, you know, actual implementation?

• 17:11Speaker 02

  Within AR, if I am right, that mobile phones are going to become edge servers.

• 17:17Patrick O'Shaughnessy?

  I love that. Yeah, I'm not.

• 17:18Speaker 02

  Heard that before. I actually think I got it from somebody named Brian Norgard on Twitter. I know Brian, yeah. I feel like I don't have all that many great ideas of my own, but when I hear a good idea, I can instantly identify it and write it for a long time. So I think that came from Brian Norgard, who I've actually never met, but love his tweets. So AR, I think if the phone is an edge server, it is highly likely that the dominant phone operating systems will be the dominant providers of augmented reality at a platform level, whether it's platform or aggregator, she used the Ben Thompson terminology. Within virtual reality, it's fascinating. A lot of people want to control the metaverse, be the platform provider for this.

• 18:00Speaker 02

  You've seen Facebook, and by the way, I should reference that we're involved in various ways in a lot of the companies we've discussed. Facebook, they brought C T R L Labs, which is one of the providers of brain-computer interfaces. They bought Oculus. They missed the mobile phone platform revolution. They want to have a platform play in VR and AR. And if I'm right about edge servers, it's going to be hard for them in AR. They're making all these moves in VR. What is fascinating is that I think it is semi-inevitable that the platform layer in the metaverse, in the oasis, you know, to pick either William Gibson or Ready Player One terminology, there are going to be video games. If when you're going to go into the past, you're going to go into an Assassin's Creed game. When somebody wants to indulge a soldier fantasy,

• 18:45Speaker 02

  whether it's going to be Call of Duty, or if you want a lighter weight fantasy, that's going to be Fortnite. And this is already happening. Owen Williams, I believe, wrote a great article called Fortnite is a game, not a place. Matthew Ball wrote a great article on Fortnite, basically being the first true instantiation in some ways of the metaverse. Video games, this is something that if you look out five, seven, nine years into that hazy edge of intuition, I, this is a semi-realistic outcome that the dominant video game franchises today become the platforms within the metaverse, and they're all linked by some sort of substrate. That's part of how I try to put into the portfolio today.

• 19:27Patrick O'Shaughnessy?

  Can we talk more about video games specifically? So the landscape, the key players, the rising market share. I think Matthew Ball's done an awesome job. I'll convince him to come on here at some point. Hopefully, he's listening. The growth is spectacular, but I also think you have a fundamental market insight here that's similar to your insight from the early days on just Facebook. And its control of your attention being much higher than its control of ad revenues. And then maybe there's some analogy, but maybe tell that original insight and how that might apply to video games today.

• 19:55Speaker 02

  So I think Facebook was in some ways the first time I really put that kind of Apple framework where you have a really powerful long-term insight into effect. So I looked at Facebook and it's amazing, this was 2012. The stock had gone down 50% after its IPO. Mary Meeker published her annual slide deck, which is great. I've never met Mary, but wow, has she been important to my career. And she had on her slide deck that the internet, mobile and desktop, they used to break it up was, was I think 35% of consumer time spent, 23% of advertising revenue in the United States. And you know, as a student of history, I know that anytime a new format comes out

• 20:37Speaker 02

  that engages consumers, the advertising revenue always follows with a lag. So radio comes out, a lot of consumer time and attention switches away from newspapers. And it actually takes a long time for the 15 to 30 second radio ads to be standardized, for advertisers to become convinced that there's an ROI. But eventually, in a semi-linear fashion, ad dollars moved to radio. And then TV comes out and consumer time and attention shifts probably even more dramatically than it did with radio. The first TV ads were basically repurposed radio ads, and it took a long time for advertising dollars to catch up. So we were living through this with the internet. And so I was very confident, based on nearly 100 years of history, that that 23% of advertising revenue would go to 36% of that.

• 21:22Speaker 02

  And then for Facebook specifically, Facebook was roughly 7% of consumers' time spent across all mediums in the United States. And it was just under 4% of advertising dollars. So it was $5 billion in 2012. And so I was very confident, hey, I can underwrite to $11 billion in US ad revenue, just based on that one really simple mental model. And then I could extend that to the rest of the world, which is, you know, a $550 billion ad market. You get to something like, hey, their fair share should be $35 billion. That seemed conservative to me because there's a couple of important adjustments that you need to make to that. First of which is, search spending is not ad spending. Search spending is just demand fulfillment.

• 22:06Speaker 02

  You're not creating consumer intent, you're not generating demand, you are fulfilling demand. It's the digital equivalent of slotting fees. And slotting fees, if they could be measured precisely, would be dramatically higher than they are. You could just measure search in a way you can't measure slotting fees. Anything you can measure generally gets, in some ways, it may be overvalued in today's internet world.

• 22:26Patrick O'Shaughnessy?

  And slotting, just so people understand, might be like where something sits on a shelf in a store.

• 22:30Speaker 02

  Absolutely. Eye level is worth a lot more than the bottom shelf. And people have been paying slotting fees for a long time.

• 22:36Patrick O'Shaughnessy?

  And there's digital equivalent.

• 22:37Speaker 02

  Yeah. The second adjustment that you could make to that $35 billion was, hey, Facebook, it will be dramatically more measurable than any other non-internet medium. At the time, it's amazing. And in 2011 to 2012, print advertising was bigger than the internet advertising. The world, it changes very fast. But you can measure, you know who someone is, you know their interests, you can serve their ads at a more target. And theoretically, those should be a lot more valuable. And so the internet should, internet advertising should actually punch above its weight. And then the third adjustment that I thought about is, I thought it was pretty clear that the online economy, so to speak, would be significantly more advertising intensive than the offline economy.

• 23:21Speaker 02

  Many years later, it became very popular on FinTwit, and it's a great way to frame that idea up, which is just CAC is the new rent. Customer acquisition cost, online ad spend. It's not just replacing other forms of ad spend. For a lot of businesses, it is replacing rent.

• 23:36Patrick O'Shaughnessy?

  Storefronts.

• 23:37Speaker 02

  Yeah. And what is the global market for rent? So I thought without making any of those adjustments, you could get to this $35 billion revenue number for Facebook. Put a 50% EBIT margin on that, tax it at 20%, 14, 15 billion dollars in free cash flow. And I think the stock had an EV of 30 to 35 billion. So I'd been buying it in 2012. And then Mark Zuckerberg at TechCrunch Disrupt said, hey, I am 100% confident that our mobile ads, our newsfeed ads are going to be dramatically more valuable than our desktop ads because we have so much more telemetry about the user. We know their presence. We know their identity exactly. We know if they're looking at the screen. They're just going to be more valuable. And so that's slotted into this model. And I made Facebook a big position.

• 24:21Speaker 02

  With video games, I think there's a couple of things. So first, the global video game population has more than 10xed over the last, call it 10 to 15 years. And the reason for this is twofold. One is the video game industry used to only have one point of entry, and that was Nintendo and arcade games. The iPhone was a new point of entry that was dramatically more widespread than Nintendo's or arcade games ever would be. And then now you've had Fortnite is a third point of entry. But so the population has grown dramatically, but it's still, I think, less than a third of the people. Everybody on planet Earth listens to music or watches TV. Everyone on planet Earth will play video games

• 25:04Speaker 02

  in one form or another in my lifetime. It's a statement I'm reasonably confident about making. So number of players is growing. Hours per player is growing. From a monetization perspective, your average mobile phone game monetizes, let's call it 8 to 10 cents an hour. If it's not average, that's a reasonably well monetized game. Your average console or PC game monetizes at 50 cents per hour. Your average cable channel monetizes at 85 to 90 cents per hour. And the ones that are really engaging monetize at $2 to $3 an hour. I would just argue that over time, at a minimum, video game monetization should converge with your average cable channel. And just think how engaged someone is if you watch them

• 25:48Speaker 02

  playing Call of Duty or Fortnite or Assassin's Creed relative to how engaged they are during Shark Week. I would argue the only comparable form of engagement is really passionate sports fans. And that's that $2 to $3 an hour of engagement. So I think it's inevitable that monetization is going to increase. And it's important, none of that includes esports. If you're under the age of 25, chances are you spend more time watching esports than real sports. And none of those numbers are encompassed in that. Incidentally, one of the companies we've invested in on the private side, which hasn't announced yet, so I can't say their name, I think they may have the big monetization unlock for esports. And that what they do, I don't know if you've seen The Hunger Games or read them, but the audience can participate in the games.

• 26:33Speaker 02

  They could spend money and give a little bit of an edge. This lets audiences watching an esports match have an impact on the game. And I think that is going to be an enormous unlock for monetization. It's a company I'm super excited about. So we have engagement growing, big monetization opportunity, and then I think a big misperception in public markets, that these are hit-driven businesses. They're not. Full stop. For the last 20 years, Call of Duty has been the best-selling video game every year, except for when there is a Rockstar game. Red Dead Redemption or GTA. That's very consistent. If there's an Assassin's Creed, it's going to be in the top 10. If there's a Battlefield, it's probably going to be in the top 5.

• 27:17Speaker 02

  These franchises are super consistent, and the reason for that is they are social networks. Going back to these games are places as much as games. You have groups of people who like to play together, who like to play certain games together, and it's really hard for them to switch. And this is something I understand intimately. I play video games the way a lot of my peers play golf, and it's made me appreciate two things. One is, for sure, they are social networks. If I want to play a new game, it is hard. Something like Fortnite, that's something that happens every 5, 10, 15 years at most. Probably more like every 10 to 15 years. I'd say the most important thing it's made me appreciate, though, is the role of luck in my life and in everyone's life.

• 28:01Speaker 02

  There are people I play video games with who are brilliant, ice-cold under pressure, great teachers, natural leaders, and they didn't graduate from high school. In a different set of scenarios, this person could have been a CEO, could have been the president. But it's tough in America if you didn't graduate from high school to have that kind of outcome. Now, they're great people, happy lives, but it just makes me appreciate, wow, luck is the dominant.

• 28:33Patrick O'Shaughnessy?

  Sounds like the most interesting recruiting pipeline I've heard of in a while. Why has someone not tried to go identify really talented gamers and recruit them into businesses?

• 28:41Speaker 02

  Well, I'm actually a little bit embarrassed that the idea had not occurred to me. Yes, it's an interesting thing. It is a great recruitment pipeline. You know, it goes back to that movie long ago.

• 28:50Patrick O'Shaughnessy?

  I'm gonna write that one down.

• 28:51Speaker 02

  Exactly. There's this video game in the United States. It's a great movie from the 80s. There was a video game, and if you won the game, a sophisticated alien race came to Earth, took you away to serve as a pilot in some sort of war they were fighting with an implacable enemy. And the game was the recruiting tool.

• 29:08Patrick O'Shaughnessy?

  Again, the value accrual in this process is interesting to me. So we've got like a huge secular tailwind, let's call it, in video games. You've laid out a lot of fascinating stuff. The question then becomes, it sounds like the answer to how do you invest in this trend is via the game builders, not via like sports teams or stadium companies or ancillary parts of the stack. Because I had a really interesting conversation with a major league sports team owner who had said he looked at all these things. And unlike his ownership, there's no moat around it. Like, you know that there's not, probably not going to be another baseball league, and there's not going to be many more teams. So there's like a scarcity value here that doesn't seem to exist in that part of the stack. Would you agree with that?

• 29:46Speaker 02

  Well, I would make two observations. High confidence, whoever made that observation is probably over the age of 40, A, and B, does not play video games. Because in the same way that baseball, golf, tennis, football, basketball, there are only going to be so many dominant leagues. For Overwatch, there's only so many slots. Fortnite has approached esports in a very different way. Really good approach. There's only going to be so many slots for the Call of Duty League. So the teams that own those slots will be valuable. I don't think there's been a monetization unlock yet. I think this company we invested in could be a big part of it. Most of these teams today, they monetize primarily has, it's really cool, if you have the Cloud 9 or the FaZe merchandise, it actually really means something to people under the age of 30. So they're basically...

• 30:31Patrick O'Shaughnessy?

  It's emerging.

• 30:32Speaker 02

  Yeah, they're DTC, CPG brands today is the way esports teams monetize. But I do think there will be scarcity.

• 30:38Patrick O'Shaughnessy?

  Yeah, yeah, that's fascinating. What have been your favorite video games that you've ever played? Like maybe top two or three?

• 30:43Speaker 02

  I make a big effort to play every game that comes out and spend three to five hours on it. Because I sometimes feel like as a public equity investor in video games, the analogy I would make, imagine a world where of all the people who are, you know, investors at long only shops or hedge funds or significant participants in the market, less than 2% of them actually went to stores regularly, or shopped on amazon.com. And then most of them were trying to be retail investors. Okay, so it is an enormous advantage, I think, from a first principles perspective, to actually play the games. This goes back to the Peter Lynch. If you like the store, if you like the product, you'll love the stock. So I think it's important to play video games to understand them.

• 31:27Speaker 02

  But I did that for many years. I used to love Assassin's Creed, the Elder Scrolls. But the game that really hooked me was a game called Destiny, which is, I'm going to give you a nine-letter acronym. It was the first, in some ways, FPS, MMO, RPG, particularly set in a science fiction setting. I love science fiction. It's been an enormous part of my life. So I really love, the two things I love are both science fiction and then Lord of the Rings type history or variations of history, fantasy stuff. But science fiction has always been important to me. So it really spoke to me. I got sucked in.

• 32:01Patrick O'Shaughnessy?

  So FPS being first-person shooter.

• 32:02Speaker 02

  First-person shooter.

• 32:03Patrick O'Shaughnessy?

  But online collective.

• 32:04Speaker 02

  Massively multiplayer online and then role-playing game.

• 32:07Patrick O'Shaughnessy?

  Yeah, I think you'll like this. I was excellent at Counter-Strike for a long, long time online. So I think I know like it's not a fantasy elements, but an amazing game.

• 32:15Speaker 02

  It's actually been very hubbling for me. There are very few things I'm competitive about. Investing is one, ping pong is one, chess is another, and video games have become another. But just as, you know, a 43-year-old man, it is really tough. I have to be super crafty and have high map knowledge to do well in PvP. I get carried through by the sub 25 contingent of the group that we play with.

• 32:39Patrick O'Shaughnessy?

  Yeah, we've talked a lot about technology specifically. We've got some more topics to cover in that vein as well. But I know you also invest in consumer businesses and really just those two sectors as your primary focus. And I know you find those to be the most alpha-rich of the sectors. And I think even your track record in the other sectors is not so good or subtractive from your total performance. So what is it about those two sectors that you think makes them good breeding ground for finding real alpha?

• 33:03Speaker 02

  The last numbers I saw, if you're to measure alpha richness, has the spread between the top decile and the bottom decile in a given year. And that's your opportunity to generate alpha. It's one way to measure it. On a scale of one through 10, tech's a 10, consumer's a 7, healthcare is a 5. I think nothing else is above a 3.5 or a 4. There's a lot of alpha richness. I think it's because there is a huge uncertainty about the future in tech. So you get these wild swings and overreactions and dislocations. So I think tech is relatively easy to understand why it is alpha-rich. Consumer, I've actually never thought about it before. Consumer, I think part of it is, is that in some ways it is the most immediately impacted by those technological shifts.

• 33:47Speaker 02

  So when radio came out, there's probably an opportunity to build new brands. And the brands that moved first to radio build value. TV, same thing. Internet, same thing. Consumer tastes and preferences, on the one hand, they're very stable. You have these really enduring businesses, whether it's Starbucks or Louis Vuitton. But on the other hand, you have a lot of businesses that have not stood the test of time. That is probably why those two sectors are alpha-rich. There was a quantitative study done on my performance. It was actually somewhere between embarrassing and humbling to realize that I destroyed alpha in, very consistently, in industrials, in energy, in healthcare, in financials.

• 34:28Speaker 02

  But luckily, I generated enough alpha in consumer and tech to overwhelm all of that. Part of that is the alpha richness of the sectors, and then part of it is just personal interest.

• 34:38Patrick O'Shaughnessy?

  Yeah, yeah. You mentioned also that you always want to be in the top 1% of knowledge about a company among investors in order to take a position. So talk about that little model. Why 1%? How does one even do that? There's a lot of smart investors out there. So to be in the top 1% of just about anything in this landscape is difficult, let alone across a lot of businesses. So what is the method by which you get to know businesses to that level?

• 35:03Speaker 02

  Insatiable curiosity, hard work, and then tech, and to a much lesser extent, consumer. It's a game of cumulative knowledge. Kind of an interesting thing about tech. Is a lot of people got washed out by the year 2000 bubble. And then Warren Buffett had been saying in the mid to late 90s, tech was outside of circle of competence. So I think a lot of people looked at the bubble, the collapse, Warren Buffett statement, and you had a whole generation of brilliant investors who avoided tech. And I would actually argue that it's harder to be in the top 1% of knowledge about banks, insurance companies, what your 100 year old businesses that my generation of investors, I think, really focused upon than tech. Cause so many people got washed out and walked away.

• 35:47Speaker 02

  And then 08, 09 happened, a lot more people got washed out, walked away. There are that many people, we've all been going to the same conferences to some degree, we know each other, who have been doing tech continuously at a high level since the year 2000. And so tech being a game of cumulative knowledge, I think that's very important. So in some ways, I think it makes it easier than in other industries. There's so much dynamism.

• 36:13Speaker 02

  I think it was ignored for so long by so many. But yeah, it just takes hard work. This is a very hard business. But I do think if I've been doing this for 20 years and one of ex people who have been really focusing on tech intensely for 20 years, it is reasonable to think that I can do that. How many people read the Google S1 when it came out? The Netflix S1 when it came out? The Salesforce S1 when it came out? It's a realistic goal, but it is really, really hard.

• 36:41Patrick O'Shaughnessy?

  I think the best evidence of this idea is just read Ben Thompson for a year, read him every day. Like the only way that guy could churn out such high signal content so quickly is if you had that accumulated knowledge.

• 36:52Speaker 02

  Absolutely. Now Ben Stratechery, what a resource.

• 36:55Patrick O'Shaughnessy?

  Yeah, he's incredible. So I want to talk about value investing now. We've talked about growth investing and your general take on what is, I think, one of the most interesting questions in the market right now. So the setup is value's done very badly. Value is also arguably very easy to measure, very hard to know what one element like we've talked about is going to drive a business for the next seven years. Very easy to say what a company's PE ratio is, let's say. So it's done badly, despite a lot of great historical evidence that it works, just as a standalone factor. I'm curious, your take on what you think the present and future of value investing is?

• 37:29Speaker 02

  So I think in the present, many reasons that it worked, there's natural mean reversion in the economy. You know, if companies get really cheap, the stocks go down a lot, executive talent leaves, capital leaves, and that sows the seed of less capital, higher returns going forward. Companies are really expensive and the stocks are going up. It attracts capital, it attracts executive talent, sowing the seeds of future pressure on that industry. And I do think at a fundamental level, two things have happened that I think are challenging that mean reversion, and you're seeing this. Top decile ROICs are dramatically more persistent than they were even 10 or 15 years ago. I think there's two things for that. One is, without talking about politics, but there's dramatically more regulatory capture

• 38:11Speaker 02

  in modern America than I think there's been the last 70 or 80 years. And so regulatory capture generally entrenches incumbents. But the second thing is, if you were to make me choose one buried entry, one competitive advantage, it would be scale every time, and particularly relative scale. It's great to be at 40%, but if you've got two competitors who reach at 30, that's not nearly as good as being at 70 and having everybody else under 10, or even being at 15 and everybody else under 1. And scale is actually more important online than offline. If you're going to similarly make me choose one thing to kind of understand AI and the worlds we're going into, is my understanding, and I am no computer scientist or expert,

• 38:54Speaker 02

  but I do try to read all the research papers. The single most predictive element of knowledge about AI quality is the quantity of data used to train the algorithm. The algorithms, they don't matter that much, although beginning to change with, there's a lot of innovation in the last three years. The infrastructure used to train it doesn't matter as long as it's adequate. All that matters is the quantity of data. And it's been very well established in multiple papers from both Google and Microsoft research that for every order of magnitude increase in the data you use to train an algorithm, the quality of the AI doubles. And quality means AI is fundamentally used to make predictions, and this is the variance from zero error.

• 39:35Speaker 02

  So going from 96% accurate to 98% accurate is a doubling of quality. That creates all these powerful feedback loops for large tech companies, where if data quantity Drives AI quality and you have a dominant market share position. You have this feedback loop where you have the most users. They're generating the most data. That's training your algorithms. And so your algorithms are improving at a faster rate than anyone else's can improve. So I think when you put those things together, it's why you've seen less mean reversion. So if you had an algorithmic breakthrough that changed that, whether it's in GANs or CNNs or whatever it is, generative adversarial neural networks and convolutional neural networks. A lot of research is going into solving this problem.

• 40:19Speaker 02

  That would probably introduce more mean reversion within technology. And then the second thing is, why did value work in addition to those fundamental principles? There was this human element where you were perceived as taking career risk if you owned a really unpopular stock and algorithms don't feel career risk. And it's pretty easy to put into an algorithm, hey, this is the bottom decile. Within quant specifically, I think a lot of AI has been applied to it with great success, but by probably a few players. Renaissance, I would bet what is at the core of their success is proprietary data. They went around the world and bought up proprietary data sets with 50 to 100 year

• 41:00Speaker 02

  licenses and they intersected those with the stock market and they're running all sorts of incredible pattern recognition. And you can't get those data sets because Renaissance has them locked up. If you put all of that together, it's probably why value has struggled. And I also think even within the career risk, everybody's steeped in Benjamin Graham now. Everybody knows that chapter eight and chapter 20 are the most important chapters of the intelligent investor. Everybody is steeped in Warren Buffett. My observation would be, I think today at a big long only, and you have some sort of quarterly or semi annual or annual review with your CIO and you lose money in an expensive stock.

• 41:43Speaker 02

  That probably counts against you more than if you lose money to cheap stock.

• 41:47Patrick O'Shaughnessy?

  Yeah, it's amazing. Say a little bit more about why regulatory capture has increased and maybe specifically like, what is behind that trend and maybe an example of the type of company that might benefit.

• 41:57Speaker 02

  I would rather not wade into controversy, but I would just say, I think that companies and their lobbying organizations have become super adept at hiring former chiefs of staff to influential people in Congress, to hiring former regulators and assembling an army of regulatory expertise to the extent that I think a lot of important laws in America today are actually written by the companies and by their lobbyists. The modern economy has become so complicated that I think it's hard for

• 42:29Patrick O'Shaughnessy?

  A legislator to

• 42:30Speaker 02

  A legislator, no matter how brilliant, to understand.

• 42:33Patrick O'Shaughnessy?

  Yeah. What are some of the potential headwinds to, let's talk specifically maybe about technology? So obviously the antitrust talk has bubbled up again, specifically the regulation of very large technology platform companies where the concern is that it may not look like monopolies of old because so many times it's free or extremely low cost. Consumers tend to love these companies, but nonetheless, it is an issue that I think would probably affect investing outcomes. So how do you think about a potential headwind like that?

• 43:01Speaker 02

  For sure, it's the most important thing to think about in the context of a lot of these large tech companies that we've spoken about. And it is a risk. It's absolutely a risk to Google, to Facebook, to Amazon. It's not as clear to see it as a risk for Netflix. It's a risk to Apple in some ways. But the way I conceptualize it, while being super aware that it is a risk, is that I think the most logical way to regulate these companies that might be the best for the American economy would be to simply break them up. And I think there is a degree of conglomerate discount embedded in most of these companies and breaking that up. Probably the capital allocation would improve. Within Google, search is probably not growing that fast.

• 43:44Speaker 02

  And so if that were a standalone business that was paying a distribution tax to Android and Chrome, it might have very different capital allocation. It might be running a much higher buyback yield. What do you think about breaking these companies up, getting rid of the conglomerate discount, having appropriate capital allocation for each segment of the business? I could get comfortable with them being broken up. But of course, there's another outcome where there's very heavy-handed regulation here in the United States that really disadvantages these companies. And I would argue that that would be both a big risk to those equities and very negative for the United States because in that world, Chinese internet companies would dominate. Full stop.

• 44:22Patrick O'Shaughnessy?

  You anticipated my exact next question, which is the Chinese internet. I know you're not an investor there, but it's an obviously critical part of the global technology ecosystem. So summarize kind of what your take is on how and where that matters most to US technology companies, the Chinese internet.

• 44:40Speaker 02

  Absolutely. This goes back to that 1% of knowledge. I have been following the Chinese internet from its earliest days, from when Tencent was the only public company. And I followed it closely because it was primarily a gaming company. But I will never be in the top 1% of knowledge about a Chinese internet company. I don't speak the language. And so being true to my process, at some point, could we have a very small 50 or 100 basis point position in a Chinese internet company? If there's an enormous dislocation, absolutely. But it is critical to study Chinese internet companies because in some ways, and they're more innovative than American internet companies. And it is largely because they don't have the established retail and payments infrastructure to contend with.

• 45:24Speaker 02

  So you have these super apps in China. Connie Chan from A16Z, who I've never met, she's written brilliantly about these super apps. I've learned a lot from her. I go to China a minimum once per year to be on the ground and try and just feel, wow, forget using cash. It's hard to use a credit card. You go to a Starbucks in China or in a restaurant and you want to use a credit card and they're like, oh, where's that credit card reader? And literally, it's like buried underneath. They get it out and it's dusty. So Chinese internet is super important to see the shape of things to come for, I think, US internet. And they are great companies, very dominant, but I don't think they'll ever be regulated in the same way as US internet companies.

• 46:08Patrick O'Shaughnessy?

  How often do you see, I'm reading this really interesting book about, we'll call it the borrowing of technology from certain countries into others. Do you see US companies' management teams trying to look to China that's moved faster in some ways than we have to borrow ideas, whether it's in payments or in other areas?

• 46:25Speaker 02

  Absolutely.

• 46:25Patrick O'Shaughnessy?

  What's some examples of that?

• 46:27Speaker 02

  The first cut at monetizing WhatsApp was driven by what had worked in China. You know, hey, we're going to have this be a B to B customer service channel. That didn't really take off. A lot of people just read that Uber, they're very focused on the potential. This could be a super app because we have so many users who are using it daily and you can hang all these other services off of it in the same way that WeChat is a super app in China.

• 46:52Patrick O'Shaughnessy?

  What is the role today in your process, or do you see more broadly, of alternative data? We've talked a lot about just data more generally speaking, but in the investing process, I would say this is one of the major, very fast-paced things changing. So what's your take as a more fundamental investor, but obviously one that cares about information? What's your take on the role of alternative data in the investing process?

• 47:15Speaker 02

  If you're a fundamental investor, I think it has become table stakes today. Everybody has the credit card data. Everybody sees how sales are trending during the quarter. But I think it is very difficult to get a sustained competitive advantage from alternative data unless you're, again, Renaissance and you've locked up these proprietary data sets. They're sold to everyone. I'm here to tell you, they kind of have scale-based pricing. It's a great story if you're a big fund to say, hey, we've got proprietary data. No, you don't. Really great data scientists, they're making 25 to 50 million dollars a year, either at Google, Facebook. So I don't think it's a source of competitive advantage. I do think it's table stakes. And I will just say, It is the biggest change I have ever seen.

• 48:00Speaker 02

  In some ways, even bigger than Reg FD. There was a very sharp change in the investing world, pre and post the implementation of Reg FD, and companies became much more circumspect in what they said to select group of investors, which, by the way, was all to the good. But this is the only comparable change. And I do think, I would observe, a lot of the big moves that you see in earnings season are generally the alternative data. It feels very precise. Hey, here's what their sales are. And here's what their sales are month by month. But it's a tiny sample set. There's a lot of error. And a lot of the moves you saw this past earnings season were because the alternative data was predicting one thing, and it was wrong, and people were off sides. So I think it's just important to be aware of.

• 48:45Speaker 02

  It's table stakes. You need to be aware of it. It's kind of dark matter in the universe. The universe weighs more than we think. The dark matter of public equity investing is alternative data, on one hand, so to speak, which has a huge impact on prices. One of these big providers comes out with a report saying a company is tracking to miss numbers. That company is down a lot that day. The other dark matter is what's happening in private markets. And they have a big influence on public equity companies without being, I think, immediately observable. But I do think you can use it in interesting ways. In some ways, it may be more helpful in venture. We have an app where we can actually get an alert for any company that's private, whose sales are growing more than 200%. And then that's interesting.

• 49:29Speaker 02

  It may end up being more useful from an investment perspective as venture, but then everybody will go to those, so the valuation of those rounds will incorporate it. But you can also use it to do, you know, the core of most venture capital-style investment analysis is looking at customer cohorts. And if you see the cohorts, you can get a reasonable degree of conviction, looking out two to three years, if the cohorts are stable to improving, how they're going to act. And then you can model the revenues out with a higher degree of confidence than is generally possible to do with public equities, where you don't have that cohort data. And you can begin to kind of construct cohorts for public companies and do fundamental analysis that wasn't possible before.

• 50:08Patrick O'Shaughnessy?

  I saw you reference somewhere that great Mac Kohler from Benchmark quote about not having to predict the future, just having to notice things in the present first. I love that idea. What other big things have you noticed in the present that we haven't talked about that you think will turn into big trends?

• 50:23Speaker 02

  Such a powerful statement. My job is not to predict the future. It's simply to notice the present first is the exact quote. Coming back to video games, there is kind of an example of this. You know, if you go back to 2012, these businesses used to be dramatically more cyclical around a console cycle, and a lot of that has been mitigated, has these games have become social networks, consoles are backwards compatible, but they used to be perceived as cyclical. And generally, at the start of a new console cycle, they would have super high multiples. But if you go back to 2012, a new console cycle was right in front of us. And yet, public equity, video game equities were generally trading at trough multiples. And there was a fear, again, I think driven by a lot of investors who don't play video games

• 51:06Speaker 02

  and don't understand them, and there was a fear that the reason that the video game companies were, their sales were declining was because of the iPhone, that this was a permanent change, it was a substitute. And so I looked at the video game industry and thought, hey, it's behaving just the way it normally has, but there was this huge fear, this big disconnect. And from a first principles perspective, I believe that there was no way that a game you played on a four inch screen with your fingers, which are a very imprecise input method, was in any way a substitute for playing Call of Duty on a 50 inch screen in surround sound with your friends. It was a compliment. And so that was just noticing the present, that, hey, there is this fear in the market

• 51:48Speaker 02

  that the iPhone is driving substitution away from console and PC video gaming and being able to say from a first principles perspective, that's not the case. What's actually happened is this is the longest console cycle in history. So you could almost argue the relative gap between consoles and iPhone at the time was the smallest it would ever be, even the relative gap between consoles and PCs was as low as it would ever get. And so the new console would actually have the biggest uplift ever. It was the PS4, the Xbox One, they would have the biggest uplift in processing power ever over the prior generation because they'd had the longest from Moore's Law to run. So I looked at all that, you know, and I made public equity video games a very large position in my fund.

• 52:30Speaker 02

  I think I owned between eight to 10% of a majority of the public equity video game companies in America. So that's an example of simply noticing the present first. Another example of being able to invest simply based on an accurate understanding of the present happened in the summer of 2017. Generally, most of my career as a long only investor, I was underweight retail because I thought physical retail was a structural share loser to e-commerce. And then beginning in mid 2016, you started to hear from really forward-thinking DTC brands and e-commerce companies that they're finding that, wow, if we have a few stores, it actually dramatically impacts our online advertising efficiency, which is the single

• 53:14Speaker 02

  most important metric, along with customer retention for any e-commerce company. So it makes sense to have 25, 50 stores and hey, maybe they're just showrooms, but wow, there is a value to physical retail. So you started to hear that. I started to hear it more. It made sense to me from a first principles perspective as a consumer. And then in the summer of 2017, Amazon bought Whole Foods. And I thought, this is a complete validation of the value of physical retail. From the world's biggest and most sophisticated e-commerce company, they're saying physical retail has value. And yet, your average retailer went down somewhere between 10 and 20% that day on

• 53:55Speaker 02

  what to me was kind of the absurd idea, what Amazon is going to start putting TVs and PCs and game consoles and Whole Foods? You know, they're going to start selling apparel in Whole Foods? How does this change the competitive dynamic at all? I think it's very simple, the mental models you want to have for physical retail. You either want exclusive supply, or you can't find it on Amazon, or you want high cash pay as a percentage of your customers, because that means you're not competing with Amazon Prime. Competing with Amazon Prime, really hard. Competing with the Amazon non-Prime, not nearly as hard. And then you want to filter both of those through. You can get a good idea how sophisticated a company is from a digital perspective. You know, how many people are in your loyalty program?

• 54:40Speaker 02

  How many personalized messages do you send, send out per week? You know, so what is a degree of digital sophistication? So you look for proprietary supply, high cash pay, and then a reasonable degree of digital sophistication, and that's what you look for in a retailer.

• 54:52Patrick O'Shaughnessy?

  Yeah. What is the most interesting company that you do not own?

• 54:57Speaker 02

  Well, right now, we are not involved in Netflix.

• 55:02Speaker 02

  Netflix throughout my career is by far my biggest mistake. I never owned it in size. And this perfectly fit the Peter Lynch. If you love the product, you'll love the stock. It snapped really neatly into a pre-existing middle model, which is just the internet kind of gets rid of all distribution layers between the producer and the consumer. And content in the pre Netflix world was basically being marked up 400% and then resold to the consumer. So if you're really talented director, actor, writer, you go, you work for a large entertainment company, a production house. They mark your content up 100%. You can look at their gross margins. And then they sell that content that's marked up 100% onto Comcast, DirecTV, whoever, marked up another 100%.

• 55:46Speaker 02

  So there's a 400% markup between the original content creator and the consumer. Netflix got rid of all of that, which meant that they could deliver dramatically superior consumer value. So I've always thought it was kind of inexcusable that I miss Netflix. Earlier at a tradies, we were short Netflix. And the reason we were were short it, I'm completely aware there, there's this great long-term, very simple bookcase. It's just like, hey, let's say they're eventually going to have 500 million subs, $10 a month, $60 billion in revenue. They're going to run at a reasonably high margin. There's going to be a couple of global video distribution oligopolies and producers, and this is going to be one of them. Completely get it. But in my experience, one of the most important things is to look for

• 56:32Speaker 02

  as a technology investor is changes in competitive intensity. And it is even more important in technology than other areas of the economy because of the way the Google and the Facebook ad auctions work. These are both vicry auctions, they're second price auctions. So if you operate in a relatively uncompetitive segment, you have incredible advertising efficiency because your winning bid is always the second bid. But it also means what auction pressure can do to that customer acquisition cost. I've actually never seen anyone model it correctly. It generally blows out in a way that people cannot imagine. So I looked at Netflix and I thought, okay,

• 57:17Speaker 02

  they've had a relatively uncompetitive online customer acquisition world. Maybe it's them and Hulu to some degree. Maybe they're bidding, I would guess Netflix is bidding on Google keywords every second. I would also guess they're probably the only bidder of scale on 50% of those. So they have incredible ad efficiencies. So when all these other companies come in, you're going to go from incredible advertising efficiency to much lower advertising efficiency. So I was reasonably confident that had not been modeled correctly. And then I think what drove Netflix from 250 to 350 was realizing that they had a lot of perceived latent pricing power. It's one of Charlie Munger's mental models for how to make money in the stock market.

• 58:00Speaker 02

  And I was, wow, all of a sudden, let's run that math that instead of a $10 per sub, let's run it $20 and geez, you get something really exciting. And I thought, well, as we go from a world where it's kind of just Netflix to one where they have a lot of competitors, pricing power probably goes away, your CAC goes up. And then I fundamentally thought, no one knows what a piece of iconic content like The Friends, The Office is actually worth. And I would just say for my own Netflix usage, my wife and I, we watch 45 minutes of a drama, we watch 15 minutes of comedy, and we actually just cycle through The Office and Parks and Rec. And, you know, those are some of the most watched shows on Netflix. So I thought, hey, nobody really knows how valuable those are. And so you had a bunch of inputs into their business model that I thought after people

• 58:44Speaker 02

  feeling very certain were going to feel really uncertain. And it also felt like, wow, a very well-owned name. There's ways you could look at it and say it was cheap. There's other ways you could look at it and say it's expensive. And generally, when the uncertainty about five to seven year outcomes goes up, valuation horizons come in. And so I thought people would start to value Netflix on earlier numbers. So put all that together, it was a short for us, but now it's what I would call, it's a meaning of livestock for now, where I do still believe in that long-term outcome, but the degree of difficulty is so hard. And I avoid really high degree of difficulty stocks.

• 59:19Patrick O'Shaughnessy?

  One of the things you talked about earlier is this accumulating knowledge 20 years in, having learned so much about these businesses. What advice would you give new entrants, young people that are interested in getting into the investment business in terms of what to focus on, what skills are going to become most valuable to be successful investors over the next 20 years?

• 59:38Speaker 02

  I would just say you have to be steeped in Buffett, Peter Lynch, Soros. You have to know those fundamentals, the basics. I would encourage them to listen to your podcast. I think there is a lot of accumulated wisdom here. I think the most important advice I would give is focus on what you're passionate about. It just happened my entire life I've loved science fiction. And so it was very natural for me to focus on technology because I've always had an interest in the future. If you are passionate about an area of the market, odds are actually high that you're going to end up being a really good investor because I do think knowledge and hard work, they matter. And it's tough to get to that top 1% if it's not fun for you. So I think you want to get to that top 1% knowledge level.

• 1:00:23Speaker 02

  Recognize that it's going to take a long time, you know, hey, if you focus on three stocks, can you get there in three years? Maybe, but recognize it's going to take a long time, approach it with humility, but pick something you're passionate about. Where, you know, the first thing I do when I wake up on Saturday and Sunday morning is I read about technology. It doesn't feel like work, it feels like fun and pick something like that.

• 1:00:49Patrick O'Shaughnessy?

  So three closing questions for you. The first, picking up on what you just said, what is the most maybe non-obvious source of reading in the technology sphere specifically, so Ben Thompson's not an answer that's allowed? Something that you read consistently that you think is really valuable.

• 1:01:03Speaker 02

  I check TechMeme 10 times a day.

• 1:01:05Patrick O'Shaughnessy?

  TechMeme, okay.

• 1:01:06Speaker 02

  TechMeme.

• 1:01:07Patrick O'Shaughnessy?

  I don't read that, yeah.

• 1:01:07Speaker 02

  There's so many tech blogs, it's hard to read them all. You know, Stratechery is one of the best, there's a couple of others that are quite good. But TechMeme surfaces the best content of that day. And then Twitter, Twitter is the world's greatest interest-based network.

• 1:01:21Patrick O'Shaughnessy?

  Yep, I have to ask a slightly different version of the sci-fi question. Rather than ask your favorite book or series, I'll ask for your favorite sci-fi character, individual character.

• 1:01:30Speaker 02

  I do love the two people who in the Second Foundation are actually the representatives of the Second Foundation and they go along with the mule.

• 1:01:38Patrick O'Shaughnessy?

  Beta Durel?

• 1:01:39Speaker 02

  Yeah, Beta Durel. I think that's a great character. Low-key, humble, under the radar, changes the course of history for the entire galaxy.

• 1:01:50Patrick O'Shaughnessy?

  My closing question for everybody is to ask for the kindest thing that anyone's ever done for you.

• 1:01:55Speaker 02

  So I feel I'm a big student of happiness research and happiness research would say many things, but one of them is that the most important emotion I think in some ways to feel is gratitude. So I feel really grateful to so many people. I feel very grateful to my junior English teacher, a woman named Nancy Eisenberg. I sent her a note in 2014 explaining this, but I was actually not a good student in high school. I loved to read, I loved to do other things, I was very social, I played video games, but I did not study that hard. Junior year at my high school in Houston, Texas, and the big thing was the junior research paper. You had to write an enormous paper that was really going to be the centerpiece of your grade junior year. Of course, junior English is very important.

• 1:02:39Speaker 02

  So I thought, wow, I better be super serious about this. And it had been, you know, a six-month process. And I thought, I'm going to work on this for three days, really hardcore. And that was a lot of work for me at the time. So I turned in the first draft and it comes back F. And I think, geez, I worked pretty hard on this. I objectively think it was pretty good. So I went to see Mrs. Eisenberg and I said, you know, Ms. Eisenberg, this is the worst grade I've ever gotten. And she said, well, Gavin, I have very high expectations for you and I know that you can do better than this. You know, that was perfectly designed to appeal. She was a very good teacher to a 17-year-old young man to make him work hard. So I went and I worked hard for the first time in my life and it was super fulfilling.

• 1:03:23Speaker 02

  And I ended up getting a B+ or an A-, she wasn't going to give me an A. But that was an incredibly fulfilling experience for me that I think drove a lot of future outcomes in my life.

• 1:03:32Speaker 03

  Your enthusiasm jumps through the mic, as I'm sure people will hear and will have enjoyed very much. So thank you so much for your time and all the interesting ideas.

• 1:03:39Speaker 02

  Awesome. Thank you, Patrick. Thanks for the awesome questions. Thank you.

• 1:03:43Speaker 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, at Patrick underscore Oshag, O-S-H-A-G.

• 1:04:11Speaker 03

  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.

• 1:04:32Speaker 03

  You