Pembridgecap

A Wealth Creation Journal

Category: Investing philosophy (page 1 of 5)

Concentrated Investing vs Change

My initial introduction to investing exposed me to different strands of thoughts and notions about investing. Only a few of these notions about investing are fundamental principles and exist as objective truths in my opinion. (yes, I see the contradiction here) One such principle includes the notion that the intrinsic value of a business is determined by the sum of all future cash flow that is generated by the business discounted at an appropriate rate. Another is the notion that shares represent partial ownership in businesses. Besides these fundamental principles, there are many tried and tested investment lessons and stylistic preferences that work for different individual investors. For example, many successful investors prefer to do highly concentrated investing. Warren Buffett famously said:

“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”

I am intuitively attracted to the basic premises behind concentrated investing – 1) great ideas are hard to come by and when given the chance needs to bet big, and 2) high concentration forces discipline to focus on companies that are within one’s circle of competence. The mantra of concentrated investing contradicts the conventional investment wisdom which preaches diversification. In the name of diversification, most investment funds would routinely own hundreds of stocks. Investment managers who own 20+ stock would be considered concentrated by average industry standards. As a fully-signed up practitioner of concentrated investing, I generally own no more than 10 businesses and currently, my top three positions make up over 50% of my portfolio.

Lately, I am observing something strange. As I learn more about businesses in the technology and creative industries which typically exhibit extreme pay-off characteristics, I am struggling to apply the concentrated investing to investment opportunities with small chances of success but have huge pay-offs in the event of success. For example, video game companies are typically considered by the investment community as a hit-driven business and hence not investable because no one can figure out the long term earning power of a game company. However, there are compelling situations where the combinations of valuation, unique insights into the business and historical track records that can lead to profitable investment opportunities into a game company. Any cursory look at Nintendo’s historical earning profile, which is very highly cyclical, would seem to reinforce the view that video game is a hit-driven business and hence uninvestable. However, a confluence of technological trends and industry changes seem to herald a very bright future for Nintendo. Through the proliferation of cloud computing, higher Internet speed and adoption of the subscription business model, Nintendo could be building a direct and continuous relationship with its customers and transition the hit-driven revenue model into a stable and growing earnings stream. In this case, Nintendo could be worth multiples of its current market cap.

Nintendo is in a state of change – it could navigate the changes perfectly or it could fail to transform itself and relegated into the oblivion. I believe Nintendo has a non-trivial chance of wild success due to its unique culture, extraordinary game development track record and strong IP. Let’s call a non-trivial chance of success as 10%. And let’s assume that if successful, it could be worth 10x more.  But it still has a 90% chance of failure and would be worth 50% of its current valuation in the event of failure. The expected return for Nintendo would be 1.5x which seems like an attractive bet to make. However, it is not reasonable to have this as a large position size, say 20% of the portfolio, because there is still a 90% chance that I will lose 50%! The logical strategy is to spread the bet over a large number of these opportunities such that we can achieve the expected return. But spreading the portfolio over a large number of bets runs counter to the mantra of concentrated investing!

Now consider another investment opportunity that has the following characteristics – 70% of a 1.7x payoff and a 30% chance of 5% loss – which has the same expected return of 1.5x as the Nintendo example. Now, this looks like a classical asymmetric bet and could be a big bet in the portfolio despite having both investment opportunities having the same expected return. The second investment opportunity is likely to be a stable business with a solid asset value to act as valuation backstop. It could be an elevator OEM going through a cyclical low point and the earnings are depressed because new elevator sales loss is masking the true profitability of the maintenance income. If both investment opportunities are available to me, I would always pick the second one over the first one! It becomes really challenging if the opportunities with the best expected return exhibit extremely pay-off structure like the Nintendo example.

While I have not done a rigorous study, it does seem like concentrated investing works better in a stable industry environment where the company’s intrinsic value is relatively stable and the difference between the best operator and the average operator is relatively small. However, companies that are currently in a rapidly-changing industry with winner-take-most characteristics can produce extreme pay-off structures because the winner is able to grow its intrinsic value dramatically. Maybe these binary investment opportunities might not be so suited to the highly-concentrated investing style. But what if the best investment opportunities lie in these rapidly-changing industry with extreme pay-off structures?

This runs into another notion of investing where Warren Buffett famously said that change is the enemy of investors. Four years ago, I would agree whole-heartedly. I am less sure now. I think change could be the friend of an investor if, and only if, the investor has unique insights into the nature of the change that allows the investor to handicap risks confidently and figure out the pay-off structure clearly. One still has to do the work to gain real insight into an industry / a company that is undergoing change.

Arguably, it requires a lot more work to gain insight into a changing industry versus a stable industry. So all else equal, I would much rather make the same amount of money with the least amount of effort possible. Alas, the investment management field has gotten more competitive and what used to work before might no longer work so well anymore. So to stay ahead of the competition, one has to do things differently. Maybe this includes being open-minded about how to conduct concentrated investing and perceive industry changes in the context of investing.

Investment Decision Log – User Manual

I have recently created a spreadsheet to record all of my investment decisions. The goal is to track decision quality and try to learn from mistakes and reinforce things that I am doing well. This is a long term project to improve my decision-making skills.

Decision-making is inherently statistical in nature. Hence the nature of this assessment should be statistical in nature too. With a sufficiently large sample size, the assessment of the decisions should start to become meaningful as the quality of my decisions will converge with share price performance.

I also included ideas that I have done some work on but not acted on….

Each decision will be given a rating based on two dimensions – 1) share price performance since decision; 2) facts that evolved since the decision to measure the soundness of decision logic e.g. I sold DTG because I think the risk of long term price competition is not sufficiently captured in the valuation.

The second dimension is still subject to my own judgement and hence the risk that it is not sufficiently well captured. The good thing is that I still have share price performance as an objective measure to capture things that clearly look out of place. For example, if the share price is down 90% while I claim the original decision is good then I need to have a very convincing explanation backed by strong evidence. I trust that I can be brutally honest to myself.

To assess the second dimension of decision making:

      1. Did what I predict to happen actually materialise?
      2. Based on the outcome of the events, was the original probabilistic assessment correct?
      3. Was luck involved in the magnitude of the outcome? (added to comments)

If the answer to all three is positive, then it is a good decision. If 1 and 2 are conflicting, need to explain why they are conflicting. Will still need to make a collective judgement. Also need to comment on the role of luck. For example, I expect a positive event to yield a 10% increase in share price but it went up 50% because of extraneous factors. Then luck was responsible to push up the magnitude of the return

There are five possible ratings for each decision:

      • G – Good Decision and Good Outcome
      • U – Good Decision and Bad Outcome
      • L – Bad Decision and Good Outcome
      • E – Bad Decision and Bad Outcome
      • X – Unable to evaluate decision quality regardless of the outcome

The goal is to prevent U decisions to discourage me from making the same decision in the future. Nor should I let L decisions to trick me into over-confidence. And allow for reinforcement by G decisions and learn from E decisions. Rating X is given to decisions where there is insufficient facts and time to evaluate the quality of the decision.

The assessment period for each decision depends on the nature of the underlying decision. For example a special situation investment decision depends on the outcome of a specific event. So even if I sold the position before the event crystallises and make profit on it, I must still wait for the outcome of the decision to determine the quality of my decision. On the other extreme, an investment in Games Workshop requires a longer time to evaluate because the fundamental investment thesis is a long term one. For example, Warhammer IP is a very good one requires continuous assessment. Hence each investment decision should be assigned to different assessment periods.

Ways to analyse my own decision:

      • Based on position size – big vs small – am I good at making big position decision vs small position decisions
      • Value of add and reduces
      • Decision by investment categories – General / Compounder / Workouts
      • The magnitude of mistake of omission
      • The decision over the lifetime of each investment
      • The decision that yield the best returns vs worst returns

Shortcomings of this decision log – it doesn’t capture a lot of passively made decisions such as to do nothing to an existing position when stock prices go up. This is something I need to think about how to capture better.

Should you invest in franchises or managements? It depends.

Note we wrote this post last year.

Many investors categorize themselves and either say

  • they make judgment call on management or
  • rather focus on the franchise or business (it’s rather cool for some in the value investing church to say not getting to know management is a good thing)

Should we focus on the horse or the jockey?

Investor Robert Vinall is known to focus a lot on management. He believes it’s a hard but important question. Important, because it is difficult to quantify, and therefore there’s less competition from conventional investors and quant funds.

Guy Spier, on the other hand, likes to think of himself as a merely good investor, with lots of limitations, such as judging management. He therefore avoids talking to management. Getting to know managements opens us up to get manipulated by their – often perfect – act.

On bad business turnarounds Warren Buffett has said this:

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

While we definitely think there’s great arguments for both point of views, we think the relative importance of analyzing franchises versus managements changes a lot with one critical variable: growth.

Focus on the racehorse and on the show jumping jockey

As the entrepreneurial HBS author of the book Buying a small business often repeats

With revenue growth comes new customers, and with new customers come new (types of) problems

In other words, growth brings change. While changing companies are not necessarily growing (e.g. turnarounds in the above Buffett quote), growing companies are always changing.

Another recent observation I had redrafting this post one year later is that venture capitalists tend to focus much more on the founder or team.

From the above, we make a case for focusing on the franchise in mature companies in markets with stable competitive dynamics.

In fast-growing companies, management becomes much more important as they need to make a lot of judgment calls in execution and capital allocation of growth investments.

In show jumping, the horse needs the jockey.

Lastly, the only competitive differentiator in commodity companies is management (companies with fast-changing circumstances).

We believe there is an opportunity in looking at jockeys in commodity industries as 

  1. investors hate commodity/capital intensive industries
  2. investors are focusing on “great franchises” right now (peak quality?) while growing more sceptical of looking at management 
  3. we believe management can be the (non-durable) competitive advantage for these businesses

While media attention tends to go to the folklore of billionaire jockeys of once-fast-growing start-ups, some examples of great commodity Jockeys: 

  1. Philip Meeson in Dart Group plc
  2. Belgian owner-operator Luc Tack in Picanol and Tessenderlo
  3. Buffett overseeing (mostly incentives) in (re-)insurance operations

We’d love to hear your under-the-radar commodity jockeys and thoughts!

MC & TC

Great presentation by Ben Evans

https://youtu.be/RF5VIwDYIJk

Some great points and examples being made. We are indeed still in the early phase of tech. Marketing is indeed unrightfully being forgotten when looking at digital advertising as a percentage of total ad spend. Online shopping curation – as opposed to logistics – is just getting started.

Investing implications/call to action: which public companies should capture some of the value of this opportunity, parts which are often forgotten such as shopping curation and marketing spend (largely confined to offline today)?

It seems this is a simple bull argument for digital ad duopolists FB, GOOG: well positioned with undemanding valuations.

The New IBKR Credit Card: Potentially Superior Fintech In Disguise?

Summary

  • there’s much fuzz on app-only fintechs issuing FX commission free credit cards
  • we compare these fintechs with the capabilities of the unknown and unloved new IBKR MasterCard and conclude it could be superior to any existing card
  • the IBKR card could be a game changer for IBKR investors: the card could drive further customer equity growth as IBKR accounts have been gaining turnkey online-banking and brokerage capabilities

Introduction

Because of regulatory differences, Europe has been faster than the United States to adopt online-/app-only banking services such as unicorn Revolut, N26, and Monzo. Revolut already claims more than 2 million users.

These players offer online banking solutions with pre-paid credit cards that allow users to pay globally with drastically lower or “no” forex commissions. At a typical bank in the mainland of Europe, one pays 1.5-4% forex commissions outside the Eurozone, while in the UK and the US these commissions have outliers as high as 8%. Withdrawing cash from an ATM can be even more expensive, paying the same range of percentage commission with fixed costs on top as high as ~5-10 USD per withdrawal (excluding the fixed costs the ATM charge). Other benefits from these fintech services are the immediate information to consumer about a payment confirmation, never needing to go into a bank again to block your credit card, change its limits, with in-app control over security features.

In the US on the other hand, the lowest-cost online broker Interactive Brokers “IBKR” recently launched its own credit card. As opposed to the above players, IBKR credit cards are not widely known with millennials or in fintech circles. As I will show, the unknown and unloved IBKR credit card could be superior compared to all current European counterparts but has extra advantages on top such as deep borrowing capacity (the ability to pay large sums is typically a unique credit card selling point) at the absolute cheapest rate in the world. TransferWise and Revolut are launching their own credit card soon in the US as well.

While the IBKR MasterCard is currently only available to US clients, it is coming to Canada and Europe respectively in ‘Q4 ‘18 and in ’19-’20 (as per investor relations’ answer).

A comparison of the fintech players

First, let’s compare the European fintech players to pick the financially most attractive proposition to clients. I will then compare this player to the all-new IBKR credit card.

While the pan-European German start-up N26 and exclusively-UK player Monzo offer “zero commission MasterCard forex rates” (i.e. they offer the same FX terms) for payments in foreign currencies, pan-European Revolut claims to offer the “interbank rate” during weekdays, with an added 0.5% commission during weekends to “compensate for the FX risk”. Because MasterCard (and Visa) do not offer any transparency on their official FX rates calculations but do publish daily official rates here, my comparison is based on empirical data.

As it turns out, none of the providers of “commission free” credit cards are fully commission free. While the “commission free MasterCard forex rates” has a hidden wholesale FX commission for MasterCard embedded in N26 and Monzo’s case, Revolut says it uses the real-time interbank bid price. However, based on my analysis using live data from the deep IBKR forex market that is freely available for customers, I found Revolut settlement rates are a bit worse than the real interbank bid prices of IBKR. Let’s first do a comparison between the “fintech” players before we move on to why “old” IBKR could be even better.

Based on datapoints in a personal holiday in Mexico using both N26 and Revolut, I found that Revolut is generally better during weekdays, while Monzo/N26 (same FX terms) are better during the weekends. This is corroborated by another analysis I recommend here. What I find is that the officially published daily MasterCard rates are typically a bit worse on the settlement day. The typical Revolut FX improvement to the “commission free official Mastercard rates” on weekdays is about 0.2-0.4%. A misconception: “Official MasterCard daily rates” are not FX mid-prices but inherently have a small commission embedded called the wholesale FX margin for MasterCard. Note that cards based on the official MasterCard rates settle your payments based on daily published rates on the settlement day, i.e. a few days later. When I say Revolut is 0.2-0.4% better, this means Revolut uniquely settles your FX rate immediately at payment, while N26 and Monzo payments will settle days later through MasterCards system at an on average 0.2-0.4% worse rate, but this is subject to relatively large FX fluctuations. However, the interbank rate at the time of payment is of course the statistically expected forex rate of the other providers in a few days at their settlement time, minus the wholesale commission of Mastercard (or Visa) that is hidden inside these players’ published rates.

In the weekends however, Revolut’s 0.5% commission (except for a few illiquid currencies, most notably the Russian and Thai currency, the commission is 1.5% instead) will trump the MasterCard wholesale commission of ~0.3%, making payments using N26 or Monzo more attractive. For the most liquid currencies however, Revolut offers users to convert and hold monies in advance in the app, allowing them to voluntarily bypass this 0.5% commission. For many emerging market currencies, this is however not possible. Of course, holding multiple zero-yielding pre-paid currency balances for a credit card is not very attractive from an investment point of view anyway. The peace of mind of using N26 (exclusively Euros in the app) and clearing payments at a slightly worse FX rate 5 out of 7 days versus Revolut might not be so bad after all.

Another advantage of N26 is the ease to transfer money as a client gets his own personal bank account, while Revolut – for now – requires you to wire money to an omnibus bank account with a structured code to redirect it to the user. This gets us closer to an all-purpose bank account.

ATM Withdrawals: Revolut offers a monthly 200 EUR no-commission foreign ATM withdrawal limit while charging 2% on any amount in excess of that, while N26 charges 1.7% for all amounts on top of the official Mastercard rate which has 0.3% commission embedded (both charge no fixed costs which are typically 2-6 USD per withdrawal at conventional banks). I don’t expect Revolut to continue the free 200 EUR ATM promotion for long however as they stated it is very expensive for them.

I would recommend N26 for peace of mind and efficiency, while recommending Revolut for nerds.

Lastly, there is the TransferWise MasterCard that is already available in Europe, while soon in the US. This card charges its own commissions published on TW’s website. As this ranges from 0.35% to 1% to the true mid-price, it is the “worst” card. However, for people that often get paid in foreign currencies, paying directly using monies in their foreign TransferWise “borderless account” currency balances in which they got paid (cheaper international transfers is TransferWise’s bread and butter) allow them to circumvent commissions using this MasterCard.

Some referral links to get a free card and account at N26Transferwise Borderless, or Revolut.

If you want to cherrypick the best features of any card and retro-actively change the payment from one underlying card to another card for free, start using Curve, a fintech card that aggregates all your existing credit cards into one. If you sign up with code WJ29Z here, you and I get 5 bucks.

How do these players make money

Judging from internet forums, people assume Revolut makes its money from add-ons such as buying cryptocurrency at higher commissions, insurance and premium card subscriptions. While true, I suspect the bulk of income right now is from a piece of the pie Revolut has negotiated with its issuing bank of credit cards: credit card payments collect interchange commissions charged to merchants and paid to the issuing bank. While Europe has capped credit card commissions for merchants at 0.2%, in the rest of the world these interchange commissions for the issuing bank are typically 1.2-2% (note there’s other commissions paid by merchants for the payment terminal operator and MasterCard/Visa). Lastly, I suspect Revolut makes a tiny spread on forex versus the true interbank rate it trades at, as I will detail later.

Why IBKR’s credit card could be the unknown better alternative to the current fintech players

While Revolut offers the best rates amongst its fintech peer group most of the time, it is using the rate offered in the market to convert (not the mid but the bid) and hence the customer should lose half of the bid-ask spread in a conversion. Broker customers of IBKR get direct access to the live interbank market. IBKR aggregates for its clients the best quotes of 16 of the world’s largest FX dealing banks that have an aggregate 60% global market share. Using real-time FX data as IBKR clients, we can see the real-time bid and hence can test Revolut’s claim.

Could IBKR be better than Revolut to pay in Mexican pesos?

I made screenshots of IBKR’s FX bid prices seconds before and after two consecutive Revolut payments at 11:50 and 11:53 local time. I also appended the FX traded range of the minute and compared it to Revolut’s payment settled rate (minute resolution for the zoomed candlestick chart). Note the time in my Revolut payment screenshot is shifted by 7 hours as I made this screenshot when back home and there’s a 7-hour time difference to Mexico.

Chichen Itza

Figure 1 Own screenshots of Revolut app and IBKR live forex rates

In another payment on another day, I show the bid-ask spread that is quoted minutes before the payment, and the traded price range of the minute on the other hand.

Monica Herrera.jpg

Figure 2 Own screenshots of Revolut app and IBKR live forex rates

At the second payment in my first picture, the average bid rate of the bid rate seconds before (middle screenshot) and bid rate after payment (right screenshot) was 22,74565 while my Revolut payment was settled at 22,7437. The difference is 0,00195.

In the second picture, the Revolut settlement was at 22,6553 while the bid price in the minute of payment should have been at worst 22,6585 minus 0,015 or 22,6570 (that is, the bottom of the candlestick on the minute of payment minus the bid-mid spread). IB is at least 0,0020 better.

I did not make bid screenshots for the first payment in the first figure (on the left). I believe the rate I saw but did not take a screenshot of was close to the upper end (ending price of the candlestick). Based on this, and the bid-mid, I estimate in this instance IB was 0,0033 better.

Wrap-up: it seems Revolut in this example is at least 20 pips worse than IBKR’s interbank bid price. For the Mexican Peso Euro pair, IBKR rates give you at least a 0.0088% better rate (20 pips divided by EUR MXN of ~22,7), or 0.88 basis points. However, for small trades, the IBKR FX commission is 0.2 basis points. The net improvement should be 0.68 basis points. When spending 5000 $ in Mexico, this gets you to a very small saving of 34 cents. Very small compared to the difference between Revolut and contenders N26/Monzo using the “official MasterCard FX rates” in which the difference was 0,3%. For a 5000 $ spend using Revolut versus these competitors, this makes a 15 $ difference.

Why IBKR is not as good for FX vs Revolut today, but could be: IBKR actually uses the currency conversion of MasterCard for its credit card payments (your FX payment will be deducted from your base currency in your brokerage account), while customers can trade in the interbank market on their brokerage accounts at a 0.68 basis points better FX rate than Revolut. This doesn’t make any sense and I will recommend IBKR to implement the Revolut system.

Other IBKR credit card USPs versus fintech players

  • Deep borrowing capacity: remember how credit card providers pitch deep borrowing capacity as a selling point in “gold cards”? IBKR credit card payments are only limited by your brokerage account net worth. If you want, you can heavily indebt yourself using margin debt up to 2-3X your brokerage net worth
  • Unrivalled cheap borrowing at the overnight rate plus a tiny spread (see here)
  • Commission free foreign ATM withdrawals with a fixed cost of 0.50$ (using of course Mastercard’s wholesale FX rates): remember N26 charges 1.7% on top of the wholesale FX rate for withdrawals
  • More efficient use of your assets: pooling effect as you spend from your brokerage account instead of having many zero-yielding cash balances at different brokerage/bank accounts (as of recently, IBKR added a lot of daily banking capabilities such as recurring payments etc.)

Conclusion

The IBKR credit card is not discussed on Fintech forums but has the potential to be even more attractive than the payment cards of Revolut, N26, Monzo and especially Transferwise*.

Another post will follow with an IBKR investment thesis, digging more into the brokerage account details.

I recommend an IBKR account for anyone above >100K$ (for smaller accounts, I only recommend IBKR if you are at least making two trades per month). You can open an account here.

To get a free FX credit card and account, here’s some affiliate links to N26Transferwise Borderless, or Revolut.

If you want to cherrypick the best features of any card and retro-actively change the payment from one underlying card to another card for free, start using Curve, a fintech card that aggregates all your existing credit cards into one. If you sign up with code WJ29Z here, you and I get 5 bucks.

* This post was about payments, but IBKR is much cheaper than TransferWise for large international money transfers: note that if IBKR clients have local bank accounts in multiple countries (e.g. a US expat living in Australia), clients can use local transfers via their IBKR brokerage accounts to transfer huge sums of money from one country to another at the real interbank rates (e.g. depositing AUD from Australian bank account to IBKR, converting at the real interbank rate, withdrawing the converted USD to a US bank account). This can save them 0.3-1% of TransferWise FX commissions. When our expat returns from Australia and buys a 1 MUSD house in San Francisco, he saves 4500$ (as per this TransferWise fee link; TW charges 0.45% for AUD-USD transfers).

Disclosure: I am/we are long IBKR and used affiliate links of the cards we recommend and used above.

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