A Wealth Creation Journal

Category: Investing philosophy (Page 1 of 2)

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!


Great presentation by Ben Evans


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?


  • 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


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.)


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.

Why is successful investing so hard?

I am fascinated with the notion that investing is “simple but not easy”. The principles of investing look deceitfully simple, buy low and sell high, while the execution of these principles can be hellishly hard. And the execution is hard because the process of learning and improving from the mistakes in investing does not work in the same way as it does with other activities such as sports.

First, unlike most sports activities, investing lacks an immediate feedback loop where the outcome of an investment decision is presented at once and mistakes analysed. One must, sometimes, wait for years before knowing the outcome of an investment decision which meant useful learnings and improvements potentially come on the back of a string of mistakes. It is the equivalent of trying to improve baseball batting skills but only knows the result of each bat one year later.

Second, the quality of the feedback is very weak as the investment outcomes do not always reflect the strength of the investment decision, i.e. one can be right for the wrong reasons or wrong for the right reasons. The inability to determine the precise causes for a particular investment outcome is very dangerous as one can put huge confidence in the wrong lessons learnt. It is analogous to practising basketball shots in the dark. One would have to rely solely on the sound of the basketball hitting the rim to determine how much more or less strength to apply for the next time. The lack of information for shot calibration impedes the basketball player’s rate of improvement.

Third, most lessons in investing have nuances and contexts such that they can only be applied to certain conditions and environments. In another word, these lessons are seldom generalised. The trick here is to balance between following the broad prescriptions of investment lessons but also able to recognise the exceptions to the rule. For example, a shrewd investor would rightfully conclude that based on historical precedents to avoid heavy-indebted companies is a wise thing to do. However, John Malone’s TCI supported by its steady cash flow is heavily indebted, but it turned out to be a great investment.

Fortunately, we stand on the shoulders of giants today. We can study the life of great investors and learn from their success and mistakes. We can observe the rise and fall of companies to find patterns. However, there is no better way to learn and grow as an investor than to work alongside like-minded and very accomplished investors.


Loyalty program series: Blue Chip Stamps case study

Loyalty program operators are similar to insurance operations in the sense that they issue a claim “stamps” or “air miles” in exchange for cash upfront “float” (industry term “billings”). This cash or “float” can then be invested while the clients slowly (or never, see breakage) redeem their points or miles (industry term “redemptions”).

Earning streams

Ordered by increasing amount of uncertainty, money is earned through

  1. taking a margins on a mile billed minus a mile redeemed
  2. selling customer habit analytics to companies
  3. breakage: this can be a significant ~20-50% of billings, with ~100% pre-tax margin
  4. investment income and capital gains from investing the float (other people’s money)
  5. point devaluations: this comes at the expense of the loyalty program’s reputation if done visibly, but remains largely unregulated. Companies should take an example from central banks and slowly but steadily devalue (as in “the optimal inflation target is 2% p.a.”)

Float from customers and the government (other people’s money²)

From day one the “billings” cash comes in with most of the revenue still unrecognized (except for a conservative breakage estimate), and offsetting “deferred liabilities” on the balance sheet. This means that almost no cash taxes are paid upfront.

In other words, this business uses other people’s money (clients) to earn extra money on the investment side, while deferring the cash taxes due on real loyalty earnings far into the future (after accounting for real breakage and devaluations down the road).

Powerful psychological biases working in favor of loyalty operator

I think there are some powerful psychological biases working in a loyalty card issuer’s advantage:

  • small amount of miles in every purchase “feels” like it was earned for free, or an “extra” (this is far from the truth, as loyalty programs get paid cash on day one for these points and an alternative to miles is cash back credit cards)
    • people do not value things they got for free as much as things they “worked” for
      • Result n1.: neglect of points that leads to slow devaluation of redemption liability and breakage
  • because the points are not expressed in usual fiat money terms, and they feel for free, the urge to buy unnecessary goods is bigger (perfume, hotel upgrades etc), this is similar to buying presents for friends.
    • see Dan Ariely’s The Perfect Gift : something you always wanted but never wanted to feel the pain of paying for
    • these products have a knack of carrying higher profit margins
    • the loyalty company will use its purchasing power pool to negotiate hefty discounts from retail cost on these high-margin products
      • Result n2.: sales mix is typically profitable for redemption partners (perfume, seat or hotel upgrades) and loyalty partner will take a nice piece of those economics

Case study from the past: Buffett & Munger’s investment in Blue Chip Stamps

I now want to present a very interesting case study from the past, Buffett and Munger’s purchase of loyalty program Blue Chip Stamps (’70s business).


The main takeaway is that Blue Chip Stamps’ revenue (~’gross billings’) declined heftily in 10 years, while the float more or less kept up. Why?

  • part of the declining revenue cumulatively adds to the float, while
  • the redemption frequency drops as the program loses mindshare and people forget/delay spending points


In other words, permanently declining loyalty programs can still be valuable vehicles to compound investments in, using other people’s money.

Case study today: Aimia

Today, Aimia is trading at ~1.5 x current cash flow, with gross assets (excl. loyalty card liabilities) worth about 2x current share price because of the uncertainty surrounding the major partner Air Canada “AC” that is leaving in 2020 (10% of accumulation but 50% of redemption).

Aimia’s loyalty card “Aeroplan” is one of the biggest in Canada.

Network effects of being big

There is many-sided network effects involved.

What makes the program valuable?

  • # of Accumulation Partners (partners that pay upfront cash “billings” to Aimia for offering clients miles)
  • # of Redemption Partners (partners that allow to redeem miles with products, getting paid by Aimia)
  • # of Clients

Each category interacts, e.g. more redemption and accumulation partners makes the program more valuable for clients, more redemption partners and clients makes the program more valuable for accumulation partners, etc.

Lastly, it’s all about “the big data” nowadays. More # of each category makes Aeroplan’s data analytics more valuable because the number of interactions (data) increases faster than the individual amounts.


Case study investment case


  • Aeroplan’s cash flow remains stable until 2020 and
  • post-2020 cash flows minus its real liabilities are worth at least 0, this is an attractive investment (worth ~10$ per share).

It seems unlikely that management would not be able to manage its way through a “run on the bank” redemption before the 2020 expiry of AC by delaying customer redemptions through two control mechanisms that induce clients to delay and forget:

  1. “gating” (offering limited redemption options ‘temporarily’, e.g. only flights on wednesday and sunday)
  2. devaluing points faster: this has the effect that more people will have insufficient miles to redeem products they deem valuable, hence delay and forget

Given the network effects and switching hassle for customers, I do not believe Aeroplan is going away abruptly as the market seems to think (maybe slowly, but then again Blue Chip Stamps is an interesting case).

Disclaimer: no position*

*Not yet comfortable in the industry.

Comments are welcome.


How Margin of Safety made me take more risk

In my previous contribution An exception to the no genuine value-add to society filter, I discussed a recent personal deviation from value investing.

This time I will expand on how reading Margin of Safety for a second time made me realize my personal context warrants more risk taking than generally advised in investment literature.

An imperative in investing is diversification. A portfolio of eight equal-sized stocks might be called risky “concentrated investing”.

Again, it is the context that is of great importance. For a wealthy investor holding close to 100% of net worth in stocks, I fully agree (the books are generally written by or for these types anyway). However, for investors that are invested across asset classes and/or benefit from large cash flows from relatively uncorrelated sources, the riskiness of this strategy is mitigated (e.g. an endowment with cash flows from forests, farms and real estate, or an individual that has a job and/or private business).

Seth Klarman highlights the advantage of having liquidity from high cash yielding positions in a downturn in his seminal book Margin of Safety:

The third reason long-term-oriented investors are interested in short-term price
fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.


Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others. Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration. Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value (discussed at greater length in chapter 10). Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends. The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase. Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months. An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well.

–  Margin of Safety, chapter “At the root of a value-investment philosophy” paragraph “The Relevance of temporary price fluctuations”

It was only after investing on my own and reading this book a second time that I realized that my personal situation is similar to an investor with high cash flows from sources with relatively low correlation to the price of equity markets. Indeed, I derive significant cash flow from a job (rest assured that my employer is not an asset manager. Indeed, AM typically have a revenue ‘beta’ of ~2 to the stock market).

These sources of liquidity are not often discussed in investment books, but once I came to the above realization (in my 7th out of 10 years of investing!) I was embarrassed with my own lack of independent thinking. 

Today I hold a lower cash balance in general as my “replenishment rate” is high. However, I do believe that having no cash is only “optimal” in theory. In practice, a small amount of cash can have the huge benefit of getting psychologically undamaged through a market correction, allowing oneself to rationally grasp the opportunities at hand.

Last year I started asking this:

What is the threshold of cash level that would actually make me happy when the market crashes? 

What is yours?

My answer is 20% (taking into account my moderately high replenishment rate and the fact that I am a young investor, not an older disinvestor). Note that this is a theoretical question, as a certain M. Tyson said: Everybody has a plan until they get punched in the face. Likewise, the level that will truly feel good is probably a bit higher. Lastly, remember what Warren Buffett says about plummeting markets:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.


But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.


‘[S]mile when you read a headline that says ‘Investors lose as market falls.’ Edit it in your mind to ‘Disinvestors lose as market falls— as investors gain.’ Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other.”

– Buffett in ’97 BRK chairman letter

Oddly, most newspapers and books are written for disinvestors (older and wealthier participants). We can guess to the reasons why:

  • in part because this audience has the most money to spend on content
  • on the other hand most is probably explained by the insurmountable instinct for many to focus on short-term nominal gains

In the last market correction (Feb ’16) I actually felt content, but that probably meant that my cash level was too high in practice (i.e. 30%). Today it is at 10%.



Kahneman’s on what’d most improve our world understanding

Some gold from Cialdini’s new book Pre-Suasion, para. “What is salient is important”:

[Kahneman] was once asked to specify the one scientific concept that, if appreciated properly, would most improve everyone’s understanding of the world. Although in response he provided a full five-hundred-word essay describing what he called “the focusing illusion,” his answer is neatly summarized in the essay’s title: “Nothing in life is as important as you think it is while you are thinking about it.”

What is salient is indeed important, Cialdini:

As the tenth anniversary of the terrorist attacks of September 11, 2001, approached, 9/11-related media stories peaked in the days immediately surrounding the anniversary date and then dropped off rapidly in the weeks thereafter. Surveys conducted during those times asked citizens to nominate two “especially important” events from the past seventy years. Two weeks prior to the anniversary, before the media blitz began in earnest, about 30 percent of respondents named 9/11. But as the anniversary drew closer, and the media treatment intensified, survey respondents started identifying 9/11 in increasing numbers—to a high of 65 percent. Two weeks later, though, after reportage had died down to earlier levels, once again only about 30 percent of the participants placed it among their two especially important events of the past seventy years. Clearly, the amount of news coverage can make a big difference in the perceived significance of an issue among observers as they are exposed to the coverage

Kahneman’s most important thing is worth repeating for investors:

Nothing in life is as important as you think it is while you are thinking about it.



An exception to the “no genuine value-add to society” filter

TC and MC (the blog authors) discussed investing in Philly Shipyard (PHLY on Oslo Börse) a while back, and one counter-argument for not investing was that this company would not exist without the force and subsidies of the Jones Act. As such this company could not be labelled as a genuine value-add for society or customers.

Many value investors have mentioned they do not (generally) invest in companies that do not genuinely add value to their value chain or society. Usual suspects are cigarettes, gambling, time-share rentals etc. In different ways, these companies prey on humanity’s weaknesses (respectively addiction and ignorance). Another close to home company I like to use is Edenred (rearview mirror high and stable ROIC ‘great’ company that through regulation in France and Belgium enjoys operating in an oligopoly for a product that is fiscally advantaged but ultimately destroying value for society in TC’s humble opinion).

In different ways, these companies prey on humanity’s weaknesses.

However, I will explain why I have come to believe this rule is not (as) applicable to investments like Philly Shipyard ASA.

The great danger of investing in the above businesses is that they optically look like great companies from a rear-view mirror perspective (and near future perspective, with high and stable ROIC). Indeed, human weaknesses are time-invariant, or favorable (but questionable) regulations create a stable subsidized high ROIC, and these companies are generally valued as ‘quality’ by the market.

If the valuation multiples reflect quality this also means the investment only works out if the company is still flourishing 10 years from now (unless one is relying on future greater fools).  The problem is that investors are very bad at predicting the future more than five years out. Once public opinion turns against these companies’ (the timing is highly uncertain), the valuation can tank towards liquidation value. I think I sketched an investment that has unknowable (immeasurable) uncertainty to the downside. 

Value investors should prefer the inverse type of uncertainty. I believe immeasurable uncertainty vs risk is not often enough discussed, which is why I recommend having a quick read through The Dhandho Investor.

Why I made an exception and invested in Philly Shipyard

We have been following Philly Shipyard since Nov. ’16. Philly traded comfortably below liquidation value, and we found there was clarity that the Jones Act would not be repealed in the medium term (see also Trump’s slogan). Philly’s management seemed to have cared well for shareholder value in the past, and even a repeal of the Jones’ act could have accelerated the  (liquidation) value realisation, locking a small profit or loss. In other words, the Jones Act regulation was not a large risk factor by virtue of the valuation. The upside was that there was a decent ~ >50% chance that this company could soon be valued on a going concern basis once a new shipbuilding contract would get signed (in that case it would be worth 2.5X – 4X).


Clearly it is always important to assess a company’s true value-add to stakeholders. However, I hope to have made a convincing argument that this factor’s weight in decision making is dependent on the context (“great company” / “cigar butt” valuation?). In case of cigar butt valuation, this factor is not on top of my checklist. 

It is only through thinking about real-world case studies that I have found the courage to deviate from value investing dogma. Honestly, this is dramatic, as I only have one remaining personal example of a deviation worth sharing (in a next contribution). 


Summary of French Bollore documentary

For those that understand French, I very much recommend this excellent documentary on Vincent Bolloré. I found it to be quite unbiased, surprisingly.

Disclosure: long a bit of BOL (main thesis being that a full simplification is a catalyst for the unlocking of the NAV which is at ~2X the share price by virtue of the economic share count which stands at around 50% of the total share count, after accounting for the circular ownership loops. The timing is very unclear, but in the meantime NAV is compounded at a decent rate. The author did a very similar exercise as the highly recommended Muddy Waters analysis that came out just months after)

For everyone else, I have summarized the documentary:

  • in France, Vincent Bolloré has the nickname “two-faced smiling killer”
  • Bolloré has a smartphone app counting down the moment he steps down. I think this shows he is obsessed by providing the “right” company to his family successor (whatever that is, importantly it could include a simpler structure)
  • when Bolloré started at the family company after his Rothschild banking experience, he managed to negotiate a 25% wage cut in his family’s rolling paper factory legacy business when the factories faced cyclical headwinds. This is almost unheard of in France and it shows his influencing skills.
  • the name Bolloré in Africa is very famous. Bolloré uses his abundance of smarts, political connections (including personal friends Sarkozy, Hollande* and Macron), capital and synergies from the media business to gain profitable contracts in many African countries

I didn’t build my empire from one franc by being a passive investor, it’s not in my genes, I am an activist. – Vincent Bolloré at the Havas board meeting.

*Although Sarkozy is one of Vincent’s personal friends, the documentary shows an example where a Hollande visit to Africa allegedly helped Bolloré win a bid for a Cameroon port concession.

Book Summary – Capital Returns part I

Capital Returns is an excellent collection of investor letters and essays by Marathon Asset Management, edited by Edward Chancellor and originally intended to be distributed within the firm.

Although it looks like many of Marathon’s calls were prescient, there is definitely some selection bias involved in the picking of the essays (this is acknowledged by Chancellor).

Because I am a huge fan of the essays, I will be posting a large summary in three parts on the blog. We will finish with a more condensed ‘main takeaways’.


Capital Returns by Edward Chancellor

What is capital cycle analysis

Capital is attracted to high-return sectors of the economy and leaves when returns become dismal. This process is never static, always dynamic. From the economy’s point of view, this process is Schumpeterian, flushing the misallocated capital.

Capital cycle analysis is about how competitive advantages change over time from the investor’s perspective.

Professor Ken French writes that firm asset growth is a larger determinant of consecutive five year returns than value, momentum and size (Fama, French 2014).

Larger firm investment is followed by lower returns. This mean reversion is not only due to animal spirits, companies that earn more than their cost of capital expand their capital base, hence increase supply in their industry, while those that fail behave in an opposite fashion.

Corporate investment rates is also a negative predictor for corporate profitability in national aggregates. The US has had very low rates of reinvestment after the mal-investment of pre 2007 was revealed, and is subsequently earning very high profit margins.

Why does French’s ‘asset growth anomaly’ exist?

  • Overconfidence : Managerial and investor fetishism for asset growth. Future levels of demand are very hard to forecast.
  • Competition neglect: Corporate investment that looks like it will earn above its cost of capital looks rational when looking at it from the isolated point of view. However, competitors are probably making the same decisions at the same moment. The feedback lag because of investment lead times makes this problem worse.
    • TC comment: this is discussed in Buffett’s shareholder letters on Berkshire’s textile operations as well. Textile capex for efficiency gains looks great in isolation, but every competitor is investing in the same efficiency gains. I’ll call this “the red queen effect”

Now, here, you see, it takes all the running you can do, to keep in the same place. – The Red Queen in Alice in Wonderland (TC’s analogy to Berkshire’s textile capex in reality versus )

  • Insight view and neglect of the outside view: Management focusing too much on the specifics of their investment story versus the wider base rate of success given the competitive backdrop. This leads to overemphasis on “my case is different”.
  • Extrapolation: Linear forecasts are made because of anchoring bias, anchoring on recent data because of recency bias. This myopic element creates linear extrapolations ignoring that reality is cyclical. For example, trade cycle, credit cycle, liquidity cycle, real estate cycle, profit cycle, commodity cycle, industry capital cycle. Linear extrapolation is hard-wired deep inside us. Low multiple value stocks with depressed earnings exploit this tendency to extrapolate the near past. To discriminate between low multiple depressed and inflated earnings companies means investors have to dig deeper in the capital cycle.
  • Skewed incentives
    • Executive pay is often linked to company size regardless of profitability (ROIC) so even reinvesting below cost of capital can perversely be attractive
    • Companies with large investment projects tend to exhibit short term momentum on the same time frame that executives are rewarded
    • Investment managers’ pay is also often short-term based
    • Investment banks need to cheer
      • as corporate investment is often associated with fees for raising capital for another department in the bank
      • the brokerage fees don’t help not cheering for stocks
  • Prisoner’s dilemma: Maybe future demand can accommodate one player from expanding operations. If everybody refrains from expanding for the good of the industry but one player, the non-cooperative gets the gains. Retaliations to protect market share often follow.
  • Limits to arbitrage: Shorting can be expensive in terms of risk budget (nobody knows when the cycle will turn exactly). Also, companies that invest in new assets typically have higher multiples hence market caps so not investing in them makes investors deviate much from the benchmark.


Fundamentals of analyzing the cycle

  • Focus on supply: Supply prospects are much less uncertain. Look at how capex-to-depreciation is evolving over time.
  • Beware the investment banker (analyst): Investment banks are being paid for capital expansion projects. Hence they are paid to drive the capital cycle.
  • Selecting the right corporate managers

“After 10 years on the (CEO) job, a CEO that retains 10% of earnings will typically have been responsible for 60% of the capital invested in the business”. – Warren Buffett

  • Generalists make better capital cycle analysts: Industry insiders are prone to take the inside view, as opposed to Kahneman’s Outside view, not seeing the wood for the trees. Generalists adopt the outside view and do capital cycle comparisons between industries. There’s also an element of job protection at work.
  • Adopt a long-term approach: Short-term timing the cycle is impossible. Make general calls and sit them out.

The Story of Cod

For two centuries, the pinch-point between abundance of cod on sea and scarcity on land were the small ports that processed cod. When the industry scaled to transatlantic trade, that pinch-point became the large market of Boston. A triangular route emerged where ships transported New England cod to Europe, subsequently took African slaves to the Carribean sugar plantations, and finally brought Carribean liquor to Boston.

Boston flourished until technology catched up:

  1. steam-powered ships
  2. freezing food (1920s)
  3. sonar to locate fish

Overfishing became commonplace as the new owners had to bear high fixed costs to buy these new technologies. After ports, markets and processors of cod, and consumers, became main beneficiaries of the trade.

The questions for investors is which company will become the equivalent of the Boston fishing market?

The commodity super-cycle

  • On oil (Feb 2012): OPEC countries have high spending budgets, creating a high “break-even oil price” for them. This will limit their quota discipline if prices go down
  • On buying and selling Vestas (March 2014): Marathon took a position in the wind turbine company Vestas when one of the key indicators of the capital cycle was close to bottoming out (i.e. around 1.2X capex / depreciation for a leader in a sector that has long secular tailwinds). They sold most of their stake in 2009 when Vestas had outperformed MSCI Europe by a total factor of x4 and the capex-to-depreciation multiple was at a stellar number of 3-5X. They added a lot to their residual position in 2013 after the stock got slammed and capex-to-depreciation was depressed at 0.5x.
  • Why EPS growth has lagged GDP growth (Sept 2014): EPS growth has lagged GDP growth despite general corporate profits growing from 1960 from 6% to 10% of GDP.


  • Buybacks and dilutive equity raises at the exact wrong timing
  • Management share comp.
  • M&A, IPO is procyclical
  • Private companies becoming more profitable relatively because of less agency problems

If supply outpaces demand growth, profits suffer. Hence it is possible that sectors with high demand growth bring little or no benefit to investors as capital floods in (e.g. airlines, semiconductors, mobile phones). This is also true on the country level, with negative correlations of subsequent equity returns and country GDP growth. Public equity returns in China are a perfect example.

Rather, investors should focus on supply. The starting point of company analysis should be prospective supply, not demand.

Figuur 1 Value in depressed and growth industries

Value in growth

Warning labels (Sept 2002)

High moat “quality” companies that revert slower to mediocre ROIC’s than the market implies do so because competing capital inflow is somehow restricted.

Quality small companies are easier to find in Europe because there’s an excess of large institutional investors. Some sectors are overrepresented in this universe, e.g. industrials, while sectors like pharma are overrepresented (typically >10bn companies).

A “growth” label company typically gets a “value” label after excess capital flows into its sector.

Long game (March 2003)

Long term investing works because there is less competition for really valuable bits of information.

Low turnover reduces friction costs and fewer decisions leading to hopefully fewer mistakes. The real advantage to this approach, in our opinion, comes from asking more valuable questions. The short-term investor asks questions in the hope of clues to near-term outcomes. The value of this short-term oriented data is modest at best, and to build a long term significant track record, this investor needs to pull off this trick many thousands of times to exploit marginal opportunities sustainably. The competition is ferocious.

The info Marathon seeks is long term oriented, typically capital allocation skills.

An example is Colgate’s line extension advertising investment in the ‘80s. It created a huge amount of value eventually but the focus at the time was short-term earnings drag. Apparently even today no investor questions have been raised to Colgate’s management about its large marketing spend, except for Marathon’s.

Double agents (June 2004)

In his University of California talk, Munger asked students when demand goes up if you raise prices. Students responded with certain luxury goods.

What Munger was waiting for in fact were goods sold through friendly middlemen. Geberit (also covered in Quality Investing book, extensively uses plumbers in their push – pull strategy: plumbers pull their product to where it was pushed, i.e. wholesalers. Geberit invests a lot in free plumber training so that it becomes more time efficient for them to choose Geberit. Also, Geberit invests a lot in innovation and quality of the product, as the plumber gets a commission as a percentage of sales and hence does not care about the price (indeed, a plumber rather sells a high priced product). Rather, the plumber thinks about factors such as hassle-free installation, durability and quality to protect his own reputation. By investing heavily in training for plumbers, innovation, and quality, Geberit is able to raise prices disproportionately.

The agent’s interest is typically quality, safety, reliability, availability. Cost to the customer is ideally not a concern for the agent (to the contrary, if he earns a personal commission).

Other examples: dentists, doctors, opticians, electricians, architects.

Digital moats (August 2007)

Marathon has been a long term investor in Priceline and Amazon, and stresses how investors back in the 2003-2006 days were stressing short term margins instead of focusing on execution of the long term stated plans of the founders.

Quality time (August 2011)

Commentators are focusing on mean reversion of elevated aggregate corporate profitability. Marathon stresses that it is more productive for bottom-up investors not investing in indices to focus on specific sectors and firm capital cycles (or lack thereof, in case of sustainable competitive advantages).

TC Comment: See John Hussman’s newsletters as an example for aggregate profitability views.

Escaping the semis’ cycle (Feb 2013)

The Philadelphia semiconductor index has underperformed the Nasdaq since ’94 inception by 200 basis points p.a. with greater volatility.

Some firms, such as Analog Devices, have performed well over the long term. Analog semiconductors bridge the gap between the real world and the digital world, e.g. sensors in airbags, microphones in mobile phones, temperature sensors etc. According to Marathon, sustainable competitive advantages exist in this niche of the semi sectors, because capturing what is happening in the real world is harder.

The human capital component is hard to replicate because engineering talent deepens with experience. The design process is more trial and error. To become an expert in analog devices requires many years and the tenure of the average engineer at Analog devices is 20 years. Lastly, each analog company’s process technology is quite distinct. [..] Thus, it is difficult for an engineer to be poached by another analog company without his productivity being significantly impaired. Lastly supply of new engineers is more constrained for the analog niche as new graduates are more likely to pursue the digital semi route.

This is all compounded by the fact that analog devices have more diverse end markets. While the overall market is relatively fragmented, market segments is much more consolidated.

Pricing power is aided by the fact that analog chips play a very important role but represent only a small portion of the total cost of devices. Moreover, once an analog chip (e.g. sensor) has been designed specifically for a product, switching costs are high as the whole production process has to be revised. This makes revenues more recurring as well over the product life-cycle.

Finally, the analog production process is less standardized than most hardware, and thus less vulnerable to obsolescence from Moore’s law. More than a third of Analog Devices come from products which are more than ten years old.

To be continued,


Takeaways Q2 17 Horizon Kinetics letter

I really like the Horizon Kinetics letters. This can be interpreted in the way that Thorp qualified his ‘favorite books’ list on the Masters in Business podcast I summarized by saying

“I don’t necessarily agree with the books, I just believe that great books should provoke thoughts”. – Ed Thorp

On the NASDAQ 100 ETF

The top 5 holdings of the NASDAQ 100 ETF ‘QQQ’ account for 41% of the total AUM (FAANG + Microsoft). If this fund were active, this concentration would be forbidden in European UCITS. Yet, it is available in the passive vehicle iShares NASDAQ 100 UCITS ETF.

QQQ P/E calculation

The P/E ratio advertised for the QQQ ETF is 22.2x, by taking many assumptions:

  • trailing earnings
  • excluding loss-making companies
  • for the positive earning companies, excessive P/E companies are weighted less by using the ‘weighted harmonic mean’

TC comment

Electrical engineers are familiar to the harmonic mean, as the equivalent single resistance of two parallel electrical resistances is calculated by taking the harmonic mean of those two parallel resistances. What happens is that the harmonic mean for the equivalent resistance is closer to the smallest value (in case of QQQ, the smallest P/E companies) as electrical flow takes the path of least resistance. Another way to put it is that the smallest resistances (P/E companies) will be weighted the most in the average.

It is evident that real-world portfolios cannot return the harmonic mean of position returns.

Active manager YTD S&P500 tracking error from not owning FANG stocks

Bregman writes that by merely excluding Facebook, Apple, Amazon, Netflix, Google, Microsoft from the index, one would trail the YTD S&P500 performance by 243 basis points, or more than a quarter of the S&P500 returns!

In fact, the situation is even more dire when looked at over the last years:

  • 2015: owning 5% of the S&P500 accounted for 50% of the index return
  • 2016: the 10 best performing stocks, including FANG, accounted for more than 100% of the index return
  • 2017YTD: FANG accounted for 25% of the index return

TC comments

The key takeaway is that I think that the monstrous performance of FANG creates an unbearable fear of not owning FANG for many active managers as well. The huge upside volatility of the last years creates career risk of not owning FANG. Moreover, because of the great performance the weight increases every year so the buying pressure mounts, thus sucking in more capital each period.

It is interesting from a historical perspective to see how the fear of missing out reappears in different forms.

Google and Facebook versus AOL

The fund extrapolates 25% annualized ad spend growth on Facebook and Google, while assuming a 4% annualized growth of worldwide ad spending. Using these numbers, by 2020 the two internet giants would account for 40% of worldwide ad spending (offline + online). Today this number is at 23%.

It is funny how Horizon Kinetics voices exactly the same concern as I have written about just weeks ago on this blog:

Of course, as Google’s and Facebook’s share of worldwide advertising expenses increases, they must eventually reflect the cyclical attributes of the industry that clearly everyone expects they will dominate.

The appendix contains an Horizon piece from 1999, reasoning from first principles, how AOL was overvalued. This reasoning proved correct. For an introduction to reasoning from first principles, see the book Elon Musk and Superforecasting (and The Fermi Technique in my Superforecasting summary).

Til next time,



Takeaways from MiB podcast interview with Ed Thorp

I very much recommend listening to the podcast episode of Masters in Business with Ed Thorp, through iTunes or through this Bloomberg link. It might well be one of the greatest podcasts of 2017. Thorp talks about how much he liked working with Claude Shannon, the father of information theory (my favorite class in uni). Shannon helped Thorp to optimize his position sizing in blackjack, given the odds and the estimated edge calculated by Thorp’s own card counting system.


Some takeaways:

  1. When Thorp didn’t ace a chemistry competition because he did not bring along the right slide rule to the exam, he learned that there’s many different ways to fail in real life. Takeaway being that in investing one should think creatively about different downside scenarios.
  2. Thorp was asked whether managing money did not get scary when the stakes went higher. His response was that he gradually got used to new amounts of money and that the fundamental problem of investing does not change along with scale (although the type of successful investing changes because of scaling). I relate a lot to this argument that investors should always start small to get comfortable with managing money.  This could be one of the reasons why many of my friends that were not investing as students feel uncomfortable now with the higher amount of money that they accumulated throughout their careers as they did not “grow” into investing. For my personal portfolio, I started out with a small amount of savings 10 years ago and I am managing an amount almost two orders of magnitudes higher today. Compounding has the property to feel slow in the short-term, which is why I feel completely at ease managing this new order of magnitude. I also make abstraction of absolute money amounts as I agree with Buffett (and Thorp!) that I do not really need the money.
  3. Thorp, being both a great practitioner and scientist, likes to use the rule of 72.

 “Don’t confuse the cost of living with the standard of living.” – Buffett & Thorp

For those that are looking for position sizing literature, I recommend Thorp’s work on Kelly betting (Wikipedia). For example, this paper by Thorp (page 27-28) shows that in a world with uncertainty of Kelly parameters (i.e. not gambling but the real world), it is better to use fractional Kelly betting as one gets penalized twice in case one’s estimate of risk/reward is too good (once for extra risk and once for less growth). As I will explain below, the way I think about which fraction to choose is besides the point.

Limits of the Kelly criterion for investors

I think the use of full Kelly betting is very dangerous in the stock market as the parameters are (very) uncertain. Too many quants go bankrupt by applying full Kelly  when it turns out they had overconfidence in their ability to estimate the risk and reward parameters. This is what Nassim Taleb (a great fan of Thorp, he wrote the foreword to his biography) calls victims of the ludic fallacy.

How I use the Kelly criterion in practice

If (full) Kelly betting cannot be done in the real world with uncertainty of parameters, and we don’t know how to choose our fraction, you might ask why bother. I let some years pass to think about this (as I was not able to find someone that addresses this), and I think the point of fractional Kelly is that, although we never know which fraction to pick, we should try to do our relative position sizing between individual portfolio positions proportional to the expected value versus risk (or signal-to-noise for the information theory folks) of each pick.

For example, the way I use the criterion goes like this: if I estimate that position A has three times better risk/reward ratio than position B, it should be sized three times the size of B. This is what I call internal position sizing consistency, and I try applying this in my portfolio.

Lastly, even in a portfolio that is for example 20% cash and 80% invested with internal position sizing consistency, it is of course dangerous to trust one’s relative risk-reward estimates if some position sizes go beyond 2-5x of others and reach high absolute sizes in the portfolio, because of idiosyncratic risk.  Thus, position sizes should also be capped on an absolute basis (for the real Buffetts among us this is probably in the ballpark of 30-50% in exceptional circumstances, for the rest it might well be in the 15-20% range).

If we estimate that position A has three times better risk/reward ratio than position B, it should be sized three times the size of B. 

Remark 1

I follow Greenwood Investors letters with great interest. However, I find the following in their latest letter a bit distasteful:

At quarter-end, our ratio of reward-to-risk stood at 38.3x, which is marginally better than the 38.2x at the beginning of this year. – Q2 2017 letter Greenwood Investors

  • first of all, I find it absurd to report a difference in reward-to-risk of 38.3x Q2 vs 38.2x Q1, this looks like pseudo-accuracy to me
  • secondly, if reward-to-risk for the portfolio would really be so huge as 38x, it would take huge uncertainty on these parameters to justify not having a huge gross exposure like 500 – 2000% for a rational investor like Ed Thorp (and which I trust Greenwood doesn’t have), which kind of proves my first point.

Remark 2: W. Poundstone popularized the Kelly criterion in his book Fortune’s formula, easy read.


Til next time,




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