tech confessions from a value investor

It was about a decade ago now that a friend and I started an investment partnership.  The venture was my first foray into managing money for others (friends, family), and it accomplished its intended goal.  First, it made us concentrate on discussing investments on a regular basis.  It established a disciplined feedback mechanism.  It’s like having a running partner – you don’t want to let the other person down.  We discussed strategy, generated ideas, developed reports and wrote letters indicating our thoughts on a regular basis.  The letters are fun to go back and read.  Some things were missed in those reports, however, including many errors of omission that appear glaringly large now.  This post somewhat of a post-mortem along those lines.  While we made plenty of mistakes on the stocks we actually bought, in retrospect, far worse decisions were made with respect to those we discussed but did not buy.  Case in point: Amazon.

Almost from when I began investing, I have been a devout value investor.  (Exception: about the first year.)  The books I read were almost exclusively ‘value’ based.  If I had a mentor, it would be those books and Warren Buffett.  Almost all of them, save a few, dismiss investing in technology stocks almost out of hand.  Buffett, for example, hasn’t touched Microsoft – except for 100 shares in order to receive the annual reports – even though his friend Bill Gates is one of the most brilliant folks he’s met.  (Also, Buffett has jumped into technology lately with his BYD investment, but that’s another story.)  The point is, when I started my mentally was to do the same: dismiss ‘tech’ investments almost out of hand.  “There are enough investments without technology stocks,” I’d say, plus I put them in the ‘too hard’ category.  It’s too hard to figure out what the future will look like.  So I avoided them.

The first rule of investing is ‘don’t lose money’ and the second rule is ‘don’t forget rule #1,” so looking at it from this perspective not investing in fast-changing tech makes a lot of sense.  It IS hard to figure out what the future economics of a business will be, let alone one that is heavily involved in technology.  Underestimated, however, was just how powerful some of these businesses could become.

Anyway, we went on to pass up investing in Amazon.com, at $7.  It was mostly my fault.  I would later pass on the IPO of Google.  I read about the pricing of the offering and considering it too expensive.  (In my defense, IPOs tend to be horrible times to invest.  Who would want to buy from a super-knowledgeable seller?)  Of course, the $85 IPO price looks like a bargain now.  Netflix was another.  I actually bought puts on the stock, trying to profit when the stock fell.  (It hasn’t.)  I must also note that I used Amazon a lot, performed web searches via Google, and was also a Netflix customer.  I loved each of their services.  I thought all three were great companies.  It came down to what I considered a high price in relation to value that I wasn’t willing to bet partners, client, or my own money, on them.  While I’m being masochistic, throw Apple in there, circa 2001.  I passed this over in spite of having several friends who used Macs and loved them.  Oh, then iPods came out…

Buffett has said that “growth” is a part of the “value” equation, that they are not distinct and separate.  This is something  I agree with wholeheartedly.  I’ve always used growth when valuing companies.  It’s the stinginess that, I think, made me not properly consider how growth could impact valuation if returns on capital could be maintained even at very high rates of growth.  Statistically this is very rare.  I also failed to weigh heavily enough how much the people running these companies mattered.  Bezos, Brin/Page, and Hoffman are phenomenal folks — that’s a key takeaway.

Allocating scarce capital involves many tough decisions, and for me the errors of omission keep me up as much as those of commission.  Of course, it’s easy to look back at the winners and say I missed them.  In the intervening period, there were successes in more ‘boring’ companies.  Still, reviewing one’s mistakes is FAR more useful as a learning tool than reviewing successes.  Failure, like success, can involve more luck than skill, but if you know you passed it over for ‘rational’ reasons it’s worth exploring those reasons and considering their validity no matter how much time has passed.   Too, I didn’t buy a bunch of high-flying technology stocks only to see them collapse 95% and lose it all.  So there is some advantage to investing – or not investing – according to a value discipline.

This post is already long enough to make folks who are reading it start to drift off, so I’ll stop here.  In closing, I am certainly more open to technology investments now, but I still prefer to buy the profitable toaster manufacturer trading at $5 with $10 of net cash on its balance sheet.  If I can have a 90% probability of a base hit versus 5% probability of a home run, I’ll still lean toward the base hit.

Disclosure: I own shares of Google (GOOG). 

private market froth-iness

While it’s not clear there is a bubble yet, some of the private market valuations I’ve seen are bubble-icious. My evidence is more anecdotal since I’m not an “on the ground” venture capitalist. But here is something from Fred Wilson, offering a good overview from a very credible source that there is a froth in the private markets. Money is sloshing around the bathtub, and I’d argue it’s spilling over into all asset classes.

Remember W.B.: “The first rule of investing: Don’t lose money. The second rule: Don’t forget Rule #1.” Remember the downside, grasshopper.

start-up-tomism

It strikes me today that optimism in the professional investment community remains at a relatively low level. Why? Out-of-control government spending. The $1.4 trillion federal deficit. $13 trillion in national debt. Eurozone economic concerns and the implications for the future of the euro currency. Not to mention the Federal Reserve’s actions which could spur inflation. The potential for an abrupt rise in interest rates. Rising commodity prices. The rise of China and India as competitors to the U.S. An equity market still meaningfully below its 2007 highs.

Many of the above are valid concerns and indeed are areas that need work. The equity markets today are implying decade ahead returns around 5%, certainly not a place to take unmitigated risk. Interest rates are low (but rising), benefiting borrowers/spenders at the expense of savers. The volume of the above factors is loud and the focus on them disproportionately high among investors and the public at large. They can lead us to forget a couple of things.

First, most of them we can’t control. We simply can’t, other than through elected officials, reduce government spending. We can, however, get ourselves into better financial shape through our own actions and position ourselves for worse economic times through higher savings, for instance.

Furthermore, these things tend to work on one way or another. Let’s take it to the extreme and say that government debt continues to rise and short-term interest rates go to 10.0%. With the government rolling over roughly a third of its total debt each year we’re looking at another $300 billion in interest expenses each year just on short-term debt. Say we print money and devalue the dollar in world markets to pay for this extra debt. Interest rates rise across the country, prices rise for consumers and unemployment rises dramatically. We couldn’t have stopped it, but we could have assets invested and liquid assets available to ameliorate the personal impact. Okay, enough of that since it detracts from what I’m really trying to say.

That is, in the fog of our short-term focus on the above issues and the maddening tendencies of the media to bloviate about them 24/7, we forget the ingenuity of the U.S. spirit and what’s going on in the entrepreneurial community today.

At this point, startups are being created like wildfire and funding is rabid. Several prominent venture capitalists have declared that there could be a bubble forming in early-stage technology companies, especially so-called Web 2.0 companies. I’ve heard many write and speak about the prices at which early funding rounds are taking place. Apparently, they’re not grounded in reality at this point and to some it “feels” like 1998-1999 again. (However, there are certain fundamental differences that differentiates this period from then. I may touch on this at a later date, but it mostly relates to valid business models and actual earnings.)

Anecdotally, it’s becoming more prevalent to see local articles about new companies being started dealing with the tech space. I’m encouraged by these signs. Let me point out that first and foremost I am a value investor. I try and figure out the stream of cash flows (both positive and negative) that can be expected over the life of an investment and discount it at an appropriate interest rate. Startups don’t have the luxury of much visibility on this front and so I haven’t (not yet, at least) invested in them. Also, I understand macro and micro-economics that makes me reticent about trying to pick winners.

Surely, there is no way that all startups receiving attention and/or funding today can reach the level of the most popular examples – such as Groupon, Twitter and Facebook. It doesn’t work like that. Many, if not most, won’t survive another year. As Warren Buffett has said, first come the innovators, then the imitators, then the idiots. Probably a lot of the incremental funding is coming from those in the third category and when the level of sophistication falls, so does the quality of the overall pool.

My broader point can get lost in the micro discussion, so I’ll finish here. Just because the effects of competition will ensure that most of these businesses fail (90% as goes the statistic?), the activity speaks to an entrepreneurial spirit that is alive and well in this country. And it’s a spirit that will endure in spite of the broad economic, fiscal, and monetary concerns that receive disproportionate attention in media coverage.