Invest Like the Best with Patrick O'Shaughnessy
00:45:53 · Jeremy Giffon, Patrick O'Shaughnessy
I'm always interested in these structural shifts and how that starts to change things where The Valley is a place where you're liquid and you're getting cash out yearly and you're jumping from firm to firm and Wall Street is a place where you have a bunch of RSUs and you're sort of thinking more about the long term and the interest value of the firm. [00:46:12] S0: If you add all this up, where are you looking for opportunity? You have such an interesting mandate because you could do a venture style growth equity deal. You could do a special situations private equity style deal. You've historically across your career invested in dozens of software companies. You've, I think so far wisely avoided companies that could get railroaded by Cloud Code. But nonetheless, I think you're still curious about where there might be value in software. Just as a pure investor, how are you approaching this very strange high vol, high uncertainty landscape? We're very fortunate to
00:46:49 · Jeremy Giffon
[00:46:49] S2: have such a wide mandate and sort of what we can do and look at. Maybe the only consensus view is the niche sort of apocalyptic vision at some of the core zealots at the labs. But outside of that, I think it's really sort of a jump ball. Markets lack a lot of nuance. SaaS is a business model of this idea that you pay usually per person, per month or per year for access to a tool that helps you use your computer. I think in that sense, SaaS is in a lot of trouble, but I don't think for a lot of these businesses that are being really sold off today out of fear that that is actually what is important to the business at all. It is actually interesting to me, I wrote a post recently about the idea that a public manager being long, the Mag seven is without taking up specific view on the trade, probably like good capital allocation because sometimes you just got to do the really obvious thing and just follow consensus. Consensus is usually right. One of the pushbacks I got to that as well, these things, you know, they're the biggest companies in the world, they're priced to perfection. I think it's underrated the fact that the fifty two week variance and these things is like nearly a 100% for the biggest companies in the world and so they're not priced well at all and the market lacks lacks extreme nuance. I think it goes back to what we were talking about which is probably someone smarter than me could draw out a much clearer picture, but there's something to do with passive flows and the marginal price of security and what's informing the marginal price of securities is The posts. In the group chats that the random people are writing that the algorithms chosen. In this way the algorithm, the AI frankly, my understanding is that's what's driving most of the algorithms now on Twitter and YouTube is pricing the market in some very real sense because it's choosing the narrative that it wants to show to people and then those people are pricing off that. It's another lesson which is markets are not efficient, there's no nuance. That would be the big thing that we're seeing today. I think there's a lot of delusion either direction.
00:48:38 · Jeremy Giffon, Patrick O'Shaughnessy
The most honest thing for a lot of managers to do would be to sit it out, but they're structurally unable or unwilling to do that and so you just sort of, you know, hope for the best and put capital out the door and it's sort of a problem for tomorrow. A lot of things are still getting priced irrationally in the private markets in ways that are totally unrelated to the quality of the business but are more of a function of just the incentive structures of the funds. [00:49:02] S0: You mentioned the SaaS is just a model and there's good and there's bad. What do you think about this trend of super CapEx heavy, token heavy, real world asset? There's this new genre of company that seems to have emerged as really dominant. I was looking the other day, was curious in our portfolio, what percent was not pure bits? And it's like 60 something percent is not just software based on the market value of our investments. I was surprised by that. Like it's a really high percentage, whereas VCs have mostly historically been all software for the last ten or fifteen years. What do you make of this trend, this class of business, lower gross margins, things like this?
00:49:40 · Jeremy Giffon
[00:49:40] S2: One way that you can look at this is we were really in the late innings in, let's call it 2016, 2017 on of okay, returns in venture capital have been very high and now we've seen whatever 20 of venture returns being very good and so logically capital is gonna flow into the asset class. The problem is that the venture market is largely constrained in that the amount of great businesses that are started is relatively fixed. Probably I believe downstream of how many great founders there are. I think there's just a finite amount. More and more capital flows into venture, there's basically a finite amount of companies, so you have to put more money into the same amount of companies. This was becoming a real problem before AI and COVID, which was that there's only so much money that you can cram into a B2B software business and especially when annoyingly the companies are getting cheaper and cheaper to start. Functionally what you saw and what you still see to some extent but what you really saw was that all this capital was just flowing to landowners and to compensation packages basically. Capital hates getting blocked, it's like water, it wants to find the most efficient path and it was getting blocked because it wanted to flow into venture because there was backward looking higher returns. It was just constrained. You can only cram so much money in these companies and it was a lot of what inspired me to start my fund was seeing this problem, which was just the the amount of money these companies are raising is unrelated to the amount of money they need. Almost as if Deus Ex Machina, all of a sudden there was two great categories that could just soak up this capital. And I really do believe in some sense that they like businesses and assets are sponges for capital and that the excess in an era of back then we had negative interest rates and stuff, the capital has to go somewhere and if it has nowhere to go it will create somewhere for it to go. And I think that there's a very fortuitous arising of these high CapEx businesses of AI, the ultimate high CapEx project, obviously all the hardware stuff.
00:51:35 · Jeremy Giffon
And so I think in some sense like you could say that the capital markets were desperately looking for a place to go to put the capital and there was no place and so these companies almost got created downstream of capital, which I think is a little bit different of the narrative than most people would look at. So that's sort of the philosophical view. The economic view, part of the reason SaaS is getting punished so much today in the market is because it was this idea of you're selling a copy of a string fundamentally, that's what a software product is and the marginal copy of a string is very close to zero and so, with zero marginal cost, the thing that you're selling should be highly profitable. The vision of that was that you will have high upfront costs and then you will have very high gross margins and hopefully one day a very high net margins, although the net margins seem to never sort of materialize until private equity gets their hands on things, and sort of forces that a margin out. That era is largely just a downstream coincidence of this like selling strings, and now I think we're in an era where we're selling compute, and selling compute you can't write the prompt once and then sell copies of the output, you have to do the compute every single time and so the marginal cost obviously is not zero. And I think this is like a fundamental huge change to the software business and I think it means that this era of high gross margins being the norm is just gonna go away and what's gonna make up for it, think is lower gross margins, much thinner net margins and much more scale. And I think that's what you're seeing, is that the capital is flowing to the top end provider of the scale. It would have been unthinkable that we talk about companies in 3 to $4,000,000,000,000 market caps ten years ago, big part of that is inflation I believe. Another part of that is just the scale dynamic which I think it's uncontroversial to say we're gonna have $10,000,000,000,000 companies and so on and so forth. Because margins are gonna drop, all the returns are gonna accrue to scale because obviously low margin, low scale is not a very good business.
00:53:32 · Jeremy Giffon, Patrick O'Shaughnessy
It's crudely a bit of a Walmart effect in software which is that the future looks like low gross margins, razor thin net margins, huge scale and this is probably a problem if the SaaS provider is the mom and pop shop like Walmart's coming to town. [00:53:45] S0: You have this funny view that the whole myth of how difficult it is to beat the market, however you want to define the market, is wrong. I'm curious you'd expound on that. That seems to have become post Jack Bogle one of the deeply held truths of the market is that it's extraordinarily difficult to beat the market so you shouldn't even try, you should just opt out of the battle. I think you have a very different view on this.