Invest Like the Best with Patrick O'Shaughnessy
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.
00:54:08 · Jeremy Giffon
[00:54:08] S2: Buffett and Munger were my kind of main teachers on investing. Buffett says that he wants his estate outside of Berkshire to be put in the S and P, that's his advice to the general public. People take that to say that Buffett saying you can't beat the market. I don't think that's what he's saying. Think he's saying for the average person you shouldn't try and beat the market. Implicit in that statement is leaving out any sort of active investor. Maybe the anecdotal side would be Buffett saying, you should put all your money into the S and P, that's the most rational thing you should do. On the other side is the sort of empirical argument, which is look, most professionals don't even beat the market after fees. This is this one two punch of the godfather of investing says don't try, seemingly the smartest people with the best incentives in the world can't do it. And then the other thing is I just think that for a professional money manager and this is sort of the paradox of the Buffett thing is that for a professional money manager it is really hard to beat the market because you have all these other factors that the average person doesn't have and this is the Peter Lynch argument. I increasingly think Peter Lynch was kind of a genius about this, which is that like yeah when you're a professional manager by and large you have all these mandates, you're running a business, you have customers that you need to keep happy, it's more difficult for the professional money manager to beat the market than like the average amateur. How many people you know who like bought Bitcoin and did really well or bought a Tesla and then they bought the Tesla stock or they bought an Apple computer and they bought the Apple stock, you can't run a hedge fund that way but they've outperformed just doing that. And so I think there's a little bit of this like weird thing where in isolation none of the advice is wrong. It's not as difficult as people think to I think outperform or do better than the average. And there's this notion that gets caught up in all sorts of other things that I think sort of sullies that view.
00:55:54 · Patrick O'Shaughnessy
[00:55:54] S0: I wanted to ask the LP's perspective, what you would do if you were an LP, what you'd be looking for?
00:56:00 · Jeremy Giffon
[00:56:00] S2: I get asked a lot by LPs where they should put their money, what managers are good or should they invest in this fund. You have to take a somewhat cynical view of these things as, and I maybe it's not actually cynical, just maybe the more realist view of these are businesses first and and you know their product is returns but like their business. You have to recognize what sort of customer you are. The question of where should I put my $500 check? You probably shouldn't put it into like marginal $5,000,000,000 growth fund, but I actually get asked that a lot. Should I put some 1 or $2,000,000 into this fund? It's probably gonna be a good fund, but could you find something much better to do with that million dollars? Probably. It sounds obvious, but in reality it's not and I think what people don't understand is that basically if you're a principal, let's say if you're a principal that can't write like sovereign or institution size checks, you're a totally different customer and the businesses are not designed to serve you as a customer. The growth fund is probably a great place if you have to park a $100,000,000 somewhere. It's probably a very very good place, but it's not a good place to park like a $500 check. If your business is set up to service sovereigns and large endowments and stuff, your product is just so different from what you're gonna serve for someone smaller and this gets into the like well okay if you have a small check what do you do? And I think this is where the emerging manager stuff is really underrated and looking for places where the managers actually most tightly aligned to returns either because returns are critical to future funds or that's actually how they're gonna make all their money.