Invest Like the Best with Patrick O'Shaughnessy
· Henry Ellenbogen
[00:00:00] S1: Yes and no. So there's really two parts of our portfolio. When we're looking at what we call early-stage growth companies, and it could be Duolingo as a private company or it could be Duolingo after it goes public. But it's still not competitively advantaged at that point in time, it didn't have cash flow, it didn't have PE ratios. We still view that as an early-stage growth company we're saying in the future there could be competitive advantage, the operating culture could be clearly established where we could look back and see the excellence of it and the adaptability of it, and then we could look at the growth formula and really understand it. And obviously along the way we've really believed these are our kind of people who could scale organizations. So when we look at something like that, we have to believe that when we look at the three plus three, we're underwriting it on a three-year basis in general, not always. If it does what we think it can… not like, it will, and I'm gonna speak to that in a second. We would then wanna buy more as it, in our lexicon gets bigger, but also de-risks and then proves to be a competitively advantaged business, and shows more resilience, and shows the ability to financially balance growth, profitability, innovation. Basically prove its ability, in the case of Duolingo, to become more of a power app, teaching speakers a foreign language for more self-improvement. Then it starts to do it for learning, that basically increases educational ability to participate in the economic world. They're obviously going to different subjects with chess. So as you progress as a business more towards what we view as a competitively advantaged business that's for lack of better word big, but still has growth, we underwrite those with a view that if it does that scenario, we would want to buy more. And if not, we just can't get involved. Now of course in my career I've invested in over a hundred private companies and I think I've been involved in over 50 IPOs. How many of them do we still own? Well, we probably still own more than anyone else in the markets. Even if I look at Durable, among our largest positions in the public markets are DoorDash, Affirm, Toast, now Figma, Warby Parker. And we led those last private rounds, they persisted and we bought more at different points on the curve.
· Henry Ellenbogen
I would say on a durable growth company, because of market volatility and this agency principle that I think about that's forcing people to have short-cycle views of the public markets, actually probably you're buying more of them when they're down. One of our favorite entrepreneurs is a guy named Jay Hennick who essentially is CEO of Colliers, but he was also the founder of FirstService and we own both of them. We're actually involved in a private investment with him also. Back to Act 2 entrepreneurs and also our belief that we do business with people and we're really good at people, and good people do sometimes multiple things well. And look, in the case of Colliers, I think it's a very misunderstood company. I think for sure the brand suggests it's a commercial real estate broker. Commercial real estate brokers don't do well in general when interest rates are high. That was the case last year. But I think what's misunderstood about Jay, and he has done this time and time again, is because of his understanding of—he was really a disciple and his mentor was Peter Drucker—his understanding of local incentives and his sharpness of capital allocation, and the way he sets up the partnership model when he buys people. What people haven't realized is he's built an incredible business, both in asset management on the real estate side and Harrison Street, and also he's building a terrific consulting platform. I think our insight there is it starts with Jay, but it starts with understanding actually the asset quality of Colliers is not the quality of a commercial real estate firm that's cyclical. It's actually a really good real estate asset manager, emerging really strong consulting firm. So last year when people were worried about the weak commercial real estate market and interest rates, we bought a lot more of that company. It sold off based on short term macro concerns. So in that part of the portfolio, probably we're buying more of the companies when they go down.
· Patrick O'Shaughnessy
[00:00:00] S0: You said something really important and interesting that I'd love to dive into, which is the principal-agent problem. And my question is a market structure question. We've talked before about some crazy percentage of just marginal volume that happens inside of the platforms, the Citadels, Millenniums, Balyasnys, Point72s of the world. How do you feel that, and I'm curious just for your thoughts on changes to market structure in general since you've been doing this, how it contributes to that volatility, what opportunities it creates, what dangers it creates?
· Henry Ellenbogen
[00:00:00] S1: I started thinking a lot about it two years ago, and in hindsight I probably should have started thinking hard about it three years ago. You don't get everything right. There was a period in my career where the quant funds really started to do great. The Two Sigmas of the world. One of the things we really stress at Durable is humility. So we never look at a problem and assume we're right and the other person's wrong, and we never assume we're good and the other person's bad. We actually look at things and assume the other person's really smart and what can go learn from them. And so this relates back to before I founded Durable, but I went and I studied the quants, and what I concluded was the short-term alpha game is probably gonna be won by the machines paired with the humans. At the time it was when, for the first time, computers paired with machines could beat the best human chess player. And this is obviously when I went to spend time with the principal at Two Sigma, I learned he was doing exceptionally well. But anyway, I got to know him and we talked a lot and I realized actually, there were real limitations to what the quants could do. I started realizing if it's a repeat actor problem based on known data, actually the quants are pretty good. So what does that mean at the time? Well, it means is if you're just a person who buys an industrial company because the PMI is down and historically when the PMI re-rates and gets better, you make money, that's not gonna work. The machines are just gonna be better at that year. But if you're like what we were at the time, people who are really good at understanding people and really good at understanding change, that was really advantaged. And I basically, at my old firm, I did an internal teach-in on man versus machine, and I said as a result what the New Horizons Fund is gonna go do is we're gonna go double down on these two things, and we're gonna get better at them. We’re gonna get more focused on what we do on the people side of our business, both in the public and private market, and we're gonna get more focused on where change impacts both our early stage growth companies and our durable growth companies. And where we're investing where we're not advantaged versus these machines, probably shouldn't have done it anyway, but we're gonna stop doing it.
· Henry Ellenbogen
But we did it of course all within our investment philosophy. And that's basically what we've done at Durable as we've gone and studied Millennium and Citadel. First, let me be very clear, deeply respect those organizations. I think they're great at what they do. And I actually believe the people who work there are very talented, and we start from the view that these are exceptionally talented people who are actually very good at what they do and are high quality people. But what we have said is what do they do and what is the limitation? And one of the limitations is if you work at a firm that deeply measures your risk every day, and then if you have a bad period of time, measured by a month but certainly three months, you get your capital cut back, I think there's a good chance you get let go. It probably means you can't have a time horizon longer than your career horizon. What we also have noticed, because we not only understand things anecdotally, we also study them—if you look at the last public market earning season, which was companies reporting Q2 this past year. If you study earnings volatility, it was more volatile than any earning season since the financial crisis. Even though during the financial crisis, as we all know, the fundamental banking system in the US was under question, which meant the economy and the markets as we know it really had a wide dispersion of opportunity and the markets tend to be a lot more volatile when they're making lows than making highs. And yet this was the most volatile earning season. I think the reason for that is just basically the fact that we estimate somewhere between 80 and 90% of the institutional flow is driven either by the firms that have one month and three month agency, or the quants that have to take these price signals into account, and then their models are optimized for this. And so what we have said at Durable is really simple, let's go do less so we can do more. Because if we're gonna accept volatility in stocks, we have to really understand the business and the people like we do at Colliers, such that if Colliers is down because people are worried about commercial brokerage because of interest rates, actually the markets are probably right, they're probably right 90% of the time.
· Henry Ellenbogen
But if we understand what's unique about that culture, how they allocate capital, we understand deeply how the quality of that Harrison Street is, because we've studied it for 20 years and we know the people who run it well, well that’s a reason why we're willing to lean into that stress. The same thing when I look at our early-stage growth portfolio. I spoke about Duolingo earlier, they came public the last time the capital markets were really open to companies, which was 2021. And there's been a lot written about the 2021 IPO class, how they came public in a zero interest rate environment and so many of these companies actually were gonna have a tough time getting to profitability. And as interest rates went up in '22, I think correctly—a lot of people said actually just throw them all out. The average loss making company in 2022 in the Russell 2000 Growth went down over 70%. Our view was, makes sense, the market's probably right, but not all of these can't adapt. Not all of these don't have businesses that are good enough to make real economic returns. Our view is not all of these companies didn't have the discipline and the organizational fortitude to transition and become successful companies in a world that actually required profitability based on the change of interest rates. Duolingo is an example of a company that we actually bought more of in '22, and that was an example of an early-stage growth company that we dollar cost averaged down. I think we're advantaged, because if you're rule-based in what you do or you have a one- or three-month timeframe, you just can't own Duolingo. You can't own more Colliers.