Invest Like the Best with Patrick O'Shaughnessy
· 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.
· Patrick O'Shaughnessy
[00:00:00] S0: You said people and change, we'll talk more about both, but starting with change, we're in the midst of probably the biggest technology shift or change maybe that any of us will ever see. You've invested and lived through several others: internet, mobile, cloud. Can you put this one in frame of reference with the other ones that you've lived through? And you mentioned so many times studying the past and studying history and seeing patterns. What patterns do you think might apply this time, and what patterns do you need to throw out and re-underwrite from first principles here?
· Henry Ellenbogen
[00:00:00] S1: So I started writing about AI in our shareholder letters in '22. And at the time I said having seen internet, cloud and mobile, this is gonna be at least as powerful as internet. And I said, we're gonna go approach this with humility, go spend time with the people who are closest to it and constantly be learning. And then I also said Durable is not a thematic investing firm, we’re a compounding investing firm. So just because we think something's gonna be big doesn't mean our investment meetings aren't gonna be, AI's gonna be big, let's go buy AI companies. It's gonna be let's really understand change and then understand how the companies that we invest in are gonna benefit from it or become better by it or at least not get disrupted. I personally—and I'll lay out in a second—think it probably is more impactful than the internet was. It's not only gonna affect every technology company which you see in the markets, but it's also gonna impact, in this case, I think almost every company that needs white collar employees and IP employees to drive their work. So let me start with the second one first because I think less people have talked about that one. As a student of business, I think that by the end of the 2010s, everyone knew that if you were a product-based business, you needed to understand your China cost. It was on the cover of every business magazine and then every popular magazine in the ‘10s. And all that meant was, in a global supply chain, if there was a part of the world with huge scale and resources like China and the Far East, that could make products substantially cheaper, when you landed it at your factory or to the consumer. You had to understand it and if you didn't leverage it yourself, you were gonna go out business. That was the first derivative. The second derivative is actually there's a lot of businesses that are spread businesses. You look at a lot of distribution businesses as an example. If you distribute… let me tell you about a great business like HVAC, the industry tends to put a spread on the raw material. If your HVAC unit basically inflates at 3-5%, that's good. And if your HVAC deflates at 3-5%, that's bad. And so if you were a spread business on top of it, that was problematic. Every company that was product based or derivative product based had to understand China costs.