Invest Like the Best with Patrick O'Shaughnessy
· 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.
· Henry Ellenbogen
And I think the same thing applies to AI, but I think it's not product based this time, it's IP based. So let's go back to Max as an example. Affirm most people would think about, and correctly so, as a FinTech company that empowers people to get access to credit in a safe way and actually pretty compliant, friendly way, with no tricks. And he's doing even more than that now. But at the end of the day, because he is regulated, he has a lot of legal costs in the company. He's got hundreds of thousands of contracts with merchants, he's gotta monitor his partners on how they communicate credit. And that just requires a lot of people. If you talk to him and he is talked publicly about this, he's got great belief that Affirm can grow at the rates it's growing at for a reasonable period of time. In addition, they can do it without adding headcount. And the reason for that, obviously he's gonna go lean out a lot of processes that were not possible to go do before AI. I'll tell you a really funny story with that. So I talked to him one day after he reports earnings and he explains to me, you're always asking me about how I'm using AI to become more efficient. I feel like I was late to the curve but I finally figured it out. And so he says, I have this team that goes around the company and understands processes, and we start from not a cost standpoint, but we start from a leaning out standpoint. And I think I'm making real progress there and that's why I'm able to make this public pronouncement. He is like, isn't this great? And I say to Max, why don't you come to DC and let's go see Mitch Rales. Because Danaher, who he and his brother started and he's chairman of, has been doing this for 40 years. It's called DBS, and they basically brought Kaizen back to the US and they started—they're obviously more of a healthcare company now—by going into factories, putting processes up in whiteboards, studying how they could lean them out, leaning them out and coming back in a month later to make sure because change is hard, that the change is held. And then they basically built a whole business system which has basically not only helped build Danaher, but there's over a dozen Fortune 500 CEOs in the United States who started their jobs at Danaher, including the guy who just has turned around GE.
· Henry Ellenbogen
So since you're so excited about this, let's actually go to the godfather of the United States. The reason I say that is this is just so profound, it's even hard to get your head around. Mitch would say for 40 years, because of China, we've been able to really lean out product-based businesses, working capital. But in many ways I feel like we're just getting started on processes that are done by humans. The second example that I'll talk about, and I'm talking about things that haven't been talked about as much on this show. When I first really understood what was going on with the internet, I ran a global TMT fund and my largest investment was Amazon. We invested in that when it was a $10 billion company, so I used to go to Seattle twice a year. So interesting the things you remember because it was far from Baltimore, no one would come with me, and it was a small company and people thought I understood it. And I used to go have lunch twice a year with Jeff Bezos. At the time I worked for the firm that was his largest outside shareholder. And it was obviously my research position for the firm. I learned so many things from those meetings, but one of the things I learned is the very best businesses that leverage technology, leverage it in a way where they use it to lower costs and drive revenue that result in them gaining 30% or more incremental market share in their end market. And then they take that unit economic advantage and they reinvest it in something that is persistent, even if their competition were to wake up tomorrow and do the exact same thing with people just as good as they are. And to me, that's one of the definitions, at Durable, of a competitive advantage, is if your competitor does a competitive moat attack, doing the exact same thing with people as well, or…
· Patrick O'Shaughnessy, Henry Ellenbogen
[00:00:00] S0: Doesn't matter because you're too far ahead. [00:00:00] S1: Doesn't matter. And as we all have come to understand with Amazon, they took that 3-5% cost advantage of getting that box to you. and their ability to put more than one item in the box, and they used that economic advantage to then go build fulfillment centers that are physical to reinvest into capital and infrastructure that allowed them to go down that 3% to 5% cost curve for 20 years. As I said earlier in the show, they woke up and the only people who could play their game, when eventually everyone realized what they were doing, were the people who still had the scale and the customer relationships and the trust of Walmart and Costco. And then eventually when they figured out, all three of them were great. Now the problem is the rest of retail was not so good. That's what we think about here. [00:00:00] S0: So if I say it back to you, we've seen through Mitch and others like him, this 40 year benefit of Kaizen brought to physical product world, and that AI represents a sort of kick-off of Kaizen to human work world and that that is going to have lots of stories like the Amazon story you just said, where someone gets on one of these curves early and they can't be caught. And so you're trying, I'm sure, to find who those people might be. [00:00:00] S1: We're trying to do two things. We're trying to find the people who that might be, and then we're trying to make sure we don't… [00:00:00] S0: Get killed by them.
· Patrick O'Shaughnessy, Henry Ellenbogen
[00:00:00] S0: Get killed by them. [00:00:00] S1: Mistakenly own a company, that based on last generation competitive risk was a great company and correctly, we thought was competitively advantaged, and had a good operating culture, was led by high quality people who thought like owners. But because discontinuous change changed the world, they weren't able to adapt. Now ideally what we go do is we go find those already advantaged companies and then they leverage this to go from good to great. [00:00:00] S0: If you think about all the people that have navigated change as CEOs the best that you've worked with. I'm an investor with Dave Duffield in his latest company and so he comes to mind 'cause now he's tackling AI and the guy is incredible. If you think about whether it's Mitch or Jeff or Dave or people like this that you've seen operate, what methods have impressed you the most, of how they themselves adapt first, their own mentality and then their teams, to these fast-changing circumstances. And this is a question for everyone out there that's running businesses, that is facing this same change that's a risk and an opportunity at the same time. [00:00:00] S1: Let's go pick on Luis. We talked about Luis earlier. Duolingo has a lot of opportunity with AI and a lot of risk. And the stock, depending on the day, reflects it. When OpenAI demos, how you can use OpenAI to basically do translation. A lot of times the stock goes down, or when Apple shows you how AirPods can be used to, in the physical world… [00:00:00] S0: Live translation.
· Henry Ellenbogen
[00:00:00] S1: Yeah, live translation. Stock goes down. And actually I don't think the market's wrong. Now, it's probably wrong on the magnitude, but I think what the market is saying is there's a risk, there's a risk here. So that's probably in our portfolio, one of the higher risk names. But what do we look for when Luis or Max or Dave Duffield, I think the first thing we look about is a business that already is operating well. Because if you're not operating well when you have to deal with change, you're not gonna be able to do two things at once. You can't do a turnaround and do well. I think the second thing we would say is a business that already was winning in its first end market. All the definitions we would have about winning. Substantially gaining market share, driving real economic profit that allows it to reinvest in this next S-curve. And also the other thing we really care about is people, we really stress resiliency at Durable. It's one of the reasons we like so much investing in Act 2 managers, we can go study their resiliency. When you're an investor in Max and you saw how resilient he was in Slide, and now you understand how he's gotta be resilient to implement AI, to lean out his cost and drive his revenue before his competition does. You're like, we've seen him under stress before. I think you're looking for people who have a perspective, can execute but also are humble. Because we at Durable write down our views on AI every six months and we update them. And as we've gone more into this period of change, probably we're less wrong. Our perspective is more informed you would say, than it was, as we change it every six months. But we're learning, we have the benefit of having a job that allows us to spend our time reading and thinking and talking to smart people. So even if these are really talented people, most likely they don't have as much time to go do it as we do. And we have to be very humble in our approach. So they have to have a perspective, figure out how to go do this, not be paralyzed, but they also have to be humble and constantly learning. And you know, the last thing I think practically we have to think about as investors goes back to the memo.