Invest Like the Best with Patrick O'Shaughnessy
· Henry Ellenbogen
[00:00:00] S1: You can't spin those things up, these things that are super messy. You gotta acquire the land, you gotta put in the right place, you gotta build the right network, then you gotta go stand it up with the right CapEx and the right systems and then you have to have the right operating culture. This is really, really hard. If you put your real estate in the wrong place, then your cost of transport's more expensive and this culture you gotta go build there is super hard. So I deeply love these physical world moats that exist. And really, our portfolio has a lot of them in one way or the other. And that's why when you and I talked about robotics, my mind went to distribution. It's like, where can robotics basically take already advantaged businesses and make them more advantaged? The other thing I really believe is these soft things that are incredibly hard. I think about the example of Danaher so much, because what Mitch and Steve have done is stunningly hard to imagine. That for nearly 40 years you've compounded wealth at 20% in something that didn't have deep physical moats or didn't have data network effects like Meta might, or Google have, or the people who believe deeply in OpenAI. Those data network effects are amazing, but the ones where you're really sharp on human capital, you're really sharp on what talent really means, not the sticker of talent. You're really sharp on your operating excellence, the culture of it, the constant improvement of it, the system behind it, like Kaizen. And then you allocate capital against your businesses to really hold them accountable. I think it's amazing. In our portfolio, even though if I were to walk you through the businesses that FirstService is in, which Jay Hennick's chairman of, and what Colliers has where he's CEO of, he's the largest shareholder of both, none of them actually have these super sharp competitive advantages.
· Henry Ellenbogen, Patrick O'Shaughnessy
But yet, if you really have studied Jay and you truly understand his human capital culture and how he basically attracts and hold people accountable, and his ability to basically decentralize incentives so people are aligned in businesses, everything from residential management of condos to roofing and restoration and then how they allocate capital, how they sell things that don't have a path to be great and how they buy businesses, but they do it in a way where it actually aligns incentives in concert with them. It's just super impressive. The other thing is if we're gonna invest in small companies, those companies by the time they form them, tend to be pretty large. We have to be pretty sharp at really understanding other competitive advantages. [00:00:00] S0: You mentioned memos a few times, the memos you write internally. What have you learned makes for a fantastic structure of an investment memo? What works for you?
· Henry Ellenbogen
[00:00:00] S1: We're a writing culture, because at the end of the day, human beings are innately human. When we are involved in something, it's very hard to have that executive distance that you need to do to really hold yourself accountable to what you thought and actually hold the companies accountable to what you would like them to do. Especially since we really do know the people we invest in, and we invest in really high quality interesting people, and we're deeply rooting for everyone to succeed. Unlike a venture capital firm or private investing firm, we have to be able to understand when things aren't working out so we can sell them. But just as importantly, if we're gonna go invest in something that has real risk like Duolingo, we have to understand when things like Duolingo are really inflecting, and maybe we see it and other people don't, so we can go buy more of it. So we gotta be able to do both. When we write an investment memo, it's in service of our investment philosophy, making sure we've done the work and we can clearly articulate why is a company competitively advantaged or will it be? What would it have to do? Why is this operating culture excellent or why does it have the seeds of an excellent operating culture? And why does this leader think like an owner where they can basically make the business better, which we define as gaining market share through cycle? And we think that they can allocate internal and external capital such to both drive more durable growth and also make their asset base more valuable over time. That's our investment memo. But then just as importantly, through both modeling but clearly spelling out what we're tracking, we have to then be able to, when we do our quarterly, what are really our operating reviews at Durable, where we go through the entire portfolio with the entire investment team on every single investment, we have to look how actually the companies are doing against what we thought they would do. And then every single investment at Durable, if we own for three years, we actually do a three year lookback on what we underwrote and what it did. And that one, like so many things in your career you wish you would've known earlier. The great thing about investing and the great investors to me actually are better at 70 than they are at 50.
· Henry Ellenbogen, Patrick O'Shaughnessy
And hopefully—I'm in my fifties—I'm better than I was when I did this at 30. And you just learn, you understand patterns better. Hopefully you remain humble so you don't actually get too stuck in your ways. You surround yourself with smarter, better people, both internally and externally, but one of them is you just develop better processes. And one of the processes that we only started two years ago was, we always did quarterly KPIs or operating reviews, but we didn't go back and look at an investment that we owned for three years and just say—and when we do them, they're so simple—we say, three years ago we thought they would do X and now they did Y. Now of course the conversation is, where was it different and why, but actually the preparation for that meeting is, at least on the written side, so simple. It's two slides. But then of course we're all human and even though we try to hold each other accountable, if you get together every quarter and something deviates a little bit, you tend to excuse it. Of course if it deviates a little bit for 12 straight quarters, actually it's staring you in the face. That's why we're such a big believer in investment memos. [00:00:00] S0: I think in 2022 you went and did a tour talking to CEOs about the state of the market and operating principles and things like this. I'm curious to hear you reflect on that tour, but even more interested to hear if you were to do a tour of every CEO in the portfolio today, and maybe you're doing this actively, what the message would be today that's different than the message was in 2022?
· Henry Ellenbogen
[00:00:00] S1: I felt in 2022 we truly had expertise to add to the conversation. And that was we, at the highest level—and by the way, I don't say we versus us—we all, every CEO I talked to every investor I talked to, and even Durable, who as a fundamental investment firm that really values stuff on cash flow and never felt money was gonna be free forever, had made simplifying assumptions based on almost a decade of free money. Anyone who has been taught how to value companies understands at the end of the day all companies have to be valued on free cash flow and organic growth. At the time we got to a point where 30% of all treasury bills in the world actually had negative yields and relative to inflation, you were being paid to borrow, which basically means it was logical for venture capitalists to value companies and not care about profitability at all. It was logical for companies in the public markets to buy low quality businesses that could never own their cost of capital, but used cheap debt to go do it. It was logical why if you sat on company's boards, you really wouldn't ask hard questions about trading off growth, profitability and innovation, because you didn't have to. And if you go back to the conversation we had when we eventually studied compounding, we went back and we ran that study, in periods we’d looked at the public markets and we asked ourselves a simple question: in the world of positive real rates, which is the entire history of the US equity market, except for that short period of time, which I don't know if we'll ever see again. There's on average about 40 compounders and during the period of time of free money there was 120. So it was three times easier to do it. And then we asked ourselves a simple question, what patterns only exist when money's free? So not surprisingly, everyone would imagine the pattern of driving growth and profitability is perennial and actually works, regardless of whether money is free or not. The other thing that was really interesting, which was really important to us and gave us confidence to go buy more of the Duolingos in '22 when we did this work, is that if you are a small company, you don't have to be GAAP profitable and you don't even have to have an ROI that is above your cost of capital, but you do have to show progress in your path towards it.
· Henry Ellenbogen
And then what doesn't work, well, a company that doesn't earn financial returns and is showing no progress. And the other one that doesn't work, which we don't do a lot of was go buy a low quality return business at a high price but leverage really cheap debt. So I felt strongly, because we had seen cycles before and because we truly had expertise, and also because we're really, to companies that we invest, in a long-term partner. We wanna invest in companies that are private and still own them when they're public, we want to help them with that transition. I thought we had expertise and a perspective that many people had not gone in before. And so to reference what this meant was we had these conversations with a number of our companies that were in this situation. And so we had some version of this conversation with Aman at Toast, with Luis at Duolingo, with Max at Affirm. And all of them were a little different. As an example with Luis, I had dinner with him and the CFO, and his CFO's very talented, just like he is. And I just presented them the data. Knowing them, I knew they would have a lot of questions on it and they asked a lot of good questions. The other thing I said to them is, look Luis, when we invest in your company, one of the things I always ask people is we'll articulate what we're looking for in you, but what are you looking for in us? And one of the things he said is, I'm gonna be a first time CEO and my sense is you're gonna see things based on your experience that maybe I don't see because this is new to me. And I said, the reason I wanted to have dinner with you is not because I have all the answers, but I have a strong view that you're dominant in what you do. AI's amazing for you. AI was just getting started. You have a very unique humic capital culture, but if you're gonna communicate to people this strength in the market, it doesn't mean you need to get to your long-term margin targets at 30%, but you have to show progress towards it. With other companies, we restricted the stock, we spent more time with them, we helped them understand what this means. We even helped a bunch of them think about how to communicate what they were gonna do in this path of this transition to their investors.