Invest Like the Best with Patrick O'Shaughnessy
· Henry Ellenbogen
[00:00:00] S1: Right. And that's true, but at the time when I did this, no one had actually asked the simple question—in the history of the US equity market, which is to me, representative of capitalism—if there's 4,000 average public stock, how many of them truly are great? And the philosophy we have today is predicated that over a rolling 10 year period, you have about 40 stocks that compound well with a 20% a year or go up a little bit over 6x. So about 1% of the stock market are the valedictorians, and that's what we want to go do. Like a lot of things in life, you get through looking at lateral examples, biology, and then you look at anecdotes and then if you like to double click or you're maybe a geek on data, you start to really study it. And then obviously since then we've tried to create an investment philosophy that maximizes the probability of investing in those 40 companies. And the other thing that we have basically found out is that what's interesting is, about 80% of those companies start their compounding journey as small cap companies. And so people always say, Henry, why do you love small cap companies? I was like, well, I love them because I love the people side of the job, but I also love them because 80% of them, of these great companies, start as small caps. That's what we're trying to maximize because we think that's what creates long-term wealth and economic growth. What we have done is basically purpose-built an investment philosophy, and just as importantly, tried to purposely build an investment organization that can go do that.
· Patrick O'Shaughnessy, Henry Ellenbogen
[00:00:00] S0: I want to ask about each. Your firm is literally named as an ode to this concept, Durable. Durable, long-term compounding growth for the companies that you back. Give us one more click of detail on after that original insight. So you've identified that you wanna be in this group of 40 companies as best you can possibly approximate. What are the common elements that you've discovered that fit your personal and your team style that are indicators that you might have one on your hands? And I know you do late stage private investing as well. So you're looking at these companies when they're at or near their IPO. We'll talk about going public later on and why that's valuable, but what have you refined to be the most important signposts of a company that might be one of these 1% valedictorians? [00:00:00] S1: The first is, if you've been one before, you have a higher probability of being one. Again, which just sounds so simple but is actually really interesting. We look at who has actually done it. And if we don't really know the company and we haven't studied it before, we'll go double-click and go essentially study it, see if there's an opportunity. But if not, go do a case study on it. So we want to go learn it. One of my partners, Anouk Dey, basically teaches a class at Columbia Business School on the value analysis program. [00:00:00] S0: She's amazing.
· Henry Ellenbogen
[00:00:00] S1: And partially this is our way of going back to school as an organization and partially is our way of giving back to our community. But the class is based on this, and the students literally do about six case studies a year, but over time you build out a library of them. So I would say you just start by basically studying the ones who've done it and then obviously trying to study the patterns of those who've done it. That's number one on how we do it. Second of all, if you go look at the data, they're diversified across the economy. So look, we're in a period of time where what's going on in AI is so impactful. My view on the impact of this is probably no different than a lot of the other speakers you've had. I would say what I think about when I think about the power of AI and really studying it, I don't only think about the companies that are the first or second derivatives, or maybe people would categorize as technology companies. I also think about the existing diversified companies outside of the technology space that could be huge companies here. So as an example, when you go back and you look at the era of cloud and mobile, for sure, you wanted to go own Amazon in that period of time, but actually if you look at retail, once Walmart and Costco really understood what Amazon was doing but still had relative scale, they leveraged their advantages. And since they basically got on the same curve, 62% of all retail has gone to those three. So for sure one might've been better than the other, but actually all three were good. What was the best Russell 2000 growth, or for your investors who don't know benchmarks small cap company, over that 10 year period in the 2010s? Well actually, it was Domino's Pizza, which was a modest growth company, didn't average 10% growth over the period of time. Why was Domino's so good? Well, it turned out having gone back and studied Domino's from the beginning, but obviously owned the stock for some period of time—if you look at the pizza market in the United States, when Domino's started its run, you basically had a third of the market that was local. So probably like a lot of listeners, I have my favorite local pizza place and I like it because the pizza's great. And then the other third, we know there's the nationals, Domino's, Papa John's, Little Caesar's, others.
· Henry Ellenbogen
And then the middle third, there used to be in DC this place called Armand's, that had about 30 places and they had local or geographic scale, but they didn't have the scale of Domino's and they didn't have great pizza. And what happened was when Domino's started its run, well first of all, it started by basically making the product a little bit better. But if you talk to Patrick Doyle, who was CEO at the time and you really study it, what they started doing was if there's three value equations in pizza, it's quality, value and convenience. And what they realized is if we really, really invest in technology, we can make convenience a lot better. And so they really invested in their app and they built a direct relationship with their customer. Very early on, they could then target that customer more efficiently with couponing, what have you, drive scale through that box. And then when you do something well, you improve the product, probably was slightly above average. You really iterate on convenience and now you have a direct relationship with those customers. All of a sudden the brand halo started getting a little bit better because people thought Domino's was with it, and it started to really help the brand. And you put all that together against a wonderful business model of a franchise business model, which is ROI light, you end up with a great stock. One of the things we think a lot about at Durable is which of the companies that are in distribution, trucking, healthcare; who are already good and maybe investing on a different curve, have the ability to use AI to either substantially lower their relative cost advantage versus their competition, gain more revenue scale and then reinvest that, in a way where you create something that's permanent over the companies that maybe get to this late, if they ever get to it. And often those are the best stocks when you go study the markets because you are already in a physical world business where the technology advantage transitions into a physical mode advantage or a distribution or scale advantage. That's one of the patterns that we've observed. We call that a good-to-great thesis internally.
· Henry Ellenbogen
The second way is people, if I think about the investments we have today, we tend to be in business with certain people we've known for 20 years now, and maybe they're doing the same thing or maybe doing the next thing, but we think these are the type of people who build great organizations. And then obviously we have to meet new people too. So one of our largest holdings today is Duolingo. So we first spent real time with the CEO Luis von Ahn during COVID. During the COVID era, as the markets reopened, it went to highs and the private markets were white hot in the zero interest rate environment. And people were meeting people on Zoom. And I remember meeting Luis with my colleague Julio. We got off Zoom with Luis like you often do back in the day, I called Julio up and I was like, what do you think? And he was like, well, it's a super impressive business. They're leading their market, they're on the right side of their consumer and the product's great. And I said, yeah, and I said, Luis reminds me of Tobi from Shopify. The last time I spent time with someone that technologically strong—Luis had been head of AI and ML at Carnegie Mellon, but also has that much business clarity and is so crystal clear at communicating that he can make complex topics simple that even I can understand them—was when I spent time with Tobi when Shopify was private. And I said to Julio, we're gonna basically clear our schedule and whenever Luis will spend time with us in Pittsburgh, we're gonna go spend time with him. And so I think, for lack of a better word, the understanding of the patterns and having studied them, the understanding of what creates the environment. Sequoia's famous for saying why now, and what could lead that not only on the technology side but across the economy. But I think the clarity you have when you spend time with at this point, thousands of executives and you have seen the ones who've done it, you wanna do more with them and then you have seen the ones who are trying to do it but remind you so clearly of the ones who have done it.
· Patrick O'Shaughnessy
[00:00:00] S0: Can you say a little bit more about this notion of Act 2 teams and management teams, and why that is an interesting concept to you when you're thinking about the relationship between an Act 2 team and a potentially very durable compounding company?