Golden Age of Investing – June 2017

Golden Age of Investing

Over the first half of 2017 we added several new secular winners to our portfolio. The pace at which we
have been doing that has been accelerating which speaks to the quality of the opportunity set ahead of us.
Our estimation of the portfolio’s risk-reward now stands at an all-time high [please read our April 2017
letter for a description of this internal metric].

Without sharing the “secret sauce”, I would like to provide you a little taste of what drives our excitement.
Please reach out to us if you want more details.
The invention and dissemination of the internet and the massification of its accessibility through
smartphones is transforming the way people live and creating new sources of wealth and competitive
advantage. This change opens up a wide array of business opportunities. A good share of these opportunities
come from businesses with a strong and growing competitive position and extremely attractive business
models.

Such a massive change in the economy, business and society has happened before and give a hint to what
we have ahead in our lifetimes. In the Agricultural society, wealth and power were mostly driven by how
much land you had and how productive it was. To preserve its power, families passed it from generation to
generation to the oldest male offspring. By concentrating it on one heir they prevented power and wealth
from being diluted. Each family county fell under the protection of a King. Social mobility was quite low.
The only opportunity to increase the wealth and power was to conquer other kingdoms and take their lands
leading to the creation of empires.

The emergence of the Industrial revolution upended this. Source of wealth shifted from land to capital.
Social mobility emerged with new rags to riches lives now possible. Business model of factories were
scalable allowing for the formation of previously unseen fortunes. New industries emerged increasing the
standard of living of everyone. Cities grew in power and influence as more and more of the economic
activity centered there. Wealth and power were no longer limited to land productivity but could grow based
on capital accumulation and new business launches. Scale and access to capital protected businesses from
competition. Wealth and power became concentrated in fewer hands.

We see a similar level of business change currently under way. Luckily for investors like us, this brings an
even higher level of opportunity than the industrial revolution. Current secular winners tend to be
knowledge / information based companies that have a much higher return on invested capital, a larger
addressable market and stronger and more defensible competitive positions than their industrial
predecessors [Table 1].

Industrial companies Knowledge Companies
Source of competitive advantage ·        Scale

·        Brand

·        Information

·        Network Economies

Competitive Dynamics Additional scale and brand yields lower incremental benefits to leader overtime allowing smaller players to survive Additional information and network economies makes the leader’s product value for its customer wider and wider vs. its competitors

 

Industry structure Large players have superior economics but several competitors can stake their claim on the market: leader tends to peak at 20% to 40% market share

 

Winner take most or even winner takes all: not uncommon for leaders to have higher than 50% market share
Capital intensity Medium to High:

 

Most businesses generate no excess free cash flow while growing or even need additional capital to grow

Medium to Low:

 

Most players can self-finance growth and still generate strong excess free cash flow

ROI Medium and stable

 

Extremely high and growing
Incremental margins High variable costs so incremental margins tend to be not much higher than average margins

 

Extremely high incremental margins: build it once and sell it many times with very low incremental costs
Geographic expansion Internationalization requires medium to high levels of additional capital with unclear path to success Minimal additional capital required;

Potential to leverage existing information and network economies increases chances of successful expansion

 

New Product/Service launch Medium to high additional capital required and medium levels of success Low additional capital required and high chances of success for adjacent product launches

 

Table 1

We have written about a few of these knowledge-based companies in the past but we have more attractive
ones currently in our portfolio. We are happy to take your calls and walk you through our current thinking.

The emergence of knowledge companies is an exciting development in our lifetimes. That doesn’t mean
that industrial companies will disappear, just like the industrial revolution didn’t mean the end of agriculture.
It also doesn’t mean that all knowledge companies will survive and prove to be extremely attractive
businesses. Discernment is important and that is what Somar brings to you.

We have an exciting journey ahead and we are excited to share it with you. The level of secular change has
never been greater in my lifetime. The speed of change has never been faster. And the availability of
investment opportunities has never been wider. We look forward updating you on our progress in the years
to come.

 

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