11 Notes on Berkshire Hathaway
The Family Papers #023
By Oussama Ammar & Nicolas Colin (Cofounders & Directors) | The Family
(This is a very long story by Medium standards. So all you millennials, busy people and social media addicts who supposedly can’t concentrate more than 30 seconds on the same text can scroll down to the short version at the end.)
There are many famous investors that could be mentioned as The Family’s main sources of inspiration.
Like many involved in early stage investment, we are avid readers of Paul Graham’s Essays. An inspiring writer, Graham has dedicated a lot of energy to reflecting on his own experiences as a software engineer, an Entrepreneur, and then an early stage investor. Many of his writings are mandatory readings in our line of business, notably “How To Make Wealth”, “Do Things That Don’t Scale”, “Black Swan Farming”, and “How To Be Silicon Valley”.
Another source of inspiration is the Andreessen-Horowitz partnership, which not only ranks among the most successful investors in Silicon Valley, but also forms a group of prolific writers. Marc Andreessen’s “Why Software Is Eating the World” shaped our investment thesis. Ben Horowitz, Chris Dixon, Scott Kupor, Benedict Evans, and Balaji S. Srinivasan (a former a16z General Partner) are also widely read here at The Family.
A third source of inspiration is the Venture Hacks team. As early stage investors, we obviously pay attention to the developments of AngelList. But for many years, our thoughts have also been shaped by our reading Babak Nivi’s seminal philosophy stories, among them “The Entrepreneurial Age” and “No Tradeoff Between Quality and Scale”. If you want a short version of our worldview, just read those two wonderful texts.
Another group of investors, though, stands out as an even more potent source of inspiration. Three and a half years ago, our co-founding The Family together with CEO Alice Zagury was kicked off by a reading of Warren Buffett’s biography The Snowball. Since then, few weeks have passed without our reflecting on our business strategy in the light of Warren Buffett’s and Charlie Munger’s extraordinary achievements as chairman and vice-chairman of Berkshire Hathaway.
This probably sounds presumptuous, even far-fetched. After all, Buffett and Munger have notoriously shunned the digital economy, a field that they declare themselves incapable of understanding. The truth is that many lessons that can be derived from Berkshire Hathaway are not easy to transpose to the digital world. It takes systemic reflection to see the relationship between what Buffett and Munger achieved and the opportunities that can be seized in today’s digital economy. That reflection is an ongoing process at The Family.
For all of you interested in that journey, below are a few notes that we’re very happy to share in this new issue of The Family Papers.
The New Value Investing
1/ In 1914, a young man recently graduated from Columbia University in New York declined a job as an instructor in English, mathematics, and philosophy, and instead took a position on Wall Street, eventually going on to start an investment partnership. He then began a long and fruitful career as a stock market investor, teacher, and author. The books in which he laid down his views, all best sellers, are still widely read today. Most of those who had the chance to attend his classes at Columbia University still carry memories of being personally moved by his teaching.
That old teacher’s name was Benjamin Graham. What he taught went on to be known as value investing. And among his many students stands one of the most famous investors in the world: Warren Buffett — who outpaced his old teacher by such incredible proportions that the very notion of value investing is now literally synonymous with Warren Buffett.
Everyone knows Warren Buffett, yet few could explain how his investment vehicle, Berkshire Hathaway, came to be so successful or what exactly Ben Graham’s value investing is actually about. So let’s start with a simple definition: value investing is about looking for stocks that trade at a price below where they appear they should be, based on their financial status and technical trading indicators.
In other words, value investors are the ones who do their homework and know secrets as a result. They differ from both growth investors (who buy stocks of fast-growing companies to sell them later and realize capital gains) and income investors (who buy stocks of companies that already pay steady dividends and count on the recurring revenue for a long time to come). Growth investors like to follow the leader (hence the occasional bubble). Income investors, conservative by heart, don’t like surprises. Value investors like to beg to differ and to be proven right on the long term.
At first glance, successful value investing looks difficult to achieve in the digital economy.
One problem is the abundance of available information. An ecosystem such as Silicon Valley is not only made of Entrepreneurs, engineers, or investors. It also creates its own media and pundits. Every company that pops up on the radar is instantaneously covered by media such as Techcrunch, Forbes, Wired, Harvard Business Review, or Fortune, featured at various global events, storytold by its own founders on the company’s blog, even scrutinized by other Entrepreneurs who will in turn publish related stories. And this doesn’t include the free and robust perspectives regularly brought forward by influencers such as Marc Andreessen, Fred Wilson, Paul Graham, Bill Gurley, and Tim O’Reilly. These thinkers may be biased because they invest in some of those companies. But they also convey a lot of insightful information for us to exploit.
Given that exponential flow of information, amplified by the power of social media, it’s become increasingly hard to see what others don’t see. Value investing meant something in the age of scarce information. It has become much harder to implement in an economy in which companies are growing out in the open instead of retaining critical information behind closed doors. If the challenge is to understand tech companies better than the market, we’re not sure if it’s still possible in the age of infinite available information.
Another problem is that you can’t trade most tech stocks because tech companies like to remain private. There are many reasons why tech companies so forcefully resist the idea of going public. It is difficult to be a public company when your highest stake is radical innovation. Since the Sarbanes-Oxley Act was implemented, it also costs much more to be a public company, in terms of both compliance and risk management. And unprecedented concentration in the investment banking sector has raised the threshold at which a big investment bank is willing to consider introducing a client on the public market.
The scarcity of IPOs brings with it an illiquidity of shares in tech companies. Of course there is a grey market for secondary transactions, but it is so confined to certain insider circles that it tends to concern only the hottest companies in town. Thus the logic is the opposite of value investing: it’s not about buying stocks of an overlooked public company that’s trading low; instead, it’s all about buying shares in an over-hyped private company whose valuation goes through the roof. All in all, because many tech stocks can’t be traded, it looks like you can’t do value investing within that asset class.
Or can you? Maybe the definition of value investing is worth a second look. Last year, following Peter Thiel, Ben Horowitz argued that good Entrepreneurs succeed because they have a secret. An alternate version is Paul Graham pointing out that “the best startup ideas seem at first like bad ideas.” And in fact, only a few words need to change in the definition of value investing to match the reality of early stage venture capital. The opportunities all early stage investors are trying to seize are those companies whose “value stock trades at a price below where it appears it should be, based on its founders’ talent and initial idea” (instead of “their financial status and technical trading indicators”).
That’s right. It’s a different world, but value investing still exists at the earliest stage. Price is highly dependent on the abundance of capital. Once it’s become clear that a company is a future leader, the price will go through the roof and become decoupled from the fundamentals. As we’ve written, rising valuations are the mark of a healthy ecosystem, in which the best tech companies are able to raise the capital they need to conquer global markets. But if you want to protect your interests as investor and pay a fair value-based price, you’d better not arrive late in the game.
Indeed, the early stage is when you can discover a startup’s many secrets: an exceptional team (secret #1) who tackles a problem that counts (secret #2) on a large market (secret #3). The early stage is also when you are most able to build a trusted relationship with founders, without the friction of negotiating high-dollar deals with complicated term sheets. And this is why early stage startups are the new value stocks.
Homework
2/ Warren Buffett would probably enjoy angel investing in tech startups. After all, as argued by David Teten, “angel investing is the highest-performing asset class we know (albeit the most illiquid and opaque)”. Successful early stage investors are precisely those who do their homework to counter that opacity — even if it’s in no way the same homework done by value investors several decades ago. All of a sudden, a whole new type of infrastructure for doing one’s homework has to be created.
This is where The Family’s business model becomes relevant. The Family invests cash down the stream: as some of our portfolio startups emerge as potential winners, we invest cash as they grow, with the goal of becoming a strategic and long-term partner. But as capital costs have fallen, cash doesn’t create as much value at the earliest stage. Before we invest cash, our business is to solve many problems by way of an infrastructure in order to hasten discovering a startup’s secrets.
This infrastructure is difficult to describe as it includes so many different resources and so much goodwill. It is best understood as a model designed for value investing in the digital economy. Like all value investors, we do our homework. But the way we do that homework is not by crunching data in order to select just a few founders. Instead we provide an infrastructure on which the best founders emerge at the earliest stage. This infrastructure is key both in sustaining our business model and making it similar to value investing.
Capital costs — “the total cost needed to bring a project to a commercially operable status” — have decreased in the startup world. Launching a startup has undergone a radical commoditization, mostly due to cheaper technology. The Internet is a cheap and convenient infrastructure for Entrepreneurs to use. Open source software is ever more robust, up-to-date and less expensive than proprietary software. Cloud computing provides tech startup with cheap access to powerful software resources at scale. Finally, programming languages are now higher level, which makes them easier to use for less skilled programmers. As startup capital costs fall down at the earlier stages, there are more and more Entrepreneurs willing to launch startups, which makes it even more critical to make a difference, reach escape velocity and widen the gap with potential competitors.
This is what we had in mind when we designed The Family’s infrastructure. Its purpose is to provide a continuous education so that founders become better Entrepreneurs. We also design what we call unfair advantages: a careful selection of the best products to help founders get better at critical functions such as growth hacking as well as to free them from the complexity and pitfalls of non-core business functions such as legal and accounting. We provide premium access to a pool of trained talents for hire. And finally we empower founders by establishing a more favorable balance of power with cannier investors down the stream: with enough time on our infrastructure, data has been gathered to better reveal the founders, qualify the problem they’re trying to solve, quantify the market they’re willing to enter, and document the value of the startup’s product. Once in The Family, it becomes easier to raise capital from both The Family itself and other investors down the stream.
On all those fronts, scale makes a huge difference — especially in a toxic environment such as continental Europe. As stated by Clayton Christensen,
When most products start to become commoditized or modularized, this turn of events kick-starts a decommoditization process somewhere else in the value chain.
This decommoditization is the opportunity The Family seizes with its infrastructure. Since early stage startups don’t need to buy technology anymore, they can allocate their scarce resources to other expenditures and solving their many other problems. Hence they are better served by using our integrated infrastructure that solves the many problems that every early stage Entrepreneur tackles, maximizing their success. When it’s time to finally raise cash, not only have we put those founders on the right track and provided them with all the resources they need, we’ve also protected them from the toxicity that traditionally infects the early stage investment market.
It takes that infrastructure to reveal promising founders and build long-term, trusted relationships with them. It doesn’t cost much for each startup because such an infrastructure generates increasing returns. Our obsession is not to have as much capital as possible. Rather, it is to have enough capital to seize the opportunity of investing in early stage companies on which we can have a transformative impact by way of our infrastructure.
Investing money invites selection based on signal: it always leads back to tense discussions and a premature selection process. Providing infrastructure to hedge against a toxic environment triggers a very different dynamics: it enables emergence and reveals value. To be good value investors in the digital economy, you need to invest at the earliest stage and operate that kind of infrastructure.
Long Term in the Failure Age
3/ Another distinctive trait of Warren Buffett is how much he values the long term. This is common to all value investors, whose entire thesis relies on the assumption that their views will prevail in the long term, beyond the market’s current volatility. As a result, what they look for are large, profitable businesses with long track records. Berkshire Hathaway’s favorite targets are companies that, “over an extended period, can employ large amounts of incremental capital at very high rate of return.”
The problem is how hard it has become to make long-term previsions. As the economy becomes more digital, we’re finally waking up to the idea of companies not lasting forever. It’s not only because the digital transition triggers a radical reshuffling of traditional value chains. Digital business models also generate increasing returns that intensify the volatility of the market and make organizations more fragile than ever. As a result, tech companies have an unfortunate tendency to stumble and disappear at a higher frequency. This was the core argument of a seminal 2014 article by Adam Davidson published in the New York Times:
Whereas the corporate era created a virtuous cycle of growing companies, better-paid workers and richer consumers, we’re now suffering through a cycle of destabilization, whereby each new technology makes it ever easier and faster to create the next one, which, of course, leads to more and more failure.
Most of Warren Buffett’s investment thesis is based on the premise of a stable economy. The difficulty with envisioning the long term in the digital economy is one of the reasons why he has avoided that field altogether. But we at The Family have four new perspectives to bring forward.
First, to be as long as possible, the long term has to begin early. It’s easier to plan for the long term with founders with whom you’ve established a trusted relationship very early on. Investing early is one very important pillar of our investment thesis.
Second, don’t forget that some things change and others don’t. So it’s still possible to plan for the long term based on what won’t change. As Jeff Bezos recently declared:
I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ or ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.
And this is exactly what Buffett does — looking at what doesn’t change:
Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. I don’t think it is going to be hurt by the Internet.
Of course, in the digital world there are many more things that are bound to change. For instance, as of 2014, people are not that much into chewing gum anymore, and one possible factor is… the lack of innovation in a world where customers expect things to improve constantly. Another example is energy: NV Energy, a utility owned by Berkshire Hathaway, recently lost major customers (casino chains) who were willing to pay high fees to opt out and choose other sources of energy. It’s worth noting that renewable energy has been made sustainable by the falling price of solar panels, the maturity of storage devices such as Tesla’s Powerwall, and the deployment of digital technology to improve the operation of solar energy grids. Hence even on the safest markets such as utilities, Berkshire Hathaway has to tackle the consequences of radical innovation: better technology, paradigm shifts and the emergence of new habits on enterprise as well as consumer markets. But that doesn’t mean that everything will change; rather it means that change should be considered as the trend by default and that investors should beware their tendency to express denial.
Third, once inside a portfolio such as The Family’s, a startup will create value even through failure. Entrepreneurs join The Family for the long term, long beyond their initial startup. If their initial venture fails, we encourage them to pursue other projects and to eventually launch a new venture in The Family. Thanks to the learning curve we help them sustain, our Entrepreneurs’ next ventures will bring even higher returns. This is the reason why we like to double down on the best founders, with a higher stake and better outcomes as they progress within The Family. (Additionally, a failed startup also means the liberation of talented founders and employees, who we actively introduce to other fast-growing startups that need to hire at that very moment.)
Finally, we’re transitioning from the predictable (Newtonian mechanics) to the unpredictable (quantum mechanics). The only weapon to survive in an unpredictable world over the long term is not by crunching more data, but by looking for singularity. A good way for spotting singularity is to focus both on a desire for long-term impact and the will to make money. People who want to get rich without trying too hard and without having a real impact don’t thrive in the startup world, as they’re incapable of sustaining the effort needed to succeed at the earliest stages. As for people who want to have impact but are not interested in making money, they usually can’t access the capital necessary to make a difference at a larger scale.
By partnering with singular founders who combine a drive for impact with a sense for making money, we expect to make significant returns along investment cycles that span 10 to 20 years. So just like Warren Buffett, we’re in it for the long term.
Is There Such a Thing as a Digital Moat?
4/ The “economic moat” is a core principle of Buffett’s style of value investing. As explained here, “it refers to the competitive advantage a company has in its business that allows it to generate long-term profits and continue growing market share versus competitors. The moat serves as a buffer of protection for continued profitability.”
Many people doubt that economic moats still exist in the digital economy. Digital markets may be concentrated at a given time (“winner takes most”), but their volatility makes it easier for challengers to enter the market and take on dominant companies. On digital markets, moats are not so large or deep as those which entice Berkshire Hathaway into investing.
A first version of an economic moat in the digital world consists in having part of one’s business model on what we call the “Northern Side”, namely the part of the business that consists in operating more tangible assets (warehouses, cars, real estate) on more regulated markets (healthcare, education, finance or… ride-hailing). As detailed in a previous issue dedicated to Amazon’s business model, having part of your business on the Northern Side doesn’t mean that you’re not a tech company. Only on the Northern Side, returns increase less than in less tangible, less regulated business models that are more concentrated on the “Southern Side” — the one that is mostly about technology, data, and the user experience.
As software is eating the world, more tech companies are confronted with the challenge of finding the right balance between the two sides. The more assets a tech company have on the Northern Side, the more oxygen it needs to find on the Southern Side so as to preserve its increasing returns:
While returns are clearly diminishing on the Northern Side, the opposite trend — increasing returns — is at work on the Southern Side. For Amazon, every new warehouse costs more than the previous one, especially because it has to be located closer to the city so as to shorten delivery time (= diminishing returns). But the new customers that this warehouse will enable Amazon to serve will drive more than revenue: as they join the experience made possible by the architecture of participation on the Southern Side, they create value for Amazon through many channels: revenue, higher volumes, network effects, machine learning, and content-driven virality (= increasing returns).
Now that software is entering more complicated industries, every tech company has to do an arbitrage between increasing returns on the Southern Side and having a more traditional economic moat on the Northern Side. In this Faustian bargain, Entrepreneurs have to choose: either they sacrifice increasing returns in favor of a larger and deeper moat (Amazon’s warehouses); or they embrace an “asset-light” business model and sacrifice fixing assets in exchange for a potentially higher and ever-accelerating growth rate that makes it very hard for their competitors to catch up (Uber or Airbnb).
Now, economic moats can be found on the Southern Side too:
- one version of a moat on the Southern Side is to grow a whole ecosystem made of various products to lock customers up within a single, unified, exceptional customer experience. Google and Apple somehow managed it, but we think that it won’t be a viable option in the future (see below);
- another option, as explained by the Boston Consulting Group’s Philip Evans and Patrick Forth, is to deploy a powerful, unrivaled technology infrastructure that will make your organization more agile and that none of your competitors will dare match — like Amazon Web Services;
- a third option is to build a two-sided market to generate powerful demand-side network effects and make it harder for any competitor to challenge your position. This is what Amazon, Airbnb, and Uber have achieved. It is easy to challenge Uber and steal its riders by offering aggressively discounted prices. It is much harder, if not impossible, to steal both riders and drivers at the coordinated pace that is necessary to ensure liquidity on your own marketplace.
The most obvious “Southern Side” version of the Buffettian moat would simply be growth. In the Fordist economy, growth is a transitory state, whereas plateau (along with high profit margins) is a perennial state that can last forever. In the corresponding paradigm, the challenge that a corporation has to tackle in the long term is, to quote Warren Buffett himself, “to hold their ground in terms of both unit volume and competitive position.” Yet in the digital economy, reaching a plateau (= ceasing to grow) and focusing solely on holding ground essentially equals death, however slow it may be. This is what Dion Hinchcliffe deems the “Red Queen Effect”.
Exponential growth as an economic moat is consistent with Philippe Aghion’s work on growth and competition. As Aghion demonstrated in various papers, competition doesn’t impede innovation. On the contrary, it even increases the innovation efforts of firms that are the closest to the technology frontier. This has particular consequences in the digital economy, where increasing returns contribute to an even higher pressure on competing firms. Some among them seize that extra pressure as an opportunity to innovate even more, thus sustaining even higher increasing returns and eventually consolidating their dominant position on the market. Others are simply left behind and have to relinquish their position.
Finally, another kind of moat depends on the environment: the more toxic the environment is, the less competition there will be. Hence if you manage to defeat the toxic environment, you can keep competitors at a distance for a very long time. For that, having the right investors, and operating on the right infrastructure, can make the difference.
That’s why, given our infrastructure designed to grow startups in toxic continental Europe, The Family in and of itself is a moat for the Entrepreneurs who join us! Once inside The Family, they benefit from unrivaled education, unfair advantages, and capital, as well as a nascent brand power that helps them consolidate their long-term advantage on the market. Because if a startup is part of The Family, competitors will have little doubt that their founders are (to quote Marc Andreessen) “imperial, will-to-power people who want to crush their competition.”
The End of Diversification
5/ Investors hate conglomerates. They think that conglomerate managers are incentivized to keep hold of businesses with poor performance in the false belief that they will get better in time and ride out the cycle. Another problem is that the diversity of a conglomerate’s businesses makes it hard to devise its financial fundamentals. This explains the discount that conglomerates usually command on capital markets.
In a way, Berkshire Hathaway owes its very existence to the shortcomings of diversification in the Fordist economy. Diversification remains beneficial in principle because it serves the goal of hedging corporate entities against asymmetrical risks. If it were manageable to diversify at the strategic or operational levels, then corporations would all opt for diversification and there would be no upside left for strictly financial conglomerates such as the one built by Warren Buffett and Charlie Munger. But since in practice diversification doesn’t work at that level, a different kind of conglomerate arose, having strictly financial rather than strategic or operational objectives. Berkshire Hathaway, which unusually commands a premium instead of a discount, belongs to that category.
For some time, many have seen the digital economy as marking the end of financial conglomerates, since it looked easier to operate strategic and operational conglomerates in the digital world. Indeed giant tech companies have eventually morphed into conglomerates. Apple manufactures devices and operates the App Store, all while having become a leading player in the retail business. Google owns both a search engine, a video platform, Google Maps, a webmail service, the best web browser on the market, and driverless cars. Amazon operates a retail business, a marketplace, a streaming video service, and its giant cloud computing platform, Amazon Web Services.
Numerous articles have praised that extraordinary capacity on the part of giant tech companies to diversify in various business lines. Among them are this article of The Economist, this remarkable paper by the Boston Consulting Group’s Philip Evans and Patrick Forth, or this recent story by Andreessen-Horowitz General Partner Chris Dixon. The conglomerate version of the digital economy is made possible by software technology, which is so powerful when it comes to connecting heterogeneous businesses. As devised by Venkatesh Rao, software is a soft technology, “seemingly ephemeral, but capable of being embodied in a variety of specific physical forms.”
Yet in practice, the age of tech conglomerates may be coming to an end — just as Fordist conglomerates more or less disappeared from the 1970s onwards. Of course, existing tech conglomerates won’t disappear overtime. But emerging startups will have a harder time diversifying in the future.
Consider it from a user’s point of view. Google’s search engine may be unrivaled, but YouTube is a video platform that is tolerable at best, soon to be caught by Facebook, and Google+ was an utter failure. It’s the same for Apple: the iPhone is an extraordinary device, and few of us could live without our beloved Macbook Air, but iTunes has become an unusable piece of software and Apple Music is laughed at in the tech community. Even the mighty Amazon occasionally fails on the diversification front: the Fire Phone’s failure was a resounding warning signal two years ago, even though Jeff Bezos typically rebutted reproaches by — rightfully — explaining how much he had learned from that failure and how much value it created for the Amazon empire.
Another example of conglomerate failure is Yahoo, which owns products as diverse as Flickr, Tumblr, and Yahoo Mail, all while retaining a share in Chinese tech giant Alibaba and operating a large online advertising network. With such valuable assets, it could remain a mystery as to why Yahoo failed. But the mystery is easily solved. Flickr has now been beaten by Google Image for search, by Pinterest for curation, by many other tools for sharing one’s work. Tumblr has apparently become a mess. Yahoo Mail is trailing far behind other popular webmail services. Yahoo’s diversification in publishing has made for harsh articles criticizing Marissa Mayer’s management. The Alibaba share may be the only valuable asset left in the faltering empire. In trying to rebuild Yahoo with the Google playbook — that is, through diversification and a frenzy of acquisitions — Marissa Mayer has experienced the painful implication of the famous Gall’s Law:
A complex system that works is invariably found to have evolved from a simple system that worked. A complex system designed from scratch never works and cannot be patched up to make it work. You have to start over with a working simple system.
So strategic and operational conglomerates don’t look like they work any better in the digital economy than they used to work in the Fordist economy. There are in fact many reasons why specialized companies will tend to beat diversified ones in the digital economy.
First reason: one key to understanding tech companies is to grasp their “ability to integrate their innovation strategies with their business strategies”. The problem is that you can’t integrate everything with your business strategy. It was impossible for Steve Jobs to launch the iPhone and clean up the MobileMe mess at the same time — hence iCloud is still a mess. It won’t get easier as tech companies enter more tangible industries and more regulated markets. In a context that requires more focus and energy than ever, diversifying means stretching operations much too wide, into areas beyond the top management’s core competencies and capacity to focus.
A second reason for the end of diversification is the advent of technologies designed to help break the digital moats derived from tech companies’ network effects. The resulting competitive pressure could force many companies to focus on their core business instead of diversifying under the protection of powerful network effects. As pointed out by Fred Wilson,
An open data platform, in which users ultimately control their data and the networks they choose to participate in, could be the thing that undoes [the] pattern of ‘winner takes most’. The blockchain is the closest thing to emerge that looks something like that.
Indeed more and more startups are tackling the challenge of decentralizing the digital world, notably with the blockchain. This is why, in preparing for the coming “End of the Firm”, Noah Jessop urges fellow Entrepreneurs to identify “the core work that your company uniquely does”:
Firms that don’t will soon find themselves replaced by new entrants reaping the benefits of focused efforts, or even displaced entirely by the niche-winners dominating the landscape.
A third reason for the end of diversification is that talent goes where it is most rewarded. If specialized ventures yield higher returns on invested capital, then it triggers a positive feedback loop. These higher returns will enable those firms to pay better than more diversified ones in the same industry, thus attracting more talented workers. And in turn having the best workers on board will help those same firms yield even higher returns on invested capital. As pointed out by White House economic advisor Jason Furman and then-Office of Management and Budget chief Peter Orszag,
There has been a trend of increased dispersion of returns to capital across firms, with an increasingly large fraction of firms getting returns over 10, 20 or 30 percent annually… Longstanding evidence has documented substantial inter-industry differentials in pay — a mid-level analyst may have the same marginal product wherever he or she works but is paid more at a high-return company than at a low-return company. Newer evidence suggests that much of the rise in earnings inequality represents the increased dispersion of earnings between firms rather than within firms.
Even though there is no significant dispersion of returns to capital, the best people like to work on strategic priorities rather than being stuck in non-strategic side businesses. If you’re a top-notch automotive engineer specialized in electric cars, would you rather work for the mighty Tesla Motors or for Apple’s remote side business casually aiming at diversifying into electric cars?
That doesn’t mean that a firm shouldn’t diversify at all. It’s one (dangerous) thing to go in multiple directions trying to solve different problems at the same time. It’s another one (much better) to diversify along the stack while focusing on your customers and solving their problem. As pointed out by Balaji S. Srinivasan, solving a problem in its entirety may require a large and heterogeneous range of competencies, but it also “builds respect in your vertical. Now you can recruit the best people. Their experience + your code = invincible.”
The last reason for the end of diversification is that, in the Entrepreneurial Age, competitive pressure increases forever, because it becomes ever easier to found a startup and burst onto the market. So you’d better watch out for those new entrants and be focused on improving performances within your core business — instead of reflecting on which new market you’re willing to enter since life has supposedly been so easy on the one that got you started.
Diversification is far from pointless. At the financial level, it helps hedge against asymmetrical shocks. At a strategic level, despite its many shortcomings, it can be used like a weapon to keep competitors at bay. But at the operational level, however digital your product is, it often leads to an inferior user experience, which in turn imposes a strategic threat upon the firm in its entirety.
This is the reason why diversification will be less and less on the product side (Google), and more and more on the financial side (Google-turned-Alphabet or… Berkshire Hathaway). As diversification is less and less a good practice at the company’s level, its advantages have to be brought up at the shareholder’s level, with a significant advantage for portfolio companies: patient capital. So we expect investment vehicles following Warren Buffett’s path to have a bright future in a more specialized digital economy. And this is yet another reason why we’re convinced a Berkshire Hathaway can thrive in the digital age.
Can Tech Companies Pay Dividends?
6/ Dividends from subsidiaries are a key feature of Berkshire Hathaway’s business model. Without them, it couldn’t exist. Warren Buffett’s obsession with stable, recurring dividends derives from Ben Graham’s influence. As told by Charlie Munger, Graham’s “ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.” This obsession with dividends, however distorted, was instrumental in the success of Berkshire Hathaway.
The problem with tech companies is that they usually don’t pay dividends. At least that’s what we at The Family tended to think before a new wave of reflections, discussions and business cases led us to a more nuanced view of the role of dividends in the digital economy.
The history of modern finance is easily told in a few sentences. From the 1970s on, competitive pressure has mounted on financial markets. As the financial playground got bigger, depth and liquidity increased exponentially on financial markets, making room for larger pools of capital, bigger bets, higher volatility, and more sophisticated financial products. This, in turn, led to the emergence of giant financial powerhouses who turned on corporations and forced them to increase their returns on invested capital.
The increased competition between firms to raise capital from ever bigger investors on financial markets gave the upper hand to shareholders at the expense of other stakeholders (notably employees, but also customers, with executives as the main arbiter). As a result, many listed corporations became stock-tickers. Corporate CEOs discovered a new obsession, maximizing shareholder value, and abandoned innovation in favor of efficiency. While doing so, they also converted to the practice of paying steady and predictable dividends to attract deep-pocketed income investors. There were many adverse consequences: less innovation, more inequality, andeventually a faltering competitiveness.
In contrast with what has become common corporate practice, dividends are still scarce in the digital economy. One reason is that giant tech companies are all American and that a US tax provision known as ‘check-the-box’ incentivizes them not to bring their profits back to the US; this obviously makes it complicated to pay dividends. Another reason is that tech companies, however dominant, are so afraid of waves of radical innovation that they prefer to keep their war chest intact in case they’ll need the cash to invest in new, ambitious projects (Amazon Web Services) or buy other companies at a marked-up price (Google buying YouTube, Facebook buying WhatsApp). A third reason is that paying dividends would attract dreaded, feeble, conservative income investors who would start to weigh in on the company and force it to become more adverse to taking risks.
Our personal preferred reason as to why tech companies loathe dividends has been brought forward by Peter Thiel. He points out that paying dividends would negatively affect a tech company’s brand on consumer markets. Indeed tech companies are so dependent on their customers’ trust, built within an early and strong alliance, that they want to continue to appear as if they’re dedicated to improving their customers’ experience instead of focusing on shareholder value. As Thiel declared when debating Google Executive Chairman Eric Schmidt a few years ago,
Google is no longer a technology company, it’s a search engine. The search technology was developed a decade ago. It’s a bet that there will be no one else who will come up with a better search technology. So, you invest in Google, because you’re betting against technological innovation in search. And it’s like a bank that generates enormous cash flows every year, but you can’t issue a dividend, because the day you take that $30 billion and send it back to people you’re admitting that you’re no longer a technology company. That’s why Microsoft can’t return its money. That’s why all these companies are building up hordes of cash, because they don’t know what to do with it, but they don’t want to admit they’re no longer tech companies.
At the same time, there are signs of a shift. Under activist investors’ pressure, among them Carl Icahn, Apple has begun to pay dividends — and even borrowed money to do so, in order to avoid a very high tax bill (see ‘check-the-box’ above). And indeed, almost as a result, Warren Buffett has recently decided to invest in Apple — his first tech investment ever!
Additionally, tech companies may not pay dividends, but they certainly buy shares back. As explained by this McKinsey paper, share buybacks seldom have any lasting effect on total return to shareholders. But in the case of tech companies, they most probably create value because they help sustain the value of employee-owned equity and thus play a critical role in retaining talent, one of the scarcest resources on the market.
Finally, there are many, many lesser-known tech companies that pay steady dividends. The reason why they’re less known is because they’re very focused on niche markets and don’t have the global leadership ambitions of giants such as Amazon, Uber, or Netflix. One good such example is Ask.com. Yes, that still exists. And yes, it’s profitable. And yes, it’s a search engine that is not Google. As mentioned two years ago in an article about Yahoo,
Dynamic and wildly profitable Internet companies like Facebook and Google may get most of the attention, but Silicon Valley is littered with firms that just get by doing roughly the same thing year after year — has-beens like Ask.com, a search engine that no longer innovates but happily takes in $400 million in annual revenue, turning a profit in the process.
Along that line, some more specialized tech companies appear to be on the path to paying dividends at some point. Among the boxes that those tech companies with the possibility of paying dividends will check: having conquered an entire niche up the value chain; having established a consumer brand at the same time; and being in the process of consolidating their dominant position thanks to constant innovation and superior performances without being subject to the ever-evolving business models down the value chain. This is what Intel achieved in the 1980s with its “Intel Inside” strategy. A company like Stripe may well be on the path to becoming the Intel of online payments. Berkshire Hathaway could very well buy Stripe at some point. And that’s also why The Family is happy to be one of Stripe’s shareholders.
All in all, the temporary disappearance of dividends in the current transitional context does not mean the end of dividends as much as it signals a radical change in the world of corporate finance. As written by Clayton Christensen, traditional corporate finance is incompatible with the radical innovation efforts necessary to survive in an ever-evolving digital economy. Misapplied discounted cash flow, margining on fixed and sunk costs, and a myopic focus on earnings per share all contribute to impairing innovation efforts in established companies, which is why tech companies tend to beat Fordist companies every time.
To regain the advantage, established companies must convert to a new kind of corporate finance that is more in line with the precariousness companies experience on digital markets. In the Fordist economy, we’ve been taught to think that corporations last forever and that, as a result, they should focus on resilience — a very Buffettian value. In the current failure age, we have to accept that corporations are indeed mortal, and that the key to any tech company’s survival is growth fueled by radical innovation. When that kind of growth, not resilience and margin consolidation, becomes the top strategic priority, the innovation killers that have been deployed for decades by corporate CFOs cannot be tolerated anymore. So corporate finance will have to go through radical change to accommodate this new strategic deal.
It doesn’t mean the end of dividends in and of themselves. Indeed, in many cases, dividends — even leveraged buyouts, or a variant that we at The Family call “venture buyouts” — will be compatible with growth and radical innovation strategies, thanks to a brand of corporate finance more in line with how tech companies create value and compete with each other. Thus we should expect more diversified approaches in terms of growth vs. income vs. value stocks from investors in the digital economy.
And by the way, as tech invents this new kind of corporate finance, expect Berkshire Hathaway to ultimately master it and walk back its longstanding refusal to invest in tech companies. In any case we at The Family intend to go the dividend way, too: in The Family, some startups are destined to take bold risks at a very large scale; others are to become recurring businesses that sooner or later will be able to pay steady dividends.
What’s Our Insurance Float?
7/ Thousands of articles are dedicated to better understanding Warren Buffett’s wise investment decisions. A lot less acknowledge the other side of Berkshire Hathaway’s business model, namely its very unusual way of financing investments with other people’s money obtained at a very low cost. Berkshire Hathaway has an unrivaled capacity to scale up, as opposed to more traditional models in the investing business, not only because Buffett and Munger reach better investment decisions, but also thanks to the unusual way they source the capital needed for those investments.
The secret that many miss when trying to devise Berkshire Hathaway’s success is how important its insurance business has been in the system and its dynamic. Without this insurance business and the extraordinary resources that it provided, Warren Buffett would have been unable to turn a failing New England textile company into an international conglomerate of remarkably profitable companies.
An insurance business makes a difference when you’re in the investing business because it generates formidable reserves that insurance company managers more or less invest as they see fit. It is those available insurance reserves that Berkshire Hathaway uses to finance its other businesses and make investments as large as the $5B Goldman Sachs investment in 2008 or the $28B Heinz acquisition in 2013. This “insurance float” has in effect proved the lifeblood that made Berkshire Hathaway’s extraordinary financial journey possible. As explained by Goldman Sachs in a 2010 research paper,
Put simply, float is the amount of money held by insurers on behalf of other parties — the majority of which is typically funds held to pay future claims. With premiums often collected well before losses are paid, the insurer can invest these funds for its own account. Additionally, for longer-tail lines of business, the timing differential can be decades long. Thus, while any given year will see its share of claim payments go up or down, the amount of float held by an insurer will stay relatively steady to its premium in-take. Thus, for an insurer that is not shrinking, the float can take the form of permanent capital.
Maintaining profitability of its insurance business is critical for Berkshire Hathaway to access capital at a very low cost. If you underwrite profitably in the insurance business, not only have you raised money at no cost, you even get paid to borrow money from your customers. As written by Noh-Joon Choo, “it is Berkshire’s proven ability and stated willingness to focus on profitability (as opposed to growth) in its insurance operations that has allowed the cost of its float to be essentially zero over its multi-decade history.” Or, as written by Buffett himself in its 1999 letter to shareholders,
To understand Berkshire… it is necessary that you understand how to evaluate an insurance company. The key determinants are: (1) the amount of float that the business generates; (2) its cost; and (3) most critical of all, the long-term outlook for both of these factors.
Indeed the critical importance of this insurance float as permanent capital — “money that doesn’t belong to us but that we hold and invest for our own benefit” — has led Berkshire Hathaway to impose radical strategic decisions on its various insurance businesses. One of them, GEICO, has to remain the lowest-cost car insurer on the American market, which contributes to maintaining a steady volume of operations and making it easier to cover insurance claims on a given year. Another, NICO, has been confronted with the need to drive the top line up and down, at some point orchestrating an extended decrease in volume to preserve profitability — all the while without firing employees, who otherwise would have resisted such a radical move. This constant effort to sustain Berkshire Hathaway’s insurance float is designed to ensure the availability of reserves deep enough to enable seizing opportunities on the investment side, at a mastered cost.
Cash flow generated by a side business would be one equivalent of Berkshire Hathaway’s insurance float. In a previous issue, we’ve already covered the case of Vinci, a big French corporation specialized in construction and utilities, whose dual business model had been designed for financial reasons.
Construction is a low-margin business that employs little capital; but it generates massive amounts of free cash flow thanks to a low cash conversion cycle (construction contractors take their time in paying their suppliers). On the other side of Vinci’s business model, utilities are very demanding in terms of investment and accordingly employ a lot of capital throughout very long investment cycles (sometimes decades); but in time they generate substantial net income that, ultimately, makes the most of Vinci’s profits and dividends. All in all, the two businesses are complementary: without the construction business, it would be very difficult for Vinci to invest in its utility infrastructures, lest they bear the risk of excessive leverage; and without the concession business, Vinci would be incapable of turning substantial profits for its shareholders.
In the digital economy, one equivalent to this Berkshire Hathaway’s insurance float or Vinci’s cash flow would be Amazon’s cash flow. A key feature of Amazon’s business model is how it uses its cash flow to finance its radical innovation, which in turn enables Amazon to keep on growing and to generate even more cash flow. The graph below is an attempt at explaining the importance of cash flow in Amazon’s business model.
This is a point that frequently provokes pushback. How can Amazon generate such a high level of cash flow? Well, it’s because of their negative cash conversion cycle and their impressive growth. And won’t Amazon be forced to slow its growth at some point? Well, maybe, but it will be a mortal danger for a company that literally feeds on growth. And aren’t cash flows meaningless when it comes to appreciating a company’s health in the long term?
Amazon’s cash flow is best understood as a byproduct of its exponential growth. This point has been made in this highly-recommended paper by McKinsey & Company: “Grow Fast or Die Slow”. It has also been discussed by Timothy Green in an article in which he criticizes Amazon’s dependance on growth-induced cash flow, pointing out that “this extra cash flow is a good thing, but it’s not sustainable. It exists only as long as Amazon keeps growing.”If Amazon stops growing at the current rate, it ultimately dies.
Interestingly enough, Green quotes Warren Buffett, who has long been skeptical of cash flow figures — which he describes as “frequently used by marketers of businesses and securities in attempts to justify the unjustifiable.”Buffett made his fortune investing mostly in mature businesses with high profit margins (insurance, tobacco). In his own words, spoken 30 years ago, cash flow numbers are meaningless because they miss the need for assets “to be replaced, improved or refurbished”.
Yet in fact, they mean a lot in the digital economy because they reveal the capacity of a tech company to finance the continuous reinvention of its business model and thus signal what really counts in this new world: perpetual growth. High-rate growth is a permanent feature of tech companies’ business models. As growth tends to become a perpetual state in the digital economy, it brings with it a frightening corollary: constant reinvention of the company’s business model, and cash flow to finance that effort. When their initial market is not large enough to enable further growth, tech companies have to reinvent themselves and to explore new markets. This is why, following The Economist, giant tech companies are “at each other’s throat in all sorts of ways.” Cash flow, innovation and business model reinvention are all critical inputs for any tech company, but growth is actually the key outcome.
Lacking an insurance float, can The Family access the cheap permanent capital that will help it defy the law of gravity in the investing business and eventually make it more scalable? Without an insurance float, you can’t expect to be as scalable — and ultimately as successful — as Warren Buffett. So we’ve worked quite a lot and figured out the equivalent of Berkshire Hathaway’s insurance float for an entity such as The Family, which is the cash flow generated by top-quality, profitable business service providers dedicated to startups and owned by The Family.
An entrepreneurial ecosystem is also made of non-scalable service businesses that, even though they are not that profitable, generate a lot of cash flow. What we plan to do is to own (either by acquisition or by way of organic growth) business service providers that work for startups in fields as diverse as design, software development, legal services, public relations, lobbying, accounting, real estate, etc. By the very nature of their model, those businesses generate cash flow which, in our mind — and with the tough financial discipline that is necessary to manage those businesses at arm’s length — can serve the same function in our business model as the insurance float does for Berkshire Hathaway — that is, reducing the cost of capital.
We intend for our business service providers to be the best on the market. After all, we will use them for ourselves as well as our many portfolio startups, thus improving the return on invested capital within The Family. Being the best can mean different things. Much like Berkshire Hathaway’s NICO or GEICO have different positioning on the insurance market, business service providers can be the best in different ways: being low-cost, shipping fast, etc. What matters is having the capacity to address tech startups’ particular needs and attracting more customers as a result. In particular, we expect other investors to send more customers from their own portfolio, since they will positioned to measure how much value our providers create for their customers.
As those providers will effectively work for customers beyond our own portfolio, the model is also about capturing value in the entire ecosystem while providing something in exchange — that is, strengthening that ecosystem, educating the outside startups among our portfolio providers’ customers, and imposing a virtuous competition that will eventually lift the ecosystem upwards.
As our service providers will work for our own portfolio companies, a healthy, arm’s length relationship should be imposed between The Family and its providers as well as between the various providers and their customers within our portfolio. Fortunately, it is already part of our mission to select outside providers for our portfolio companies, negotiating different rates with them in line with each startup’s propensity to pay, while also ensuring that the provider makes money too. Because this is what a healthy ecosystem is about: a group of people who all become wealthy in the end. So we’re already warmed up and armed with a clear idea of what lies ahead.
Content-Driven Venture Capital
8/ Is Warren Buffett the father of content marketing in the investing business? Berkshire Hathaway as a content producer is yet another part of the Graham legacy. As pointed out by Charlie Munger, “Ben Graham was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals — probably the only intellectual — in the investing business at the time.” Warren Buffett is following the same path with his famous annual shareholder letters. As he has said numerous times, “he assumes the audience consists of distant relatives who only pay attention to Berkshire once a year and know nothing about its business happenings during that time”.
Many in the venture capital business have followed Buffett’s path when it comes to creating content. Since 1993, Paul Graham has been writing long-form essays. Just like Craigslist, Graham’s essays have an outdated design framework, without a single picture or an inch of graphic design, and yet they’re still widely read — even though there’s now tough competition. That’s because many of today’s best venture capitalists have converted to a content strategy. First Round Capital are pioneers. Fred Wilson is another one, with the insane discipline by which he forces himself to write one story a day, however short. Marc Andreessen really helped advance the cause. He had been a blogger for many years when he published his famous op-ed “Why Software Is Eating the World”, which went on to have a profound influence. Then he invented the ‘Tweetstorm’, or long-form writing on Twitter.
Beyond venture capital, others have mastered the art of crafting content to serve their companies’ interest. Jeff Bezos, with his annual letter to Amazon’s shareholders, is an example. Elon Musk is another one. In 2006, he even published the “Secret Tesla Motors Master Plan”, which carefully mapped out all that would happen over the following 10 years, and what’s incredible is that, even though there was the 2008 financial crisis in between, most things went according to plan.
What Elon Musk did was a bold move, but a rational one because it serves many strategic goals. First (rule of thumb of producing content), it forced Musk himself to articulate his vision for the future and the plan to get there, which made him stronger, more clear-minded and more able to share his vision with others. Second, it attracted the super-fans that Musk needed to help him grow Tesla Motors and turn it into the leading car manufacturer in the future. Third, as Tesla Motors was not much at the time, the story wasn’t widely read by key players and if it was, it wasn’t probably taken very seriously. Finally, it was a smart way of burning the ships: once Musk had laid down his plans for the future, the only option left was to execute it swiftly, with the sense of urgency and the radical model of execution that makes great Entrepreneurs.
Content has so far been instrumental in ensuring The Family’s success. From the beginning, we’ve found that producing content, just like Warren Buffett does with his annual letters, added a lot of value in our business model.
First, producing content is a powerful incentive for working in depth on the issues. When you have to speak to an audience or write a paper, there’s no room for approximation. And everything that you learn creates more value in the long term, contributing to building more and more thought-leadership. And if, like Jerry Seinfeld, you do it on a daily basis, you get far more productive.
Second, as is widely acknowledged today, content is good marketing. It makes us famous and attracts people from every part of the ecosystem. It’s also a good opportunity to build a network: when you publish content, you have a good reason to reach out to influential people. In a model such as ours, in which we don’t hunt startups as much as startups approach us to join The Family, it’s critically important that there’s a lot of attractive and inspiring content out there so that we’re known to promising Entrepreneurs as well as by other stakeholders who can play a role in our success. Our content attracts those who are interested, it converts those who feel trust, and it keeps at a distance those with whom we won’t do business anyway.
Third, this is coherent with the key role played by information in value investing. One lever, among others, to access and exploit available information is to produce our own information to frame the discussion, to attract reactions and rebuttals, and to shape the industry as time goes by. In that regard, what has so far been frustrating is the unwillingness of other players to challenge our assumptions. Many talk about The Family behind closed doors. Few have the guts to challenge us out in the open. But they will make progress in the future.
Fourth, producing content is also about decision making. The best way to convince yourself of an idea is to teach it to others. If it resists being voiced to an audience, and being rebutted by the most critical among them, then it will become so solid and so obvious that it will serve as a rock for building further ideas. This is why great researchers are also teachers. And this is why Warren Buffett has invested so much in communicating towards Berkshire Hathaway’s shareholders. One of the key advantages of producing one’s own content is that it deeply ingrains your investment thesis in your mind and body, sparing you the painful task of constantly referring back to the plan.
In particular, teaching your own investment thesis is a great help when it comes to sharing it with your own team members. Our own content is mandatory reading or watching whenever a new employee joins The Family or a new Entrepreneur enters our portfolio. Our content is a rock-solid foundation on which we can grow a community of like-minded people that make decisions into a no-brainer. When hundreds of opportunities pass through a firm every month, being consistent as opposed to simply following your momentary instinct on a deal-by-deal basis makes all the difference between a good and a bad investor. This is all about the importance of what Charlie Munger dubs “elementary, worldly wisdom”:
The first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a lattice-work of theory, you don’t have them in a usable form.
Fifth, teaching your own investment thesis also helps trace the “circle of your competence”. As recently explained by software engineer Adrian Kosmaczewski, “teaching will make you more humble, because it will painfully show you how limited your knowledge is. Teaching is the best way to learn.”
What we know at The Family is how the digital economy works, what it changes industry-wide in our economy, how startups grow from their garage to conquering entire value chains, how this new way of creating value calls for a new way of financing businesses, and how the whole process weakens the institutions that we inherited from the Fordist economy. What we don’t know is the rest, which is quite a lot, but it doesn’t matter. As told by Charlie Munger, “the more you know the limits of your knowledge, the more valuable gumption is”.
Sixth, a great advantage of teaching one’s investment thesis is that it puts you ahead of potential competitors. They who keep on teaching new things will always be ahead of those who are satisfied with following. And if that teaching is done with a radical tone, it will be so polarizing — even frightening — that it will dissuade many more people from following. Thus radical content marketing, far from revealing our secret sauce, helps us to keep potential competitors at a distance.
Additionally, focusing our knowledge on the digital economy is extraordinarily promising because it’s not a sector as much as it is a technology-driven paradigm that is currently eating the entire economy. It makes sure we’re ahead of industry-focused investors who know the specifics of the industry more than the generic principles necessary to understand this particular industry’s digital transition. You can invest in knowledge (the digital transition), race ahead of other investors on that front and be able to seize investment opportunities in any industry — because ultimately they’ll all be eaten by software.
Seventh, for what those annual letters are worth, there’s what Warren Buffett discloses and what he keeps for himself. One key piece of information that is obviously not shared is how carefully Berkshire Hathaway drives its individual portfolio companies’ financial management on a case-by-case basis. As suggested here, they all monitor volume, watch their margin, buy back shares and pay dividends so as to initiate a virtuous circle and improve returns on invested capital over the long term — all depending on the fundamentals of every particular business and its role in the global Berkshire Hathaway system. Warren Buffett’s widespread communication is on his investment thesis and Berkshire Hathaway’s strategy portfolio-wide. But kept inside are the details of the virtuous circle that is carefully crafted for each particular portfolio company.
The relative scarcity of content produced by most venture capitalists never ceases to amaze us. This, alas, is a negative by-product of fee-driven investment management. If you can live off your management fee, like many investors do, there are no incentives for you to build Berkshire Hathaway-like businesses. But since The Family’s ambition is to become more scalable, producing content has become one of The Family’s core business.
Trust
9/ Charlie Munger explains that it is necessary to build a “decentralized network of trust” to succeed in value investing. That network helps attract information, deal flow, and capital. It also creates smooth business relationships so as not to lose time and money in futile negotiations, which only captures someone else’s value instead of creating more for everyone.
For Berkshire Hathaway, that network of trust is between the parent company, the portfolio companies, and the shareholders with whom Warren Buffett has built such a strong relationship. As for the rest of the market, the relationship relies on both content (the annual letters) and the class B stocks that are traded to frequently check Berkshire Hathaway’s value and reinforce trust in its class A shareholders.
As regards the shareholders, Warren Buffett builds trust because of how it delivers value to its own investors. Berkshire Hathaway’s shareholders never receive dividends. Their only opportunity to take money from the company itself is through occasional share buybacks — which are instrumental in increasing earning per share, raising the demand for company stock, and ensuring current management retains control over operations. Warren Buffett’s no-dividend policy is based on the idea that shareholders’ money is better invested through Berkshire Hathaway.
In terms of strategy, not paying dividends serves the goal of avoiding short-term pressure from shareholders. If it paid dividends just as do its subsidiaries, Berkshire Hathaway would be a simple pass-through under constant pressure to pay ever higher sums. In this process, it would renounce playing the long term and would risk drying out its own portfolio companies. Conversely, not paying dividends attracts investors who are in it for the long term and trust Warren Buffett with their money, thus initiating a virtuous circle: because Berkshire Hathaway is under no pressure to pay a dividend, it can make bold moves with a long-term view; and because it has such room to maneuver, it can deliver consistent value to its shareholders and inspire in them even more trust. We at The Family have consistently followed that path — playing the long term — since our founding 3 years ago.
As regards the portfolio companies, trust derives from the evergreen business model. Because Berkshire Hathaway is evergreen, its portfolio companies know their parent company won’t be forced to sell them on a certain timeframe. As for investment decisions, an evergreen investment entity also provides the ability to avoid bumpy markets: it helps ride the waves in a digital economy driven by recurrent bubbles; it makes room for audacious bets against the consensus; it helps to be a buyer rather than a seller, sparing us the pain of having to raise the stakes too high on any given deal; all of this contributes to building trust. Additionally, being an evergreen vehicle enables us to diversify in terms of asset classes, instead of relying exclusively on capital gains realized through liquidity events.
As for The Family, building trust begins when we first encounter promising founders. Trust exists from the beginning as we don’t generally try too hard to convince them (should they accept to join The Family after a long and painful negotiation, the relationship that comes next would prevent them from really benefiting from being part of The Family anyway). We then keep on building trust as startups grow within The Family. Our internal information system serves as an amplifier of our strong corporate culture. We use many tools, notably Slack, to share information among partners and team members, but also to sustain frequent interactions with the founders in our portfolio. What we’ve observed so far is an extraordinary correlation between how The Family as a whole gets along with given founders and how well those founders perform on the market. Also, a very positive signal is that Entrepreneurs in our portfolio don’t hesitate before becoming shareholders themselves once they reach success.
As taught by Ben Graham, equity is business ownership. Beginning such an important, long-term relationship at a very early stage is priceless. It shouldn’t suffer from long negotiations. But it shouldn’t be dependent on the mood of the day, either. What we’re seeking to achieve is the kind of trust that Warren Buffett has explained when telling the story of Berkshire Hathaway’s buying of Rose Blumkin’s Nebraska Furniture Mart in 1983:
I have been asked by a number of people just what secrets the Blumkins bring to their business. These are not very esoteric. All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with. (Mrs. B boils it down to “sell cheap and tell the truth”.)
Our evaluation of the integrity of Mrs. B and her family was demonstrated when we purchased 90% of the business: NFM had never had an audit and we did not request one; we did not take an inventory nor verify the receivables; we did not check property titles. We gave Mrs. B a check for $55 million and she gave us her word. That made for an even exchange.
That’s trust.
What About Other Asset Classes?
10/ Warren Buffett once explained that “it’s a huge structural advantage not to have a lot of money”. When Warren Buffett had $1 million to invest, he had a remarkable return on invested capital. With tens of billions, however, it’s hard to scale up: instead of investing in deeply undervalued hidden gems, now he has to buy entire companies. The principles of value investment had to be upgraded to fit that new constraint: now Buffett’s business is to use Berkshire Hathaway’s access to cheap financing to invest in low-risk situations under convenient financing terms.
As already explained, the Buffett solution for scaling up is the insurance business: it makes it cheaper to acquire entire companies. And not only does Buffett rely on Berkshire Hathaway’s insurance float, he also exploits his upper hand as a preferred investor and negotiates deals involving preferred stocks and warrants to yield higher returns from his investments. Berkshire Hathaway’s $5B investment in Goldman Sachs in the midst of the 2008 financial crisis is a case in point. If you’re willing to deploy large amounts of capital, you’d better have access to cheap permanent capital and be ready to negotiate preferred terms, just like Warren Buffett.
Obviously the same problems exist with traditional venture capital, which is a business marked by diminishing returns: the more capital you have to deploy, the harder it is to yield high returns because instead of focusing on a few exceptional ventures, you’ll end up paying too much for a lot of average companies — and average isn’t good enough in the digital economy. So how should Buffett’s acquisition practice be applied in the digital economy?
One key difference between the Fordist economy and the digital economy is that in the latter it is very difficult to acquire companies when they’re already grown up. This type of mature acquisition is what General Electric’s Jack Welch did in the 1990s. When people accused him of having renounced innovation — and having broken with GE’s longtime tradition of in-house research and development — he famously explained that whenever an innovation happened outside of GE, it was easy to spot; he could then acquire the innovative company, and boost GE’s stock even higher. Alas in the digital economy it can’t really work that way anymore.
The first problem is that even if an established corporation acquires a tech company, their respective cultures are so different that it is impossible for them to merge and create value together.
Another problem is the price. Mergers and acquisitions tend to be paid at least partly in stocks. But Fordist companies tend to value themselves in terms of discounted cash-flows whereas tech companies, whose business model features increasing returns, tend to have their value proportional to the square of the number of their users (a rule otherwise known as Metcalfe’s law). Companies with heterogeneous valuation formulas have a hard time merging through an exchange of stocks.
Last but not least, before a tech company becomes too expensive, it is very hard to detect. The reason is that tech companies usually experience exponential growth. They’re nothing, and remain under the radar, until they pass that inflection point and start growing at that very fast rate. Before that point, there are so many companies and those are so imperceptible (or to be more accurate so hard to distinguish from one another) that you can’t really do what Jack Welch did and decide on buying one instead of another. Past that point, the growth is so breathtaking that there is no reason for an acquisition to happen: founders prefer to go it alone, the price is too high, and the focus on growth is so intense that there’s not a minute to spare on considering an acquisition by an old, tired corporation.
So how do you buy entire companies in the digital economy? There are two options. The first is when the buyer is a tech company itself, which makes it easy to acquire smaller tech companies: the buyer and the target share the same culture, they both have business models driven by increasing returns, and they usually belong to the same ecosystem.
The other option is being a financial powerhouse such as Berkshire Hathaway, and even then there’s really only one way: investing at an early stage, investing a bit more at consecutive later rounds, and finally cashing the founders out to own 100% of the equity at some point. Pro-rata rights are critical on that path, as they allow an existing investor to reinvest at the minimum to maintain their percentage and thus provide a good opportunity to bid and increase their share: the idea is that, already being a shareholder, you see success coming slightly before the rest of the market. Enough with the big, one-shot deals that used to be the norm in the Fordist financial economy. In the digital economy, it takes an insider’s advantage to gradually raise your equity stake and, along several consecutive rounds, turn your line of investment into one of your subsidiaries.
At the very early stage, negotiating favorable deals — just like Buffett did with Goldman Sachs in 2008 — is easier because there is not much competition on the investors’ side, so if you’re willing to align your interests with the founders and not have too high an equity stake from the beginning, it’s easier to negotiate better terms, notably a pro-rata participation right, in exchange for deploying the small amounts of capital needed at that stage — first infrastructural, then financial. It’s a different risk and return tradeoff.
Like for Berkshire Hathaway, scaling up will invite new challenges. We intend to tackle them by diversifying in terms of asset classes. At first, we’ll diversify in stable recurring businesses to generate permanent capital by way of cash flow. The more capital we are able to access, the more we’ll be able to invest in consecutive rounds for those fast-growing, one-of-a-kind black swans. These companies will take ever more risks, and we’ll become strategic shareholders thanks to an early, trusted relationship with the founders and our iterative financing strategy.
Beyond that, there are many options on the table, and, should we be successful in the coming years, we’re certainly willing to consider them on the longer term.
One option is to finance full stack startups, as defined by Chris Dixon and later explained by Balaji S. Srinivasan. Full stack startups are those whose goal is to conquer an entire industry-wide value chain, all along the stream, in order to spare the effort of dealing with established players at any level of the value chain. Tesla Motors is the most obvious example as it controls every link of the electric car value chain, from manufacturing the batteries to operating embedded services — even, soon enough, operating the smart grid that will be dedicated to charging the batteries at home. Full stack startups are hard: they require seasoned Entrepreneurs and a lot of capital. But this is typically an asset class worth considering in order to scale up.
Another option, close to the full stack strategy, is the approach of the equity line of investing, as detailed by William Janeway in his landmark book Doing Capitalism in the Innovation Economy (page 112–114):
In simplest form, [the idea] was to acquire a portfolio… of products to feed a direct sales force… In June 1992, Warburg Pincus… launched OpenVision Technologies with a commitment to fund up to $25 million on terms agreed in advance. If this line of equity were fully drawn, we would own a share of the company determined up front, the founders would own their agreed share, and both would be diluted by a pool of stock options reserved in advance for future employees.
The equity line of investing structure was an innovation, constructed in direct contrast to the traditional venture capital funding model of multiple rounds of investments with multiple firms investing per round… Warburg Pincus had the cash to fund a venture such as OpenVision, but it only made sense to do so if we had unequivocal control. Delivery of funds under our commitment had to be entirely at our discretion. Our approach did give up the external market test represented by the willingness of other firms to invest, but it was subject to the regular scrutiny of all the partners of the firm, each of whom had a keen interest in the state of play.
A third option is to buy or to invest in large traditional companies that are currently facing their industry’s digital transition. We have a few ideas as to what they should do, and we’re even thinking about an activist investment vehicle dedicated to taking control of old, established companies to force their management to accelerate the pace of converting them into tech companies.
The underlying idea is that Silicon Valley-style startups radically transform value creation in every industry. As a result, many established businesses are back at the starting block: they are returning to the startup stage and thus have to embark on a search for a new scalable, repeatable and profitable business model. But those businesses don’t know how to swim anymore: the digital transition strikes so hard, it’s as if all of a sudden our whole economy was handled by feeble capitalists and incompetent managers. This is what Warren Buffett calls a “a one-time huge, but solvable, problem.” And the way to resolve it — and make money in the process — is to take control, as feebleness and incompetence cannot be solved through consulting. The goal is to onboard stalled companies besieged by new entrants, claim control, revamp management, hack the search for a scalable, repeatable and profitable business model, and rebuild our economy one company at at time.
A fourth option is… everything else: leveraged buyouts, real estate, corporate debt, you name it. All large financial powerhouses diversify in terms of asset class: Goldman Sachs into small loans, KKR into lending, Blackstone… So why not The Family when it reaches that point?
Even a hedge fund wouldn’t be unprecedented. Former Facebook executive, now Social+Capital general partner Chamath Palihapitiya has created a long/short public equities effort. Even though nobody knows much about what this hedge fund’s strategy will be, it clearly suggests that what you learn investing in the digital economy can be exploited to invest in the traditional economy.
Also, Clayton Christensen himself chairs an investment firm, Rose Park Advisors, that also is a long/short equities effort driven by Christensen’s theories in disruptive innovation and related fields. As stated on Christensen’s personal page,
Rose Park Advisors invests exclusively in companies where Christensen’s research gives unique and differential insights to the investment thesis. On the long side, Rose Park applies the disruptive innovation framework to identify companies whose strategy is well suited to take advantage of change and will consistently beat the market with superior earnings. On the short side, it identifies incumbent companies whose future vitality is threatened by disruptive attackers.
There are problems, though. For one, it’s difficult to short private companies. And as for shorting public companies waiting for their downfall at the hands of Silicon Valley-style new entrants, it’s tough, because it’s dangerous to hold short positions for a very long time. You only need to watch Billions’ “Short Squeeze” episode to understand what can happen. As Dave McClure wrote last year,
You can’t short the public market for an extended period of time, and certainly not for five to ten years. There isn’t really an appropriate short or hedging / derivative instrument that captures this Unicorn Disruption effect, and so the only practical alternative is to go long on the Unicorns themselves.
Well, as the saying goes, “it always seems impossible until it’s done”. In any case, to finish with a famous Buffett quote, “the important thing is finding wet snow and a really long hill.”
So, In Short
11/ Very few of this story’s readers have probably read all the way down to this point. But for you long-distance readers, here is The Family’s “Snowball” master plan:
- Build the indispensable infrastructure that no ambitious Entrepreneur in Europe can afford to miss at the earliest stage.
- Use that infrastructure to grow service providers which will maximize our portfolio’s ROIC while generating cash flow.
- Use that cash flow to leverage further investment in our portfolio’s fastest-growing and most promising companies.
- While doing all of the above, consolidate a healthy entrepreneurial ecosystem all over Europe and diversify in various asset classes.
Don’t tell anyone.
(This is an issue of The Family Papers, a series which covers various areas such as entrepreneurship, strategy, finance, and policy. Thanks to Kyle Hall and Laetitia Vitaud.)
