Introduction:
Concentration:
Qualitative:
Requirements:
Concluding Thoughts:
Introduction:
It is time for a total reimagination of investing, and what investing actually means. Throughout my experience investing, it has become increasingly clear that conventional means of investing are insufficient.
At the root of my investment philosophy is the emphasis on asymmetrical returns. I uphold a philosophy of true determinism, with full knowledge that the future is not chance and that the future is not solely a matter of fate. I believe that the future can be predicted, can be changed, and thus should be invested within.
Companies are a function or art and philosophy, much more than solely quantitative figures. For too long investments have been viewed down a very reductionistic financial lens, but in reality, this could not be further from the truth.
Investment managers, analysts, and traders on Wall Street want to focus on quarterly earnings, and trivial short term financial metrics. I want to focus on game theory, human organisation, and art.
Enjoy x
Concentration:
Diversification is a matter of spray & pray.
Conventional wisdom and society often proclaims that diversification is a necessity within life. The schooling system is set up to ensure that students are equipped with minimal levels of knowledge, across a range of domains. Parents have likely demanded that you should “not put all your eggs in one basket”. Societal consensus expects that we hedge against the future in an attempt to mitigate risk.
However, there are serious flaws within these arguments.
Diversification is purely just another method of reflecting deep-rooted philosophical views. For those that adopt this notion of mass diversification, this is another way of saying that you believe the future is purely chance, cannot be predicted, and thus accepting that fate is the determining factor of the future, your financial situation, and by extension the rest of your life.
Unfortunately, when one diversifies, this often leads to no hits at all, just many misses.
Whereas, concentration is a philosophical notion of upholding true determinism. When one concentrates their portfolio, this is a deep way of signifying a deterministic attitude of the future, acknowledging that the future can be shaped, changed, and predicted.
I would argue that in fact, concentration supersedes diversification, as true concentration stems from conviction, and conviction stems from real research and knowledge. Thus, via definition, it is not the inherent concentration that is risky, but rather the poor level of research and knowledge that can lead to poorly concentrated investment decisions. Unfortunately, it has become increasingly clear to me that whilst investing, nothing is safe. There is no such thing as a “safe heaven”, in which will garner good results without any concern. I believe as good investors we have a duty to specialise and become truly nuanced with our decision-making procedures.
Looking back historically, there are ample examples in which nuance was necessary to garner alpha. Back in the early 2000s, during the initial phases of social media ramping, there were 100s of different social media companies in whom all created products and failed. Some of these recognisable names included that of Facebook, Friendster and MySpace. From an outsider’s point of view, it would seem absurd to invest within these risky domains. Generalists stated that investing within social media companies was inevitably a disaster, however these generalists missed the nuance that differentiated these companies from Facebook.
If one actually thought from first principles, had an impartial attitude, and identified nuance when investing into these early-stage social media companies, it would have been clear that Facebook, in comparison to these other social media companies, was clearly differentiated. Friendster for example, crashed regularly, and it was a miracle that individuals even used the website for a split second. The underlying infrastructure and experience were horrific. Other social media companies adopted the idea of pseudonyms and fictional online identities, in comparison to real world identity usage. Facebook however foundationally was built upon strong underlying code, thus leading to good user experiences, and the usage of real-world identification in comparison to pseudonyms.
Therefore, one with nuance and speciality could easily see that Facebook was the likely platform in whom would succeed among the rest. Facebook later propelled as a leading social media platform generating billions of dollars in capital for investors.
As a general rule of thumb, the use of nuance and specialisation reduces the luck and serendipity associated with successful investments. When one has gained true nuance within a certain field, it is riskier to not concentrate your portfolio, in comparison to following through with your specific knowledge and conviciton.
Qualitatives:
Qualitive variables are leading indicators of quantitative factors.
Qualitative variables are pillars that measure the important, intangible aspects of a company, that are often not instantaneously reflected into the financials of said company.
Intangible factors are generally very hard to compute, however are necessary to understand. Unlike intrinsic valuations, there is no sole one figure that can be generated to understand the nature of qualitative factors. Qualitative factors are often computed after the connection of various seemingly disconnected data-points, and the obsession over a certain company.
Qualitative factors includes:
- Structure
- Talent
- Leadership style
- Culture
- Game theory
- Technologies
Structure:
One of my personal favourite qualitative factors to look into is that of structure. To understand the importance of structural variables, we must understand what a company is at the most granular level. A company, at the deepest atomic level, is solely a gathering of humans towards a set goal. Therefore, the way in which these humans are organised, structured and incentivised is fundamental towards the flow of information and ideas. Companies that have poor information flow and management, via inferior structural iterations, are companies that over the long run fail to impress.
Structure measures the flow of information, and game theory.
Looking back historically, there is a dire need to compute intangible factors. When studying Nokia during their glory days, those that specialised and deeply understood the use of qualitative’s would have conspicuously seen that this investment within Nokia was a disaster.
Nokia was a leader in their field for many years, producing innovation after innovation. However, after years of domination, Nokia rapidly fell apart, and lost market share. The reason as to why this seemingly abrupt ending occurred within the case of Nokia was based on their disastrously flawed incentive alignment system, and poorly curated structure. To cut a long story short, at Nokia, a phase transition occurred resulting in the incentivisation to focus on career and internal politics, in comparison to loonshot innovations. Over a matter of a few years, via this phase transition, instead of Nokia tending to new radical innovations, the company shut them down instantaneously via picking apart their early-stage warts and weaknesses.
Nokia did not let the artists nurture early-stage ideas.
This culminated back in the early 2000s when the innovative team at Nokia approached high level management with a radical idea of touchscreen phones, and an App Store. However, based on intangible structural features, management instantly disregarded this idea, picking apart early-stage flaws, and thus halted the project. Just a few years later, Steve Jobs would dramatically showcase Apples brand new innovation – namely the iPhone – in which included a touchscreen body, and a brand-new Apple App Store. The years proceeding this launch would result in dwindling profits for Nokia, whilst the righteous management team witnesses Apple surpass incumbents in a fairly spectacular fashion.
Due to poor structural management, Nokia disincentivised new innovations, but instead incentivised internal politics, gossip and status games.
Within this specific example, the intangible at question is one of structure.
Other vital intangible & qualitative factors are that of talent, leadership style, and even culture. As stated, these intangibles, at the most granular level, measure necessary factors that are not instantaneously reflected into the financials of said company.
Talent
Talent is another intangible dynamic that must be looked at in detail. The fascinating dynamic about technology is that the top 1% of talent, creates literally all of the company’s value. This is why I commonly look for company’s that are renowned for world class talent, as a leading variable into the future potential financials of that specific company.
According to McKinsey, there is a dramatic relationship between quality of talent, and the business performance. The productivity gap between low and high performers is shown below:
The most staggering statistic of them all is the fact that for very high complexity jobs, there is an 800% difference in productivity between average and high performers. When translated across a whole organisation, evidently there is a rapid increase within productivity – if the talent is exceptional.
Talent is a good leading indicator of the future success of that specific company.
Leadership style:
I believe that the true role of a leader is to be a gardener, who tends to the touches and balances of information flows. A leader within a company should not be a dictator, or act like Moses – namely commanding which products fail or succeed – but instead should focus on the flow of information. The company leader must be more like a gardener, rather than a dictator. This is incredibly important. When it comes to Steve Jobs, or any other innovative leader, these individuals were not outstandingly superior technologists.
Once you understand the true role of a leader, you understand that these leaders do not have to be specialists within a set industry. These leaders solely have to be gardeners – tending to human organisation and information flow. Leaders should not be analogous to Moses, namely deciding which products fail, or succeeds (as was true within the case of early Steve Jobs), but instead these leaders must focus on information flows, and human organisation.
A leader within a company should not be a dictator, or act like Moses – namely commanding which products fail or succeed – but instead should focus on the flow of information.
Game theory:
Furthermore, and leading on from the prior point, incentives matter.
I often use a fairly basic framework to understand and compute as to the utility of an organisation. This equation can also be used to understand the incentives of nations. Let me firstly explain via a story:
Imagine you are a middle manager at Pfizer. You attend a meeting to evaluate project, an early-stage new drug. Like every early-stage idea, it has warts. Some vital experiments have not been done or have been done poorly. Keynote speakers at the conference dismiss the idea, but you like the idea. Something about it captures your imagination. What do you do?
You have two main decisions:
- You could pound the table, make a case, and begin a slog up the ladder with each meeting of each committee. You might be turned down. But suppose you win that battle, and the next few. You may make it all the way to the top of the ladder, get the green light and go ahead. The next seven years will be spent surviving the three deaths of each loonshot. Every time the project stumbles, people want to bury you and your project. They want your budget. They want you out of the way. The odds are that this loonshot will not succeed. An outstanding drug may achieve $50B in annual sales within the first few years of launch. This means that the success will move the needle for your 100,000 person, $50B company roughly 1%. If the project does succeed, even with that tiny percentage benefit, 99,999 other people will be rushing in to claim credit. If it fails, 99,999 people will point at you laughing. They will mention those early stage warts you dismissed, your career will be tainted, and you may be fired.
- Or you can choose the other option: you could belittle the loonshot project, highlighting flaws and poking at the warts. You could explain why the world does not need this idea, and why it would fail. Likely, your judgement and summary of where the industry is heading is in line with your boss and what he believes. You both laugh at the idea and nod. You propose instead a modest step along with a favoured research project. It is easy to understand. If you continue to play smart politics, and sound good in meetings, you might just get your boss’s job. This would increase your salary by 30%, not to mention a double in prestige and influence. The boost in title may even help you get an even better role at another company once you start looking around.
So which do you choose?
Option one of a seven-year slog with a 1% chance of success. Or option two, the franchise project and political pursuit, with good odds of a 30% pay bump.
Dismissal of the loonshot is the obvious choice.
Without idealistic functions of game theory in practice, this can lead to skewed incentive alignments, with an emphasis on politics, in comparison to hard work.
Requirements:
Whilst I personally view each business individualistically, I do not believe that there is one specific formulation for an investment. However it is important to note that there are often commonalities between successful investments.
- Monopolisation
- Network Effects
- EOS
Monopolisation:
Every good company is a function of monopolistic practices.
Monopolisation of a certain domain stems from a deeply contrarian view on economics and business creation. I believe that perfect competition actually is in opposition to capitalistic principles. but instead, creative monopolies are the ideal that all companies are aiming towards.
Perfectly competitive markets are characterised by a range of companies selling a range of undifferentiated products. Over the long run, these perfectly competitive companies fail to generate any meaningful profit, and thus fail to produce any societal good.
In perfectly competitive markets, there is no innovation, because these companies don’t make any money.
Monopolies are bad, only if these companies are static. However, these companies are not static. There is an incentive for monopolies to improve and innovate, otherwise these monopolies will eventually fail.
Creative monopolies are actually good for society.
As an investor, it is highly illogical to invest within deeply competitive markets, in which are characterised by a range of companies who are selling a range of undifferentiated products. The automotive market provides a great example of perfectly competitive markets proving to provide horrific investment returns. A brief search on Wikipedia for “bankrupt automotive companies” reveals a staggering picture, namely of 10,000s of automotive companies that have gone bankrupt within the past 20 years alone!
The reason as to why these automotive companies have proven to be horrific investments historically is mainly based on the highly competitive landscape, and the little true differentiation between companies.
Furthermore, looking at the airline industry, the same is true. The airline industry once again is characterised by a range of companies, providing an undifferentiated service. Thus, over the long term, none of these companies generate any meaningful profits or innovations.
However, on the contrary, Google paints a different picture. Google stands alone, and the company generates meaningful revenue that can be reinvested into the company. Thus, Google has the ability to invest within innovation, and produce products and services for society in which generates meaningful change for all.
Starting Small:
Looking back historically, it is clear that leading companies commonly followed a similar trend, namely that of “starting small and monopolising”. This was experienced during Facebook’s initial inception phases. To explain, Facebook started at Harvard, and slowly expanded across multiple different universities, eventually releasing their product worldwide. Monopolisation is beneficial for youthful companies because it is far better to generate 100% market share of a smaller market, in comparison to 0.01% market share of an overly competitive market.
This use of early-stage monopolisation can generate initial network effects, incentivise usage of a new platform, and lead to other benefits – including identification of flaws and areas to improve.
With new products and ideas, there is usually friction associated with adoption. Society does not like radical technological change, and the adoption curve for new products and services can often be very difficult. Thus, to ease the friction associated with adoption of a new technology, the targeting of a small niche is necessary for getting initial users on the platform and therefore the generation of early network effects.
If Facebook solely released their product to the whole world. without any specialisation and niche market to cater towards, it is likely that nobody would have known about Facebook, and therefore the product would have slowly dwindled into the realm of failure. However, because Facebook specifically targeted only a few 100 students at Harvard, this greatly eased the friction associated with gaining initial users on the platform.
The first users of Facebook were a result of monopolisation and specific targeting.
Network Effects:
Network effects are likely one of the most important principles in technology and business creation. The use of network effects generates inhumane exponentiality in growth, thus leading to almost undefeatable competitive moats.
Network effects is defined as the utility of the network increasing, as more nodes join a specific network.
The most evident example of this is seen within the case of social media platforms. On social media platforms, as more users join the specific network, the more valuable that network becomes for all users. On Twitter, the more users that create an account, the more content there is available to consume, and therefore the more engagement that is experienced. Furthermore, in another regard, as more users join a social media platform, for those individuals that are not on the platform, this creates a feeling of isolation and exclusion, thus incentivising one to join that specific platform.
For Tesla, network effects are seen very clearly with their FSD introduction. As more individuals purchase a Tesla, the FSD system records all trips and sends this data into a centralised cloud. Thus, the more individuals that join the Tesla community inevitably results in better improvements in the quality of FSD. Once again, in other words, as more people purchase a Tesla, the utility of being part of the Tesla network increases majorly.
As an end user, the difference in utility is understood, and thus leads to an incentivisation of using a certain platform over another. Fundamentally, network effects leads to a flywheel of iterations, improvements and growth of a platform.
All leading companies today are a function of network effect flywheels.
Certain EV companies do not experience network effect creation, due to the lack of FSD & automation. For example, companies such as Rivian do not benefit from the law of network effects. This is because, Rivian is solely focused on the manufacturing and selling of a physical good, namely a vehicle. Rivian does not focus on FSD and automated driving. When a consumer purchases a Rivian vehicle, there is no increased utility associated with other nodes purchasing a Rivian vehicle.
For many companies, as more nodes join a network, the utility associated with the platform does not increase. Stay away from these companies.
EOS:
Economies of scale is another fascinating dynamic that explains cost declines and simultaneous output increases. What is seen commonly, via the use of economies of scale, is that often through the use of increasing technological systems, one has the ability to increase the output of goods, whilst the costs can be spread over a larger number of goods. In other words, companies that experience EOS will have more cost savings and higher production levels.
Economies of scale is most beautifully seen in technological software. Namely, the little marginal cost associated with replication. The dynamic of software is unlike any other good or service. For software, there is a marginal cost of zero associated with replication of the product. Thus, the product can be scaled to millions with little-to-no overheads.
All leading companies today have experienced the full wraith of economies of scale.
Google for example, has little-to-no cost associated with another node joining the network. Microsoft can code their software once, and similarly scale this to billions of people with little costs. The same narrative is true for Facebook, Netflix, and a range of other leading companies.
Without EOS, it can be very hard to scale, if not impossible. As a tennis coach, it is unlikely you will ever scale to the masses. You have fixed costs associated with the tennis court. There is only a limited number of individuals that can fit on the court at one given time. You yourself must be present at all times to coach the students. Perhaps you could hire another court, and an employee, however even then, this comes with various other unwanted overheads.
But, if the tennis coach instead filmed himself coaching on the internet, there is the ability to experience EOS. Via sharing the content on YouTube, this coach has the potential to scale his content to millions of individuals with zero costs associated with replication.
All good companies are a function of EOS in some serious regard.
EOS should be built into the original design. Twitter, even during their first product launch, had the ability innately to scale to 300,000,000 individuals. Scaling was built into the original Twitter design. Without EOS it is incredibly difficult to scale, and thus lead to a meaningful monopoly.
Proprietary Technological Moats:
“Proprietary technology is the most substantive advantage a company can have because it makes your product difficult or impossible to replicate.” As a good rule of thumb, technology must be at least 10X greater than the nearest “competitor”, by some incredibly important dimension to lead to a monopolistic advantage.
In the case of Google, it is clear to see that their search algorithm is 10X better than Bing, Yahoo, or any alternative. This incentivises one to use Google over any competitor due to the ease, and limited friction associated with use. One reason as to why it is important to have a 10X better product is due to the fact that, as stated beforehand, as a society the often we originally oppose new technologies and ways of doing things. Thus, we are drawn to stick with prior technological solutions, in comparison to brand new radical innovations. The only way to incentivise adoption of the new product or technology is through ensuring that in literally every dimension, the new innovation is 10X better than anything else.
When doing so, this is the only way in which customers can successfully recognise the supernatural capabilities of said product, and therefore this will incentivise adoption.
Having marginal improvements in certain regards is just not enough.
Furthermore, the best way to create a 10X improvement upon existing product is to create something brand new. Theoretically, through the creation of something brand new, this leads to an infinite improvement over existing systems or products. To add, when creating something brand new, via definition, you already have 100% market share of a brand-new industry.
All of the leading companies in today’s markets were a function of propriety technological advantages, and the creation of something brand new, or 10X improvements over competitors. Tesla for example, for the longest period, touted the fact that they stood alone, without any competition. Tesla was the first car company to focus on electrification.
Now, fast forward a few years later, whilst other OEMs are in a dire scuttle in attempting to compete with Tesla, it is radically clear that Tesla is in a league of their own. Not only in the context of their electrification, however also the use of FSD and the absurdity of their network effect creation, in which is leading to a likely unstoppable road towards general artificial intelligence.
Concluding Thoughts:
To conclude, I want to end with one of my favourite quotes from Jeff Bezos.
You can either choose a life of “ease and comfort, or a life of “service and adventure.”
I want a life of service and adventure.
Yours, Christian M Darnton x
