Stuff I thought about last week 2-10-19
Greetings - sucked inside the Jack Dorsey Reality Distortion Field, the video game rut, monks teaching us humility in work, and more covered below...as always, reply with any feedback you have.
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Stuff about Innovation and Technology
I’ve spent the last decade avoiding the Jack Dorsey reality distortion field (JDRDF) with some success - it’s one of those paradoxes of investing where you like and value the product, but don’t believe it’s a good investment at any given time - running contrary to the classic Peter Lynch or sometimes Warren Buffett way of investing. However, this paradox has evolved for me over the last few months for a number of reasons, and this week I was officially sucked into the JDRDF after listening to Dorsey on Joe Rogan and Sam Harris’ respective podcasts and Twitter’s Q4 2018 earnings report. I was intrigued by the widespread criticism of the podcasts and the earnings report - it always catches my attention when my view is evolving in one direction and the world’s view is continuing in the other direction - at the very least that’s worth exploring in detail to see if there is a Truth that the world is missing, or, more likely, if I am buried in a cognitive bias trap of some sort that I need rescue from.
Twitter has survived the social media wars to date and built a viable ongoing business - all while Facebook, through its legitimate and valuable network effect (along with its perhaps sometimes questionable tactics), has acquired or immolated other rivals outside of China. I believe there are uncontroversially unique aspects of Twitter that allow a new form of conversation and collaboration that doesn’t fit in other social network frameworks. In other words, it’s an important and scaled up niche use case that has proven its worth. None of this intends to ignore the problems that plague the platform (similar to what Facebook’s social networks are grappling with), but Twitter seems to be gradually improving, albeit at a high dollar cost to fix near term.
Twitter remains a more open dialog than other digital mediums. As I’ve written in the past, I worry about the opaque and opinionated algorithms that platforms like YouTube, iOS, Facebook, Patreon, etc. are forcing upon their users often without thorough explanation. These aren’t free speech issues since those companies are all non government entities free to set their own policies. But, when algorithms are controlling so much of what we see and absorb all day long, do we want to rely on heavily myopic, Silicon Valley influenced YouTube, or Tim Cook himself, setting up a biased algorithm that determines what is “fringe” content (my thoughts about the YouTube decision on borderline content are here) that ultimately amounts to mind control? Dorsey has so far taken a controversial, but more careful approach to address this issue. It remains an ongoing problem, and there is a lot of hate on the platform; but, there is something appealing about knowing what is being said without censorship as long as the threat of physical harm is not tolerated, and maybe that’s why Twitter has survived so far. Further, there does not seem to be any intent at Twitter for now to implement an algorithm that reinforces a filter bubble just to drive ad revs - Dorsey in fact seems to be constructing the opposite - a way to broaden people’s perspectives and get both sides.
Moving to the business side of Twitter - anecdotally and subjectively, I’ve seen the ad load and quality improve over the last few months - this trend appears to be backed up in the numbers the company cited on this week’s earnings call: "Click-through rates were up 27% this quarter. Ad engagements were up 33%, which suggests that both the mix shift to video continues, but also that better ad relevance is driving more interaction with the ads that people are seeing." There was a lot of angst among investors that the company would no longer report monthly active users (MAUs) in favor of a hazy set of “monetizable daily active users” (MDAUs). Both metrics can be easily manipulated, but if the company is focused long term on MDAUs, then I like the idea of aligning investors on this metric as well. One of the issues with MAUs for Twitter or Facebook is the sheer volume of ever shifting accounts attempting to hijack the platforms. By focusing on MDAUs I think Twitter is saying these are the people who are on the site or app long enough on any given day to see an ad - that seems useful to me. And the trend in this audience (which I want to emphasize can be gamed, so let’s not put too much weight on this) is quite positive, rising steadily over the last 8 quarters from 109 million people to 126 million globally.
Overall, I think the greater than 10% drop in the stock this week following earnings reflected uncertainty around the shift from MAU to MDAU along with the rising expenses to police the platform - costs which will likely outpace revenue growth for the foreseeable future. I have not done any detailed scenario analysis, but I would guess the stock is trading around a little more than a 3% FCF yield to its enterprise value on 2019 numbers. In other words, that is roughly 30x FCF, which is expensive if the company cannot compound annual FCF growth above 10% for the next 5-10 years. So, as I work the thesis out in real time, there needs to be a JDRDF leap of faith that there is legitimate, monetizable Optionality around this core base of over 100M MDAUs; my gut (controlled by the 500 million nerve cells in my enteric nervous system) tells me there is something interesting here, but my brain (with its 1 billion neurons) is telling me a 4% or greater FCF yield would be a safer spot to dip a toe in - it’s not uncommon for those enteric nervous cells to perceive something before the brain, so it’s worth listening to the gut - sometimes it’s right, but sometimes it just something you ate.
My personal Netflix show recommendations have been increasingly making little sense and offering nothing quality of interest to watch. As an experiment I created a new profile and started over with some new likes and views to see what happened. After a few interesting programs, the recommendations defaulted to the same mess of low quality nonsense that are unbearable to watch. I am not sure if the platform is in a content rut, or there is something about the movies and shows I like to watch that has broken the Netflix algorithm? This hilarious article made me think I am not alone - algorithm failure, paradox of choice, and streaming fatigue might be setting in more broadly. What perhaps puzzles me the most is why Netflix would continue to show the exact same 20-30 recommendations for weeks after someone has continued to express zero interest in them, or even watched 5 minutes and hit the escape button - it really seems like they’ve temporarily run out of content despite over $10B a year in content investments. Don’t get me wrong, I am extremely optimistic on Netflix, I think they will have 1 billion subscribers globally; however, something seems a little hard to sort out right now for me with their algorithm failure. The “Endless Scroll”: Right, right, right, right. Down. Right, right, right, right. Hover. Right, right, right, right. Down...Hey, Amazon Prime has all 7 seasons of “Growing Pains”!
Some comments on the weak video game stocks this week and a great article on the Fortnite effect from Matthew Ball worth reading in detail: this week console and PC video game makers Electronic Arts and Take-Two Interactive reported results that sent investors running with both stocks down over 10%. I think both companies had some specific issues, and, in particular, the Take-Two results were of less concern to me, but it’s also clear the industry over-monetized their core players of hardcore games in the 2016-2018 period and is now going through some digestion. This digestion comes at a time when we are seeing a new type of gaming that combines a heavier element of cross platform, real time, and social engagement, as Matthew Ball points out. My view is that Fortnite is growing and expanding the gaming market, but it’s also taking some wallet share away from big traditional games that have dominated in the past for Activision, EA, and Take-Two. The broader takeaway is that more and more of life is moving into games or game platforms, which may be an enduring trend, or it might be a fad - we don’t know yet. Longer term monetization of games, whether they be based on consoles, PCs, phones etc., is growing through in-game purchases, advertising, broadcasting (Twitch, YouTube), esports, etc. This is a big pie that is getting much bigger and more important as it becomes a broader communication and entertainment platform (see last week’s SITALWeek on the Marshmallow concert in Fortnite). I suspect the incumbent game makers need to digest and evolve their monetization strategy and add new social elements, but I think rising tides will return to lift all boats over the next few years. Fortnite’s “innovation”, like most innovation, was simply to combine in a better way many previous elements that already existed; this same opportunity is available to other game makers whose corporate cultures can adapt and evolve to the changing trends for gamers. As you know, I am fond of looking at the network effects in big platforms and who owns them - gaming creates a bit of a puzzle for this topic. Distribution is increasingly controlled by the platforms such as XBOX, Sony Playstation, iOS, Android, etc. It’s unusual for game studios to have meaningful direct relationships with their customers. Yet, the consoles and mobile platforms don’t really own the player either, so I wouldn’t characterize many of these games as strong network effect platforms by themselves, though certainly examples exist such as Activision Blizzard’s World of Warcraft franchise. So, the real question is whether someone like Epic (maker of Fortnite) and its Unreal game engine can create a durable network effect that they exclusively own? Or, perhaps the latest effort from Microsoft to create a multi-platform game engine will succeed as games transition to a streaming model? Amazon, with it’s Twitch and AWS cloud, is a contender, as is Google, with 50B hours of gaming watched on YouTube in 2018 and vast cloud infrastructure combined with the Android platform. Tencent in China has already become a dominant distribution platform for games with a strong network effect. It’s a time of “widening range of outcomes” for the industry as these huge platforms and studios look to build a durable network effect platform, and so it’s not surprising to see investors get a little timid - it’s a good time to not lose the forest for the trees and keep in mind the strong multi-year tailwind behind the video game sector.
Tesla is providing batteries to VW’s US charging station network - strange bedfellows as Tesla seems to be coming into a lot of supply of batteries either from new capacity or weaker car sales - my local Powerwall installer noted they’ve got an unexpected shipment of units coming after years of being unable to get their hands on the backup systems made by Tesla. (I am not wading into the long vs short debate on Tesla!)
Several big companies have chased the ghost of the “marketing cloud” - using other people’s data to sell higher priced ads across the web - and hopefully soon we can bury that ghost for good - it never really materialized in the expected size for companies like Salesforce, Adobe, or Oracle beyond basic tools like analytics and email marketing (which are decent businesses). Now with GDPR, built-in ad blocking, and increasing concentration of first-party consumer data at Facebook, Amazon, and Alphabet, these 3rd party systems are even less relevant. Oracle is said to recently have carried out a series of layoffs in its data business, one that was built with several billion dollars of what appears to be largely useless acquisitions.
UberEats will deliver $10B of takeout food this year up over 60% from 2018. I struggled for years trying to understand why a market with such obvious untapped network effects failed to coalesce around one or two “winners take most” power law models like we’ve seen with so many other traditional markets disrupted by the Internet. The lack of consistent service seemed to be a real sticking point, and optimizing the delivery part of the process might be the key network effect enabler. Grubhub and its acquisitions have been somewhat successful at creating a two-sided marketplace. But, a marketplace by itself has not been enough to catalyze the industry, as the user experience has remained inconsistent - with easy ordering followed by unknown delivery times. With Uber, we have a logistics company leveraging into a marketplace model - an important lesson for a lot of other businesses where logistics are a key part of the value proposition. Yet, no one, including Uber or Grubhub, has hit escape velocity - this is a crowded, dynamic, competitive situation with several companies on the hunt to own the profit pool associated with this giant market. I’ve written in the past that we should have broader local logistic subscriptions - why not pay hundreds of dollars a month, not just for rides, but for a service that also includes delivery of three meals a day? I believe one or two platforms will hit escape velocity in logistics as a service in the next few years.
There’s lots of great data for folks interest in the software as a service and cloud software industry in Okta’s bird’s-eye view of usage reported in their “Business@Work” 2019 review.
Tens of billions invested in India by Walmart and Amazon has seems to have been wasted with the implementation of new regulations. It’s hard for me to understand all the puts and takes, but it appears the Western retail leaders have now been all but shut out of India after false starts in China as well.
News that most on demand delivery services were using customer tips to subsidize wages seems pretty outrageous - perhaps folks should stop tipping and place the real economic burden of wages on the companies until this issue gets resolved with some transparency.
Every company now has customer facing and internal software and every single company in the world should have a bug bounty program - no excuses. But, it’s remarkable to see the divergence of approaches - on the one hand you have Google boasting about their $15M in payouts and Apple providing education funds for a teenage bug hunter...and on the other hand you have a senior exec assaulting a software engineer who was explicitly trying to help the company out.
Facebook adjusts bonus formula to include social outcomes.
Tensorflow, Google’s open source AI framework, is tackling that last bit of email spam as it finds another 100M messages per day with machine learning - highlighting the power of data scale in the age of machine learning.
The Benedictine monks caught up in the early part of dotcom bubble in the 90s and what they can teach about reflection in between unfinished work: The lesson regarding cessation of work until you can do that work with humility is perhaps especially important to investors. To meander off on a tangent with respect to this last point, one of my favorite exercises in investing humility is the pre-mortem: on every trade there is a buyer and seller, and, assuming similar time horizons, there is a 100% chance that one of those two parties will be wrong! So, I ask “what are all the reasons I will be selling this stock down 10-20%” - if I don’t know the answer, then I am not yet ready to buy. The inverse works as well: why would I be buying a stock or covering a short up 20%?
“Germs in Your Gut Are Talking to Your Brain”...if you are feeling blue, it’s got a lot to do with what you’re culturing in your gut: “If you hold a mouse by its tail, it normally wriggles in an effort to escape. If you give it a fecal transplant from humans with major depression, you get a completely different result: The mice give up sooner, simply hanging motionless.”
In 2011, according to Crunchbase, 16 investors did an angel round in 2011 in a used sneaker website - I’ll give that a second to sink in - and now that business just raised $100M from Footlocker at a $400-500M valuation. Word has it some of those early investors own multi-million dollar used sneaker collections. Well, eBay was started on the back of selling Beanie Babies and Pez dispensers...
Cutting all major tech platforms out of your life is nearly impossible - articles like this (one of the better one’s I’ve read) are informative to get a handle on how pervasive the connections are. There is no need to be scared into going tech-free, just be thoughtful about how you use and interact - there is still much more upside than downside to most of the services provided by these companies when used appropriately.
Stuff about Geopolitics, Economics, and the Finance Industry
Socially responsible funds appeared to experience less volatility in Q4 2018; while encouraging, you may not want to read too much into this result, which could simply be from sector over/under allocation rather than stock selection. Nonetheless, it’s interesting data from Morningstar: “Morningstar’s number-crunching found 67.8% of ESG and RI equity funds graced the top half of their investing peers for the full fourth quarter, and nearly two-thirds of them edging their way into the top half of fund performance for the full calendar year as well.”
I was intrigued by this proposal to tie social outcomes to share buybacks. In general, I’d shy away from any regulation like this one, but it’s also a possible win-win, as improving social outcomes should be good for companies under our NZS framework (i.e., good for stocks, employees, customers, etc.) I’d like to see a more rigorous analysis, but why not go a bit further with incentives for getting to 100% renewable energy or other social outcomes either through tax breaks or shareholder return restrictions? The exercise would be less about putting actual restrictions in place and more about companies recognizing, on their own, that operating with a more global consciousness is both good for business and good for share prices. Right now the free market isn’t quite nudging public companies in this direction fast enough. A side issue that came up after this proposal was the shocking degree to which even sophisticated investors don’t understand the math and ideology of share buybacks dividends, and returning cash to shareholders vs internal investment. In response, an equally surprised Mauboussin posted several tweets including this one to his 2014 paper on the topic - worth a skim if you need a refresher.
UK Stewardship code adopting ESG factors: “The FRC's revamped code will require fund managers to take ESG factors far more seriously. “Signatories are expected to take into account material ESG factors, including climate change, when fulfilling their stewardship responsibilities,” it said.”
Common characteristics of the dozens of billionaires I have met who have built a business: humility, kindness, intelligence, compassion; I’d trust every one of them to do a better job productively investing or giving their money away than I would a government taking it for other purposes. But, if we are talking about billionaires who made their money in the stock market that’s a different story...probably the government should clip them at $1B! (Sarcasm alert.) The hysteria this week over the evil of anyone who made money building a business has hilarious hypocritical parallels for the Left that look just like the deceit the Right got caught up in during the 2016 election.
Nothing in this newsletter should be construed as investment advice. I may own long or short positions in stocks discussed in this newsletter. This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I may change my opinions without updating them in the newsletter. Lastly, often I try to make jokes, and they aren’t very funny - sorry.
I was the portfolio manager of the Janus Henderson Global Technology products (ticker: JAGTX) from May 2011 to November 2018. Prior to that I held various roles as an analyst and portfolio manager at Janus Henderson Investors for most of the period starting as a summer intern in 1998 up until the end of 2018. I graduated from Williams College in 2000 with BAs in Economics and Astrophysics. A complete resume can be found at www.linkedin.com/in/bradsling
Investment framework co-authored with Brinton Johns “Complexity Investing” can be found here: http://www.evolusophy.com/complexityinvesting/
If you have any articles of interest, comments or questions please send them by responding to this email. I will generally try to read and respond to your comments or questions, but may not always be able to in a timely manner, for which I apologize in advance.