Tarpon US Equities
Investment mindset for the digital economy.
Updated: Oct 15, 2020
In the “world” in which most of us learned how to invest corporate returns tended to revert to the mean, except from rare cases where a brand like Coca- Cola proved invaluable. For example, a steel distributor likely would not enjoy a 30% ROIC for long; nor would it perpetually struggle unprofitably. Applying that thought process across many industries and picturing a “normal” distribution curve, many of us figured out it was easier to focus on the tails, especially on the left one, to find opportunities and then realize the gains by selling when they approached the middle, than on the much largely populated middle, hoping to find that “still hidden” Coca-Cola. More over, even if you found Coca-Cola early on, its returns would not be like anything we see in the new generation of winners.
In the “digital” economy, or whatever you want to call it, returns are not linear, but rather exponential, and reversion to the mean rarely applies. Due to network effects, positive feedback loops, asset lightand rapidly scalable business models, etc., that Gaussian curve we are so used to becomes a liability to our minds. Here, companies either “cross the chasm” and thrive, or really, perpetually struggle to generate any economic value on the cash they burn (through the P&L rather than on fixed assets). In other words, the middle of the curve is a desert. The left end is the new middle in terms of population. And the few winners on the right tail enjoy huge returns. For example, we own WIX, a clear winner in SaaS for website design, enjoying great economics, while we know of dozens of competitors left in the dust. The same can be said about Atlassian, which offers software tools for team work that have become “necessary” for developers worldwide, catapulting the company into the select group of exponential winners, while many peers, including some quite well funded ones that managed to reach public markets, fail to get out of the left end of the curve.
Note: by saying companies are not likely to revert to the mean, we do not mean they cannot fade away - this is rather possible, just see what happened to AOL, Yahoo or MySpace. The point is that in the digital economy the decline is accelerated, towards the left end of the curve. And even the so-called tech giants are under constant threat. Moreover, technological evolution and habit changes never stop, so that all we arestating here about businessdynamics must be constantly revised.
With that in mind it should not be difficult to grasp why those old concepts become liability.
First, when looking at that left end of the curve today, rather than simply trying to figure out when/why a business would return to its normal, we are actually trying to pick the next Amazon amid thousands of contestants. This is a game very well played by some venture investors, but we cannot fail to recognize that the venture industry as a whole struggles to generate gains above that of the broader stock market (when we exclude the dot- com bubble of the late 90s when many funds enjoyed surreal gains from exits in IPOs that later wentunder). Second, in the digital economy when a company deviates from the norm for a while and starts to consistently accelerate towards outsized returns, it is much more likely
than not to continue deviating from the mean. In other words, when we happen to own such a company, selling is often a costly mistake, which many commit due to old concepts and anchoring.
Our approach to all of this is exactly to try to take advantage of the inefficiencies created by investors tied to such concepts and anchors that are so ill - suited to the digital economy,
which, it is worth noting, is far from being where all interesting opportunities lie – for
instance, we own significant investments in more linear business models. By virtue of painful lessons over the years, we now understand that the market often fails to recognize the value of an exponential business, even when it has clearly flourished ahead of its peers. In these cases the stock has usually already advanced a good deal, but not enough– the human mind has trouble thinking exponentially. Moreover, at this point the risk of picking the wrong horse is greatly diminished, especially for investors who do the job of understanding the reasons for the accelerating performance, research the competitive landscape, and assess management’s capabilities.
To close, we will share a couple of hurtful examples:
I, Guilherme, had been studying WIX since 2016, seeing the business set itself apart and the stock advance, without investing, until when Zeca’s fresh eyes helped me pull the trigger meaningfully, and fortunately, earlier this year. Zeca, for his part, is already feeling the sour taste of having “realized” some gains in PetLove, a clear case of a company accelerating to
wards exponential success. We will get better and better on this; nonetheless, we must always remember that such lessons just apply for the very few really superb businesses, and
that the only way we can protect ourselves from opposite mistakes (buying into or holding to a misleading right-tail candidate) is to go deep, research extensively, and act verysporadically, just investing when both our odds are very favorable and we are playing the games we know how to play, preferably on home turf.
Tarpon U.S. Equities