The philosophy of investing

Art or Science?

What is Investing?

Let’s get some definitions out of the way. Investing is underwriting a company you believe in based on some thesis. A good thesis can take multiple years to play out, in some cases closer to a decade. Speculating on wether certain news will move the price of an investment up or down is referred to as investing by the liars, trading by those more honest, but I prefer the word gambling. Second, the fundamental truth of investing that everyone believes is that the value of any investment is the sum of the present value of all future discounted cashflows. From this ‘first principle’ you can reason up to everything else involved in investing or finance.

Now the fun. Investing is simply capital allocation, choosing to put your resources[1], in this case capital, into a business that uses them more productively than you could, which creates wealth and therefore generates a return (profit). Some like to measure the value of their investments on the social, environment, or moral good they provide, but beware because those who use such measurements usually are unable to successfully measure an investment on the one true metric, profit generated. After all, I know of no higher virtue than turning a profit.

I work for nothing but my own profit — which I make by selling a product they need to men who are willing and able to buy it. . . . I do not sacrifice my interests to them nor do they sacrifice theirs to me; we deal as equals by mutual consent to mutual advantage — and I am proud of every penny that I have earned in this manner. . . . I refuse to apologize for my ability — I refuse to apologize for my success — I refuse to apologize for my money.

If you ask me to name the proudest distinction of Americans, I would choose— because it contains all the others — the fact that they were the people who created the phrase “to make money.” . . . Men had always thought of wealth as a static quantity — to be seized, begged, inherited, shared, looted or obtained as a favor. Americans were the first to understand that wealth has to be created. The words “to make money” hold the essence of human morality.

It’s fine to sacrifice some profits to achieve secondary objectives, some businesses choose to run near breakeven, but at the end of the day social good doesn’t keep the lights on and your goal should be long term profit maximization. This will give you more capital to deploy and allow your worldview to have more influence. [4] After all, the ultimate voter is and has always been the dollar. When you allocate your capital, you should do so based on a future you believe in, while keeping profit in mind. You want to invest in a future you believe in because that will give you the conviction to hold an investment through inevitable dark times [5] and frankly what is more exciting that trying to usher your vision of the future into existence, to build a better world for all. Investing based on spreadsheets [3] often leads to a misallocation of capital and less conviction hence more stress. This is because spreadsheets have so many embedded assumptions, discourage real thinking, and are inherently backward looking. If you believe the future will be different from the present, you want to fund projects that will be highly productive [2] in the future, versus highly productive a decade ago. The future, by its nature, is often hard to quantify, hence opportunities will not be seen in spreadsheets, which have so many embedded assumptions in their projects based on a world that no longer exists. Again, don’t ignore profit, but look beyond the spreadsheet numbers.

Finance, a study in human psychology

Finance a superset of investing is both internally and externally a psychological game. you must master your own psychology and understand that of the other players in the game. You must also understand the psychology of money or you will come to believe the greatest lie told to man, “that money is evil”. From there, money will destroy and leave you as it usually abandons those that are unworthy.

Inward

I can give you my investments advice, but I can’t give you my conviction. If you did literally nothing but held any of the FAANG companies from 2000 to today (20 years), you would have generated returns in the high 1000’s of percents, building generational wealth, and beating every Wall Street hedge fund and ‘expert analyst’ in the process. The trick in this game is doing less yields better outcomes. In order to do so you must have high conviction and remember your original thesis. On one side there will be constant narratives and spin around any company, ‘mini-crises’ invented by the media and ‘expert analysts’ that will seek to convince you that the world is ending. Ignore the noise, check your thesis, and only take action if your thesis is significantly impaired by events. On the other side, natural human tendency is to want to tinker, to think you can outsmart the market via timing, or to lock in gains. That is a fools errand, which will only result in regret, the 2x vs the 20x. If your original thesis is meet, it however may be acceptable to cash out. Mastering your psychology to make data driven decisions as devoid of emotion and noise as possible is an invaluable and crucial skill if you want outsized outcomes as the only real validation your thesis will get is from your reading of the companies annual reports and some company news. Other forms of validation will often led you astray and get you caught up in hype cycles.

Outward

The narrative-investment fit. In a world of increasingly fractured realities [hyperlink], what is true anymore. Warren Buffett, likes to say in the long term the market is a weighing machine and in the short term its a voting machine. Of course there are objective realities, a company either generates 5 Billion in revenue or it doesn’t, it either has X product for sale that can do Y or doesn’t. Beyond that you enter into a narrative driven realm. Often times you see banks analysts upgrading, downgrading, or being neutral on a company with a price target of X dollars after some big announcement or movement in the stock price. This is a reflexive relationship. These ‘analysts’ are basically reading astrology signs to make their predictions. This matters because a company is always priced for the future, its in the name discounted future cashflows. Hence, you always have a narrative around the future performance of the stock. Even if the narrative is consistently proven wrong and profits continue up and to the right, the narrative still could be one of doom and gloom hampering performance. Currently the analyst control this narrative, but that is slowly changing to communities like stocktwits, wall streetbets etc. The internet has given the narrative control from the 2-3 institutions back to the people. This is where the art of the sale comes in. The CEO, large investor, etc or some figure with large social or financial capital needs the ability to persuade popular opinion or tell the story around a company, spin it positively so people ‘get’ it. You could have the greatest business, but in the absence of coverage or in the case of negative coverage the future of the company will be gloom and the analyst will respond according. No better example than is with Tesla, consistently called fraud, bankruptcy rumors repeated for years even when this was disconnected from reality proceeded to keep the price down for 5-6 years. The price in 2019 was the same or lower than in 2014 when the business had materially improved by orders of magnitude in all regards. Finally the script flipped with the combination of good news and notable figures (Chamath, Ron Barron, ARK invest) explaining the company’s story to the public. Does this not sound familiar to a SPAC promoter? The takeaway here is the companies with good results can be ignored or spun negatively and that can materially affect the investment valuation for extended periods of time. I agree with Buffett that the truth usually wins in the end, but don’t discount the value of having a good promoter or an online army of fans (The TelsaCult) that will give you good press, if deserved, and help you take advantage of the media hype cycle. Conversely, a company negatively caught up in the media hype cycle while the underlying company operations improve in reality creates an arbitrage opportunity when the script flips.

Thinking about Thinking

Philosophy is a science of thinking or applying a scientific approach to thinking. You should always be questioning, validating, and updating where wrong, the way you think. Wether it be how you think about markets, distribution, products, user acquisition etc. Investing is largely building a mental model or framework that you can apply to a set of possible opportunities to pick the best ones. Any framework will always have embedded assumptions, hence room for error if an assumption is wrong. You should be constantly updating your framework and worldview to discover if there is an inconsistency, in either area. Remember there are no contradictions in the truth, if you find a contradiction it is always because of a flawed assumption, hence you believing something that is not the truth. So investing really a way of trying to discover truth in its respective field.

Investing is a reflection your worldview

So, how do you find these opportunities, what do you look for, and how do you build the conviction to underwrite an investment? The answer to all these questions comes from your worldview, which is why it’s so important to define one. Without the ability to think though one, you are reduced to spreadsheet investing, being confused in the sea of narratives around investments, will not see a thesis through and ultimately will have average or subpar results. You can then extrapolation your worldview to the future and see what areas are about to hit escape velocity. Remember timing is everything. Being too early isn’t necessarily bad, but you can be waiting 10+ years for a return and any signs of validation of correctness. Being slightly early is the sweet spot and obviously being late yields subpar results. The future is unknown and the way you allocate capital can help shape the future, “invest in the future you believe in”. The more capital you have the more influence you have. Most retail investors, don’t have quite that much influence so its better to survey the field of the most influential capital allocators, understand their worldview and have yours be a combination of the most correct of theirs to get a ground truth of reality. If they generally all agree on a topic, the return has probably be arbitraged out, and if all of wall street agrees on something grab your wallet and run for the hills, it’s better to find something that <50% believe, but that you believe to be true. You should aim to be as close to reality as possible. Remember, there are no contradictions if there are you likely have made a wrong assumption, but could have spotted a place where opportunity lies. I will take you through my worldview, so you can understand how I invest, it make be wrong and there are definitely alternative views, but it is uniquely mine and what I deeply believe.

We will start at ground zero. I believe humans are mimetic creatures, we benefit from this because we are able to learn quickly, but it’s also our Achilles heel because not only skills, but desires can be copied. As we imitate each other’s desires, this brings us into conflict. The Bible tries to suppress this part of human nature by treating things like envy, jealousy, and most importantly greed as sins. If 2 people desire the same cars, the same girl, the same house they will lock themselves in never ending brutal competition based on their mimetic desires. To break this you need to create a lot of options and allow and encourage people to be different, make different choices, desire different things. The very nature of different choices is that you have different outcomes and this is good unlike some would have us believe; It stops mimetic desire from replicating itself throughout society throwing everyone into conflict and increasing overall violence. In a modern economy growth is crucial because it expands the pie. Without growth you have a fixed pie or resources to be split over an increasing amount of people. This causes increased competition (mimetic desire) for the same things, an inherently zero sum game, which produces a bull market in politics as various groups fight for more of the same pie. If you can’t force people to live with less you must grow. Innovation and growth (derivatives of capitalism) are inherently positive sum games, when 2 people co-operate both can win, you grow the pie and let everyone have more thereby preventing competition and violence. To stop the apocalypse of runaway mimesis, we must have huge amounts of growth and innovation to create wealth.

We have established, we must have growth and innovation so how do we get there. innovation flourishes in freedom. The more people are free to create and explore ideas the more they will make new discoveries. Innovation is largely an ecosystem vs the idea that it comes from individual brillance. Regulations inhibits this freedom and taxes are a misallocation of resources. Innovation means 2 things, either zero to one moments or the technological definition, which is doing the same thing in new ways to produce cheaper, better, and scalable solutions. These different from scientific discoveries, the importance of which aren’t to be understated, by whose development is another topic. A zero to one innovation would be the invention of flight, the lightbulb, the transistor etc. A zero to one innovation requires a lot more work to turn into a product and company, but can yield great results. A technological innovation would be the assembly line or a new type of battery than weighs half as much, but contains double the energy. Things that have been done before, but can be done better. These innovations create wealth and increase productivity. If you could produce 10 million cars at half the cost and with half the people (an amazing innovation), you free up capital and human labor to work on other problems to bring us into the future. This is how innovation is positive sum and wealth generative (also see create wreath link), you enable the production of more for less effort and lower cost, hence raising the base standard for everyone in society. That is why investing in these innovative companies yields such outsized returns.

So, I believe we need growth to build a better future for all and stop the apocalypse of runaway violence. We get growth with innovation, hence I will invest in innovative companies. By doing so, I stop the apocalypse, generate lots of money, and help fund the future. Let’s remember what becoming rich really means. It is either by providing something that society values a lot or allocating resources to projects that society values a lot. This results in society rewarding you with more capital to allocate, which you can waste partying or repeat the above cycle.

Define your edge

An edge is something you do really well, that is somewhat systematic that others can’t. in a hyper competitive world, you likely won’t have a super unique edge, but you can be somewhat contrarian in the sense doing something the minority group does, but is right about. The problem with short term day trading, algorithms etc. are that in a hyper-competitive world anything that is that easily thought of has probably already been done and done by people with more financial and human capital. It’s a losing game. Value investors edge used to be they were quantitive in a time when informative was scarce, now information is free to everyone, and everyone has powerful computers and the cloud, hence everyone is a mini-quant essentially. The values investors edge is gone (esp. in the world of low rates, which i’ll get to later). Quant investors can arbitrage anything that can be reduced to a spreadsheet. Hence, there is so much money chasing the same P/E ratio, P/B metrics and you aim to not compete it that game. Why start the 10,001st clothing store. Aim to be unique.

An insight is kind of a differentiated long-term viewpoint about a stock. It’s a differentiated view about the long-term state of the world. This is your edge and why you must define your worldview. These insights are usually very simple, imaginative, and. about being slightly better at seeing the future than the average person. These insights also have to be correct and tested in reality otherwise they are quite useless. Some general heuristics are if you can’t explain an investment in a page, 1) you don’t understand it that well 2) it’s too complicated leading back to 1. Aim to make the fewest assumptions necessary (Occam’s razor), to reduce the chance a key assumption is wrong, and focus on what is important not interesting. Like a technology business, if you are not growing your competitive advantage it is probably shrinking. I will take you how I think through investments and what I generally consider my edge. This will be unique to you, but maybe this will help you find it.

There are generally 3 types of risk technical risk, market risk, and execution risk. Technical risk is can the product even be built, market risk is if it is built will anyone want it and execution risk is we have a product and market but can we build a company. I like companies that are de-risked from a technical standpoint and markets that are de-risked in the sense there is overwhelming demand for a product or service. I generally like taking execution risks. What this means is I like to evaluate leadership, product roadmaps, and look for virtuous cycles. There is nothing more rewarding than finding men of ability, investing in them and watching them grow with their company. Product roadmaps help me understand how well the company understands what market they are truly in, what their customers core needs are, and what their core product is etc. If the company presents a compelling roadmap or vision for the future that aligns with my worldview then I only need to evaluate their ability to deliver it. The 2nd part of research comes from listening to podcasts, YouTube interviews with CEOs or executives in leadership positions to see how they articulate what they are doing, how they solve problems, make decisions, and structure an organization, respond to feedback, etc. Then it is tracking their progress to see if they have delivered what they promised and how the organization and its culture is evolving. Finally, virtuous cycles are these positive feedback loops where the incentives are aligned in a way that improving one area of the business kicks off a cycle that will compound the effect of strengthening the business. Example Tesla makes a the best car, lots of people buy it to drive it, this collects more Autonomous driving data, this improves the FSD on the car making the car better, more people buy the car … and repeat. These are very not super quantitative things, there is virtually no way this fits in a spreadsheet. It is systematic in the sense it’s a repeatable process, but still relies on my implicit knowledge or edge. This allows me to hopefully land asymmetric opportunities.

Product, Market, or Timing?

A common question when evaluating companies is what matters most, product, market, or timing. These are other things like distribution, user acquisition strategies, data loops etc, but I think these 3 are the most fundamental to evaluate. I rank them as Timing, Product, and Market. If the other 2 are correct, then timing will generally be the biggest factor. Why now? A lot of Dotcom companies are successfully running today (2020), while they unanimously failed in 2000. The had the right products and would find the right markets, the timing wasn’t right. This plays into the innovation ecosystem and how innovation is more determined that we often like to think. So in forming a thesis I like to ask why now?

What the hell is going on today?

Monetary and fiscal policy has been intertwined in a way we have not seen before. The Federal reserve has cut rates to zero. Under traditional portfolio theory you have a 60/40 split with 40% of your money in bonds, a roughly 60 Trillion dollar market. Now the Fed has just declared 60 Trillion of assets returning nothing by dropping rates to 0. These stranded assets will look for yield anywhere. The equity markets are the obvious beneficiary, but also alternative asset classes and real estate, which are generally less liquid and less accessible. The government has also voted to bailout companies via huge stimulus packages. This props up zombie companies. The pandemic accelerate the rate at, which traditional retail would lose to e-commerce. These traditional retailers were always going to zero, but instead of taking 5 years, with COVID that has accelerated to overnight. Propping up these fundamentally doomed companies with cheap money will not end well. It should not be as bad as 08, but a huge wave of defaults will put a drag on the economy in the future. Is there a better short case for banks. Tech and other creative disrupters will benefit hugely from this timeline moved forward fueled by cheap money. Credit spreads in the BB,BBB are still blown out. This signals a fundamental shift, not a return to the norm post covid-recession. With 0 rates and increasing government spending from both republicans and democrats, you can basically be long equities blindly till 2023 as money flows in from the bond market and as asset inflation continues unchecked. a P/E ratio of 30 is really saying 3% yield and in a world where the risk free rate is 0, that is pretty normal.

Every company is becoming a technology company. You adapt or die, you are the disruptors or the disrupted. Technology fundamentally means doing using less resources to deliver more of a product for cheaper while improving the quality of a product. This means technology is inherently deflationary. What times means for companies is that if you do not adapt your core competencies to be technology centric to help enhance the delivery of your core product or experience you will be replaced by someone who will. Of course there are pure play software companies like Slack, Atlassian, Workday, etc, but those are relativity well understood. Let’s look at some of the most misunderstood companies. Tesla, is it an auto or a tech company. It is both, a tech enabled auto company. It builds cars, but using advanced robotics. Its car is a hardware platform that can continuously receive software updates, “a computer on wheels”. Square, bank or tech company. Square uses technology to lower fraud, faster access to funds (big deal for those living paycheck to paycheck), cheaper to process transactions, cross selling oppurtunities on financial products. Opendoor, relator service or tech company. You get the idea. The most valuable companies are will be these tech-enabled hybrids that fundamentally transform their respective industries. Outside of technology and the world of bits, our physical world has decayed, we haven’t solved cancer, planes go slower than they did in 1960’s, it took us 3 years to build the Golden Gate Bridge, but now takes a decade to fix a NYC subway line, etc. This is why the most valuable companies, delivering on the promise of innovation and productivity growth while take lessons from tech companies and apply them to the physical world. Some commonalities that exist among these tech-enabled hybrids are they have vertical integrated (own their data stack) and they have a strong brand (NPS) and communities.

This has implication for valuations. An initial reaction to these new tech disruptors will be ‘dot com bubble’, ‘crazy valuations’ etc. Let’s pause. What is technology doing, it is deflationary. This changes the whole margin structure. A mining company that can now use machine learning + new sensors to do mine explore can do the same task better for a fraction of the cost. A new technologically enabled mining company for this reason will have a totally different margin structure hence deserve a higher valuation as the future cashflows increase discounted backed nets you a higher present value. Not to mention the defensibility of these cashflows with the ultimate moat, the rate of innovation which is in any tech companies DNA. the old guard simply is not prepared for a world changing this quickly.

Managing Risk and Portfolio

There are lots of good things written about risk and portfolio management, I don’t have much to add. I like to keep it simple. Like in poker don’t let any one hand bankrupt you and you only goal is to survive in the game to give one investment the chance of hitting it big. We are governed by the law of exponents after all.

I like to split my portfolio up like this. 10/5/5/80. 10% relatively low risk, cash flow producing assets, 5% angel investments with high upside, but I expect to go to zero, 5% alternative assets not correlated to the rest of the portfolio (Bitcoin, art, watches, etc) and 80% what I described above. As you get older, you generally want to shift that 10% up and 80% down as I am young, this is pretty normal. You usually aim for 8% return a year, while young while not increase the risk aim for 100%+ per year. The key thing now is to stay liquid enough to not be forced to sell at inopportune times and be patient and trust the process. Have a plan because even a bad plan is better than no plan.

-Bobby Lee

[1] human (your skills), social (network), financial ($$$) are all forms of capital

[2] productivity is producing more using less

[3] using spreadsheets is important for projecting revenue, profit, etc, but using spreadsheets blindly an apply historical margin structures and growth rates to new companies often miss the point

[4] true diversity is having multiple worldview operating and competing at scale. this quota bs, having 1 black, 1 brown, 1 orange, 1 white dude is absolute nonsense.

[5] it seems whenever I buy a stock, it will literally go down for the next month. Happens everytime, HODL