This post is a transcript of the conversation I had with Dennis Hong of ShawSpring Partners. Here you can enjoy the video of the full conversation:
Disclaimer: This transcript is far from perfect, as it was done fast and with a limited amount of ressources. Sorry for any mistakes!
Table of contents
- 1What quality dog brings to someone who invests on the stock market?
- 2So how does dog react to volatility?
- 3Dennis Hong, how would you describe your style of investing?
- 4What were hurdles for you to grow ShawSpring?
- 5How do you measure love for businesses, Dennis Hong?
- 6Do you also take the quality of management and to account for this?
- 7What Do you like about complexity in investing?
- 8How would you describe your relationship to cash?
- 9Have you found characteristics in the losers which have caused you to adjust your larger selection framework?
- 10How do you decide when to sell or trim a position?
- 11The risk of over optimizing
- 12Have you found something Chinese equivalent of Carvana?
- 13Which of your businesses is the most shorted on the market?
- 14Is the Chinese internet space more competitive?
- 15How do you discount political risks?
- 16How Corona virus infected your businesses
- 17What was your favorite chart in 2020?
valueDACH: [00:00:03] Hello, everyone. It’s nice to have you here for our last stream before the summer break starts. I’m happy to have Dennis Hong on today from Boston. Hi Dennis. How are you?
Dennis Hong: [00:00:18] Hi. Tilman I’m doing very well. How are you?
valueDACH: [00:00:20] I’m good. And I’m happy to have you here and to have a nice and relaxed conversation about investing, especially in internet stocks. But before I start, I want to drop the disclaimer and drop a question for you because you’re a passionate dog owner. And for the beginning, I have to question what quality dog brings to someone who invests on the stock market. What is the foreign investor to have the stock? But before you answer that, give me a second and let me drop the disclaimer. You find the disclaimer also linked below this video, So, you can have look at it and see what’s in there. The main message is to your own work, what we are doing here as a qualified talk and no advice and no recommendation. So, always do your own work and do your own research. Thank you. And I also want to say hello to the viewers because you’re happy. I’m happy to receive your questions through the chat. You find the chat. I think on the right of the screen, So, you can dropping your questions that I could take and to ask to Dennis, but let’s go, first go back to the question on the dog means for investors.
What quality dog brings to someone who invests on the stock market?
Dennis Hong: [00:01:44] Well, tell him, thank you so much for having me here. I don’t know if you’ve told the listeners and the viewers today, but you and I first met actually in Engelberg at RV capital’s invest today and I think you do an amazing service for the investor community by having some really interesting investors on, and you promise no hard questions, but I’ll tell you dogs are amazing animals. And I have this dog. His name is Darby is a golden retriever. And I think the one thing that I really admire about dogs is they just have an incredible open mind. They have an incredible. Everybody’s a friend. And I think with the kinds of businesses that we look at, many of the businesses we look at, if you look at them on first glance, the financial statements, it may not be apparent that there’s a really good investment here. Some of the businesses are initially quite cash burning. Some of them just their balance sheet looks like a disaster, but the one thing that is really wonderful about dogs is that you’re a good person until proven otherwise. So, I think with that, that’s probably a pretty good segue into this discussion on what we find. So, interesting about some of the businesses that we look at all around the world.
So how does dog react to volatility?
valueDACH: [00:03:01] So, how does a dog react to volatility?
Dennis Hong: [00:03:05] Well, as I mentioned, you know, you see, like you can see the corner of the screen. That’s my dog bowl. I have to tell you, we’re really lucky to have this office here in Boston. We’re in this old art gallery on new bury street, which I think is probably most analogous to a very trimming version of Rodeo Drive in Beverly Hills. And this building that we’re in is an old art gallery and it’s owned by a Dutch family. And they’re really kind, very kind people who let me bring my dog to work. So, I’ll tell you that when you have months like March and everything is in free fall and the anxiety is palpable, it’s really quite lovely to just have a dog who is just oblivious, just wants love and attention. So, I do say, I do have to say that we’re quite lucky.
valueDACH: [00:03:57] So, he also gives the calm atmosphere, the dog and helps you to focus on other things as well. If the volatility and the market drops, I think,
Dennis Hong: [00:04:08] Yeah, I think that’s right. I mean, it is one thing to kind of face this alone with your teammates, but it really is quite another thing when you have a dog that kind of visits throughout the day. When he notices one of my teammates might be really stressed and pulling their hair out, he’ll go and put his head upon their knee and says: “Everything okay. Everything’s okay.”
Dennis Hong, how would you describe your style of investing?
valueDACH: [00:04:32] I think we must do a test about returns and dogs offices one day, but let’s skip to the topics. I am interested how you came to investing. And how would you describe your style of investing, but maybe let us start with the way you came to investing.
Dennis Hong: [00:04:50] Well, Tilman that is a great question. I must tell you. And I have this conversation quite often. I am probably one of the last people that really should be in the seat. And what I mean by that is that I did not have an illustrious background or a family that has a lineage in investing. I’m the product of two South Korean immigrants, immigrant parents, my mom and my dad. They relocated from South Korea to this town, an industrial town outside of Toronto called Brampton. And it was in my parent’s convenience store in Brampton. That’s where I learned about business. I helped them sell cigarettes and lottery tickets. My parents were eager enough to insist that they did not want their son to sell cigarettes and lottery tickets for a living. So, I always knew I was going to go to university, even though they didn’t formally go. I always knew that was in my plan. So, I was lucky. I mean, growing up, I went to public schools; I went to this pretty rough inner-city high school where very few of the students went to college or university. And I had this great guidance counselor who was like, you know what, Dennis, you got great grades. You have got an interesting story. Let us throw in a couple of lottery tickets to the U S and see what happens. And at that time, I had never lived away from home. So, I was really scared, and I did not even know what an Ivy League was. So, I did some research and I thought that some of these schools are so cool. So, I applied to a bunch of them. I got into Yale, which in many ways, changed my life and put me on this professional investor Plath. So, I arrived on Yale’s campus. At that time, I was on financial aid and as part of the deal I had to work, and I did something very pragmatic. I went to the Yale campus job board website, and I did a search for highest hourly rate on campus. And there is this position at the Yale endowment. And at that time, I thought, Oh, this is an easy job. Just call up alumni and hit them up for money. Really simple, obviously that was not the job. And I did some research and I thought, wow, like, there is like this cool investment company here. And So, I applied, I found David Swensen’s book through the course of that research and I thought, okay, I really want this job. I really, really want this job. So, I interviewed, and it was lucky that, you know, at the last interview with David Swensen who basically just told me if you want this job, you have it. And I said, yeah, of course I want this job. So, I joined at that time. There wasn’t a lot for me to do. And what I mean by that was that by the time I joined the endowment, David Swensen and his team had been in place for quite some time. And they had largely evolved the strategy to what it is modern day iteration today. So, picking some very high conviction managers and very thoughtful asset allocation, it was really neat because I had a chance to be at the same conference room as people like Seth Klarman and sit across the table from people like Chase Coleman and Steve Mandell, which was very cool.
But the managers I found the most interesting were these one or two person shops. Oftentimes they were not household names. And they had very simple structures, five to 12 stocks concentrated. And they often sometimes just manage capital on behalf of just a handful of partners, maybe a family and Yale. And in the most extreme case, maybe just two clients. And it was extraordinary because that was an, an important early impression for me, because it was so clear that these managers had competitive advantage. The fact that they had simplified all variables and they were really focused on one singular optimization problem, which is generate great investment returns. You couldn’t help but see why they had edge. It wasn’t that they did better work than anybody else with significantly more assets or that they had some kind of magical machine that told them what stocks to buy, but it was just a thoughtfulness around structuring their partnerships, structuring their investment strategy, to be concentrated long term, deeply research investments and doing it on behalf of just a handful of partners. When you boil it down to a few variables, you can’t help, but see why they would have edge. And that was a really important formative experience for me. And there’s no secret coincidence why ShawSpring, my firm here is structured the way it is. It left a real impression on me. I was one of the lucky ones I always knew I wanted to pick stocks. So, anytime that I was, anytime that I was at a conference room table with a manager, I was like, clamoring to ask that manager how do I get to your side of the table? How do I get to pick stocks?
Like I really enjoyed the manager selection and I really enjoy the asset allocator angle, but it was just the excitement around digging deep into public security and meeting with those managers and, and understanding those businesses and why this would make a good investment is just something I became really, really passionate about. So, while I was at Yale, when a manager had like a really great investment idea, I dug in and concluded in for me I really want to do this. So, I got the blessing of my bosses at the endowment and they let me interview with a bunch of their managers. And I was really lucky. I got into one of their hedge funds and it really was a special opportunity for me to really grow and learn. And that firm was this firm called matrix capital, which is a very well-known tiger cub hedge fund run by David Goel. And it was a really great experience. I learned a ton I was there for two years, but I was the only associate at the time. And there were like probably a handful of really senior MDs each with various different specialties. So, I had an opportunity to work with each one of them. So, I got to see a lot in a short amount of time. And in that time, I became the resident technology and internet expert. And I was put in touch with a mutual friend by a mutual friend to this guy called Brad Gerstner who founded a firm called Altimeter Capital, who, by the way, you should try to get him to interview with you. But we were put in touch, but we were put in touch by a mutual friend. He was training at a firm called par capital here in Boston. And I was training at matrix and we both had a passion for internet and technology, and we really hit it off. And, you know, Brad launched altimeter on November one of 2008. It was an absolutely horrific time to raise money, but an awesome time to invest in Brad approached me a couple of months after he launched.
He said, look Dennis, I’m looking for a young guy to come in, be my number two, help me scale up this firm. And I told Brad, look, I’ll help you scale up this firm when it’s time for me to do my own. I hope you’re there to back me up. So, I joined, it was early 09 and I just turned 25. And in my mind, like I was thinking that I always knew in my head, I wanted to start my own fund when I turned 30, but I joined this small startup hedge fund because I wanted to help Brad. because he seemed, he was a really great friend and a great mentor, and he continues to be a really great friend and a mentor of mine. And I just thought, this is a great opportunity. Now, you know, a $2 million launch, those are the chances that, that thing scales a $2 million launch. That’s a long tail probability. And So, in my mind, I thought I was going to be here for a couple of years. It was a horrible time, Right. We were in a financial crisis and I thought I was going to be there for a couple of years and start my fund. Well, actually right at right. A great business school application about what I learned as a hedge fund entrepreneur at altimeter, and then start my fund and, and go on my way. But I joined at 25 and I wake up I’m 30 and we had scaled this thing from 2 million to 400 million and it was time. And I was like, in my mind, I was like: “It’s time for me to do my own”. And you know, I took a barrel, a very atypical path to starting ShawSpring. because I’ll tell you when I looked at my background just where I come from and then my experiences, Right. Yale endowment matrix altimeter, I thought it was an interesting background, but I didn’t think that any institution was going to take me seriously. So, I thought about this as a mental model, Tilman. Seth Klarman, who is the founder of the illustrious from Baupost, you know, I remember that he went to Harvard business school and then got his MBA and then launched out of Harvard business school, raising money from three professors and started bowel post group. And in my mind that was, that was the path for me. I thought that I was going to join go to HBS. I applied to HBS. I got in and the thought process was I’m going to network with 900, really smart, driven, rich men and women, my classmates. And see if I can show them how smart I am about business investing: Maybe raise some money from some of my classmates and come out the other side with some sort of a fun like Seth Klarman did. So, that was the business model. But I went to HBS and I actually launched a small fund, like $5 million, mostly my own money and a handful of individuals, including my old bosses who were willing to give me some token support and I managed money and I went to HBS. I had a really great first year, but then the family investment office of a very well-known technology entrepreneur based here in Boston, his CIO reached out to me and was like what are you up to. And I said, well, I am going to do what, what Seth Klarman did. I am going to go to HBS, get my MBA and then come out, raising some money for my classmates and start a fund. A real fund. And the CIO basically said: “Well, why don’t we just help you?” And you know, it was like, it was kind of awesome because again, like just coming from where I came from, I just didn’t think that anybody would be willing to give me a shot. So, I thought about it. And it would mean that I dropped out of HBS. And the only problem with that was that it really offended my Korean sensibility to drop out of Harvard before finishing, well, probably more disappointing my mom. But it was like the right decision. I mean, this investor had known me for years, years. They had been invested in funds that I was working at. They were willing to take a shot and they invested.
We launched ShawSpring on July 15th, 2014. That is six years ago, six years ago in seven days now. And we launched with $11 million and that was kind of the beginning of this journey. So, six years later we are $700 million. And we have eight institutions, a bunch of university endowment funds charities, as well as some interesting entrepreneurial high net worth families. We will have a ninth institution on August, one, another university endowment. But it’s been quite some time. It has been a journey. So, that’s kind of where we are today. So, Tilman now I’m sitting here in front of you. I do not know how I deserve to get interviewed by you, but here we are.
What were hurdles for you to grow ShawSpring?
valueDACH: [00:16:50] I Think there is an interesting story to hear. And that’s the thing I’m doing. What were hurdles for you to find funding sources for ShawSpring and growing it?
Dennis Hong: [00:17:03] So, many things. Okay. So, the first thing that I sort of think about, right, when you launch an investment firm, there is really two optimization problems as me, the founder of investment firm. The first optimization problem is to try to gather as much AUM as possible assets under management as possible. Because that’s good for me. I get all the fees. The second…
valueDACH: [00:17:30] Mmmh… There is also a problem on the other side.
Dennis Hong: [00:17:34] The second optimization problem, Tilman, is that I have to generate returns, right. I have to generate returns to justify my existence as a business. Well, you know, it’s, it was pretty easy for me to sort of dispense with optimization problem number one. Because we have a fairly explicit strategy where we articulate that we’re going to put our investors capital into five, to 10 of our very best ideas. So, we, we run a very concentrated fund and that type of fund the tendency is for quite episodic, sometimes alarmingly volatile returns. So, it’s not right for everybody. So, I’ll tell you that.
valueDACH: [00:18:17] You have to like to just own five to 10 ideas and you the journey you are doing with them. Maybe you have to get the dog as an investor to stay calm.
Dennis Hong: [00:18:26] So, starting out I did what any other hedge fund entrepreneur or investment firm entrepreneur’s going to do. You try to sell. You try to show people what you’ve got and try to convince people to give you money. But that’s hard, Tilman. It’s super hard. A fund like ours is really hard to sell. It’s not right for everybody. So, I think that for me, optimization problem, one is kind of out. And I sort of made the bat that if we build the foundations and establish the foundations for building a thoughtful investment strategy and generate good returns for the investors that are willing to come along for the ride for us, then that should be the optimization problem.
So, for me, since we’ve launched, we made a quick decision that we need to really focus on optimization problem number two, which is to put in the elements in place to generate outstanding long-term returns. And so, like you know, whereas like when I first started, I may have had grander ambitions to have built a very large fund and try to gather as much AUM as possible. You know, we really, really just focused on building the very, very best strategy that we can and just focus on doing a good job for the investors that were willing to come with us on this journey. So, we haven’t grown very fast and I always articulate to our investors as well as any perspective investors: It’s been pretty consistent. We’ve attracted probably one, maybe two institutional investors. I think has been the right tempo. We let investors take their time to get to know us. So, one of our investors: It took them four years. They are a really terrific institution. That was a wish list investor for us. They came to visit us when we were tiny $11 million. I don’t know what they thought we would be, but they spent their time getting to know us, getting to know me as a human being. And I got to know them as human beings. And then four years later they said: “I think we’re ready to do this”.
And so, I think that for us, we keep it really simple, right. Like this is a multivariate problem that we call investing the investment business. There are variables that are under our control and there are variables that are outside of our control. And I really thought about in the beginning quickly that we need to think about the variables that we can control. Because ultimately if we think about those in a thoughtful way, we can reverse engineer our way to good return as well as building a really great partnership. So, that’s definitely something that we’ve always had kind of from the outset. So, that’s number one.
But number two: We’re a small team. So, here in Boston, we’ve got four people including myself I have a, an operating partner. His name is Paul. I have two guys, two young people, who helped me on the investment side. They’re not so young anymore. I mean, we live together for quite some time.
But I’ll tell you that: One of the things that we really need to focus on from day one: We need to maximize return on time and effort spent. So, this has implications for every aspect of this investment from business, but maybe just applicable for this discussion. How do we take a universe of 40 to 50,000 public companies and narrow that down to five to 10 businesses , that could generate hall of fame returns. How do we do that?
And I think that we had to invest a lot of time establishing those foundations upfront. We had to think about very carefully, just what’s going to be scale able, repeatable, replicable over time. And in the event that we’ve made a mistake – and I’ll tell you that our performance since we’ve launched has been pretty good. But you know, we’re goanna make mistakes, right. So, I tell our investors and I tell our prospective investors that I think two out of three of our stocks will probably have very good outcomes. One of the three will probably really stink and that’s okay. But in those instances where we haven’t quite gotten it, right, we need to be able to reverse engineer how he got to that decision. So, we learn from those mistakes.
So, right up front, you know, I have this young team and I have this preference for mentoring and teaching. I love mentoring or teaching. I think if I wasn’t do this doing this, I probably would be like a university professor or a teacher of some sort. And I’ll tell you that because I recruited my teammates out of college effectively. I’m their first job. So, we sort of had to start from first principles.
So, what are we trying to do here? We’re trying to compound capital. And to me, compounding is a very simple definition. So, Peter Kaufman, the CEO chairman of Glenair who helped Charlie Munger edit his book poor Charlie’s Almanack. He has this great definition, which I love: Compounding = constant, continuous, dogged improvement over very long-term timeframes.
That is what we’re trying to do. Find investments that are growing at constant continuous dogged improvement over very long-term timeframes, which then biases us towards businesses that are growing their intrinsic values. And the only way I understand how intrinsic value grows is: Because revenue, earnings and free cash flow are growing constantly. And improvements are done over very long-term timeframes, which indicates to me that there’s probably some sort of high-quality characteristic to what we’re looking for.
So, I told my team in the early years: “Just go on Google, find a mental model on Google: ‘How to find high quality company’”. Well, when you go to Google and you do that -“What is a high-quality company?” – you get all kinds of hits. You have some kind of “Porter’s five forces” and maybe they tell you, you got a find a barrier to entry or some kind of network effect. Or maybe some kind of pricing power or switching costs. But those are all abstractions. So, we had to invest some time upfront in our early years to really think through “How do we identify high quality quickly?”. Because again: Everything we do here as a small team is that we have to return have to maximize return on time and effort spent.
So, it really began with, for us defining a mental model for high quality. We spent a year. We wrote a four-part letter. Actually, I learned a new word through that process. That a four-part series is called a tetralogy. But we came up with this heuristic on high quality. We call it ecosystem control. Every single business exists in ecosystem of itself. Customers are the initial catalyst of cash flow into that ecosystem, because that business is providing a good or a service that customer wants. That cash flow passes through various different ecosystem constituents. They could be like the business partners and the suppliers. They could be the employees or could be the management team. They could be the investors. And what we find through case study after case study – after studying the very best companies or the highest quality companies – they exhibit this characteristic that we call ecosystem control.
We wrote a hundred pages on this. I know we only have very limited time together today. I invite your viewers to contact us and learn more if you’re interested. But I think really the only question that we really need to answer for ourselves, very simplistically again: Do the businesses ecosystem constituents love the business? So, the business I do invest in, the customers love the business. Also, the business partners and the suppliers love the business. We also ask: Do the employees love the business?
We came up with different metrics to measure these things quantitatively. And it’s been a very, it’s an elegant mental model. Because one of the most important things in this screening mechanism of 50,000 companies worldwide is the question: What shouldn’t you invest in? What’s a nonstarter?
So, if the answer to any of the ecosystem constituent questions of whether or not the ecosystem constituent loves the business is negative, it’s like thrown out as a nonstarter. It’s a nonstarter for us. But for the businesses where we think it could be true, then the hypothesis could be true that this business has ecosystem control. Therefore, the hypothesis could be true that this is high quality. It potentially becomes a candidate for us. So, over six years we developed a shopping list. It’s about 300 companies internally that we focus on. They are cross geographies. They are cross sectors. They are cross verticals. We think the hypothesis could be true that these businesses exhibit ecosystem control, but really, we kind of focus on this 300-stock universe.
It’s really kind of three areas that we focus on over time: We love the aggregation business. So, aggregation business: The most common euphemism for that is a marketplace or a digital network. And they’re really neat. Why? Because there is often a very elegant asset light manner in which these things scale. And once you have sort of a competitive advantage and being the very best marketplace of whatever you do, you often have a winner take most or winner take all type dynamic. You become a quite good business for very, very long time. In this area we find the base rates of success as an investment are quite high. They’ve been a really neat area for us to focus on. So, I carve up the world of marketplaces in two ways you can be a horizontal marketplace, or you can be a vertical marketplace. So, you think about like a horizontal marketplace as being like a general classifieds type business. Like Craigslist, that is an extraordinary business. That business probably crossed a billion dollars a couple of years ago. Is growing really fast. It is a business that started in 1996. They actually monetized two cities. They’re in hundreds of countries, hundreds of cities, but they monetize basically two cities: New York and San Francisco. There they charge like three to $10 for a real estate posting or a job posting. It’s a really neat business. And it’s still the defector place where people go to find roommates, apartments, cars and jobs. At one point it had like a nice dating classifieds area, but it’s a neat business. And we find examples of these all around the world. We actually just took a stake in one based in Japan. That’s like a really neat area to find ideas. And then there’s vertical marketplaces. Every horizontal marketplace, you can rip it apart: To different verticals. So, in property in this country, you have like Zillow and Trulia, Redfin, and the UK Rightmove. In France you have REA group and so on and so forth. In the automobile vertical you have True Car, Car Gurus, Cars.com and so on and so forth. In dating, you have Match.com, OkCupid, Tinder, Bumble, Hinge, and so on.
So, but the reality is: You just need to understand one mental model, right? The aggregation business has a mental model for marketplaces. You have created an enormous return on time and effort spent by just understanding one mental model. And you have suddenly a universe of opportunities across geographies, across verticals and so on and so forth. So, that’s one area where we specialize on.
The second area where we specialize in is: We love vertically integrated businesses. There’s certain elegance to vertical integration that I think is sometimes underappreciated by investors. So, you probably have a lot of investors who you might talk to Tilman that say, we only like asset like compounders, but we actually really loved capital intensity. We love operational complexity. We love really, really interesting businesses that have this vertical integrated component. And we have two examples of these in our portfolio. So, like jd.com is a vertically integrated ecommerce business in China. And Carvana is a vertically integrated transactional ecommerce business focused on used cars in the United States. They’re in totally different geographies. They’re in totally different sectors, but what’s common is that they’re both vertically integrated. They are vertically integrated in the sense that both of them are involved in the activity of directly procuring supply. So, it could be general merchandise for JD or like the actual used car for Carvana. They’re involved in warehousing those and preparing those things for sale. They’re involved in the logistics activities for those types of goods all the way to last mile delivery. So, it is actually coincidental that JD and Carvana hire “comparable men and women”, whose job is day in, day out to do the last mile delivery. Their delivery is vertically integrated. They hired the men and women whose job is, day in day out, to deliver, for Carvana, cars to people’s houses or general merchandise to people’s homes in China. And what’s neat is that when you think about the coronavirus shutdowns all around the world: Whereas the pure marketplace guys, who are very reliant on third party merchants and third party logistics companies to fulfill their customer promise, both JD and Carvana, we’re able to grow effectively unimpeded all the way through the crisis, which is a really, really neat concept.
But the thing is that they take a lot of time to build. They take a lot of money to build. They’re very, very difficult to build, but if you can make a lot of mistakes, but if you’ve figured this business model out and you’ve gotten a careful control over the entire value chain of that customer experience, you can be a very good business for a long time. Because it’s very hard to replicate. Then, Tilman, the third area that we find some neat ideas is this area that we call cognitive reference. Have you ever heard of that?
valueDACH: Nope. You have to explain it.
Dennis Hong: Yeah. First three more things, but I start with that. So, we didn’t come up with the term cognitive referral. Actually, it’s a term coined by a Harvard business school professor called Rory MacDonald. But it’s an area that we found very intriguing as an area where we found some pretty interesting investments. So, think about it in two ways: Product cognitive referral or a service cognitive referral product. Both are interesting. So, think about, if you go into a pharmacy and you say: “Excuse me, do you have any Kleenex?” Do you mean Kleenex? The brand name that is owned by Kimberly Clark. Or do you mean Kleenex? That is top of your mind and synonymous with the generic category of facial tissue?
Also, Ping pong ball. It’s the same thing, Right. Ping pong is actually a trademark that’s owned by a company, but to you, it’s synonymous with the generic category of table tennis balls. So, that’s a product cognitive for him, but I think that its service cognitive friends are even more interesting. Why? For the simple reason: They are harder to replicate than products, but services are often likely to have controlled distribution – often through a native app or a proprietary app. So, think about this. “I ubered it. I ubered it to the office today.” Or: “I’m going to go Airbnb”. As a cognitive front, it’s an ecosystem of hosts and travelers who are looking for each other to facilitate bookings and unique experiential alternative, often urban accommodations, booking.com and Expedia are good businesses, by the way. They kind of do the same thing, but I got to tell you, no one’s ever said: “Oh my God, Tilman, that Expedia was incredible.” “Or gosh those booking.com. They’re so great.” And most people sort of smile a little bit when you say those things, but it’s kind of true. Because it’s kind of natural to say:” “I’m going to go stay at an Airbnb or I’m going to go Airbnb it.” But no one ever says that about Expedia and Booking. And that has real implications actually on the unit economics.
So, cognitive franchises have two competitive advantages on that LTV over CAC equation. So, long term value, which is just how much cash flow comes in over the lifetime value of that customer over the cost of customer acquisition. So, if you have cognitive difference, you immediately have a huge competitive advantage on CAC (=cost of customer acquisition). Because you have immediate recall. And then on the LTV side, you have very high levels of customer retention because you have this cognitive difference. You almost are synonymous at that category and there’s nothing starker actually, then to just look at the businesses at face value like juxtaposing, Expedia and Booking to Airbnb. So, Expedia and booking – up until last year – we’re spending 9 billion on Google AdWords just to get people to go to their websites. Airbnb in comparison spends very little on Google. So, we try to look for cognitive referrals of all kinds.
I want to summarize my little talk again: We’re looking for 5 to 10 stocks and we can buy at a very high underwriting threshold. So, we’re looking for 30% IRR and here internally. We often say, we’re looking at a five-x over three to five years. We’re only looking to do this within our universe. Our shopping lists, where the starting hypothesis is that these businesses exhibit ecosystem control or they’re very high-quality businesses. Within these 300 stocks on our watchlist, I think there are three different mental models that we have specialized in. This are the marketplace business model, the vertically integrated business model and then the cognitive referral business model. All we’re looking to do is generate hall of fame returns on behalf of 15 to 20 partners. Full stop. We’re at nine partners today. We’re trying to boil down the number of variables in this multivariate problem. We call this the investment business. And that’s all we want to do.
How do you measure love for businesses, Dennis Hong?
valueDACH: [00:37:17] One question: how do you measure love and businesses? You said you have a certain framework to do that. How do you measure that? What are your variables for that?
Dennis Hong: [00:37:32] Yeah, So, there’s a lot of different ways you can do it. We do quite a bit of consumer research. And So, we look for evidence of just a universality of praise, but there’s other ways to do it. So, I’m sure you’re familiar with this concept of a NPS: Net promoter score. It’s a fairly easy quantitative way to measure how much a consumer loves a business. So, an NPS score is really a survey of like a sample of people. And I have a sample of 10 people. How many of those are willing to evangelize or recommend that product to a friend or family member or to somebody else versus the detractors who basically say avoid this business. And what we found is that the very, very best businesses exhibit very high levels of NPS. They have very high levels of net promoter scores, and that has real implications. Because if you have more word of mouth advertising or you have customers who are willing to evangelize for you, that’s an enormous competitive advantage on the CAC line again, right. Cost of customer acquisition, and then your loyalty is higher. So, then your retention is much higher. So, what we find out over time that this is one of the ways we can measure it quantitatively “Do the customers love the business?”. It is by measuring a high NPS score.
You can do that for employees, too. So, we have something called an eNPS. That is employee Net Promoter Score. What percentage of a random group of employees are willing to evangelize this company as a place that people want to work versus those that say, “Oh my God, stay away.” “Don’t ever work here.” And so, we’ve found little ways over time through pattern recognition, but also just finding ways to quantitatively measure and validate those patterns.
Do you also take the quality of management and to account for this?
valueDACH: [00:39:21] Do you also take the quality of management into account for this? How you experience the management, for instance?
Dennis Hong: [00:39:32] Yeah, it, I think that’s an important part of our process. So, you know, I started my investment career at the Yale endowment doing something very different. But in my mind, I actually find that there’s quite a lot of synergies between what I did at the Yale endowment – which is assess investment managers and their partnerships, the structure of their partnerships and their strategies, but also them as people. It’s really important, especially because we want to own these businesses for multi-year periods. So, we look for evidence of structures and incentives for how a manager wins. And if the manager wins: Do the shareholders win? When we first started the fund some years ago, we actually looked at some really big companies, like Visa and MasterCard. They are run by really good managers, but we consider them more professional managers. But over time, you know, our portfolio companies all changed to be run by owner operators. So, it was the entrepreneur that scaled up this business. They started the business and scaled this business and continue to run the business. But these entrepreneurs also have significant personal holdings of stock. That represent a very significant percentage of their net worth. So, Tilman for us, it is really important to be able to gauge the intentions of the management team, to public shareholders, and to really understand what the incentive schemes are. You know, there’s a saying: “Show me the incentives and I’ll show you the results.” I’m a really big believer in that. I think that’s a really, really important thing to be able to get right – considering just our intention to be long term multi-year shareholders of these businesses.
What Do you like about complexity in investing?
valueDACH: [00:41:21] That’s interesting to the audience. Thank you very much for the first question that came in. You can drop more questions for Dennis. And if you liked the interview, as I do, please hit the like button that’s a nice support. Thank you very much for this. I’m interested also on the thing you said about complexity. Maybe you can give more detail on what you look at here and how do you get a sense that it isn’t “creating mistakes in a complex environment” or “not getting things done”, but trying to figure things out that do work.
Dennis Hong: [00:42:32] So, we don’t look at everything. We’ve only really specialized really in three different mental model types over the last six years and vertical integration is one of them. So, when we look at a vertically integrated business, which is probably the most complex of all the business model types, I mean like a marketplace is pretty straightforward in relative terms, right. You build a nice website and you try to scale up liquidity on the different types of parties and try to attract and create a virtuous circle of value creation
valueDACH: [00:43:03] Which is complex as well.
Dennis Hong: [00:43:05] But vertical integration is tough, Like, think about, think about what Carvana promises. So, you come to our site. You can pick from 20,000 vehicles on our site from anywhere in the country. In comparison, if you go to a brick and mortar dealership, you’re limited by just the lot size and CarMax does this really well, but they probably only have like two to 300 cars that from you can choose from depending on whichever lot you go to. But in Carvana’s case, you go to the website, you can pick from 20,000 cars. And then on top of that, you’ll find a car that you really like. And it’s typically $1,000 to $2,000 cheaper than the brick and mortar competition. And then what they promise is that they’re going to help you finance it. They’ll warranty it. They will deliver this thing to your house. You can try it for seven days. If you love it, you keep it. If you don’t like it, – that happens occasionally about 5% to 7% of the time – you can return it. But 50% of those returns ends up in an exchange. They want a different model. They want a different color or any number of things. And that’s an exceedingly difficult proposition. If you think about it moving 20,000 cars around the country to be located where your customers are: That’s an insane amount of value chain control that you need to have to fulfill that customer promise. It’s easier said than done.
valueDACH: [00:44:40] You might lose a lot of money in some fields.
Dennis Hong: [00:44:43] but you know what. Carvana had a hack. So, you know, Carvana was born inside the fourth largest chain of physical car dealerships in this country drive time. So, in some sense, they had the benefit of already probably like $2 billion of physical plant infrastructure in the ground. So, if you think about it: If you and I wanted to create our own vertically integrated eCommerce business focused on used cars, probably putting two to $3 billion into the ground in the United States, it’s just table stakes. So, there has to be some sort of unique, competitive advantage. I will tell you that we don’t look for complexity just for complexity sake. I think the reality is: We’ve got nine stocks and we don’t turn over the portfolio very much. Actually. It’s been pretty consistent. We’ve only added maybe one or two ideas per year. The rest of the time, the vast majority of the time, I actually spend most of my time studying are already nine businesses in our portfolio. Because I think those are really terrific. The quality of those businesses is really great. We know the managers of those businesses. We’re familiar with those businesses. We’ve underwritten those businesses. So, anything getting into the book has to represent a higher quality and a higher return threshold than anything.
In our book, we run fully invested by the way. So, anything new has got to take away from something we already own. So, the bar is very high, but that means that our time is freed up here internally for looking at ideas with kind of above average levels of complexity. We don’t see complexity for complexity sake. I mean, I’ll tell you that I would kill to be a great biotech investor but nobody in my firm, certainly I don’t, have a scientific background. I don’t have a PhD. I don’t have an MD, but we can spend some time in Southeast Asia earlier and then most other institutional investors and do some legwork and develop a network, develop some relationships. And hopefully those networks and relationships do pay off over time. So, that’s what I kind of mean by collect complexity. We don’t seek out complexity for complexity sake. But when we do look at something like a vertical integrated business, we need to understand like: “Do they have a hack. Is there something unique about this business?” That’s going to give them a competitive advantage over anybody else. And otherwise it’s not obvious, but for those instances, Tilman that we prefer to wait.
You know what I mean: Like there’s some investors. They were looking at the $11 million ShawSpring. They thought maybe it could be interesting. Maybe it could be good, but if they’re good, there’s still going to be a good in five years from now. And that’s the same with us. So, if we can’t get our heads around on questions like “What is the unit level profitability of selling one unit of service or one good?” “Can they make money doing that?” “Is that replicable, repeatable and scalable over time?” Then we’re okay to wait until those are apparent. But if you can figure it out: We’re willing to go into the study of businesses with above average complexity levels.
How would you describe your relationship to cash?
valueDACH: [00:48:03] I’ve looked at your portfolio composition. I think the biggest thing that has changed is your size of the cash position. To put it in a picture: Cash became from a “friend of yours” to “a something you don’t want to have” – or how would you describe your relationship to cash?
Dennis Hong: [00:48:22] Cash represents for me a call option on future ideas, as well as our existing ideas in our book. So, every year the market sells off. No question. I like the average selloff in the market. If you look measure over, you know, 50 years, the average selloff in the market is probably about 13%, but even that two out of three years, you still have a market that’s positive and that’s a really neat feature. So, there’s always going to be opportunity to back up the truck and our existing book.
But when we started the fund, our original thought process was as follows. Cash is a call option on new and existing ideas. So, we should always have some cash around because in the moment that we have these peak distresses, like a March of 2020, we’re going to have the cash. But you know, one thing that we’ve sort of learned over time is that our partners, when the opportunities are really attractive, our partners really come through for us. We’re in close, active, productive dialogue all the time with our partners. So, everybody has access to me. I don’t have an IRR. I don’t have a marketing person. I am the IRR. So, I’m the PM. You know, if the results are bad, it’s on me and our investors deserve to have access to me. So, I wouldn’t have it any other way. And again, that’s why it doesn’t scale, Right. It’s not a scalable strategy.
We might have bandwidth for 15 to 20 full stops in this current iteration, but that’s what we’re happy to do. So, our relationship to cash has changed over time for the simple reason that we’ve just had a nice relationship with our partners, knowing that the balance sheet on our partners or the cash on our partner’s balance sheet, we could access when the opportunity becomes really attractive. And low and behold, like in March of 2020, I didn’t have anybody panic. I didn’t have anyone withdraw. Actually, we had our partners lean in and that think about that, what a competitive advantage. Right. We don’t have, we didn’t run for it with very much cash. So, like we spent whatever cash we had. And then we said to our partners, this is a really attractive time to come in.
The other thing is just a quantitative exercise. So, Cliff Sosin and I chatted about this, think about this thought experiment: You and me, we have the chance to buy a business for a million dollars. Okay. We can buy that today. And we can earn 250,000 in cash earnings today. Okay. Let’s say that in a recession, we can buy that business for 30% off. So, if you can buy that 1 million dollars business for $700,000 in a recession. But let’s say like a recession, what statistically happens once every 10 years. What if we get to year nine and there hasn’t been a real recession until year nine, we’ve basically given up earning millions of dollars of cash earnings just to save 300,000 bucks. So, the arithmetic doesn’t really make a lot of sense. And I sort a thought like in my head that, you know, having cash on our balance sheet, that’s like kind of market timing and that’s not what we’re hired to do. We’re hired to put our investors capital in what we believe to be the 5 to 10 very best ideas that we internally have researched, and that we’re willing to put our own money into.
I have all my money in this thing. I don’t have any other money. So, I’m very, very happy essentially this being my PA that I think for us really just dawned on us over the years. So, it’s a factor of that. We’ve had six years with the same partners and they’ve always responded in the way that we expected them to respond. And then just the mathematics of waiting around for a recession to save 30%, especially for businesses that are growing and generating good cash earnings, just hasn’t made a lot of sense for us.
Have you found characteristics in the losers which have caused you to adjust your larger selection framework?
valueDACH: [00:52:24] And you have to get the nine ideas, right. You were invested in things, that should have worked out well. And on that I want to ask a question, coming from Justin, on your expected 2/3 hit rate. Have you found characteristics in the losers which have caused you to adjust your larger selection framework?
Dennis Hong: [00:52:45] That’s a really good question. So, I’ll tell you that it’s been some time since where we had truly in a sprint that hasn’t worked out. And the last time that we had made a mistake was we bought this physician in TripAdvisor years ago and we thought, that there’s a real chance with this instant book initiative, that they were going to try to take some of their traffic. And it Trip Advisor’s a fantastic property. It’s the place where people go to read about hotels and restaurants and experiences and so on and so forth. Great, great, great little digital media business. And we thought there was a reasonable chance. They could maybe convert some of that traffic, not to leads to other OTAs like Expedia and Booking.com but keep solve some of that leakage and keep it internally.
We thought they could do that, but we totally overestimated the capabilities of this management team to build that type of a marketplace because it’s really hard. If you think about it: You have to scale up a marketplace with millions of alternative accommodations in all the major cities of the world. That’s an enormous effort. It’s a human capital-intensive effort. Expedia and Booking.com have thousands of people boots on the ground, whose job is day in, day out to go knock on hotel doors and say, excuse me, can you join our marketplace. And it was a not necessarily an investment that TripAdvisor was willing to make
It was an earlier investment for us. And that’s also kind of why we developed some of these mental models and frameworks on “How does a great vertical marketplace get constructed?”. “How does a great horizontal marketplace get constructed?” “What’s common?” And maybe we would have avoided that mistake on Trip Advisor. But there’s going to be a couple of reasons why a business exits the book. One is: We’ve just start dead wrong. At TripAdvisor we were dead wrong and the thesis. They didn’t become an OTA.
And number two is: Some of our businesses age out. So, the most recent business that we departed ways with was Tencent. Tencent is an extraordinary business. We’ve owned that for some time. And the outcome was fine. But at $500 billion of enterprise value, it’s just going to be really, really hard for them to generate outstanding returns. And for us, again, we have this bar: We want to try to analyze our investors capital 30%. Well, let’s just say that Tencent creates a hundred billion in incremental enterprise value. This year. That’s a 20% gross return on that Tencent position. Let’s say if they are being a hundred billion of venture creation, every single year. You’ve run into kind of the base rate effects that this business is so large, that you just have a linear decay in the growth. Sometimes like our businesses we’ll just age out.
I kind of analogize it to some of the investors that I really, really admire. I really admire Chris Hohn at TCI. But he’s managing like $40 billion. And for him to generate a 20% gross return – and he’s been extremely successful doing this – he needs to find 8 billion incremental, gross profits. And there’s only so many ways that you can do that. But you know, for me, I’m 700 million bucks. I need to find a $140 million of value creation to generate a 20% gross return. And there’s so many different ways I can do that. So, we don’t necessarily have to limit ourselves to the largest companies. We´re constantly maybe seeding the portfolio every year with one or two ideas that we hope will drive the portfolio’s return going forward. But I’ll tell you something: We’ve made a lot of mistakes along the way. I am a lot of like errors of omission or errors of commission that we didn’t invest in. Right. Like we’ll study something for some time. And the thing that we have to do here at the firm – again with just very few people – we need a fail fast. We’ve got to maximize return on time and effort spent. And that’s why we invested in these frameworks and these mental models just to help us like fail fast So, that we make fewer of these errors of commission. Now we’ll always make well we make them, I mean, just over time where it is absolutely clear you very best investors, like have 51% hit rate. I’m aspiring to a little higher than that. But again, like we’re trying to allocate all of her efforts to one or two really great ideas a year but that’s kind of. I think how I think about it where we’re at today,
How do you decide when to sell or trim a position?
valueDACH: [00:57:10] There’s a question coming from Hendrik. “How do you decide when to sell or trim a position?“ You answered it partly, but maybe it’s there another aspect on that?
Dennis Hong: [00:57:21] Yeah, it’s a good question. If we are wrong: It’s out. We are just out. We are quite KPI focused. So, we have key performance indicators for each of our businesses, and we’ve been fortunate as we scaled up, we’ve been able to bring on and retain a data science service. So, we have this external data science service that gives us some indication of what’s going on in our businesses on a weekly, monthly, quarterly basis. So, it allows us to kind of stay on top of the businesses and make sure that they’re tracking according to the KPIs we set out for them.
I mean, I’m long term, but long term is the summation of a lot of short-term accountabilities. So, I think that if we are going to represent that a business is going to grow 30% annualized for five years, clearly there has to be, markers along the way that show that we’re going to achieve that. I mean if we underwrite something and we think it’s going to grow 30% annualized. But then suddenly we go to like 0% growth or minus 5% growth and we’re just totally dead wrong So, we have to find ways to course correct in that circumstance, but then trimming and adding. I mean, that’s been a real process, too. I do want, I think this is worth an in-depth discussion, because we’ve learned a lot about portfolio construction along the way. It’s like probably one of the hardest things that we do. So, let me, let me tell you about what we do and it’s still going to be an evolving process for us. When I, the firm, I interviewed quite a few portfolio managers and peers of what I and also our institutional partners, I asked them like: “How do you construct the portfolio?” “Why do you size like a position like X” To an allocator I’ll ask, “Why do you size a manager in this way?” And it’s hard. It’s really hard. The conclusion I drew is that I think a lot of people use gut instinct, and I think we did too. Like we found ourselves doing it in the early years: We were investing in like very high-quality businesses, like Visa. And I feel more comfortable putting on like a 15% position in Visa, but I feel a little bit like “eeek”. I’m investing in like a position like JustEat, which is going to generate probably a far more superior return than visa, because this is a large company. And again, the base effects are going to run in, are going to catch up with that business and JustEat has just like really long runway ahead of it to continue to grow super normal growth. But why am I more comfortable putting visa as like as a larger size and JustEat as a smaller size? Well, here’s the reality. So, most people, I think, do it by gut instinct. And what they’re really probably doing is that they’re trying to minimize personal stress and not necessarily maximize return. So, internally here we spent some time really thinking through a portfolio construction framework, because what I found with my teammates, we were spending a lot of time in our investor meetings, investment meetings, discussing like: “Well, you know, Visa probably should be like 15%. Tencent should be like 15%. Cause you know, like they just feel safe and they’re going to generate good returns.” We had to hack, why do we feel that way. And we could save ourselves a lot of time by just really understanding, why we do what we do. Why are we so reluctant, when rationally we’re looking at some businesses, that are going to be much higher return than other businesses. So, we came up with a framework where every single one of our businesses, when we underwrite a three to five year return, a return outlook, or a three to five year IRR for portfolio construction purposes, we realize not all IRR are created equally. What I mean by that: Some businesses are more predictable than others. Some business models are easier to execute than others and some businesses, if they’re based in China or India or Southeast Asia, well, sometimes those can be pretty basket case economies. If we’re going to invest overseas: We have to be paid.
So, for each of our explicit IRRs, that we underwrite – we adjust them for portfolio construction purposes across three dimensions. So, we think about the predictability of those cash flows. I’ll give you an example. So, if we were to invest in a software SAS business, that is a predictable business: So, say like you have a customer is willing to pay you $120 upfront for a year’s worth of service every single month. You recognize $10 of revenue. Very simple, very predictable. So, at a score of one at a 10, like that’ll rank very, very highly right. But selling, like a used car, that’s pretty unpredictable. And it’s really hard to know when somebody is going to be buying a car. So, that will maybe rank lower on a score of one to 10. That’s again, the predictability of the business.
The second dimension is just the ease of execution: A vertically integrated business. It’s just going to be much harder to pull off than a business that maybe like is a food delivery app. So, we’ll rank order, just a business against like the dimension of just the ease of execution and how easy is this business to pull off.
And then the third area is just this catch on macro. We’re here in the United States, US dollars are home currency. We’re familiar with the rule of law here. If we’re going to invest in Southeast Asia, if we’re going to invest in India or China, we need to be paid. So, on a score of one to 10, there’s a framework that we measure all of IRRs against. And then we have this adjusted IRR. And then we put this into a simple portfolio optimization model that we created internally. We usually star with a 10% position. And our rationale on that is that if you’re not willing to put 10% of our firm’s capital into the position, you haven’t done enough work on the position. You don’t have enough conviction or it’s not cheap enough. So, it’s 10% position or generally no position. And then we cap it out to about 20% at cost. So, it’s all dependent on just how attractive the business is from an IRR and addressed at IRR angle. This is again, just a straightforward, quantitative exercise where I don’t have to say: “I feel safer making visa a larger position than Carvana, larger position.” Well, now we actually have a quantitative framework where we can talk about in a fairly systematic way, why we would size from something a certain way.
Now, the other question that they asked was about trimming. Well, some businesses will do very well and become very large percentage of your portfolio. Generally speaking, we are fairly realistic about the revenue earnings and free cash flow trajectory of our businesses. So, if the stock really, really runs ahead with no commensurate increases intrinsic value: No surprising increases intrinsic value, we’ll trim it back. And that’s what our portfolio construction model will dictate for us to do. It’s just common sense. A stock that goes up a lot is much riskier than a stock that goes down. So, like a hundred dollars stock, you can lose a hundred dollars, a $5 stock. You wouldn’t lose $5. So, for us, like we take a fairly pragmatic approach to portfolio construction because we’re trying to maximize return on time and effort spent. So, instead of like talking about kind of the abstractions of why something should be sized in a certain way, we actually have some quantitative measures that actually help direct the conversation. I think in a more productive manner, especially for portfolio construction.
The risk of over optimizing
valueDACH: [01:05:01] But isn’t that a risk of over optimizing?
Dennis Hong: [01:05:04] Of course.
valueDACH: [01:05:05] Just focusing on optimizing things, because you “have to do so”.
Dennis Hong: [01:05:10] Of course but you know what really helps us with the outlier positions. So, for example, right, So, we’ve owned Sea Limited for quite some time. And that business has twice hit close to 30% of our portfolio. We sized that at 20 %because we thought it was like a really exceptional idea, but every single time it went up, the portfolio IRR or the position level IRR deteriorated, and we were not necessarily willing to hold like such an outsized position in something where we didn’t see commensurate increase in intrinsic value. Now, if like Sea Limited was outperforming beyond our expectations, we may have more comfort in holding such an outsized business and shouldn’t have a reluctance to trim. But without a commensurate increase in intrinsic value and expectations blown out of the water it behooves of us from a risk manager angle to size. But you’re absolutely right. We’re not trying to over optimize, but it’s really to like to create some guardrails as well as just a framework for us to have more intelligent discussions, more productive discussions. And then simply like: “Well, I feel safer with visa being 15%”. It also avoids these types of situations where one of our stocks has done really, really well. And we feel really compelled. Just sometimes human’s natural inclination is to like to continue to ride your winners. And, but then a stock again that goes up is inherently riskier. So, we generally try to shy away from that. And if we have sort of a framework that is like rational and quantitative, it gives us some baseline for us to make those portfolio allocation decisions,
valueDACH: [01:06:54] It may remind us, that some feelings aren’t productive in a certain way, for instance, fear.
Dennis Hong: [01:06:59] That’s right.
Have you found something Chinese equivalent of Carvana?
valueDACH: [01:07:01] There are some questions from the audience coming in and I’m also happy about more likes because we only got six. So, please hit the like button. There is also Sebids asking a question about Chinese equivalent of Carvana. Have you found something?
Dennis Hong: [01:07:25] My friend Steven, who’s a very talented investor focusing on trying to stock’s based in Toronto. He claims that there’s a really great business in, in mainland China in the lower tier cities focus on luxury cars. It’s actually a very traditional dealership, brick and mortar dealership. It’s called China Meidong. We’re still doing our work on it.
The founder is an MIT educated engineer, and he’s really neat. He writes these really great letters and you can actually just go to the website and download the letters. And I have to tell you that I thought Carvana was really good, but this Meidong is pretty exceptional. And I had liked the engineering mindset that this founder has brought to this business. He still owns like 60%. He and his family owned like 60% of the stock. It’s not a big company but we have not invested in it. So, that’s the caveat and I’m not making any recommendation to invest in it.
But I think, I think that there’s a possibility, you know, the thing about China, which is really interesting is that there are many traditional businesses, that are compounder businesses, that are growing very fast. Just the baseline growth is like 20 to 30% annualized. What is powering that is just a structural consumption update. So, Chinese consumers are getting richer every single year and they’re desirous of packaged goods and professional goods and less informal type goods, but more like branded goods and luxury items and so on and so forth. So, in some sense, like in mainland China, and I think that it’s kind of be an area that I think we’ve focused continuously our efforts and finding some of these really outstanding franchises: you don’t necessarily have to look at like the technology companies to find some really terrific returns. If you think of the equivalent of like Nestlé in China or the equivalent of some of these like branded CPG companies, that many, many investors like in the developed world, some of these like fairly traditional businesses are generating the kind of growth rates, that will meet our hurdle rate.
Which of your businesses is the most shorted on the market?
valueDACH: [01:09:48] Interesting. That’s another question from Franz. Best wishes to Austria, France. Nice to have you on! Which one of your businesses is the most shorted on the market and what makes you comfortable owning it?
Dennis Hong: [01:10:10] It’s not pretty.
valueDACH: [01:10:11] i like the question.
Dennis Hong: [01:10:12] Yeah, that’s a great question. I mean, So, the hallmarks of a ShawSpring investment are:
- ecosystem control or high quality,
- 30% IRR, and there’s often some kind of mystery and that mystery can come in a couple of different ways.
So, sometimes when you look at a company at face value, it’ll look like an absolute disaster. And that was very true with several of our businesses, like most notable Carvana, Right. When we looked at this, like a couple of years ago, we looked at the income statement. I thought, gosh, this is a short and I’m absolutely certain, this is a short. It’s a car vending machine company. It’s like garbage. And at that time, I was looking at the financial statements and I was like, “Good God, this is a cash burning, dumpster fire”.
valueDACH: [01:11:01] We Germans say “Bumsbude”.
Dennis Hong: [01:11:06] So, what I like about our businesses is that sometimes there’s some kind of mystery and the unit economics are not necessarily apparent from looking at the financials at face value. So, there’s a bit of digging that’s involved. So, that’s one form of mystery.
And then another form of mystery is like, there’s often kind of like this hidden asset. So, when we invested in IAC in 2016 – four years ago – we were investing in this holding company of Barry Diller’s holding company. We were investing in a holding company for their stake in match group, which is the holding company for all the major dating franchises all around the world. And then within inside Match Group, we were really investing for Tinder. And that time Tinder we were assessing the financials is that a $50 million revenue run rate, not making any money. We thought reasonably that this could scale to maybe like three, four hundred million dollars and become profitable over like three or four years. Boy, were we wrong! So, that business did like over a billion in revenues, like 70% gross margins, probably like 50% to 60% operating margins if they weren’t investing is extraordinary franchise and still growing really fast.
I think that for us, a classic ShawSpring investment is one where we can really assess ascertain ecosystem control or high-quality characteristics at 30% IRR. There’s often some kind of a mystery, Oh, the other form of mystery is: Sometimes there’s like a larger player that seemingly is threatening this franchise. For example, Just Eat: So, years ago we invested in Just Eat. At that time, we took advantage of a dislocation because there’s all kinds of narratives. Like Amazon was entering the market and Uber was going to destroy them. And delivery was like destroying them. But you know with a lot of real franchises, really terrific franchises, especially like the marketplace type, when you have kind of that first mover advantage and you’ve established yourself as a dominant marketplace, you can be a good business for a very, very long time. And it’s very common that the narrative that you’re going to get Amazon, it doesn’t necessarily hold a lot of truth. I mean, I’m going to say something really controversial: I don’t even know if Amazon’s really that good at e-commerce. I think what they’ve built, is pretty exceptional in the United States. But within that context, maybe what Amazon has been able to do in the United States is so notable, because all the competitors are so weak. Who is their competitor? That’s except Walmart. So, if you think about it.
Is the Chinese internet space more competitive?
valueDACH: [01:13:47] The Chinese internet space is more competitive in this matter.
Dennis Hong: [01:13:50] Oh, absolutely. Absolutely. Amazon was a very dominant company in the early years of trying to Chinese internet. They, I think had a third of the market at one point now they barely even register, not even 1% market share. So, and then even in Southeast Asia, you know, they’ve had some fits and starts in Southeast Asia, but you don’t really hear about Amazon as like a heavyweight in Southeast Asia. Maybe India is interesting or could be interesting. But I’ll tell you that, “when a big guy and a big player is entering a market that impacts our business” – oftentimes those narratives are overstated. And it’s it behooves us to pay attention when, especially for a new idea that we might be looking at, if like “a big player” entering the space, it may behoove us to pay attention because their ability to come in and really disrupt the leader, the category leader. I mean, Facebook Dating, same thing a couple of years ago: There was like this narrative that Facebook was going to take 2 billion users, mine, all their information, and to make the perfect matches for people. And that makes sense. They have all the data, but nobody wants to date on Facebook. It’s a little bit creepy. So, you know, that time when Facebook made that announcement and dating, Match stock went down. That was not a great day for us. But when we really thought about it and really underwrote: “Can Facebook really make an impact and disrupt, what Tinder has built?” It was kind of a long tail probability for Facebook dating to be successful, if when you really, just thought about the attributes that make a really terrific dating platform. So, I hope that’s helpful.
How do you discount political risks?
ValueDACH: [01:15:39] I think so. otherwise France can ask another question.
I think it’s also about incentives, because at a smaller company, you have high incentives to grow, and it’s also the careers of the people in the company are more affected by this compared to employees at Facebook, who have only impact on a smaller part of a big business.
I have one question on how you discount political risks. I think it’s attached to the idea of getting paid for investing outside the US.
Dennis Hong: [01:16:22] That’s such an interesting question. So, I’m not sure, like what context. In a US context or the Trump administration or are we talking about like the Chinese communist party and China. Well, I have a couple of reflections on this. China is a remarkable place to be an investor because in some sense, yes, it is a very closed ecosystem, but within that ecosystem, there is an incredible capitalist dynamism. If you think about it, you know, Jeff Bezos has this concept of “It being day one at Amazon”. So, I talked to the first day at Amazon. Amazon’s day one. And the excitement and the fears and the paranoia that other guys will come in and try to take your business.
It’s like day one every day for everybody in China, you have to be paranoid. You have to be a hustler, right. it’s been remarkable. Just, I’ve been like looking at Chinese stocks since like 2005. So, it’s been like 15 years and it’s a remarkable place to invest when you think about it. It can be like one of the most entrepreneurial, one of the most like, um, dynamic places to invest, because like, if you have a good idea, chances are good that 50 other entrepreneurs have the same idea. And I’ve raised hundreds of millions of dollars, if not billions of dollars to chase after the idea. But in that context, if you out hustle at work and then you create a business and by the way, the margins get competed away so quickly.
I mean, it’s funny, like one of my friends who is an avid investor in China basically tells me that when an entrepreneur tells you that something’s going to happen in the long term, what do you think Tilman like long term means to you. What’s the time span 10 years when an entrepreneur tells you long term, it means like 18 months. So, if he or she hasn’t figured it out in 18 months, they failed. So, there’s often quite a very fast validation of an investment or a business strategy in China. But I want to just answer the question directly. And I’m going to answer it like a little bit more of an out of the box way. So, you know, a lot of investors ask me, aren’t you worried that the communist party is going to screw up Tencent or Alibaba or JD. But, you know, it’s been like probably over 20 years since 10 cent, which was one of the first companies to go public and they’ve had 20 years and they’ve had like relatively little interference in Tencent’s affairs since that time. That seems to be a pretty good track record of non-intervention. So, sometimes the question I have is that, should I worry about, be worried about the communist party messing up Tencent and Alibaba, or should I be more worried about the European union breaking apart, Amazon, Netflix, Amazon, Facebook, and Google. And it’s really hard to say it’s really, really hard to say. So, I think that for us, like, I absolutely think that if we’re going to invest overseas, especially in an emerging market country where it’s not our home currency, not our home rule of law, not our system, we have to be paid. So, a 30% IRR is typically the bar for inclusion into the portfolio here in the United States, for anything we’re looking at here in the US or maybe even Europe, it’s about 30%. But if we’re going to invest in like Latin America, Southeast Asia, China, that IRR has got to be materially north at 30%. Because when we do the adjustment factor for portfolio construction, that explicit IRR, the unadjusted IRR, it gets adjusted quite a bit downwards just given the quality score that we put on the macro front against that IRR. So, I hope that’s helpful and answers the question.
How Corona virus infected your businesses
ValueDACH: [01:20:18] I think so. We are in 2020 in this is a kind of wild year. And I’m curious what comes in the next months. There is still some time for this year left. So, we have to be patient. Do you already have indications how this year and the coronavirus affected the businesses you’re owning? What can tell us about that?
Dennis Hong: [01:20:42] It’s been an amazing year from analyzing in that angle. It’s pretty a pretty unprecedented year. So, what you had basically over the first part of this year is effectively governments all around the world, declaring eminent domain over their own economies. Basically, you had like one of the largest demand shocks you’ve ever had in history, Right. Economic history.
ValueDACH: [01:21:08] And the economy is also shutting down freely because people have stayed at home and it was only government.
Dennis Hong: [01:21:21] It’s pretty amazing. Isn’t it never seen anything like that? So, I will tell you that it’s been a remarkable year, but like the thing is that many of our businesses are quite interesting, because they often are sort of the epicenter of disruption anyways. So, whether it be e-commerce is the disruption of traditional brick and mortar retail, whether it be digital payments or that this disruption of cash payments and other traditional forms of money transfer, or even mobile games, right. Competing for consumer attention from physical world activities to virtual world activities. So, in some sense, like when I look across our portfolio, we had this like portfolio largely of mobile gaming, eCommerce, and digital payments. Almost the, kind of like the very interesting pandemic portfolio. I’ll tell you though, when everything sold off in March, none of our stocks were immune. We had a very, very tough March. One of the worst, worst 31 days of performance in the history of our partnerships in six years. But you know what though: When you look at the businesses, putting the stock price side, if the businesses are intact – we really thought about three different ways. Like we assessed our business across three different dimensions. So, we had a portfolio of eight stocks. We assessed each of our businesses across three dimensions. We were in touch with each of our managers. So, that’s the benefit of, forming long term relationships with our portfolio companies. You get to know their managers and they give you access. And we spent a lot of time with our LPs, our limited partners. And for me, I thought about just from an investment angle, the world in three ways for each of our positions, it gave us an opportunity really, to reeducate and reassess and. Ask “Are these the companies that we really want to continue to hold?” Because you have this unique opportunity to course correct if you want. And so, we assessed like our business across three ways. So, one the most obvious thing, we’re fiduciaries for our partners. We want to avoid permanent capital impairments. And I think about the world that I think about this term, permanent capital impairment, very simplistically: “Is the stock worth zero?” So, in an era or in a time period where there’s an extended one year, 18 months, two years of zero revenues: “Does this business have the liquidity and the balance sheet to make it to the other side and have the equity still be intact, be worth something?” And with each of our businesses, that was true. And so, then the next level is we have these long-term theses. We have this thesis that this is very high quality. And its capital a PI capitalizing on a certain opportunity e-commerce in Southeast Asia or selling used cars in the United States, in a digital format or online dating and so on and so forth is that long term thesis intact. We can accept that revenues and earnings and free cash flow might go down this year. It might go negative. But if we come to the other side: “Is that the system intact?” “Are we still going to be a very dominant business capitalizing upon what we wrote as the long-term thesis for our business and the third area?” I think for us, like, which I think is probably really, really important, particularly in the context of we have a rare chance to really make adjustment to the portfolio and take anything out and put something else in that meets this criteria.
And these final criteria are: “I don’t want our businesses just to survive. I want our businesses to be improved and I want our business to be even more competitively advantaged than when they came into this crisis”. And there’s this great quote by Andy Grove that I love. I’m going to just paraphrase it because I don’t have the exact quote, but it’s like: “Bad companies are destroyed by crisis. Good companies survive them. Great companies are improved by them.” We have an opportunity to buy anything in the world.
We don’t have to be married to anything that we own at that time period. So, every single position, why not like add this additional selection criteria of having a business that is going to not only survive, but thrive and actually become more advantageous, it be more competitive advantage coming out of this crisis. So, I don’t want our businesses. I don’t want our managers to say like look we’re going to cut costs. We’re going to trim down our expenses. We’re going to shut off investing. We’re going to lay people off until we get a handle on this. I don’t want any of that. What I want to hear is we’re going to continue to push ahead with investing. We are really excited because this is an exceptional time where our business model shines. We’re going to invest more, to do more for our customers to take care of our customers better. It’s those types of businesses that I wanted to partner with. And I think that that’s what made this period really, really unique.
We don’t often get sell offs like this, right. Probably like once every 10 years, like a massive sell off like this. And then at that time period, like, it’s really just a chance to like to reassess and reeducate and take advantage of the fact that everything’s down. And you now have a chance to really like kind of buy anything that you want and why not buy those companies where everything’s down by those companies that are going to take advantage of this crisis become better businesses coming out of it than they were coming into it.
ValueDACH: [01:27:26] Thank you. I’m a bit sorry, because we are hitting the 90 minutes hurdle now and we’re still having some questions, but I think we should stop at this point and maybe have the chance to have you back on in a few months or something like this. Or if people want to reach out to you, they are happy to do so.
Dennis Hong: [01:27:26] Yeah, it would be my pleasure. I always love connecting with really interesting people. I you know, I am a big believer in the adage. So, Biema has this adage: “Network intensely”. This business requires a lot of luck and there is no better way to maximize your luck than to know as many people as possible. So, I love connecting with investors. I love connecting with businesspeople. So, if there’s something here that really resonates and you want to get in touch, I’d love to hear from you.
What was your favorite chart in 2020?
ValueDACH: [01:28:12] You’re also on Twitter. DennisHong17 I think it is. That’s a great option to follow up. Thank you very much for the talk. Let us finish with one question: You like to post charts, a lot of charts. What was your favorite chart for 2020? Do we have one? Maybe you have to re tweet it on Twitter, then people can find it there.
Dennis Hong: [01:28:41] Hey Tillman Do you have screen share capability.
ValueDACH: [01:28:45] I can I think you can do it in a second. Yeah.
Dennis Hong: [01:28:53] This chart, you see it.
ValueDACH: [01:28:55] Yeah.
Dennis Hong: [01:28:57] This chart was so neat. So, we created this chart internally just to make the point that within this crisis where all the economic shutdowns kind of happen. And what was really neat about this. It took 10 years in us to get e-commerce penetration from about five and a half percent to the double digits. But then in the course of eight weeks, through that shut down, you basically had 10 years’ worth of penetration happened within eight weeks. And it was like such a powerful illustration. We created this chart internally and got a little bit of notoriety it was one of those trusts that kind of went viral any even I think the Shopify guys actually even noted it, which was kind of cool.
ValueDACH: [01:29:44] Cool.
Dennis Hong: [01:29:45] But I think what’s cool about this is a lot of people kind of talk about how all these like digital stocks, all these e-commerce stocks have really gone up a lot over the last couple of months. And if it’s true that we’re entered a new paradigm. And there’s actually clinical psychology. Clinical psychology theorizes that eight weeks of habitual usage, ingrains a habit. And if it’s true and you know, many of these economies have been shut down for like eight weeks. And if it’s, if that’s true, then the trends that we’ve seen kind of accelerate could have some persistency, which means that everything that you thought was going to happen in the out years – in the modeling – has suddenly been accelerated the presence. So, in some sense, like there’s a real chance that the free cash flows and the earnings and the revenues you thought you were goanna earn three, four, five years from now actually kind of brought forward into the present. Which is why it’s not surprising to me that some of these stocks, these e-commerce stocks, these digital disruptors, these stocks have gone up a lot. And in fact, it could end up being that if we’ve entered a new paradigm shift that these businesses could continue to be quite attractively priced from here on out.
ValueDACH: [01:31:04] Is it an interesting to watch because there’s also the question of things go back to a lower level, but we will see.
Dennis Hong: [01:31:12] Yeah, no, it’s definitely interesting, yeah.
ValueDACH: [01:31:25] Thank you very much. it would be great if you stay on for a second and to all the others: Thank you very much for joining us. If you liked the content, please leave like a comment, or subscribe to my channel. Thank you very much. Thank you very much Dennis.
Dennis Hong: [01:31:44] Thank you Tilman. It’s great to be here and I appreciate you making the time for me.
ValueDACH: [01:3148] Thank you.
Dennis Hong: [01:31:49] Bye.