Here you can find a transcript of my interview with Dennis Hong and Fred Liu. I already interviewed them in two different interviews. Here you can find the interview with Dennis and here the interview with Fred.
Here you can find the transcript of the video:
Table of contents
- 2Their single biggest challenge of Dennis Hong & Fred Liu
- 3Fred Liu's and Dennis Hong's friendship
- 4Where are they different?
- 5Investors they admire
- 6What other business they would start
- 7Books they like and recommend
- 8Cash in Dennis Hong's and Fred Liu's portfolio
- 9The current strenght of internet businesses
- 10Riding rockets like Sea Limited
- 11Evaluating management
- 12Dennis Hong on Square & Sea
- 13Square & JP Morgan
- 14Sea’s gaming arm
- 15Fair multiples for company
- 16What they might do after investing
- 17A message to young investors
[00:00] Tilman Versch: Hello, everyone. We are happy to have you back on Good Investing Talks. Today I am having Fred and Dennis. We had a great conversation with each of you. But together, it is even more fun. Great to have you here, guys.
[00:18] Fred Liu: Thank you, Tilman.
[00:19] Dennis Hong: Thank you, Tilman. It is great to be back. Thank you for having me.
[00:20] Tilman Versch: And also hello to the audience. It is great to have you on, I already collected a lot of questions to both of you. So, I am happy to ask them during our live stream and also add some questions I thought about in. Let me start with the question that might make you think for a second or two. What is currently your single biggest challenge? Before you answer that, I give you some time to think about it. Because I also want to introduce our sponsor for today.
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And as always, I want to show you at this point, the disclaimer. You find it also linked below. The main message is do your own research. This is no advice and no recommendation. Always do your own research. So, guys, I am happy to get back to my challenging question. What is the answer on that?
Their single biggest challenge of Dennis Hong & Fred Liu
[04:31] Fred Liu: Sure. Oh, I go first and give Dennis some time to assess it. Yes, I think the biggest challenge for me and something I have been thinking about a lot, especially this year is: Scaling the firm and how we keep the culture. How I find the right because we talked last time, right? And I said I am always looking for these hunters, who can help us.
[02:54] Tilman Versch: I like to picture of a of a hunter. Yeah, it is cool.
[03:00] Fred Liu: Yeah, so that is always something I am looking for. And that is hard to find, right? It is hard to build relationships and because of a lot of our processes around, you know, having coffee with people finding information, getting it out of their heads. How do we scale that? On top of that if we want to prove certain thesis quantitatively. What information do we need to buy? What information can we source ourselves? Can we do it in house? And then even on top of that, as a firm – our structure. We are currently all public equities, eventually, five years, 10 years down the line – do we want to enter kind of the private markets? What right do we have to win in that market? Or how do we earn the right to win in that market? So, these are all things that I am thinking about. And yeah, it is still open question at the moment.
[03:49] Tilman Versch: Dennis.
Open mindedness is probably one of the most underrated traits in this business.Dennis Hong
[03:51] Dennis Hong: So, our first five years, were really about foundation and formulation. And really developing scalable, replicable, repeatable mental models over time, over cycles. And that period was probably one of the most exciting times in my life. I probably learned more in the last five years, then and any given five-year period of my life. And I think part of it was just this kind of feeling of it being kind of as Amazon’s Jeff Bezos puts it: It being day one.
So, there is always this sort of urgency and paranoia, and how are we going to make this long tail probability of an $11 million launch? How are we going to actually scale this and make this more probable? And I think part of that was that we just had a lot of intellectual tension. So, we were constantly learning and growing, and everything was new. And so, our first five years, they were really good. A lot of things came together that were very fortunate, we had great investors – were not only willing to bankroll us with capital -, but with time and patience. And we are generous with their input. And it is my job really, as the CEO of this company to keep that intellectual tension very, very high.
Open mindedness is probably one of the most underrated traits in this business. When I first started, the fun, I would have told you, and you probably would laugh at our day, one portfolio, our day one portfolio would have looked like a pretty run of the mill, blue chip large cap portfolio. We are looking at things like Philip Morris, and Visa, and MasterCard and Booking.com. They are great businesses – do not get me wrong- , but I wanted to generate Hall of Fame returns. So, we had to do something different. And we had to take advantage of the fact that we really had a blank canvas to really do anything we want.
So, our first five years are really about that formulation and fostering that intellectual tension. I think our next five years is going to be very much the same. But you figured a lot of stuff out. I got to tell you; things are going pretty well right now. But a certain level of paranoia, the sentiment that you have to earn it every day. That is pretty motivating. So today, we have 10 institutions that we have as partners, and I operate at their pleasure. We are in this client service business. And ultimately, I think that we exist to not only take care of them and protect and grow their capital. But the way we are going to do that really, really well is if we keep the intellectual tension at this firm, really, really high, and continue to be open minded. So that is my job. I have four responsibilities at this firm, as I tell our partners all the time.
The first is protecting and grow the capital, which is very obvious. The second is to be there for LPs when we need them to be. The third is to mentor my team. And the fourth, which has become a goal of mine – in this current five-year period that we are in – is to try to add value continuously to our management teams. I want to not only be just a passive shareholder, right. I want to be an active participant and add value and input whenever our management teams seek it out from us. So, this next five years is really about executing on this proposition.
I hope actually in year 11 to 15 that were seen as really kind of a partner to our management teams, a real thought partner to our management teams, and we have to earn that. So intellectual tension, keeping an open mind and creating that urgency, creating that sentiment of it being day one here at our firm and creating a little bit of paranoia that that’s going to be my most important challenge over the next five years.
Fred Liu’s and Dennis Hong’s friendship
[07:59] Tilman Versch: Thank you very much for these open insights. I did get some questions on your relationship. And I want to ask you how you would describe it? And maybe, is it the kind of role model like these two guys – Warren Buffett and Charlie Munger – have? Or would you describe it differently?
[08:22] Fred Liu:I do not know. I mean, obviously, Dennis, and I think similarly, and that is why we connected several years ago. I think investing, at least in the way that I pursue it, and those investors that I really respect – everyone loves to share ideas, everyone loves to talk about their ideas, everyone loves to share: What did I learned this week? And share that with others, right? It is a very collaborative nature. So, I really love the relationship that Dennis and I have for that reason, because we talk a lot about these names through different chats and whatnot. And occasionally.
Sometimes investing can be a pretty lonely art.Dennis Hong
[09:06] Dennis Hong: I love the relationship that I have with Fred. Because Fred is incredibly thoughtful person. And I really admire his hustle. And Fred is a masterful networker, I sometimes I am blown away by the people that he is able to source. And he shares generously those insights with me and my teammates. So, I think that it is probably a little bit different from Charlie Munger and Warren Buffett. I think it is a really terrific friendship. Sometimes investing can be a pretty lonely art.
And it is pretty fun when you come across various individuals all around the world. And that is an amazing thing, especially in the time that we live in. It is pretty hard to believe that. Here we are here on October 21, Tilman, you are based in Germany. I am here in Boston. Fred, I think you are in New York now. But you might be moving to the west coast. I think it is amazing this time period that we live in. And I think that having relationships with people like Fred were incredibly talented analysts, investors, as well as just really great thought partners, when it comes to sharing ideas on how to scale and grow funds. I feel very lucky. I feel very, very lucky. I think Fred, like you and I, we first met through the course of a conference. So, at the HBS conference, maybe this is like three years ago.
And it is really a matter of serendipity. And we just really struck up a conversation at one of their happy hours. And it was just a really fun conversation. And after it was, we just we just kept in touch. And it has been just fun. It has been fun to watch you scale up Hayden, it has been fun to share a pretty fantastic meal in Jakarta. I think that’s last time we traveled together last year in the fall. I forget where we have dinner. But it was a pretty cool place. Sharing beef rendang, out in Jakarta and then traveling together to Singapore, where we are actually, we spent some time with the management team of Sea Limited, which we hold in common. It has just been really fun. It is fun to work with just this incredible group of individuals like Fred, that are incredibly thoughtful, generous with their insights and, and also kind, just really nice.
We’re both in this industry, because we’d love to learn something new every day. And we’re we may be looking at different things.Fred Liu
[11:30] Fred Liu: Exactly. I mean, I can say that Dennis is basically like a role model for me. Like you started your business earlier than me, you have been through the similar steps. And so, I have actually learned a lot through our conversations together. We are both in this industry because we would love to learn something new every day. And we are we may be looking at different things. But then you can talk about those ideas and what you learn that day or what you learned that week, month, whatever. And yeah, just that sharing of intellectual knowledge. I think that is what formed the basis of this relationship. And yeah, we have met in person many times over the years afterwards.
[12:06] Tilman Versch: So, the advice here is: “Never miss a happy hour”- when corona is over – because there is a Dennis or Fred waiting for you?
[12:15] Fred Liu: Yeah, I mean, in terms of network. And Dennis said I am a great networker. I do not know about that. But I will say that one thing that I learned early on in my career is, when you are trying to get a job on Wall Street, everyone says network, always say yes to things. Just go to any event that you are invited – you never know who you are going to meet, right? The whole idea that you create your own luck by exposing yourself to a lot of opportunities. That is 100% true. Yeah.
The whole idea that you create your own luck by exposing yourself to a lot of opportunities. That’s 100% true.Fred Liu
Where are they different?
[12:42] Tilman Versch: I already sent you a few questions before and one made up an interesting conversation. It is: Where are you different than the other? In which way does your strategy differ? Where are you approaching things differently?
[12:57] Fred Liu: I mean, I think probably the most obvious difference is the way that we structure our firms. But I think that is a personal preference as well. You know, we run all separate accounts, we have full transparency with our partners. I philosophically do not believe that lockups – not necessary like Dennis -, but many other funds out there do have lockups. And I try to get to know our partners, personally. Because again, I think this business is built on a foundation of trust. I think that is probably maybe the largest point that we differ. You know, we were talking before this about individual ideas or philosophy – I think the reason we connect so much, and the reason we share so many ideas to each other, is maybe there is a little bit of an echo chamber. But you know, we are looking in the same areas, we are interested in the same names, we generally see the world the same way. It creates a better relationship.
[13:56] Dennis Hong: I think another point of difference is I have got a team; I have got a big internal team – not really a big internal team- in comparison to Fred it is pretty big. But we have this one team, one portfolio, one P&L approach, and I rely very heavily just on insights from my team. I enjoy having this group of individuals who are sort of pulling on the same and trying to move this boat forward. And it can be hard. There are certainly some competitive advantages to doing it sort of as a one man show.
I mean Rob Vinall at RV Capital does it as a one man show. Fred, you are ultimately the key decision maker, you are the most important person at Hayden. And for me, I draw a lot of input and insight and really unusual ideas sort of bubble up to the surface – because I tried to surround myself with very different people on my on my team. Another thing is: Our pool of capital is pretty flexible, so we can really look at anything really any instrument, it could be equities, public equities, it could be private equity, venture – everything competes for capital. It just so happens though, that we’ve spent most of our time investing in public equities, because we’ve been able to find the returns that we need from the public markets without encumbering ourselves in a complicated private equity deal flow process. We can pick our price with public equities. We do not necessarily have to encumber ourselves in a long lockup with privates, where if it does not work out, we are sort of stuck and married to the idea. But in public’s – if we do have something that we do not get quite right – it is relatively easy to correct that mistake.
So it is sort of my hope that over time that maybe we find some real, extraordinary private equity opportunity that it’s kind of like one of these: It’s going to be 100 X and we’re full up in our fund. And we go to our partners and tell them to co-invest with us. And, you know, we were full up, but you should put this in your fund too, or on your balance sheet too. Because this is going to be extraordinary. It is my hope that we find something that is really, really extraordinary. But so far, our publics have kept us busy enough. And we have found the returns that we would like from the public markets. So, we do have a bit more of a flexible pool of capital, then then limiting ourselves to just the public markets.
Investors they admire
[16:25] Tilman Versch: So, to the audience: If you find these great ideas, you send a message to both of them. They are happy to receive your message. What are like minded investors you admire? Or you find interesting – as they are fishing in the same pond as you?
[16:45] Dennis Hong: I would love to hear from Fred. I have lots but I would love to know who Fred likes.
[16:51] Fred Liu: Yeah, I mean, I do not necessarily want to name names, because I am sure I am gonna leave out people that may get offended.
[16:58] Tilman Versch: But maybe name two or three, that just came into your mind. If you leave someone out, it is my fault then.
[17:13] Fred Liu: Dennis, why don’t you go first?
[17:16] Dennis Hong: Well, obviously I am a huge admirer of Rob Vinall at RV Capital. I think he is incredibly thoughtful investor. But he is also incredibly thoughtful about the business side of things. And he’s incredibly generous to young and hungry and emerging managers with his insights and in sharing his perspectives on the challenges of building a fund and scaling a fund – especially if you don’t come from sort of one of these illustrious backgrounds where you can go out and raise a billion dollars in one shot.
So, I really admire Rob. There is a young guy based in California, who Tilman – I really do hope you are able to get him on because I think his approach is very unique and very interesting. He runs a highly concentrated investment partnership called Bonsai Partners. It is a guy called Andrew Rosenblum. And I think he is a really sharp analyst, really thoughtful investor and pretty under the radar. But he has got some pretty stupendous returns. And he has been very, very thoughtful, also about investing and about building his business. And then let me add two more, who I think are really, really terrific. There is this guy called Jason Israel, who is at Feroz Dewan’s family investment office. Feroz used to run public investments at Tiger Global and he has this phenomenal family investment office.
One of his partners over there is this guy called Jason Israel who is a really extraordinary investor who’s pretty under the radar and I think he definitely deserves some kudos because he’s definitely made us better investors and is quite thoughtful about various different businesses. And then one more – the guys at Kora, I am actually quite fond of. Kora is an emerging markets focused investment fund. They are based out of Brooklyn, here in the United States. But they have a fairly unique model, they have a lot of on the ground people at these various different research offices around the world. And, and I have definitely admired Dan Jacobs over there and the thought that has gone into building Kora and the type of investments that they focus on.
A lot of the venture capitalists are probably smarter than public equity guys, because there’s not a daily mark the market on your book.Fred Liu
[19:34] Fred Liu: I will say, number one: Charlie Munger. We talked about this before this, I think it is the Bible. Like I said, I have a picture of Charlie Munger in our apartment. There is a lot to learn from him. I would say number two, Dennis alluded to this – the tiger ecosystem. Not just Tiger Global in particular, but the entire ecosystem that they have built over time, how they share ideas, how they share resources, research. I really love that collaborative nature. And I think there is a lot to learn from that. And then number three, without naming names, I will say just as almost as an asset class in general: Venture capital.
A lot of the venture capitalists are probably smarter than public equity guys, because there is not a daily mark the market on your book, right? You are really focused on the fundamentals of business? How do I partner with these entrepreneurs? How do I add value to these entrepreneurs? How do I help them hire? How do I help them scale their business? I think that is really respectable. In addition to the way that they structure their portfolios, I mean, I cannot exactly sell one of these positions, right. And so, you start off small, and you add to your positions that are working in subsequent rounds. I think that’s really something to learn from, on the public side, as well, because I think a lot of public equity investors don’t quite understand that idea of watering the plants that have already sprouted and are going to become big and not water, the seeds that never germinate.
And then there’s a couple of venture funds that do a really good job of doing cross border learnings between businesses. So, whether it is – they sit on the boards of companies in Asia, and then they will sit on boards in the US, and they will take those learnings and kind of cross pollinate those business models. So, yea, I would say those are probably as a general category what I would recommend.
I think a lot of public equity investors don’t quite understand that idea of watering the plants that have already sprouted and are going to become big and not water, the seeds that never germinate.Fred Liu
What other business they would start
[21:30] Tilman Versch: Maybe it is a good time to drop this question: If you had to start a non-asset management business now – in what industry would you start now?
[21:40] Fred Liu: Okay, so I will go first. I think there is a difference between good businesses, and what you are capable of, and what you are interested in. I think for me, the intersection of all three of those is investing. So, I think anything that I choose is going to lie outside of that intersection. But I will say I have always told my wife – when I will ever retire from this business, I am going to run a food truck. I think it is a bad business model. But I think I am a decent chef. And I would love to expose New York City, to some of my cooking, and I think it would be a fun business to run.
Or I think the other thing is consulting or teaching. My dad was a professor, once you hit tenure – you have a decent lifestyle, you basically have the ability and flexibility to do your own research, right? And we are all in this business because we just love the intellectual pursuit of learning different things. And I think being a professor or a consultant, being able to dictate your own schedule, being able to dictate your own interest and where do you spend your time – that is amazing. I love teaching. I try to teach maybe a little bit through our letters, but I would love to -. maybe after I retire from this business -, spend some time in that field.
[23:04] Tilman Versch: I think you are doing some kind of teaching already at the moment.
[23:10] Dennis Hong: I would love to go to Fred’s house for dinner.
[23:13] Fred Liu: Ya. Come on over.
[23:18] Dennis Hong: I think this is a really hard question for me, because growing up – when I arrived at the Yale endowment, I pretty much knew from that point that I really want to be a professional investor. It is just an amazing business. It is a field – I mean, we are so fortunate that three of us here are so fortunate. We are talking about businesses, we are talking about entrepreneurs, or we are talking about really like studying. So, it is almost like professional school. Like every day is almost about learning and growing and applying that knowledge. So, it is pretty hard. I was trying to think about what would be helpful to the audience on this question. So, I like Keith Rabois. I know he is very controversial – for a lot of reasons.
But I thought he had this really great formula. And it is really more applicable to a formula for startup success. His idea was that if you want to be really successful in building a startup business: Find a large, highly fragmented industry, with the incumbents having low NPS scores, and vertically integrate a solution to simplify the value proposition. So, I sort of think about what Ernie Garcia Jr – the founder of Carvana – did, was that he saw this incredibly bad business: the used car industry. Bad in the sense that nobody likes the used car business. I mean, this statistic is pretty shameful that seven out of 10 customers who go to a used car business feel like they’re going to have some sort of shady sales process, some sort of lemon or bait and switch, some kind of a dishonest customer experience. And that is really sad. But I think what really distinguishes Carvana from the traditional use card business is, is that, and I love the way that Cliff Sosin puts it: What Ernie Garcia and his team at Carvana are building is “economies of trust”.
And I think that’s part of the reason why Carvana has been able to scale so quickly, in a relatively short period of time. I mean, the business, de facto is only about eight years old, less than a decade old. And for that business to scale to over 4 billion in revenues – and still growing very fast – it seems to be that there is a customer proposition that is really resonating. And so, I think that if I were to think about leaving the investment business altogether, I try to think about an industry that is just plagued with very unhappy customers. And hopefully it is very fragmented. So, there is no obvious incumbent to begin with their cons in the industry concentration is not really large. And I try to find a way to create ecosystem control by vertically integrating a solution to just make a better mousetrap – as Fred would say.
If you want to be really successful in building a startup business: Find a large, highly fragmented industry, with the incumbents having low NPS scores, and vertically integrate a solution to simplify the value proposition.Dennis Hong
[26:31] Tilman Versch: I like the idea.
[26:33] Fred Liu: Dennis, anything come to mind in terms of industry wise?
[26:39] Dennis Hong: I think about that. So, work in progress. Let me think about that.
Books they like and recommend
[26:47] Tilman Versch: Sounds good. I want to pick this question up from the chat. There are many great questions coming in. But I am sorry at the moment that I can’t pick them all up. I already did get a lot of questions beforehand. This might be also interesting for all: What book would you recommend one should read?
[26:12] Fred Liu: I will say most recently, you know, I have been reading “Alchemy*” by Rory Sutherland. It is just basically about the idea how some of the best decisions or the things that work for businesses are not necessarily rational. It may be an emotional reason why something works, right. He gives the example, for instance, Uber. Uber does not necessarily shorten the wait time that you are waiting for a cab or a black car. But by having the map feature and being able to track that car and being able to rely upon it and say, have another cocktail while you’re at the bar, we’re just having that reliability, that really was a game changer for that business. So, kind of think outside of the box and basically go after a business that are at the extremes. Do not try to tailor towards the average also. So, anyways, that is a book that I recently read that I thought was pretty interesting.
[28:15] Dennis Hong: I love biographies of all kinds. You know, I love Brad Stones’ books, because they really highlight not only just the business attributes and business characteristics that make franchises like Amazon*, or Airbnb, and Uber, so great, but they really dive deep into the psyche of the entrepreneurs building them. So, I really love this book “The Upstarts*”. And it is really neat because it’s a juxtaposition of Uber and Airbnb and the two entrepreneurs that founded Uber and Airbnb.
So, Travis Kalanick and Brian Chesky. And they are diverging and converging stories about their own challenges and their stories to build these like really terrific franchises that everybody knows today. They are effectively cognitive difference of their own their own various different segments. I just love the human side of things. So anytime that a really great biography is written on people that I really look up to and admire, I read it. I love books that really dive deeper beyond just the surface level, and really dig into sort of the heart of the matter of like: What’s going on inside their heads? Why is it that they made certain life decisions? Or professional decisions that they did? Those types of books really get me really excited.
[29:39] Fred Liu: Oh, I actually add two more to that as well. I think we made this before. “The Sleuth Investor*” – I’ve recommended that book numerous times just about doing primary research and doing channel checks and how to build your network in the investment space. I think again, that is probably one of the best books or only books written on the subject. Number two is actually very different.
Or I guess there is the third book on it is a book called “Pachinko*”. This was actually recommended by my wife. It is a fiction book. But it basically follows the story of a Korean family through four generations. Um, it’s really starts before World War Two and how that family basically had to flee Korea to go to Japan, how this how they struggled in Japan, and kind of build their businesses and then some of the kids eventually think about start being educated in the US. It just follows the four generations, and you can really see the evolution of maybe not Asia as a whole, but definitely Korea and Japan and kind of cultural differences and everything there. So, I think it is a really good book for anyone interested in the region and the development of those two countries over the last hundred years.
Cash in Dennis Hong’s and Fred Liu’s portfolio
[30:52] Tilman Versch: Tim did ask if you are always fully invested. Or how you managing cash?
[31:00] Fred Liu: Well, for us cash is a residual value of any ideas that we put into the portfolio. When I started Hayden, we were over 50% cash on day one. And over time, as different ideas matured, the IRRs went down – those positions became our first source of cash. And so, we left the cash balance untouched. And because we only invest in one, two names a year, it took a long time for that cash balance to basically reach single digits. Right now, we are below 5%. And so, hopefully, our bar for getting a new position has gotten higher in the portfolio, obviously. Because with cash your opportunity cost is cash, right? Its whatever interests’ rate, cash flow is basically zero. Nowadays, it is our lowest or worst idea, right, which is still hopefully a positive IRR for us. Right now, we are running fully invested in most likely going into the future. That is how it is going to be.
[32:08] Dennis Hong: You have had a bit of an evolution in our relationship to cash. So, I have always had this thought process that cash is a call option on existing and new ideas every year, because pragmatically, the market sells off. I mean, if you look at the last 50 years of history of the S&P 500, there has not been sort of a single year where there is some major systematic drawdown. So actually, peak to trough, the average drawdown in any calendar year is about 13,5% percent – about two out of three years, ends up being very positive, and often quite a bit positive even with very significant draw downs. So in that context, when we first started the fund, I thought that we’d always have a little bit of cash, just in case we had this real “backup that truck” opportunity in any given year.
But the thing is that over time as a partnership I began to realize that maybe in the beginning, I was a little bit afraid of the potential for quite episodic levels of volatility and that scaring our investors. But over time, we have had sort of a real experience of having these big draw downs every year, I can’t remember a year where ShawSpring has had a drawdown of at least 15% peak to trough in any given year. But in each of those instances we’ve had partners who have remained calm, who’ve remained very constructive about what it is that we own, have been very excited even to add to our portfolio when we are down. So, for us like we realized over time that cash can be a big drag to the portfolio, and there’s certainly investors that I respect, who always have very significant levels of cash at all times. But for us, like I realized that the cash is probably best kept at on our partners balance sheets. Because more often than not, we have found that our partners have had a willingness to add to us when we are down. And so, it has been more efficient for us over time to run, essentially fully invested at all times. I think mathematically, I also sort of think about this.
So actually, Cliff Sosin also had some really, really nice narratives about this. So, if you think about this: Let us say the three of us here, we have an opportunity to buy a business for a million dollars. That business is throwing off $300,000 in cash earnings this year. That is a pretty nice 30% cash yield. Now, we can buy that business today for a million dollars. Or we can wait for a recession and get 30% off. So, you can buy that business for $700,000. Let us say like a recession, statistically, probably only happens once every 10 years. So, let us say we get to year nine. And we have not had a real recession until year nine – we basically shortchanged ourselves 2.7 million in cash earnings – all for the opportunity to buy this thing and save ourselves $300,000. So just the arithmetic of holding very large cash balances at all times:
That has not necessarily made a lot of sense to us, just from an arithmetic point of view. I will tell you, though, we have been very, very lucky to have partners who consider themselves asset owners, they are genuinely interested in the underlying holdings of what we have acquired on their behalf. They know what they own. We are very transparent about what we own. We share all of our underwriting materials about what we own. And I think that makes our investors more engaged, and more willing to put money with us, or double down with us when we do have these systematic dislocations that happen quite frankly, every year.
But for us, like I realized that the cash is probably best kept at on our partners balance sheets.Dennis Hong
[35:57] Fred Liu: I would actually say that’s a great example of why building trust with their partners and having that transparency is so crucial, right? Because it if you have partners who support you act like asset owners, as Dennis says, and really understand your portfolio and have that emotional stability to withstand that volatility. It benefits you as an investor, because you are able to run fully invested and focus on what you do well, which is finding great companies. And it also benefits the partners themselves because they are able to realize higher returns right without that cash track. I think for a lot of funds out there, they may not have that trust level with their partners, which is why they may have a portion of cash in their portfolio. So, for some funds, it could be a business decision, as well as a portfolio management decision.
The current strenght of internet businesses
[36:51] Tilman Versch: This year was kind of the year of the e-commerce, software as a service and internet companies. There is a question from Michael – he is asking: Why did it take so long for the market to recognize the value on the greatness of this businesses?
[37:10] Fred Liu Dennis?
I think e-commerce is pretty tough to paint with a broad brush. I think that the recent resilience and as well as incredibly enthusiastic price behavior of e commerce businesses, in general, has been really due to the acceleration in the growth that we’ve seen.Dennis Hong
[37:14] Dennis Hong: So, I think e-commerce is pretty tough to paint with a broad brush. I think that the recent resilience and as well as incredibly enthusiastic price behavior of e commerce businesses, in general, has been really due to the acceleration in the growth that we’ve seen. So, we posted this neat chart back in April, that showed that we have seen probably within the scheme of two months, like almost like 10 years of penetration. And so, it was it has not been surprising actually to see that the stocks also reacted appropriately with that acceleration in growth and especially what also really helped is a bit more of a benign CAC environment.
So, the cost of customer acquisition has been a little bit more benign than then in recent years quite simply for the fact that aside from e- commerce businesses or those businesses are a competitive advantaged through COVID. There was not a lot of people spending money on TV or pm other online advertising channels until recently. It is to be determined what that cost of customer acquisition environment looks like going forward. It has become a lot more competitive in the recent environment, especially as everyone is now moving online, and everyone is not chasing after customers. But the resilient growth that we saw back in kind of the April and May timeframe, in many instances across our portfolio – we actually assume that there would be sort of a linear decay in the growth rates in this back half of this year, quite simply for the fact that as people sort of go back to work to the places that they love to eat to the places that they love to shop in the physical world.
And as these economies have opened up, we naturally assumed that there would be this linear decay in the back half. The growth that we saw was, was relatively transient. We may have like, achieved a new sort of penetration level on e-commerce as a percentage of all retail. But we also made the assumption, what we thought was realistic that as economies opened up again, you should start to see a bit of a deceleration. What has been interesting, though, is that the contemporaneous data was suggest otherwise. In fact, the growth rates that we saw in the early part of this year, in many cases have not tailed off but have actually persisted. And in some cases, actually have been reinforced.
Even in places like China, your saw a very, very strong adoption rate of e-commerce, that was extremely resilient across categories, whether it be online health, whether it be online grocery, whether it be continuation of the trend within e-commerce writ large. But actually, in China, what we’re seeing is, again, like a second wind, and a second acceleration, across platforms. And that has been an interesting one to watch. So the assumption that we would have made back in March and April of all these businesses that we bought that there’d be sort of a linear decay in the growth rates in this back half of the year, that has so far not been the correct forecast. And in fact, actually, what we thought was going to happen has proven to be more conservative than reality.
Even in places like China, you saw a very, very strong adoption rate of e-commerce, that was extremely resilient across categories, whether it be online health, whether it be online grocery, whether it be continuation of the trend within e-commerce writ large. In China, what we’re seeing is, again, like a second wind, and a second acceleration, across platforms.Dennis Hong
[40:41] Fred Liu: Yeah, I would also say that, I think that there will be a bifurcation, when you know, there’s a vaccine and things do return to normal, kind of what Dennis alluded to, is, if you’re a mature business that, has basically won your market. And if everyone is basically buying online today in your market, and people return to buying a brick and mortar, your business is going to decline along with that, right. But if you do own a mousetrap type of business, that is earlier stage in its S curve, where the biggest friction is around consumer behavior and changing consumer behavior, this is one of the best periods for that. It has been, what, eight months, already close to eight months, – habits supposedly take about two months, three months to form or well into that.
And if you have 3% – 5% penetration, those habits that people form right now are going to be permanent. And so that is going to exhibit a step change function. But if you are just a beneficiary of the industry tailwind, and you’ll already have dominant market share inside of your market – I think those are the businesses that you want to be wary of that may suffer the client when things normalize.
Riding rockets like Sea Limited
[41:58] Tilman Versch: That is interesting. Both of you were riding rockets this year, if you take a look at the portfolio and see how your positions developed. You had a Carvana that is eight X – or Sea limited. How are you dealing with this riding on rockets? How you decide to sell or to stick to stocks?
[42:20] Fred Liu: Well, I you know, talking about mousetraps and consumer behavior change and everything, I think Sea is the best example of that. Right. I think that again, this is a business – nowadays they are about mid-single digit penetration. Two years ago, they were lower than that. This is a company that I do not think will suffer that decline and that if you look at their earnings power- it is justified. I still think a business like that, even though we have made ridiculous returns on it, it is still our largest position. Because I think even from here, it is a network effect type of business, right?
The more entrenched you become, the stronger the business becomes, which means that investing in it today is actually less risky than it was when we originally invested two years ago, which means you’re able, and you should have a larger position size, all else equal, right. And so yeah, I think it is still very early days for a business like that. And that is why we continue to hold it and have not sold it in fully.
It’s a network effect type of business, right? The more entrenched you become, the stronger the business becomes, which means that investing in it today is actually less risky than it was when we originally invested two years ago.Fred Liu
[43:26] Dennis Hong: So, we are pretty algorithmic about our portfolio construction, and we’re at any given point in time, we’re trying to maximize our portfolio for the best three to five-year IRR. So, we have made a few changes to our portfolio, we are still quite enthusiastic about everything that we own, for the very reasons that Fred highlighted. But there’s still I think, quite a runway for businesses like Sea, which have choppy as probably the largest value creation opportunity within that group of companies in that franchise and in the management team has just absolutely taken advantage of the competitive dynamic, with two major competitors who are externally financed.
So, you have like Etsy, Shopee being a depresses advantages, because it is two largest competitors are really kind of doing different things. So, in the case of Toko, you have an external financer in SoftBank, that is requiring profitability. And that is a very hard choice to make, when you have a competitor that does not have to do either, or actually can press both advantages. And then you have the case of Lazada, where you have quite a bit of management turnover, which has been very, very challenging. But also, just, quite frankly, the fact that they run that franchise from Hangzhou. And the insights that we get from that company, are that the Lazada team must really figure out the unit economics in order for the guys in Hangzhou to give them more resources.
So that is a very, very challenging spot to be in. What I like about what I like about Sea is that there is still some embedded call optionality. It is still very early days with the digital wallet, business, within Sea Money, it could be something quite valuable. It is probably worth more than zero, which I think that there is probably not a lot of value being attributed to that. And then I think that one of the questions that has recently come up both internally, but also just as a debate I see online quite frequently is: “What are they going to do in South America?”. And it is pretty interesting. I know that I think that Fred is more bullish than us on this. But it is an interesting dynamic that we will have to monitor to see what they do in Brazil, ultimately. It is still pretty early days.
The current model is mostly cross border to allow shopping merchants to sell into Brazil. We are talking basically taking like cheap stuff from China – mostly apparel demanded by consumers and in LATAM, which takes like a month or two to arrive. So, it is not exactly a wonderful consumer experience. But the very, very fact, that Shopee has been able to carve out what is pretty significant share with minimal effort, that has been very, very surprising. So that would be kind of an interesting thing to watch. I think that the Sea Ltd team is ambitious, they are thoughtful, they are savvy. They are hustlers.
And I suspect that if they see something really interesting, in LATAM that they’ll go for it. I sometimes wonder about this very question. Is it going to be easier for Sea to compete against Mercado Libra in LATAM? Or is it easier to compete against Alibaba Group and SoftBank in Indonesia? I think time will tell. But it is exciting to see where that franchise potential could grow.
[47:08] Fred Liu: I mean, as Dennis said, that’s optionality. Right? And I think what’s interesting is: They’re currently they’re doing cross borders, but there’s starting to be evidence that the people who buy cross border wait for a month for those goods to arrive from China, they are then reselling it on the same platform, right? Which is exactly the model that they followed in Southeast Asia. A lot of the goods were shipped from Shenzhen or it could be from Korea or elsewhere.
A lot of these goods were across border. So that is exactly the model they followed. And what is also interesting is – I remember talking to some investors in Brazil last year when they started launching this stuff. Investors in Sao Paulo and Rio they had no idea that Shopee was even in their backyard. And the reason for that is if you look at the surveys from two years ago in Indonesia, the biggest use case for Shopee was outside of like tier two cities right, tier three and below cities inside of Indonesia. That was where they were penetrated. So, they were really going after a more rural market, a lower income type of market where generally investors do not sit. Investors sit in these major cities.
And they do not operate there, they do not see the advertisements. And so, I think a lot of Brazilian investors or even some Brazilian competitors were caught a little off guard. It is an interesting development to watch over the next couple of years and see if they can be successful there as well. But according to different metrics, it seems like they are doing well.
[48:42] Tilman Versch: I want to ask a question from the chat: How do you make sure that the companies you are invested in has a great management team? And how do you evaluate management in the companies you are invested in? Maybe you could explain that on the example of Sea.
[49:01] Fred Liu: I would say, part of it is just watch what they have done in the past, right? In order to make a judgement about a person or a management team, which at the end of the day is a judgment about person, it’s you have to put yourself in their shoes and understand the business well enough to have an independent opinion of what would I do, if I were them, given the facts that are available in this world today? And then you make an opinion, hopefully, obviously, you think your opinion is correct, right?
And then you see if management agrees with you, or they chose a different route? And if they did choose a different route, I made a decision different than yourself: Why did they do that? What data supports that? What was the rationale for doing that? And given that new information, do you agree with them or not? I think at the end of the day, it just comes down to judging people and how do you build trust with someone you know, that you meet in regular life? It is the same process.
[50:06] Dennis Hong: The great thing is that, as public investors, we have a lot of access to information. So, the financial statements, the quarterly reports, the annual reports, how management crafts the narrative around their business. And just looking at the numbers: How fast is the business grown its revenue, its earnings, and free cash flow? How have they been deploying capital? That is just the mechanical aspects. But I think the more interesting aspects are doing the due diligence process of talking to competitors, talking to former employees, talking to other investors who may have invested with them through their prior lives. We are looking at this business in Japan, it is a software business that is growing really fast, focused on bookkeeping, accounting, and payroll, it’s a really, really interesting company. And the entrepreneur there, he is a former Googler.
And the way we found it actually was just doing a survey of some of the analog companies and in the US, and Europe, and as well as like the really big one called Zero, which is listed in Australia and New Zealand. But we always ask the question: Who in your space do you really admire? Which company in your sector? Is it really good? And who do you keep an eye on? And it is very interesting. So, there is this some bookkeeping accounting and payroll software business in Sweden called Fort Knox. And we have bill.com here in the United States. And, and they both zeroed in on this Japanese software company. They found over the CEO and how he was building something really special. They would be lucky to replicate even half of the capabilities that he is building for this business.
So, I think that that is probably the fun part about what we do. Looking at the mechanical numbers, and the track record is one thing. And also, just understanding if they win, do we win as well? And so, we tend to have a bias towards managers that have very significant percentages of their own wealth in in their own company shares. That is just seems to be sort of a bias. When you look across our portfolio today, we have very, very few companies that are run by professional managers, so to speak, and most of them most, if not all of them are owner operators. And in fact, actually the owner operator themselves are often the largest, if not among the largest shareholders in the businesses that we’re excited about. So, there is a lot of like, really, really fun things that you can do to do due diligence around management teams and assess the quality, but that’s part of the fun. I mean, ultimately, these are these are businesses run by people. I think that Fred and I, we probably would agree that Forrest Lee at Sea is pretty exceptional.
I think he has really come into his own as an owner operator. I think what I really admire is just his ability to think really big. And find optionality and build optionality into his business and leverage the resources that he has at Sea Limited to get into all these adjacencies. Taking it from gaming to e commerce, to digital payments to LATAM maybe other markets around the world. The best management teams create optionality. And they are very, very thoughtful about using the resources at their disposal to chase after that optionality.
When you look across our portfolio today, we have very, very few companies that are run by professional managers, so to speak, and most of them most, if not all of them are owner operatorsDennis Hong
[53:31] Fred Liu: Right. I would add on just one more thing. One angle that has been really fruitful for us, because what the management teams’ control, they control the strategic decisions. And they also instill the culture inside of the firm. Right? Those are your two primary levers that they pull, I would say on the cultural aspect of talking to middle level employees has been one of our best sources for gauging a culture inside a firm.
I mean, on the topic of Forest, every single employee that we have always talked really respects the management team there. Not only forest, but you know, their direct superiors and whatnot, they get probably some of the highest levels of autonomy out of any company based in the region or even globally. And then also just talking to competitors, like: “Who are you afraid of?” And often, those are the companies that you should be investing in.
Talking to middle level employees has been one of our best sources for gauging a culture inside a firm.Fred Liu
[54:35] Dennis Hong: I want to make one other point, Fred, just to segue into your point on the mid-level employees. So, one of my teammates is this guy called Nihar, and he is a former Google engineer. And he said that one thing that is a pretty interesting phenomenon to follow is: Where all the top engineers going? Because the top engineers go to places where they are attracted by visionary entrepreneurs or really thoughtful entrepreneurs. It has been something that that we have started to pay attention to, particularly in a place like Japan.
So, we own this Japanese mobile classified business with this manager, who just has a real cult of personality around him. And there’s been an incredibly compelling sort of due diligence, that this business has been built to attract some really extraordinary tech talent in such a way that: It’s like a choice between this company and then and then like something like a Facebook, or Google in Japan. So, following tech talent – particularly the kinds of businesses that we look at – it can be quite illuminating.
Where all the top engineers going? Because the top engineers go to places where they’re attracted by visionary entrepreneurs are really thoughtful entrepreneurs.Dennis Hong
[55:46] Fred Liu: I am just thinking we should aggregate all of the top engineering schools as a career template as they put up each year and figure out where all the engineers are going. Yeah.
Dennis Hong on Square & Sea
[55:58] Tilman Versch: That would be interesting. I hope with this talk, we also make the light go on for some of the viewers. So, if you like the content, drop us a like, it helps me very much with my work. I have a question from Kermit capital. Does Square have to potential for a global super app? And do you expect to see them follow the Sea playbook? And might they Sea and Square compete in emerging markets?
[56:33] Dennis Hong: I thought that was a really neat question. And I am a big fan of Kermit capital on Twitter.
[56:39] Tilman Versch: That is a shoutout to him!
[56:41] Dennis Hong: So, Squares ambitions are global. But I think their efforts are probably likely focused on the US and in Europe, where there are not scaled up super app or digital wallets today. So, we think the highest potential is scaling a digital wallet, likely in these markets, leveraging their P2P transfer service as a core initial use case, as in the US with cash app. The UK is increasingly becoming a focus and actually Square recently purchased a business in Spain called Verse.
So I think that there’s probably going to be a similar playbook to the US in these markets, but it’s probably pretty unlikely for square and Sea to sort of face each other in competition in the emerging markets anytime soon. It is hard to forget that. global players often find it very, very challenging to enter into foreign markets because the rules and regulations governing various different businesses, they’re often very hard. So Square actually had quite a bit of challenge entering into Canada. Because Canada has a very unique payment system called Interact. I am Canadian, so I grew up with this, but it is really kind of this consortium of banks.
Square had to navigate all the kind of rules and regulations to enter into that market, I think that’s Square is going to probably find very similar challenges globally, where they just have to face up to quite significant incumbents that have already been really, really good at what it is that Square is promising to do. Now Square certainly can do it. They are in Canada, and it seems like they are scaling a nice business there. But it is not as if you enter the market, and you are Square, and the business automatically comes to you. I think Shopify is also had very similar challenges in Japan. So, there is this really extraordinary business in Japan called Base. Again, a great Japanese tech business growing like triple digits, and has basically created the same proposition that Shopify is offered in the developed markets.
But even Shopify has had some difficulty really getting traction in those markets, just because again, the nuances of local culture, local customs, local regulations, they’re often very, very difficult for a global player to get everything right. I think that it’s probably very similar to the reasons why Lazada has been finding it so difficult, getting a significant traction in Southeast Asia, of course, they’re really, really big business and they’re doing fine compared to everybody else. But I think it’s still very, very challenging to run a business like Lazada from Hangzhou, and have Chinese managers come from Hangzhou to and try to implant a Hangzhou Alibaba style management culture inside of what really requires a localized mindset.
[59:39] Tilman Versch: Do you have something to add, Fred?
[59:42] Fred Liu: No, I have nothing to add. I agree with everything that Dennis just said.
Square & JP Morgan
[59:47] Tilman Versch: That is great. That is a question on what Dennis thinks about JP Morgan taking on Square and PayPal with their smartphone card reader.
But it is not as if you enter the market, and you’re Square and the business automatically comes to you. The nuances of local culture, local customs, local regulations, they’re often very, very difficult for a global player to get everything right.Dennis Hong
[1:00:00] Dennis Hong: I almost knew that someone was gonna ask this question. So, I am gonna start with the caveat that was just announced today. So, we are still thinking about this impact on Square. Our current initial thoughts are as follows: So, there is a significant number of Square sellers who do not use Chase at all. So, I am not sure that that JP Morgan’s announcements necessarily going to have an impact on those. For those merchants that use both – there could be compression on the instant transfer fees, which JP Morgan has basically said that we are offering that for free. So, there could be compression on that income stream over time. But I think there is probably two things to consider: For people who were sort of bearish against square based on the news today.
So, square has a more robust ecosystem than what Chase is offering today. So square is not just a POS payments network. They offer things like payroll appointments; they have an app store. And chase simply just does not have that. And many, many merchants use Square to power their businesses effectively as like the heart of their operations, and not just to process payments. The second thing is that Square really excels at hardware, which it sounds like it is very, very easy. That it is basically just a dongle that you plug into your phone, or it is just a card reader. But it is very hard to make this work seamlessly. When it comes to processing payments: If it does not work, then that is a dissatisfied customer, and lost sales. So, we are not saying that Chases solution will not work well. But it is pretty difficult to really make an assessment of that until we really see it in action.
And then I want to make just one last point. What is Square known for it? Well, we think most of new seller acquisition will still continue to accrue to square just because they’re the kind of the cognitive difference in sort of small business empowerment. Chase might be successful in cross selling its existing customers. But again, this is still to be determined. So high level takeaways, I think that it is really important to really understand what’s going on with Chase. And you do not you do not ignore a competitor, that like Chase or JP Morgan, but I will say it’s still very, very early days to really understand what the true impact to Square will be. I will also say is that Square is not likely to sort of sit down and be happy to just let this happen.
Square is an incredibly thoughtful, aggressive, constantly iterating on product. They are a very innovative company. And so, it will be very interesting to see like how these two businesses JP Morgan and Square sort of compete with each other. But in my mind, I have never known JP Morgan to be necessarily a very innovative company. So, we will see.
Square is an incredibly thoughtful, aggressive, constantly iterating on product.Dennis Hong
Sea’s gaming arm
[1:02:22] Tilman Versch: That is another question on Sea and especially the gaming arm of Sea. Are they a one trick pony with the successes they have? Or are they able to repeat the successes and the high margins and fight against the competition in the gaming space?
[1:03:24] Fred Liu: I think one thing to understand about the gaming universe is just the shelf life of these games have become much longer over the past called five years 10 years, right? You think about Liga of Legends? It is well over 10 years now. World Warcraft before still playing it.
[1:03:40] Tilman Versch: I am still playing Age of Empires 2.
I mean, a lot of these games now exhibit aspects of network effects, right. Network effects are much more stable. It takes longer to unwind and unravel that because it literally is a web.Fred Liu
[1:03:42] Fred Liu: I love Age of Empires. I saw StarCraft installed on my computer (laughs). I mean, a lot of these games now exhibit aspects of network effects, right. Network effects are much more stable. It takes longer to unwind and unravel that because it literally is a web, right. Free Fire has only been around for a couple years, I know Forrest thinks that it is going to be at least a 10-year type of game. But you can never call with these things. You can never call where the top is because that is based upon gamer behavior.
And if there is a cool new game out there that everyone migrates to, but you can because the unraveling is usually slow in these you can watch for when there is an unraveling starting to happen. And with the latest numbers that they have put out in the data you can look at, there is no sign of that currently. So, think about it almost like riding a wave. You do not know how large that wave is going to get. But you can start to feel when it starts to peter out. And that is what you should be looking for. You should be looking for signs of that. And the meantime, for Sea: Yes, Free Fire is a large part of Garina’s business. But the gaming business is really about having as many shots on goal as possible. If you study a business-like unity, for instance, and understand like the developers that they serve, it is almost like a lotto ticket, right? You need a lot of shots on goal to hopefully get that one game that makes it big.
And there is no way you know, what is going to make it big beforehand. So, for them, it is really about just partnering with as many students as possible developing games themselves, you know. They just bought Phoenix Labs’ Dauntless. It seems to have early traction. They are going to port that over to mobile sometime within the next year or so. So, there is a lot of shots on goal here. And so, we will see if there is another lake. But even if there is not really our thesis, when we originally invested, you can look back at our 2018 presentation, it was: I have no idea what’s going to happen to this gaming business. But what I do know is that unraveling happens slowly, and there was no sign of that. And in the meantime, it is a funding mechanism for Shopee, which means that they do not need to dilute their capital or take on external funding. And Shopee will become self-sustainable. By the time that way before Free Fire starts to be petered out. That is all you really have to underwrite. And hopefully they have another cash flow stream, whether it is through payments or gaming to help fund these investments afterwards.
[1:04:24] Tilman Versch: Do you have something to add?
[1:06:30] Dennis Hong: We have, I mean, I think we share a very, very similar thesis on that on it. In fact, I actually have a little bit more of a stark assumption on this. I actually thought that Garena’s peak year would be this year. So actually, if you go back to our original underwriting work, we made an assumption that there would be a decay in Free Fires momentum. And so, this would be here in 2020. This would be the peak year for Garena’s valuation, and then we round trip back to the valuation that originally, we had for Garena in the year that we owned it. Now, the assumption then was that actually that the street would be less focused on Garena, because you have a very large Shopee business that is growing very, very rapidly, already profitable, quite highly profitable in Shopee Taiwan.
And actually, with very significant market share in Taiwan, which was a nice roadmap, that management sort of highlighted, I think maybe as a pathway towards profitability in Indonesia, which is their largest and probably arguably most important market. So, there was going to be a handoff in the valuation that the street would be less focused on Garena. We would have a round trip, but then it would not matter because you had a Shopee business that was quite ascendant and so actually Garena has momentum this year. And it seemingly has not been dented, we might be able to have another sort of strong earnings year from Garena. So, the decay that we assumed in Garena might have been pushed a little bit out into the out years. Now, what has been interesting is that India is I think the number two region for Free Fire, which is pretty interesting. I think that maybe part of it is just the relationship that India has with China right now.
And the various banning of Chinese apps in the country may create a competitively advantageous position for the Free Fire franchise in India. But to our understanding, that seems like Free Fires also seemingly gotten some adoption in the United States and in Europe. Both are markets that I would never have considered this franchise would have entered. So, I think it is still very early for those markets, clearly, but the management team of Garena has definitively executed ahead of our expectations.
Fair multiples for company
[1:08:55] Tilman Versch: I have got two questions left. And then I want to give you the room, if you have something to add, we have not discussed, and you want to share with the audience and the community. The first is coming from the chat. And I really like that: How do you think about a fair multiple for a company? Especially with the high multiple expansion we have experienced.
[1:09:18] Fred Liu: The last interview we did, I kind of drew that S curve chart, right. Um, the way that I think about it is really, we are trying to buy companies below a mature market multiple. So, for instance, with a lot of these network effect businesses: If they do dominate their market, if they do become mature in this business: What type of multiple valuation will they trade up? Because you are, we are referring to high multiples of this year. And the question is that usually, because these businesses are earlier stage, there is a bit more uncertainty around these businesses. Historically, investors would not, you know, place as high of a multiple or the type of valuation that you would get when the pathway is certain.
And so, we were able to buy these businesses for cheaper multiples than a return market multiple. In addition to being able to benefit from the value creation that the business creates over time, right, the earnings power CGAR. So, you would get the twin engines, right. You would get earnings compounding at whatever rate 30% 40% 50% in addition to as that uncertainty dissipates, that valuation will also expand as well. And that is how you kind of create you are really great investments. In cases like this year, sometimes occasionally, the multiple will expand on top or above what you would normally pay for a mature business. So, you will have some multiple compression in these businesses over time.
So, the question is, over the next three years over to five years, even with that multiple compression, can that earnings power CAGR quick enough to overcome that headwind? It really differs case by case and it really differs in terms of what you think that slope is for the intrinsic earnings power GAGR. But for our names tend to be a bit earlier stage, historically, they have had a bit more uncertainty around them, which has allowed us to buy it at a cheaper valuation.
[1:11:19] Tilman Versch: Dennis, do you have something to add? I am curious here, what do you say on this point?
Paying more than 40 times normalized earnings, things start to get really, really tough when you pay higher multiples than that, because you have to make sure that that these businesses are truly robust, have truly truly indisputable ecosystem control.Dennis Hong
[1:11:25] Dennis Hong: So, we are probably pretty similar, actually, in terms of valuation discipline and how we contextualize the world. I will say that it is definitely an area that we’re going to continue to learn and evolve. So, when we first started the fund: We had a very DCF type approach to valuation. But there are certain limitations, and practical limitations to employing a DCF for the kind of investing that we do. Because quite frankly, the discounting period is often quite long. And most of the values captured in this terminal year, which is very, very challenging sometimes.
We talked a little bit in one of our letters about, for example, investing in Tencent in 1998, when an IPOed at $2 billion. But if you’re if you’re running a DCF in 1998 and you sort of prospectively looked at what is this business worth in 1998 – this $1 billion business, it would have implied that this business is worth 62 billion. Now, clearly, in that year, you are not going to have that business trade up to $62 billion. There is just no way. It just makes no sense. And so, we have evolved from sort of a DCF based approach to one that takes into account normalized multiples, normalized earnings and multiples approach. So, we start with the premise, the long-term rate of returns of equities, let us say the S&P 500 has been about 10% annualized. So, if you think about that as kind of our cost of equity, and start with the premise: What would you pay for a zero-growth business discounted by 10% cost of equity?
It is 10 times multiple. So, in the rare, really rare instances, when you have like these massive market meltdowns, like we had in March of 2020, or the fall of 2018, where all these stocks just go down. Nothing is up. All the stocks go down. And you get this real rare opportunity buying a high-quality growing business for 10 times, either explicit earnings, or 10 times normalized earnings – that tends to be a pretty good risk return. But what we found over time – and this has been sort of six years of this – paying more than 40 times normalized earnings, things start to get really, really tough when you pay higher multiples than that, because you have to make sure that these businesses are truly robust, have truly truly indisputable ecosystem control. Because otherwise, there’s just not enough margin of safety. And you can really, really have some damage to your portfolio, if you are starting to pay inexorably higher and higher multiples. So for us – we are pretty algorithmic about when we construct the portfolio, and we think about sort of what is this business going to be commanding in the 1, 2, 3, 4 or 5 year discounting period that we look at.
We try to be very, very thoughtful. Now, we also make the assumption in our in our underwriting that over time, just base effects alone, the business is just going to show some linear deceleration. It is going to it is just going to decelerate. Take a look at like, for example, Netflix today, right? Consistently, for the last several years, Netflix has generated an incremental 5 billion in revenue roughly. But 5 billion in revenue on a $30 billion base, if even if they were to repeat that year, after year after year, you are going from like 30% growth to like 17% growth to like 12%, etc., etc. And so, you make the assumption, if you want to be an owner in that, the market is not going to be willing to pay sustain high multiples. And in fact, you have to make the assumption that actually the multiple comes down. The market is simply not gonna be willing to pay that high of a price for a business that has a deceleration like that.
So, in our underwriting, we make the assumption that over time over our ownership period, that there is going to be a natural deceleration or decay in the multiple. But what is going to carry that is hopefully that we have bought a business that is growing its intrinsic value rapidly up front. For us, like when we are looking at a new idea. You know, it used to be that we opened up our minds to a lot of different ideas. You know, even businesses that sustainably regrowing 10 to 15% a year, that was kind of our early years, we’re looking at businesses like Expedia and Booking.com and Visa, which were very good businesses and sustainably growing – regardless of the economic environment. But what I realized is that base effects catch up to those like very, very quickly.
So as a starting point, we often have to find businesses that are growing – and we look at gross profit growth, by the way, because I can grow revenues to the moon very easily, right? I could just say: “Hey, Fred, would you like $1?” “Just pay me 50 cents for that dollar.” I could do that all day long and generate lots of revenue growth. But the unit economics clearly do not work. So, we actually look at gross profit growth. And so, for us, if a business is generally not growing gross profit north of 30%, as a starting point, it becomes less interesting to us. Because that business will clearly at some point have to overcome base effects. And then there’s gonna be a deceleration in the growth and therefore the multiple will start to decay. So, we have to be very, very thoughtful about what is a good starting point for us to take a look at these businesses. It is a weird period in time. I mean, we are not macro investors, but it is really, really hard to ignore the fact that the macro, and the general condition in the markets are very odd. And coupled with the fact that there are not that many companies that are growing, let alone seeing accelerating growth.
So, in some sense, it is not surprising to see leading dominant software, businesses, growth businesses, and so on and so forth. A couple of these low rates, you are starting to see like really, really escalating multiples and in many of these businesses. Fortunately for us, we have a global approach. So, for us, like we generally are looking at things all over the world, but we are finding that increasingly our best ideas are probably overseas. And I have told some of our LPs that ShawSpring’s future is likely Asia. And it would not be surprising to us – probably in the coming two to three years – that that we probably would be doubling down our investments in Asia.
Explicitly even as a firm and probably start a research office in Asia. Quite simply for the fact that I think that some of the most exciting, most interesting, most talented entrepreneurs are in Asia today, and it is less competitive. So, I am 38. And the international students I went to school with: They’re not staying in the US. They are going back to places like Shanghai, Shenzhen, Hong Kong, Singapore, Jakarta, Bombay. They are taking over businesses. They are starting businesses. They are scaling businesses. And that is really exciting because they have US education. They have a capitalist mindset. They have sophistication around capital markets, discipline, capital allocation and competitive strategy.
I think that is really exciting. Because I think that puts these individuals at a very, very significant competitive advantage. And the fact that they are taking over these businesses and creating real disruptive businesses against quite slow-moving traditional incumbents, I think that is where we are gonna find some of our best ideas.
Quite simply for the fact that I think that some of the most exciting, most interesting, most talented entrepreneurs are in Asia today, and it’s less competitive. So, I’m 38. And the international students I went to school with: They’re not staying in the US. They’re going back to places like Shanghai, Shenzhen, Hong Kong, Singapore, Jakarta, Bombay. They’re taking over businesses. They’re starting businesses. They’re scaling businessesDennis Hong
[1:19:03] Fred Liu: Yeah, and when those seeds are planted, and their employees become wealthy, and they spin off and create their own businesses, it creates a whole ecosystem around it. That is the beautiful part of it. And so, to Dennis’s point: Move east! In terms of your original question, I just want to add, that sometimes with these businesses that are growing so rapidly, I’m caught, like growing 100%, 80%, what have you, they don’t normally decelerate to zero percent or flat the next year, right? Generally, there is some sort of fundamental momentum within it, there is a reason why customers are continuing to buy their products. And so, it may go 80% 70% 60%, what have you.
And so if you are able to underwrite the next two years of growth, maybe you do have some leeway to pay up for the multiple a bit, because you’re highly confident that it won’t decelerate to zero immediately. It will not fall off a cliff. But I would caution that there are some investors, I mean, I have seen models that go out to like, 2035, or whatever. That is just nuts to me, right? I understand how you can have confidence around the next two years, but who knows what new products are going to come out in the next 15? Right. So, I would say to Dennis’s point about the DCF approach.
A lot of these businesses, there are certain years where they have like step function changes. They launch a new product, they launch a new feature, they re-accelerate, and you are never going to capture that in a DCF. I went to undergrad business school; we were always taught to just model out the out years in a linear decelerating fashion. Like times point nine, five for every year going forward. I think that is pretty ridiculous. Because the value creation comes from those inflection points that you are never going to capture.
And so, for us, it is really around: If this business stopped growing, what would we pay for it if they won their market? And then we can get all that future growth for free. And if we are highly confident next two years, maybe we can pay a little bit more and then get yours to infinity for free. But really, that is the core of it. I think it is really tough to project very accurately a business 15 years into the future.
I went to undergrad business school; we were always taught to just model out the out years in a linear decelerating fashion. Like times point nine, five for every year going forward. I think that’s pretty ridiculous. Because the value creation comes from those inflection points that you’re never going to capture.Fred Liu
What they might do after investing
[1:21:33] Tilman Versch: You are early in the S curve with your personal value creation. Have you already thought about an idea what you want to do with the capital you accumulated? Do you want to start a charity? Start a new business? Or a food truck empire maybe?
Fred Liu 1:21:52 Could be a big business? I do not know. Yeah, I mean, I’ll just say that,, I don’t know who said this quote, but I just remember hearing it years and years ago, it’s like: Spend the first third of your life learning as much as you can, and being a student, spend the next third of your life really perfecting your craft and honing it. Spend the last third giving back. I am probably in the second third right now. In the last third, I think that education is a big focus for me. I mean, I think on our third date, my wife and I, girlfriend at the time, we went to tutor at KIPP charter schools. That was our third day, right? I think, when I do retire from this business, I would love to spend more time in that aspect because I think financial literacy and just education in general is probably one of the great equalizer in society and a way to close that wealth gap within the US or even globally. So that is an area that I would love to focus on a bit more later in my career.
[1:23:02] Dennis Hong: I personally feel I am still getting started. So, I am quite a long way off, before even thinking about sort of the sunset of my career. So, you know, the thing is that I love entrepreneurship, and one of our investors is this phenomenal entrepreneur. And he has been incredibly successful financially. And I think the best way that he is giving back is actually by investing in innovation in places like India.
So, some of the some of the poorest countries in the world. Here he is empowering entrepreneurs, to build businesses and solve problems. And I think that that is such an amazing, amazing concept, too. It doesn’t take a lot of capital to make a huge impact, actually, in fact, like, even just like the seed capital, for entrepreneurs who get overlooked by traditional sources of capital, and if they have the opportunity to really like change the worlds with their franchise make life easier for everyone. I think that would be so interesting. But as of right now, I am really focused on building this firm, I am really, really focused on undoing my four responsibilities, even better than before, right?
So, protecting, growing or capital, like that is going to be a lifelong, lifelong learning, a lifelong of experience that I have yet to experience. Taking care of our LPs, right. This firm does not scale beyond sort of from scratch for us. Like, I have identified that it is not an AUM constraint or us. It is bandwidth. I do not have an IR person, I do not have a marketing person, I am the IR, I am the marketing person. I am also the portfolio manager, and I am also the CEO, and for me, it is very, very important that my partners have access to me. And I want to not only be a great partner, I want to be the best partner. And that only scale so far, I think that we have bandwidth probably 15 to 20. Full stop. And that is it. And, and doing a very, very good job, a superlative job for that constraint group of partners. That is really important to me, and then mentoring my team. So, I tell my teammates all the time, I want to build the kind of firm where, where if choose, you could easily see yourselves building your career in my firm.
And the only reason why you should leave is because you want to start your own thing. And that is pretty cool. That the idea that somebody left my firm to go start their own franchise, and I may have had a small part in inspiring them to do that and trained the next generation of Great Investors. I think that that is such an interesting concept, but I hope that my teammate stays here and grow with me and are with me for the duration of their careers. And then finally, it is adding value to our management team. So, I was telling an LP the other day, that in our first five years, we are really about foundation. So, building this foundation to build scalability, replicability, repeatability. Our second five years, which we are living through right now, is about executing. Our third five years, so year 11, to 15. I want to be the kind of investor that our managers, if they see us show up on their shareholder base or shareholder registry, that they feel that “Wow” like “I’m really, really thrilled to have them because they’re helpful, they’re thoughtful, they’re value added”.
And it is a really good thing that ShawSpring is there. And that reputation takes a lot of time. And we are a long way away from doing that. But I look at I look at firms like Tiger Global, I look at firms like Hillhouse, I look at individuals like Lee Fixel, who just raised an extraordinary firm called “Addition”, and he is a shareholder that is desired by everybody. To have Lee Fixel on their cap table is a pretty big endorsement. And I think that that is really, really cool. So, we have some ways to kind of get there and show management’s that we can add value and be thoughtful and be the kind of shareholder that they want.
Spend the first third of your life learning as much as you can, and being a student, spend the next third of your life really perfecting your craft and honing it. Spend the last third giving back.Fred Liu
[1:27:24] Tilman Versch: Thank you very much. And at this point, I want to say sorry, to all the questionnaires, which questions I could not ask. There was a long list of great questions I was not able to ask. I am sorry. Dennis and Fred – for the end of the conversation, you have the chance to add something we have not discussed, and you want to share with our audience. It is also fine to say we already have discussed so many things. So, I have nothing to say here.
[1:27:55] Fred Liu: I just want to say, and we alluded to this, you know even before we started this conversation is the resources like this, that you provide Tilman for younger investors. It is amazing. Because I mean, I named my firm Hayden after my freshman year dorm where it was a bunch of friends and myself. Just literally, we were living through the financial crisis, trying to vouch for everything that we could in terms of investor letters and whatnot. You know, YouTube was not as popular as it is.
Now, there definitely were not resources like this. I think I would have accelerated my learning so much more. If other investors were even open to interviews like this, maybe 15 years ago. I think the industry has changed because of the Internet; Information has become a bit more democratized. And people are more willing to share and you know, share ideas and not be a black box in terms of how they run their funds and what they are investing in. I really love that change in the industry. So, thank you, Tilman, for doing things like this, and I also got to thank the internet for existing like this, because I don’t think we could run Hayden the way we do without, without the internet.
[1:29:07] Tilman Versch: I want to say thanks to the internet as well, at this point. It is a great thing.
A message to young investors
[1:29:12] Dennis Hong: Yes, yeah, tell me I did want to just express my humbleness, thank you for having me on and sharing your network with us. Because I think you have put together one of the most interesting group of under the radar, boutique managers, and I learned so much just watching your videos. I do want to leave maybe two things for the younger people that are listening. So I’ll tell you the last time I did this video, I some of my most favorite emails and pieces of correspondence were from really really young people who wrote and said: “You know, I’m Korean American and it’s, it’s amazing to see a Korean American who’s a leader at a firm and I’ve been looking for that type of role model for a long, long time”.
It was really really touching to receive those types of correspondence. Because it is you give visibility to quite a diverse group of people. The two piece of advice I wanted to give young people, which we talked about a little bit by Byron Wien of Blackstone Group. This business requires a little bit of luck. And there is no better way to maximize your luck than to know as many people as possible. So, network intensely. That is one piece of advice that I want to give. And the second piece of advice I want to give is: Find ways to make yourself intellectually and personally uncomfortable.
And what I mean by that is that do not necessarily just work on things that you are already really good at. You are already good at those. Work on the things that scare you to death. Work on the things that just make you so fundamentally uncomfortable to your core. I will tell you, Tilman, I hesitated to do that previous live stream with you. One because it is live. And number two, growing up: Public speaking was one of my biggest phobias growing up. And it took me a lot of courage. I think I told you this, that the two weeks ahead of that livestream, I could not sleep. Because I thought that man like this is very intimidating, it is live.
And I just do not know how people perceive me. But I’ve sort of also made it at a point in my life that I want to work on the things that I am not good at. Work on the things that make me really, really uncomfortable and being able to spend some time with you in the course of that 90-minute interview. That was really valuable to me. So, I just wanted to thank you for that. And to encourage your listeners and viewers out there that work on the things that you are not good at. Do not work on the things necessarily that you are already good at, because you do not grow. So, I wanted to leave those two pieces of advice.
This business requires a little bit of luck. And there’s no better way to maximize your luck than to know as many people as possible. So, network intensely.Dennis Hong
[1:32:09] Tilman Versch: Thank you very much to both of you. And thank you very much for the audience. I hope to have you back again one day. It would be great! For now, it is time to say goodbye to everyone. Thank you very much for joining our live stream. You too, please stay on a bit. But to the others I want to say bye bye!
[1:32:30] Dennis Hong: Bye, everyone.
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