Here you can enjoy the transcript of our conversation with Joe Frankenfield of Saga Partners. We discussed his way into investing and why he switched from investing in linear businesses to non-linear businesses.
We have discussed the following topics:
- Check out In Practise
- Joe Frankenfield's first steps in money management
- Is investing gambling?
- Being based in Cleveland
- Setting up Saga Partners for long-term investments
- The ideal investor
- Philosophy of Saga Partners
- Choosing the right partner
- Strength: patience
- Saga's definition of Value Investing
- Balancing opportunism and deep-knowledge
- Evolving & replacing portfolio positions
- Dealing with "mistakes."
- Finding stable investments for the future
- Example of Roku
- Handball and the parallels to research
- Dealing with bias
- Community Exclusive
- Long-term portfolio construction
- Managing money privately vs. professionally
- Saying no
- Defining high-quality companies
- Culture and team
- Customize your approach to investing
- Thank you
Check out In Practise
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[00:00:35] Tilman Versch: Welcome! It’s great to have you all back today. Today we have Joe Frankenfield of Saga Partners. Hi, Joe! It’s great to have you here.
[00:00:44] Joe Frankenfield: Hi, Tilman! Thanks for having me.
Joe Frankenfield’s first steps in money management
[00:00:47] Tilman Versch: You’ve lived here in Cleveland, Ohio, almost your whole life. You spend some time in Miami and Phoenix, I think you said to me, but you never worked there at a prominent hedge fund or a giant tech fund. But now, if we look at your portfolio, you own some of the great tech and online companies not only since 2020. How did you do that, man?
[00:01:11] Joe Frankenfield: How did I start?
[00:01:12] Tilman Versch: How did you start from a small place and be able to move into the right names and invest in the right way and also have this outstanding performance? There are so many questions, especially as we go into details, but you can try to give an answer.
[00:01:27] Joe Frankenfield: Yeah, that’s a good question. I get that often. I’ve definitely started from an unconventional place for managing money. I think it just kind of was a natural progression of what my interests were. I just kind of took it one step at a time. As you said, I was born and raised in Cleveland. I spent some of my grade school years in Phoenix, Arizona, and then went to Miami University in Ohio. Some people get that confused with Miami, Florida.
[00:01:57] Tilman Versch: Like me!
[00:02:00] Joe Frankenfield: Yeah, it’s funny. We hired an analyst over a year ago, Richard Chu. He is great, very smart. I love working with him. About a month or two ago, I didn’t know what brought the conversation up, but he messaged me, or we were speaking, he’s like, “I just realized that when you say you went to Miami University, that was in Ohio and not Florida.” Like, “Why would Miami name themselves after a famous city in the US? And the response of people that went to Miami University was Miami was a college before Florida was a state of the United States. So, it’s just kind of a random name.
Anyways, I didn’t know I was going to manage money professionally. I kind of followed my interests. I’ve always been one who likes to understand how the world works and try to figure out puzzles. I loved history in high school. I was kind of turned off from the idea of investing in the stock market because of my dad. He’s a mechanical engineer, a very analytical, smart guy. But he always considered investing in stocks somewhat to be gambling. And so, that always turned me off when I was younger.
In college, I studied finance and business. I was interested in how the economy works, how money moves around, and how people are motivated by different things. I got a job in corporate banking during the Great Recession. It was hard to find a career in finance at the time. Still, I was happy to find a job where I would work directly with companies, figure out what made a company successful and what made one not successful and work directly with the decision-makers of middle-market-sized companies.
It was really interesting to speak with the presidents and CEOs or CFOs of at least mid-sized companies. But at that time, when I was right out of school and started making money for the first time and having money that I could save and invest, I came about Warren Buffett’s letters kind of randomly.
Obviously, in business school, you study Warren Buffett, and you look at his success and how he thinks about investing. But it was the summer after school I picked up the book by Robert Hagstrom, who wrote the Warren Buffett Way, and that was kind of my first entry to the value investor world. I went down the rabbit hole of trying to understand how to value businesses and compound capital over the long term.
What I thought would be a pass time to invest my savings and grow it kind of turned into an obsession. I believe that it’s common for people to get the investing bug. The next thing you know, I was spending my nights and weekends reading filings and understanding industries and reading every book I could on Buffett, Monger, Peter Lynch, Phil Fisher, all the well-known value investors and just trying to learn and figure out a puzzle. We’re just trying to figure out these anomalies in the market that we think are mispriced and inefficient.
|What I thought would be a pass time to invest my savings and grow it kind of turned into an obsession. I believe that it’s common for people to get the investing bug. The next thing you know, I was spending my nights and weekends reading filings and understanding industries and reading every book I could on Buffett, Monger, Peter Lynch, Phil Fisher, all the well-known value investors and just trying to learn and figure out a puzzle. – Joe Frankenfield
I knew pretty early that I thought that’s what I wanted to do for a living, for a profession. The question was, I was already in the business world, but I wanted to get into the investment management world. And so, I went through the CFA Program. And then, after I got the CFA, I got a job on South Side equity research, covering the transportation and logistics sector. I thought that job would be living my dream, like analyzing and studying companies to value them and write about them. It was a great experience. And you get to work with people who are allocating billions of dollars. These are Fidelity’s level, or the Kiger Prices, or hedge funds. So, you get to understand how people within the industry work.
It was pretty apparent early on, but when I had already formed my philosophy and thought about investing, which is a very long-term fundamental outlook, it was not how most of the industry operates. Most of the industry, at least for the clients that we worked with, is very short term and trying to figure out whether a company would be or miss consensus each quarter kind of momentum investing, where the stock was up or down five or so percent every day. Whenever I would talk to clients, my response is that their stock is up 5% because there are more buyers than sellers for whatever reason it may be. That makes sense because when you are on the sell-side, most sell-side shops function this way. You get paid by having trading activity. You make a spread on the trading. And so, you research your clients and incentivize them to trade with you and give you research dollars as well.
Anyways, I knew pretty early on that’s not kind of where I should be for the long term. Over the years, as I was managing my portfolio, I was getting more and more conviction in my ability to pick winners. I was learning. I made mistakes as everyone does, and I still make mistakes, and I will continue to make mistakes. But I was beating the market by a wide margin in my portfolio. I was getting more conviction that I think I could do that for other people and have the confidence to do that for others. That might seem gutsy. People say, “How do you have the confidence to do that?” But I just thought if I could manage money the way I thought it should be managed, as though I would handle it for myself, I would like anyone who agreed with that philosophy to come on board and hopefully form this multi-decade record of compounding capital.
Over the years, as I was managing my portfolio, I was getting more and more conviction in my ability to pick winners. I was learning. I made mistakes as everyone does, and I still make mistakes, and I will continue to make mistakes. But I was beating the market by a wide margin in my portfolio. I was getting more conviction that I think I could do that for other people and have the confidence to do that for others.Joe Frankenfield
And so, I got to that point in 2016, over five years ago at this point. I started my portfolio, and that’s kind of where I went. I can speak about Saga Partners and how we formed it and stuff, but that’s kind of where I got to just managing money full time.
Is investing gambling?
[00:08:26] Tilman Versch: Let’s talk about this in a second. I still have questions about your father. Does he still think you’re gambling? Or did you convert him at a certain point in time? And how maybe, that is also interesting.
[00:08:38] Joe Frankenfield: Yeah, when I was getting more interested in the mark, which was in college, he would roll his eyes a little bit. And then, when I was starting to manage my portfolio, he would still roll his eyes and say it’s gambling. But then I was having success, and I would talk about the stocks or the different ideas I had with him. And so, he knew for years that I was obsessed with just understanding how the world works and understanding these weird anomalies, and solving puzzles.
Ironically, when I wanted to launch Saga Partners and start my portfolio, he gave me a significant chunk of his savings. He was our largest investor at the time. We’ve done well for him, so I think he’s maybe turned from thinking it’s gambling to thinking maybe there’s something to it. I think the way we approach investing. I think he understands that we’re investing. We’re not speculating. We will make mistakes, but if we can pick a few of the big winners, then we could potentially outperform the market over the long term.
[00:09:47] Tilman Versch: If he starts pitching Papa Saga Partners in three years to you, you’ve made it.
[00:09:52] Joe Frankenfield: Yes. Yes. [Laughs]
Being based in Cleveland
[00:09:55] Tilman Versch: Let’s come back to Cleveland and being in Ohio. Is that an advantage for you?
[00:10:03] Joe Frankenfield: That’s a good question. People have claimed that there might be an advantage if you’re outside of the major money center cities like New York City or Boston. I don’t know. It’s tough because, in this day and age, information is at everyone’s fingertips. There is no informational advantage for the most part in the market. So, we get the same news feeds as people in New York and Cleveland.
Buffett has said being in Omaha has been an advantage. You can think and not be surrounded by a kind of momentum or groupthink and things like that. I don’t know if that’s the case or not. But I do think, where you’re born and raised, and there’s a culture. There’s a culture within your family. There’s a culture within the school you go to within the city. Maybe a Midwestern culture impacted the way I think about not having day trading or being kind of slow to buy a stock and being slow to sell it. Maybe that’s part of the culture. I don’t know. But the same thing is we get the same information as anywhere else. You can manage money anywhere in the world with the internet these days.
I do like Cleveland because it’s where my family and friends are. I do feel comfortable here. It’s funny because right after school, I live in Cincinnati for several years. And then I moved up to Cleveland when I got a job on the sell-side. Yeah, so Cleveland had a bunch of sell-side shops. I think there’s a little hub of finance in Cleveland compared to other cities the size, but at the end of the day, I think there’s probably a slight advantage to wherever you’re located. It’s more about your process and about how you think and approach investing. So, I imagine there are tons of amazing investors in New York City or Boston, or anywhere. I think it’s just how you approach investing overall versus your location.
Setting up Saga Partners for long-term investments
[00:12:02] Tilman Versch: Then let’s move on to Saga Partners and your process. How have you set up the firm to optimize it for great long-term returns?
[00:12:13] Joe Frankenfield: Oh, that’s a good question because that’s so important. When you’re young and trying to figure out how to establish the foundation and infrastructure for a firm, you’re just trying to learn from people in the industry, so it’s very easy to get bad advice potentially.
I knew if I could manage money the way I thought it should be managed, as though I was managing my portfolio, I would have a high level of conviction to outperform over the long term. People don’t do that because of their investor base, who invest with you in the portfolio, and what they are looking for. And so, you’ll find that a lot of times, and this is just a general statement. Still, for institutional investors that often make decisions by committee, it’s hard to be a generalist to go wherever you find the opportunity because they often like to bucket you into a certain category of investing, whether it’s value versus growth, or large-cap, mid-cap, small-cap, US, foreign, whatever is your bucket. I just wanted to invest wherever the opportunity was, the opportunistic. So, I knew that your investor base is very important and who we would let in Saga Partners was very important for our long-term success.
You can say that if you have a big launch of a hedge fund, and to clarify, we’re not a hedge fund. We’re investment advisors. So, we do manage money through separately managed accounts. We are fiduciaries for everyone who invests with us. Anyways, who is in your industry has a competitive advantage, right? And so, who you let in kind of forms the culture of your portfolio, which also those people may refer, people within their network say, “Hey, this is a strategy that makes sense for you.” So, it creates this virtuous cycle where this culture becomes self-reinforcing, where you think long term. You think about a company’s intrinsic value. You’re not trying to trade daily.
Who you let in kind of forms the culture of your portfolio. Your investor base is important. Also, the way we manage the portfolio, I think, is where we have to survive over the long term.Joe Frankenfield
And so, to answer your question, your investor base is important. Also, the way we manage the portfolio, I think, is where we have to survive over the long term, considering a long time. We can’t have our hands tied behind our back. And so, the way we think about using leverage or shorting or using options, that stuff could potentially hurt you if you go through really difficult periods like March of 2020. And so, we have to survive all ups and downs. And so, that’s how we structure the portfolio. But really, it’s getting the investor base right, I think, is key to how you structure when you launch a strategy.
The ideal investor
[00:15:00] Tilman Versch: Do you have an ideal investor you want to have in your investor base?
[00:15:06] Joe Frankenfield: The two things we look for in investors are: One, that they’re looking for a long-term relationship. They have a multi-decade outlook for this capital that they want to compound. They also think long-term. So, they’re looking to build a long-term relationship and not looking to get in and out of Saga Partners. And two, they also don’t need this capital for five or 10 or 15 years. And so, if they fulfil those two criteria and they align with how we manage money, then they’re suitable.
The two things we look for in investors are: One, that they’re looking for a long-term relationship. They have a multi-decade outlook for this capital that they want to compound. They also think long-term. And two, they also don’t need this capital for five or 10 or 15 years. And so, if they fulfil those two criteria and they align with how we manage money, then they’re suitable.Joe Frankenfield
I think that getting that long-term, making sure you don’t get hot money. If it’s really easy to raise a billion dollars, it means it’s probably pretty easy to lose a billion dollars. It could be hot money. And so, we’re just looking for long relationships. And it kind of creates this value chain of capital allocation, if you think about it, where we need those who are investing dollars in us long term so that way in our investments, we can think long term, so that way the managers that we invest in the companies, they can think long term, right? It creates this virtuous cycle where everyone’s thinking long term. We’re making these decisions that make sense for the long term. Versus if you have hot money that needs you to perform every quarter every year, then you’re thinking, I need to outperform whatever your benchmark is every quarter and every year. And then, you start rethinking how your investment process works. And that means your companies have to perform every quarter and every year, no mistakes, no tripping through the race. And so, if management teams have to worry about making the quarterly numbers, that changes how they manage their business.
It’s kind of scary when you hear stories about people that work at Fortune 500 companies and how management is so incentivized to make their consensus numbers every quarter. They will potentially push costs back a quarter. They’ll try to book revenue earlier. I guess anyone knows they will change their accounting and change how they manage the business. Not for the benefits of the long term but just so that way, their stock price doesn’t crash if they miss numbers. That’s not how the economy should work. That’s not going to create the most value.
And so, there’s has to be this value chain of capital allocation. We’re just a drop in the bucket. But like, the more that capital is allocated with this mindset, the more efficient the economy will function and work. And so, if we’re looking for long-term investments, we need long-term investors. And then, that means management can function over the long term. That’s just so important, I think. So yeah, that’s kind of what we look for in investors.
There has to be this value chain of capital allocation. We’re just a drop in the bucket. But the more that capital is allocated with this mindset, the more efficient the economy will function and work. – Joe Frankenfield
There has to be this value chain of capital allocation. We’re just a drop in the bucket. But the more that capital is allocated with this mindset, the more efficient the economy will function and work.Joe Frankenfield
Philosophy of Saga Partners
[00:17:47] Tilman Versch: They also have short-term optimization issues for excellent results with the current shipping and logistic crisis. All of the buffers have been taken out and optimized for short-term metrics. Shipping is an amazing bridge to the next question because Saga Partners has this boat as a logo. We also show it here. Let me make a wild guess why you’ve chosen the boat. Do you live at the Great Lakes? Long-term, when you are successful already, you plan to own a boat and sail across the Great Lakes? What is the reason you’ve chosen the boat?
[00:18:23] Joe Frankenfield: That’s a good question. I’ve never been asked that question, which is funny. But I guess that gets into the question of why we’re called Saga Partners. When Mike Nowacki, my partner and I, started working together, the first thing that we did was try to brainstorm a name. We’re trying to come up with something short, clean. Kind of like, I don’t know, Google, something that was just a short name that represented our philosophy. And we couldn’t come up with a name for a couple of days. Finally, something just clicked, and one of us said Saga, which is a word for a long epic journey. That’s a Norwegian word. And so, that kind of just sounded right. It kind of filled our philosophy of thinking long term. I hope that we’re beginning a long-term epic journey, and Saga just made sense.
The ship is just a logo for like the Vikings, right? It kind of represented the journey part of the idea behind Saga. So really, it’s not because of being on the Great Lakes or about me wanting to buy a boat one day. It just was a logo that we picked. Really no huge reason behind it.
[00:19:41] Tilman Versch: Maybe I’ve created an idea in you with this question.
[00:19:43] Joe Frankenfield: Maybe. Yeah.
[00:19:44] Tilman Versch: We will see.
[00:19:46] Joe Frankenfield: You don’t want to own the boat. You want to have friends that own boats. I am not a boat person because I don’t get much value from the idea of having to maintain and take care of a boat. I do get value from skiing. That’s like something I love to do. But boating is not one of my pastimes.
Choosing the right partner
[00:20:06] Tilman Versch: You are also a person that has a partner. You’re not the typical one-man shop with Saga Partners. You have your partner, Michael Nowacki, and an analyst, Richard Chu, someone I know from Twitter. What is the advantage of such a setup? How do you all make sure that you build for long-term success?
[00:20:27] Joe Frankenfield: Yeah. I mean, I think there’s a lot of benefits to having a partner. You want to share in the success. You want to be able to share ideas. As long as you find the right partner who thinks similarly and has a similar philosophy, there’s a lot of value creation. One plus one equals three, that type of idea. I have that with Mike. We met very serendipitously when I was looking to launch my portfolio in 2016 through a mutual friend. He was a big Buffett fan. We went together for coffee and just spoke for hours about businesses, the economy, and starting a business. We just really aligned on that philosophy.
I think there’s a lot of benefits to having a partner. You want to share in the success. You want to be able to share ideas. As long as you find the right partner who thinks similarly and has a similar philosophy, there’s a lot of value creation.Joe Frankenfield
And so, I always liked the idea of having a partner. If you look at a lot of well-known investors, they did have a partner. And so, I get that with Mike. With Richard, I never really thought we would hire an analyst because I kind of love the idea of digging through the filings and doing the first-hand research. I never wanted to outsource thinking. But with Richard, he aligns with how we think. And it was very just again, serendipitous on how we kind of came together. He wrote a research piece on Livongo, which was one of the holdings we were researching. It was well written.
Mike reached out to him and said it was great. And then, if he ever was in Cleveland, he lives up in Toronto, and if he ever was in Cleveland, we should get together. And so, I think it was two weeks later, he came down to Cleveland and met with Mike and then met with me later. We could see his passion. He pushed us. He’s so impressive for his age. He is a great analyst and a pleasure to work with. So, I think there’s just this idea of a team. You cover more ground. You push each other. And what’s important is just that you create more value working with others. And so, yeah, I get that with having a partner with Mike.
I would mention. When we first launched Saga, Mike and I were co-portfolio managers of the Psyker portfolio. Mike was already managing an investment advisory for clients before he met me, who had kind of tailored portfolios for their suitability. Cybers is kind of a core strategy that we wanted to launch. That is where we put all our effort behind. When you have co-portfolio managers, it’s hard to have two company CEOs or investment management to Portfolio Manager. So there’s maybe some confusion over decision-making. And we won’t always agree, even though we agree with each other a lot of the time, but we adjusted that structure in 2019, where he could focus on a few other things that he was interested in and support the Saga portfolio. So then, I became the decision-maker, the lead Portfolio Manager of the Saga portfolio in 2019. But it works well for us. I think it aligns with our long-term goals and what we want to do with the business.
[00:23:43] Tilman Versch: If I ask Mike and Richard, what do you think would they say your strength are? Also, in relation to the team.
[00:23:56] Joe Frankenfield: My strength is probably that I can sit and dig through filings for hours and not make any final decisions until I finally see the light or something. I think it’s hard for people not to be active. I’ve always been able not to trade or feel the pressures to trade.
My strength is probably that I can sit and dig through filings for hours and not make any final decisions until I finally see the light or something. I may not necessarily be the smartest business analyst globally, but I believe I would excel at the marshmallow test. I wouldn’t be able to do deferred gratification until I see the light at the end of the tunnel.Joe Frankenfield
An interesting study, I think, is the marshmallow test, which was done decades ago, but when you put a marshmallow in front of two or three-year-olds and tell them if they would wait 15 minutes or an hour you would get two marshmallows. I may not necessarily be the smartest business analyst globally, but I believe I would excel at the marshmallow test. I wouldn’t be able to do deferred gratification until I see the light at the end of the tunnel. So, you have Point A to Point B. Point C gets you to the end of the light and plans around that in an opportunity cost analysis.
And so, I think that’s always been one of my core strengths is kind of looking long term, thinking long term. I think that’s something pretty important if you manage money the way that we do.
Saga’s definition of Value Investing
[00:25:14] Tilman Versch: That’s good to know. When I searched on Google for Saga Partners, your website showed up with Tech Saga Partners, Investment Management Value Investing. When I looked in your portfolio, they came up in your portfolio. Carvana, TradeDesk, or Roku. How did you guys modify the value investing framework to be comfortable to still name it to value investing and own companies like Carvana, TradeDesk, Roku, you name it?
[00:25:45] Joe Frankenfield: Yeah. I guess it gets to the question of value versus growth discussed at Nauseam. I mean, that debate between value and growth. Like Buffett and Munger say like, “Oh, intelligent investing is value investing.” That’s what we’re trying to do. We’re trying to buy things for less than they’re worth to earn attractive rates of return. I think that traditional value investing was based more on lower multiples from current fundamentals. The mental model doesn’t necessarily apply as much as it did in the past for many different reasons, but we are value investors.
I think the law of investing that will always be true is that the intrinsic value of any asset is the net cash returned to owners over its remaining life. And that’s what we’re trying to figure out with the goal to compound capital. And so, when you look out in the investing universe, and you’re trying to find attractive Internal Rates of Return (IRR), I would be happy to own a no-growth company. We’re not growth investors. The thing is, what would you be willing to pay for a company that you could see forever that was completely stagnant/stable? What would you pay for those earnings?
I think the law of investing that will always be true is that the intrinsic value of any asset is the net cash returned to owners over its remaining life. And that’s what we’re trying to figure out with the goal to compound capital.Joe Frankenfield
Historically, the market has returned at, say, nine or 10% annually for equities. And so, maybe a ten multiple. But when you look at the market, those opportunities aren’t available. We’re not looking for average returns. We’re looking for excess returns, 20+% IRR. And so, you’d pay five times multiple. You’d have to have a lot of conviction that those earnings are owners’ earnings, which could get distributed out to owners and not stuck in the company.
And so, that’s a good starting place for thinking about growth and how you incorporate that into your intrinsic value analysis. But historically, when you look at the stock market returns, the best return in companies over 10-20-30 years can compound that had this growth aspect to them. They’re not the ones who have been stagnant and stable in the public markets. And so, that kind of leads you to kind of finding the patterns of what made these companies special.
A lot of times, and this makes sense, is the market will value something, thinking that if it’s doing well, we’ll revert to the mean. Fundamentals will revert to the mean. And that is a good, I guess, mental model. That’s good for average companies. That’s often the case. Poor companies will revert up to the mean because other competition will go away and whatnot. It’s just how the capitalistic economy works. But very few companies, very few, have these durable competitive advantages that the market undervalues because they don’t revert to the mean as fast over time.
And so, when you look at what provides this nine or 10% annualized return on the market, it’s actually very, very few companies, single-digit percent of companies, 5% to 8%. There have been studies. Looking back at historical data provides nearly all the returns of the market. When you break it down, nearly 50% of publicly traded companies provide negative returns in the market. So, the idea is there are all these landmines. We can invest in any public company, and their prices fluctuate every single day. So, you have all these options, but most of them are going to be very poor. I learned from experience the longer I do this, that the market is pretty generally good at valuing businesses, but sometimes it undervalues when you take this 5-10-15-year outlook on what a company could be.
The idea is there are all these landmines. We can invest in any public company, and their prices fluctuate every single day. So, you have all these options, but most of them are going to be very poor. I learned from experience the longer I do this, that the market is pretty generally good at valuing businesses, but sometimes it undervalues when you take this 5-10-15-year outlook on what a company could be.Joe Frankenfield
We found this in companies that really have the ability to scale farther than what the market is pricing into that price. To go further, what’s interesting is it’s scary. You don’t want to project 20% growth returns on companies, generally because, if you look at historical companies, very few companies have the ability to grow 20% per year. But as you see in our portfolio, they’re these companies with many intangible assets. They’re often associated with the knowledge economy. Michael Mauboussin recently came out with his new book, Expectations Investing, and he would break down companies into physical companies, service companies, and knowledge companies. And obviously, there’s a blend for what a company does. It can be a mix of those. But the more intangible you have; it changes the economic characteristics of the business. And if you look at how companies scale historically, say, a very physically tangible asset-heavy company, they scale sub-linearly similar to living organisms. And so, as they get bigger, the costs also don’t necessarily benefit from economies of scale. Eventually, economies of scale hit these economies of scale as we become more efficient through customer acquisition costs, bureaucracy, whatever it may be the case.
And so, what the intangible companies’ characteristics have become is that they’re able to scale much larger, and they benefit from network effects often. And so, they scale cities, which are super linearly scaled cities. These are very durable businesses. And so, a lot of our companies that we own have this business model of a marketplace, a platform. And so, in our view, that is more durable, more often than like a linear business, which is more tangible, asset-heavy.
But anyway, to get to your question as a long roundabout, we are value investors. We’re just looking for things, maybe in a different light. I think the market is getting a little bit smarter about some of these companies, obviously as multiples have gone up, and many of them these intangible asset-heavy companies.
Balancing opportunism and deep-knowledge
[00:32:06] Tilman Versch: You also said you would own a no-growth company in your answer. I think that’s also adding to a claim or a point you made in other talks that you say you’re opportunistic. You go where the market offers opportunities. But how does this go about with what I’ve observed from other investors that you need a certain specialization, focus, deep thinking, and orientation for the long term to outperform and not really like a nomadic opportunity-driven investment style? So, how do you balance this being opportunistic and the deep knowledge you need to have to outperform?
[00:32:45] Joe Frankenfield: I think that if you manage a portfolio based on opportunity costs, you constantly weigh what your best opportunity is. If you’re doing it right, your portfolio is going to consolidate naturally. If you have the 20th idea and consider what your expected returns for your best ideas are, you’re like, “Why don’t I put more in my first idea?”
I think even if you’re right in picking these investments, they truly are undervalued. Still, over time, those really good ideas will probably appreciate greater so that your portfolio will just naturally consolidate. And so, I think when you make decisions based on that, you can focus on your best idea. So, you do get into understanding the DNA of every single business that you own. We spend months and months and years and will own a company for years. And so, you know it well.
I think that if you manage a portfolio based on opportunity costs, you constantly weigh what your best opportunity is. If you’re doing it right, your portfolio is going to consolidate naturally.Joe Frankenfield
[00:33:44] Tilman Versch: An investor needs to have a deep knowledge of the company. For example, you wanted to buy a Roku stick. You have to know how this stick functions and what software is behind it. You want to be mad about knowing where the suppliers are and any problem from the chip shortage, etcetera. These questions also lead to deep knowledge. The idea of the circle of competence somehow conflicts with the idea of being too opportunistic because if you’re investing in something you don’t know that deep, there’s also a cost.
[00:34:25] Joe Frankenfield: Yeah. When you look at the best investments or the ones that we can understand, you want to have deep knowledge and understand the DNA of the business. But really, it often comes down to just a few variables, one or two, maybe three. It’s, “What are the revenue drivers?” Right? What’s the new breakdown? The unit economics of the business. What drives that?
For instance, you’re trying to invest in high-quality companies. Those are the ones that are likely to do well over the long term. We’re trying to answer two questions. One, what is the problem this company is trying to solve? Why are customers hiring this company to outsource a problem? And two, why can’t other companies solve this problem for that customer today or far into the future?
You can think of this from a commodity business to a monopoly. We’re trying to get as close to a monopoly business. If you can understand why that company is able to provide a product or a service better than other companies—a durable thing that has pricing power and has a check of economics—it often comes down to focusing on a few of the drivers of value. And so, is it because they can offer a lower price for the product more than others, like a Costco or Walmart or an Amazon? Is there some type of economies of scale? What protects that advantage?
When you specialize, and the company is more generalist, we don’t need to code or write software. Still, we need to understand the economics of those businesses and why they can provide that product or service while others aren’t necessarily able to the same extent. We’re looking for differentiation. What is different about the specific business, and why will that continue to be the case far into the future?
When you specialize, and the company is more generalist, we don’t need to code or write software. Still, we need to understand the economics of those businesses and why they can provide that product or service while others aren’t necessarily able to the same extent. We’re looking for differentiation.Joe Frankenfield
Evolving & replacing portfolio positions
[00:36:31] Tilman Versch: When I look back in your letters from 2016, I had the feeling that you did give up some kind of investment and made a shift to the companies you own now. Why did you give up these investments? Thinking of opportunity cost, was it worth it?
[00:36:50] Joe Frankenfield: Yeah. When we launched the portfolio at the beginning of 2017, we probably had 14, maybe 15 investments. Mike and I were working together for like three or four, maybe five months at the time. So, we were putting this portfolio together to launch.
The thing about investment ideas is they just don’t come when you want them to. And so, we liked the companies we launched with. But as you do this every day and you’re constantly looking for ideas and analyzing what’s going on in the economy, we’re always trying to improve the quality of our portfolio. And so, we’re weighing our ideas, and we’ll replace the ones that we like less with the ones we want more. That’s how you manage a portfolio based on opportunity costs.
The thing about investment ideas is they just don’t come when you want them to. As you do this every day and you’re constantly looking for ideas and analyzing what’s going on in the economy, we’re always trying to improve the quality of our portfolio. And so, we’re weighing our ideas, and we’ll replace the ones that we like less with the ones we want more. That’s how you manage a portfolio based on opportunity costs.Joe Frankenfield
Similarly, I think the companies have somewhat obviously migrated more into these marketplaces, these platform companies over time. I remember having this debate of how is Amazon able to scale so fast? Why is Google so successful? You’re looking at the economy, trying to understand what makes these companies special. What are they doing? You just ponder over this over and over, and you’re analyzing these other businesses.
And so, over time, we found companies that exhibited similar characteristics like TradeDesk. That’s probably our first notable example in 2017, where we replaced and found the qualities of TradeDesk to be exceptional and durable while the market, obviously at the time, didn’t agree based on where the stock was trading. But just constantly trying to learn and understand why these companies are creating value.
What we have found is the longer we manage this portfolio, the cyber portfolio, the lower turnover becomes. We constantly try to improve the quality of the businesses that are in it. And so, for the next best idea to get in must be better than the last idea, and as you do that longer and longer, you kind of form this solid portfolio, where it’s hard to get into it. In the first year or two, maybe we did switch out in and out some businesses, and quite frankly, when we underwrote certain ideas, it might have been like 15% types of expected return because those are the ideas that we could find at the time. But as you find better ideas with a higher expected rate of return, those companies that we look back at just wouldn’t make the cut today.
And actually, going back to our old investor letters in 2018, it’s almost like you see how you change as an investor. You evolve and learn and become better. That’s what we’re trying to do. So, in five or ten years from now, I hope we look back and say we’re much more improved. I read the letters from 2018, where they’re fine, but it’s a good way to timestamp what you thought at that point and then what happened. Looking back, you learn from that, and you get better. That’s part of the benefit of writing newsletters and your investment theses is you can go back and see, “This is what I thought.”
I think we’ve probably made 25 or 30 or so investments. We currently own eight. They have all generally done okay. There’s never been a huge blow-up. But you can see where huge returns come from is that power-law where a few companies drive most of your returns. And so, if you can focus on those companies that drive the most returns, you won’t get it right all the time. But if you think you have a strong level of conviction that you found one, concentrating on it makes the most sense. And so, that’s kind of how we’ve evolved over the past couple of years.
Dealing with “mistakes.”
[00:40:42] Tilman Versch: Looking back, do you see any mistakes of selling any of the companies you hold before, and the opportunity costs are high for not holding them anymore?
[00:40:53] Joe Frankenfield: We talked about our mistakes, and I don’t like calling things mistakes because all that happens is we have this investment thesis as an expected outlook. As we get more knowledge over time, we might revise our long-term outlook. And so, if we call it a mistake, it’s painful. People don’t like to be wrong, and we are wrong because the future is messy and unfolds differently than we may previously believe. But as you get new information, you have to readjust your long-term expectations based on where the stock is today. And if it’s no longer attractive based on this new information, then you should readjust and reallocate your portfolio accordingly based on your revised expectations. That’s basing all our decisions on opportunity costs.
I don’t like calling things mistakes because all that happens is we have this investment thesis as an expected outlook. As we get more knowledge over time, we might revise our long-term outlook. And so, if we call it a mistake, it’s painful. People don’t like to be wrong, and we are wrong because the future is messy and unfolds differently than we may previously believe.Joe Frankenfield
We have made mistakes. When we have sold companies, it was generally the right decision because we reallocated to opportunities, we thought were much more attractive even when those companies performed well after we sold them. After all, the ones that we bought, on average, have done much better. And so, that’s how we think about it—mistakes and selling and just constantly trying to revise our outlooks. If you find that your long-term outlooks are constantly changing materially, it makes you rethink when you initially have new perspectives for new investment. What are the chances of this succeeding? The more you look at the history of business investments, the more you realize it’s tough to have a few good ideas. And so, when you do find good ideas, concentrate on them, but also have this appreciation that it’s hard to find things that are mispriced. That’s how we think about reallocating the portfolio and selling things that we believe are less attractive than new ideas.
The more you look at the history of business investments, the more you realize it’s tough to have a few good ideas. And so, when you do find good ideas, concentrate on them, but also have this appreciation that it’s hard to find things that are mispriced.Joe Frankenfield
Finding stable investments for the future
[00:42:52] Tilman Versch: You said you’re looking out 10 to 15 years with the companies you’re investing in. So, let me ask a question. Where are some of your investments in 2030-2031? You can pick two or three fighters you want to choose to answer this question and talk about them.
[00:43:12] Joe Frankenfield: Yeah, that’s a good question. I think what investors do when trying to make a decision is this kind of decision tree. You’re trying to find each node. You might have two different outputs, and you put a probability on whether a company will reach a certain, I guess, key performance indicator. I think the short-term, quarter, or annual, it’s random. It’s a 50/50% chance of whether a company will go up or down. I think you have the ability to place higher probabilities when you think long-term, multiple years, 5-10-15 years so that they can rank higher chances on a certain outcome. It’s often these companies that have these durable competitive advantages.
Jeff Bezos has a famous quote saying, what are the things that will not change from a consumer demand standpoint? They’re likely going to want lower prices, a better wide selection, and a great process or a good “experience” is the word that he uses. And those things aren’t going to change. If you can focus on continually improving those over time, those few variables around all the noise to get there, that is key in making those assessments. So, could you envision Amazon continuing to do that in, let’s say, ten years? Or that’s Costco keeping prices low, or GEICO, or these companies.
I think Nick Sleep may have coined this term of like, scale economy shared, where these companies are able to continually use their scale to offer lower prices to competitors, which makes them more durable. So, you look back at the history of businesses. Even going back to Standard Oil with Rockefeller in the late 1800s. He did very well by consolidating the refining industry throughout Ohio. He’s from Cleveland, and Pennsylvania, and New York. And consolidating the supply, the refining oil, but he passed on those savings from his ability to negotiate attractive transportation with the trains and retail at retail outlets with customers. So actually, the cost of kerosene for lighting before gas was used for cars brought the cost down for consumers.
Each had economies of scale shared. Ford did the same thing. And so, if you can find these ways that these companies can continually offer more and more value to the customer, that’s interesting. And so, companies that we look for. I try to think through our portfolio for a good example, but one of an easy example, if we want to stay with retailing, I know a few of the people you’ve interviewed have spoken about Carvana. So we’ve owned Carvana for a while now. And you think through why will Carvana succeed for the next ten-plus years? And the question is, will they be able to make it easier to transact used cars on they’re essentially turning into a marketplace? They’re vertically integrated today, but they’re making it easier to transact used cars. And is there an alternative to that model? What’s the alternative to customers? And historically, that’s been brick-and-mortar used car dealerships. They’re infamous for not having a good customer experience. And the question is, in 10 years, what would compete with Carvana?
I think it’s almost clear to say that if they continue to succeed and execute, the alternative will be so much, far worse, suitable? Whether it’s trying to find something in the newspaper to do a private transaction, or using a traditional brick and mortar car dealership, which doesn’t have the inventory, the selection, the process, also is more expensive. It seems so clear that they will have this value proposition if they continue to execute. And so, I think that’s what we’re thinking about. If they can continue to lower the frictional costs of transacting cars, they’ll be very successful. If you can get to that point in your analysis, the more important question in 10 years is, would people even be driving or owning cars in ten years? And that’s a real thing to think about, especially with this metaverse stuff in the press where people are just functioning in the Metaverse. Will they be driving? So, you have to think about your autonomous vehicles and all those things that could impact car ownership. With Roku, which I think you held up earlier.
[00:48:07] Tilman Versch: He has it again.
[00:48:09] Joe Frankenfield: Yeah, I convinced you to buy a Roku stick. Have you tried it?
Example of Roku
[00:48:13] Tilman Versch: Yeah, it’s good. Honestly, I’m not into using it more than other services. I went to prompt directly. I know who’s Roku and a Disney director was Roku. We have to talk about this later.
[00:48:27] Joe Frankenfield: Yeah. Roku is building an operating system on the TV. It’s a similar playbook, I guess when you look at personal computers with Microsoft Windows or then going on to mobile phones with Android and iOS. But with Roku is, are they able to aggregate the proliferating supply of TV content? Content is just becoming so abundant. Will they be the platform to be able to filter that for consumers better than alternatives? How will TV transition over the next ten years?
And suppose they are successful in providing the best consumer experience. In that case, that will attract more consumers, which makes suppliers of content want to be on Roku, which attracts more customers and creates a virtuous cycle. And so then, Roku will be able to monetize that marketplace better, that platform they’re creating. It kind of does get into Ben Thompson’s aggregation theory, where the power players going forward with technology are ones that provide the best customer experience. And you can look through the history of business. And what technology does is democratize these products and services. It empowers the consumer.
And so, thinking it through like let’s say a Roku and the KPIs (key performance indicators), are they able to continue to take or grow their market share in the TV operating system? That is kind of the different data points on our road to ten years. But the vision is, how will people consume TV in 10 years? Will they consume TV in 10 years, right? We’re just trying to think through these questions and make an educated guess, a probabilistic guest, on what Roku could look like in 10 or 15 years.
Talking about how we’ve transitioned in some of the businesses that we’ve owned, I have just gotten less and less comfortable with linear businesses, businesses that have to manufacture.Joe Frankenfield
Talking about how we’ve transitioned in some of the businesses that we’ve owned, I have just gotten less and less comfortable with linear businesses, businesses that have to manufacture. In their value chain, they buy goods, they do something to lose goods, and they sell them for more because it’s more likely for that to get disrupted. It’s easy to copy a TV monitor, or computer monitor, or physical goods and manufacturing. Some businesses are very good at building these high-tech, tangible goods but creating these customer-friendly platform companies, I think, are more durable.
And so that way, the terminal value risk is less. So, I feel less comfortable owning Ford or General Motors that manufacture cars versus a platform or marketplace that helps transact cars. Because like I said earlier, typically linear companies scale sub-linearly like living organisms, while cities scale super linearly. The bigger they get, the more powerful they get. It’s that Brian Arthur increasing returns to scale. So, these marketplaces scale-like cities, and they get stronger the bigger they get. And once you established that marketplace, it’s tough to disrupt it unless you have some paradigm shift.
And so, that’s what we’re looking for is the actual potential risks of complete disruption in a paradigm shift. That’s what we think about in 10 years, but I get more conviction in these types of platforms. We got other examples in the portfolio too. I know we’ve spoken about the TradeDesk, GoodRx, or things like that, but that’s how we think through these business models.
Handball and the parallels to research
[00:52:35] Tilman Versch: For the ones who are interested in trying out Roku as well, I will add the link in the show notes. I would love to hear your feedback. Joe would love to hear even more from the Europeans who listen to this because they just started in Europe.
I also want to use the option to show a video to you and combine it with a question. One of your hobbies is handball. I want to connect it with a video like this. We can start to play it here.
Like when you hit the ball very hard and are feeling intense and fighting hard, you want to make sure that your vision for the companies you are invested in is solid and you managed to build certainty. How does your research process look like? Is it a bit like this game where you hit it hard? How do you do it?
[00:53:41] Joe Frankenfield: I can make that type of analogy. Did you find that on YouTube?
[00:53:48] Tilman Versch: Yeah. There are many videos of you. You are good at it.
[00:53:52] Joe Frankenfield: I play handball, which is that sport. It’s like racquetball but with your hand. It’s like an underground sport. It’s not very popular, but my dad played it throughout my life. And then, I started playing more in college on our college club team. It’s my favourite pastime outside of snowboarding. Snowboarding you can only do during the winter months, but I play handball probably once or twice a week if I can get out. It’s such a fun sport.
I find those activities to be freeing and releasing. My mind is always turned on to what’s going on in the world and trying to understand things. And when you can focus on a sport or an activity, it’s therapeutic.Joe Frankenfield
I find those activities to be freeing and releasing. My mind is always turned on to what’s going on in the world and trying to understand things. And when you can focus on a sport or an activity, it’s therapeutic. Anyways, I play handball. But I guess if you want to relate that to how I invest, I can do that.
Handball is a very defensive game. Unlike racquetball, which is an offensive game where you can shoot and kill that ball anywhere in the court with a racquet, a racquet is this big, and you can reach the whole court with this long racquet. With handball, you’re trying to hit it right here and your hand. And you can only reach so far. So, it’s very challenging to make accurate shots. So, 80% of that court from the front, but nearly the back of it, it’s defence. And the only time you shoot and try to kill the ball for an offensive shot is when you’re perfectly set up. And so, it’s defence, defence, defence. And then, when your opponent makes a mistake and sets you up, you go for the kill shot.
I guess that’s pretty similar to investing, with how we manage the portfolio in this kind of very concentrated manner. Owning a company is mostly concentrated in five or six names. We’re very risk intolerant. Risk-averse is a better word for it. We’re very risk-averse, very hesitant. I mean, we look at hundreds of ideas. In fact, we go through the thousands of listed companies quarterly to look at ideas, but we say no to everything because we don’t understand them. We can’t get a conviction out of them. But when we do get an insight, we go for it.
From my experience, since I’ve started investing, the best ideas just pop out and hit you on the side of the head. Like, “Oh, my God. This is something very special.” And those typically have been very good investments. That happened to me with TradeDesk.Joe Frankenfield
From my experience, since I’ve started investing, the best ideas just pop out and hit you on the side of the head. Like, “Oh, my God. This is something very special.” And those typically have been very good investments. That happened to me with TradeDesk. It happened with Carvana. You’re looking at these metrics, and you understand the story. You understand the vision of the management team. They lay it out there. You’re like, “There’s something special.”
I remember the day we were looking at the TradeDesk for the first time. I was listening to the investor presentation from Jeff Green, the CEO. I remember I turned to Mike, and I was like, “This is our Geico.” I literally said, “This is the company that will compound.” From our initial look, it looks like something very special. And then, we spent months analyzing the ecosystem because it was fairly complex on the surface. But when you break it down, it’s just a few key important variables that have to go right to make it work as an investment. Same thing with Carvana. Same thing with Trupanion. Same thing with these companies. And so, we’re very defensive. At least that’s how I approach investing, very risk-averse. And then, when we get an insight that is differentiated from the market, that is unique, we just jump at it, and we’ll buy into it a certain position as we gain that conviction level. So, that’s similar to handball. I guess if you approach portfolio management in the same way.
Dealing with bias
[00:57:32] Tilman Versch: But this is a great idea if you have this endorphin kick. It’s sometimes hard to judge this as a rational investment because if you’re falling in love a bit with an idea and insight you have, you have to also control it, make sure that this company can own it in 10 years, and it’s getting stronger and bigger and gives a great return. What is the process to make sure that you’re not falling in love with the wrong one?
[00:58:03] Joe Frankenfield: Yeah, that’s a very common bias, right? The new shiny syndrome, is the new thing that attracts your attention. You think it’s the best idea because it’s new. We all have to deal with these biases and try to protect ourselves from them. Believing you’re less biased than others is a bias, right? It’s just like these heuristics. One thing that I kind of have incorporated in my guests’ portfolio management is when we come across a new idea, and I think it’s an amazing idea, I usually like to sit on it for a couple of quarters, right? Because I want the shiny syndrome to go away. What is the probability of this new idea to be better than TradeDesk or Carvana, or these other companies that we own, or GoodRx? It’s probably not very high, but sometimes you do come across these ideas. And so, I tried to be slow in making sure I understood the situation.
But you’re right. For me to get comfortable with a company, I need fundamental proof of concept, at least initially. I wrote about this in the last investor letter, where companies like everything that’s alive, companies are living organisms too. They are made up of people working together interacting. They follow a similar growth pattern as organisms, the S curve. A lot of times, they’ll hit that inflection point. It will reach scaling when they get product-market fit of scale. And once they’ve saturated their end markets, they’ll hit stall point and then become more mature. And so, what I’ve just spoken about before is like these companies are able to scale for sometimes decades. The market has often undervalued them because the market usually doesn’t want to weigh the probability of it being able to scale for a long period of time, so it potentially is undervalued. But I need to see the unit economics. I need to see proof of concept.
For example, Trupanion does a great job of explaining how they invest and how they get a return on those investments. They break down the unit costs and the lifetime value of each pet that they acquire, or at least each cohort of pets. And so, when we invested in Trupanion, it must have been out three years ago. They showed a track record of being able to continue to scale, and they broke it down. So we could see, “Oh, people do value being able to buy pet insurance.” The concept seems a little funny for some people that you would actually buy health insurance for a pet that lives for ten years on average. But people do value that, and you can see that proof of concept in their ability to invest, and they were scaling.
Similarly, for like Carvana, they’re still barely breakeven. I don’t think they are. They reached, I believe, the third quarter of 2020 for the first time. At least, breakeven. We could see this track record. They were scaling their fixed costs. There was a strong demand for this product. And the question was how they’re able to scale and build their infrastructure, which is expensive to do. It’s a very tangible heavy infrastructure that built the IRCs and the transportation network in many ways. Still, we could extrapolate those trends that have happened since they were founded in 2013 to potentially in the future, where not only they would be able to be breakeven, but then reach a tipping point scale and become cashflow generative once they get to a certain point.
We need some proof of concept. And where we have made mistakes is where we didn’t have as much proof. We weren’t able to get a conviction in those fundamentals.Joe Frankenfield
We need some proof of concept. And where we have made mistakes is where we didn’t have as much proof. We weren’t able to get a conviction in those fundamentals. But the thing is that they’re still very early in their lifecycle, right. So, we’re just trying to extrapolate these trends into the future. We own Facebook. We have a relatively small position on Facebook. We have a proof of concept. I think it’s pretty well accepted that they have won the social media game, at least for user-profiles and even businesses. When you look at Facebook, there are a lot of haters on Facebook for many different reasons. But this company, if you look at when it was founded and how big it is today, it’s one of the younger companies that we know. We invest in companies relatively younger than, let’s say, S&P 500 companies that are like 10, 12, 13 years old on average. Facebook was founded not too long ago, and it’s going to have $100 billion in gross profit. So, the fundamentals speak for themselves, I think. But the question is how we’re trying to extrapolate that and see where the price is relative to the cash flows that potentially will be returned to owners. I had my news of the Metaverse and changing their name to Meta.
I wouldn’t invest in Facebook because of the Metaverse. I like the idea. I trust Mark Zuckerberg to allocate capital. I think more because he has a track record of being very successful at doing it. He’s much more intelligent than I am. And so, I trust his ability to allocate capital, but I wouldn’t invest in this optionality. I’m investing in their advertising model, which is significantly cashed generative, and I think shares are selling below the core business. But I love the idea that this owner, operator, founder-led company, crazy he’s 37 managing this one of the largest businesses in the world, is thinking 10 or 15 years out. He’s thinking through this and investing some of his core business profits into this new potential paradigm. I’ve read a lot about the Metaverse to understand how it can impact our different investments. Like, if there’s a Metaverse, how does that impact car ownership? How does it impact TV watching? How does that impact anything? Software companies? It gets really sci-fi. It gets into this crazy potential. You can go down a crazy rabbit hole.
Anyways, to answer the question, I wouldn’t invest because of the optionality. Similarly, I would think Carvana has so much optionality. So does Trupanion. So does TradeDesk. They have this optionality baked into the business model. It’s a very entrepreneurial culture. But that’s the upside, I think. And so, with Carvana, what if they are the transfer net transportation network direct to consumer for even new OEM cars? What if Ford and GM potentially use Carvana because it’s more efficient than doing it in-house? We’re utilizing third-party haulers that don’t have the infrastructure. That’s optionality. I don’t think that’s baked into just exchanging used cars. There’s a lot of things that business models can evolve. That’s part of what they are trying to do, and that’s trying to lower the frictional costs of transacting cars.
TradeDesk, what are they trying to do? They’re trying to lower the frictional cost to allocate advertising dollars. That is their mission. How they go about that may evolve. So anyway, that’s how we think about optionality and the different variables that we look for with KPIs. I guess specifically addressing certain indicators that we look for is in these marketplaces that we are invested in market share is a really important indicator to get a conviction. A lot of times, it’s the winner who takes most dynamic. And so, you can see quarter after quarter, for years, whether a company’s taking market share, and however, you want to evaluate what the market is. So like Roku, you can say the market share is TV operating systems owned, or it’s the connected TV ad dollars that go over and get allocated where Roku has found a market share in the United States, at least in both of those categories. And you can see how those trends, then try to extrapolate that. For these marketplaces, that’s very durable if you establish yourself as the winner.
Often, before a space becomes more mature, there are tons of companies, and then usually, one in the marketplace will emerge as the winner. And we can get a conviction in that winner. For GoodRx, they’re a cash card company that helps lower the price of drugs by aggregating pharmacy benefit managers. But I guess my point is, 10-12 years ago, there were many cash card companies, and it was hard to determine who was going to emerge as the winner. It’s evident that it’s GoodRx now. They have a 70% market share based on however you want to weigh it for this specific thing they’re doing, which is helping consumers find cheaper drugs. The next largest company has probably a quarter of its size, and GoodRx is accelerating. You can see that they’re getting stronger the bigger they get. And so, that gives us conviction in the long term once they establish themselves as a winner.
I wouldn’t have invested in Roku or GoodRx, or TradeDesk unless I could establish that I thought they were the winners. TradeDesk in 2017, there are a lot of other demand-side platforms. You can go from Data Zoo, MediaMath, or whatnot. But we saw TradeDesk was taking market share in a differentiated model that put them in a more advantageous position than competitors. It was a consolidating industry. So, we had some fundamental proof that this was happening, and we extrapolated that. That is what has happened where other independent demand-side platforms have been either acquired largely by content owners like Google, or At&t, or Verizon, or they’ve gone out of business because they can’t compete with TradeDesk. The operating leverage of TradeDesk with smaller companies competed. There are these barriers to entry, and they’re growing barriers to entry. And you can go down the list of our companies and see how others can’t compete with what they’re doing. It’s too late, right. And so, it gives us conviction in these fundamentals that we’ve tried to extrapolate into the long term.
[1:08:23] Tilman Versch: What concepts generally help you identify winners to ensure that you’re invested in winners?
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Without further ado, let’s go back to the conversation.
Long-term portfolio construction
[1:09:13] Tilman Versch: Maybe let’s move to talk a bit about the topic of portfolio and portfolio construction. How does this idea of thinking ten years reflect with your portfolio construction? Or does the size of companies have more certainty and conviction where they are in 10 years or longer? How does this reflect on the way you construct your portfolio?
[1:09:36] Joe Frankenfield: Yeah. I guess you’ve heard of the Kelly Criterion or the Kelly Formula. That mental model or thought process is similar to how we think about it. Kelly Criterion says that you’re trying to assess the excess returns in a particular opportunity, in a specific investment, and then your conviction surrounding it. And then, you kind of allocate the portfolio based on all your different opportunity sets. That’s how we do think of it. And so, we do have a general idea of our expectations of what the future expected IRR is for each of our holdings.
I have seen so many poor investment decisions based on these cash flows and assumptions. A lot of times, you might have the best opportunity available. And because of one assumption, the terminal growth rate or the discount rate, or whatever, you find it overvalued or undervalued, or whatever it may be. We’re looking more at the qualitative inputs to investment to assess our desire for quantitative outputs.Joe Frankenfield
I have seen so many poor investment decisions based on these cash flows and assumptions. A lot of times, you might have the best opportunity available. And because of one assumption, the terminal growth rate or the discount rate, or whatever, you find it overvalued or undervalued, or whatever it may be. We’re looking more at the qualitative inputs to investment to assess our desire for quantitative outputs. The quantitative output is an attractive return, which is the cash generated and returned to shareholders over time, but it takes all the qualitative input. So, we have a range of expectations for each of our holdings and the conviction. And then, we try to assess our conviction surrounding those and then allocate the portfolio accordingly.
I think a helpful exercise in assessing those expected returns and not putting too much weight into saying something will have a 50% IRR, 20% IRR, or 25% IRR. It’s like going back and forecasting Google’s revenues and operating fundamentals when they went public, or Facebook’s, or any of the big winners. It helps to have hindsight 20/20 to look at the ones I have won, but I think Google IPO was probably four or $5 billion in sales. And that was in 2014 or 2015. It was years ago, but you know what their revenues are going to be in 2021. About 250 billion, right. And so, for most of Google’s existence, as a public company, it was considered overvalued. It was very contrarian for the traditional value investors to invest in Google in 2010 or 2011.
The same thing with Amazon. It’s only been more recent. I would say even in the last two or three years that these Fang stocks, or maybe a little called Mang stocks, I don’t know, whatever that new acronym will be with Meta. I’ve heard relatively recently that it’s been more of a consensus. It’s only been more recently that this is a consensus buy. These have been the best companies for only the last two or three years. And so things change, and you find these, but trying to like extrapolate or forecast these fundamentals is because of these different qualitative characteristics that these companies have. And so, if you can find these same characteristics in different companies, it’s very hard to find.
We look at thousands of opportunities, but you find a few that we get this conviction. Who knew what the expected return of Carvana was going to be when we bought them two-plus years ago? Or Trupanion or TradeDesk. They’ve had amazing returns, but are they exactly what we expected? What we did know is that they had qualitative characteristics that made them have an attractive value proposition. And the alternatives were not nearly as attractive. So the business model was durable. And so, that’s all we’re trying to do when we’re trying to wait for the portfolio and assess where the company is selling today and kind of our range of expectations over the next 5-10-15 years.
In managing the portfolio, I’m more cautious about trading activity. I often try to leave it alone and kind of let it do its thing unless something materially happens. Like, a company price goes up 10x. We really need to re-evaluate the expected returns, or if something becomes way disproportionately large in the portfolio, which is bound to happen in these big winners, and then reassess. But that’s infrequent like we don’t trade. It could be months that we don’t trade. And we really might only find one idea. We only had one new idea this year, and maybe one or two in last year. I tend to have a hands-off approach. We make material decisions when I have material insight.
In managing the portfolio, I’m more cautious about trading activity. I often try to leave it alone and kind of let it do its thing unless something materially happens.Joe Frankenfield
Managing money privately vs. professionally
[1:14:23] Tilman Versch: You have this range of holding five to 10 companies in your portfolio. On which side of the spectrum do you feel more comfortable? On the five or the 10th?
[1:14:34] Joe Frankenfield: To answer that question, I think what’s interesting is comparing managing money privately for yourself, and then when managing money for others. It’s different. Because you don’t have to be so public, it’s about what your holdings are. If we have 100 plus investors, they can all see their portfolio every single day. There are other eyes potentially watching the portfolio.
Well, I’ve found my best ideas generally, in almost all cases done much better. My Top 5 ideas are the last five ideas are on the Top 10 versus the last time because you have conviction. And so, it hurts results by obviously diversifying if you’re writing your top five. And that’s been the case, for me at least specifically. But I do consider the idea that I’m trying to answer this portfolio as low as my own money because it is my own money and doing it for others. But when we launched, we had more diversification because we didn’t have the best ideas or as good of ideas. It concentrated more and more over time. And our investors understand how we manage the portfolio, so they get more comfortable with our decision-making and investments. But yes, I have more and more significant conviction in the top five ideas than the next five ideas. And so, it’s hard for me to add to something that I have less conviction. And so, like, that’s just bound to happen over time. And yeah, that’s just kind of how I’ve managed our portfolio.
[1:16:12] Tilman Versch: With five or ten stocks, you must often say “no.” You have to do this a lot. How do you manage to say “no” a lot and still stay a nice person?
[1:16:36] Joe Frankenfield: Thank you. I appreciate that. You’re a very nice person too, Tilman.
[1:16:40] Tilman Versch: Thank you. We have a nice audience as well. Hello, audience!
[1:16:45] Joe Frankenfield: Through your interviews, I’ve watched, I think most of them, I’m impressed with how you do your interviews.
[1:16:53] Tilman Versch: At least one guy.
[1:16:57] Joe Frankenfield: I’ve had the privilege of being able to speak with a few of them. I think we were introduced through one of them. Someone either reached out, or I reached out to them. It’s so great to engage with the people that you’ve interviewed. I do think there’s a common strategy you learn. I tried to hope that we’re not in this echo chamber because many of these people you’ve interviewed have had these 30 or 40% compounded annual rates of return over the last five or ten years and super impressive returns. There is some portfolio overlap.
It’s just interesting that we have very similar ways that we manage the portfolio. So you don’t want to get into this echo chamber. But I think when you want to manage a portfolio actively, this is the way, and at least in my opinion, this is the way to do it.
Because like, if you go to the mutual fund type of strategy of managing money and having 100 or 200 different stocks and not really adding much-aligned incentives, that’s unlikely to do very well, especially when you have a free option of disinvesting in a Vanguard ETF fund.
Anyways, I don’t get great investment ideas often. It is tough to have this very targeted strategy to find things, mispriced anomalies, and focus on them. We look every single day. I spend 99% of my time looking, researching, thinking. Through personal experience and also just analysing the history of investments and stocks and companies, I have found that it is hard to find a good idea. I have owned things that I thought were undervalued, and they were not. It’s very humbling. And so, the more you do this, the more you realize you don’t know as much, and the future is terrifying.
I have found that it is hard to find a good idea. I have owned things that I thought were undervalued, and they were not. It’s very humbling. And so, the more you do this, the more you realize you don’t know as much, and the future is terrifying.Joe Frankenfield
And so, it’s having this appreciation for how the markets are generally efficient. When I approach every idea, the market knows more than I do until I have different insights. Something makes this specific. I’m looking for these companies that are so undervalued that if they doubled in price the next day, I would still find them attractive. The question I ask myself before every investment is, how would I feel about the stock if it doubled tomorrow? Same expectations. If I don’t find it attractive, and my holding period is hopefully ten-plus years, a double in 10 years isn’t a very attractive IRR. Now, if it goes up five times, I might find it very attractive. But twice, I mean, I don’t think it’s that undervalued.
Let’s say in the next day it have and my stomach drops. And I’m like, “Oh my gosh, I think I made a mistake.” You have to make a decision. Is the intrinsic value still the same? Is it now more attractive, or it has intrinsic value that is lower than we expected? Markets realize that and price it more efficiently at a lower price, and then you’ve lost your capital. It’s not going to go back to where you thought if intrinsic value is that low. So having this appreciation and realizing that it’s very hard to have these insights, I think, is important. That leads you only to focus when you do have a few insights. On average, if you are very targeted and find these really good investments that your portfolio should do well, you won’t be right all the time because even if you do weigh the probabilities of the future correctly, let’s say there’s 80%, chance this is one of the best investments. If it doesn’t work out, you may not have necessarily been wrong. It’s just that the 20% outlook of being a poor investment is what the future unfolds. The future is many things, but the present only can be one of those things.
Anyways, that’s how I think about not having to be active. When I buy a stock, I hope it’s still in my portfolio in 2030 if it all works out. Hopefully, the only reason why it wouldn’t be in my portfolio is that I found better ideas and found better opportunities. Over time, it’s harder and harder to find the best ideas. And so, I’m okay not finding new stocks or new companies as long as the ones in my portfolio are still attractive. I’m always just weighing the opportunity cost of the portfolio.
Over time, it’s harder and harder to find the best ideas. And so, I’m okay not finding new stocks or new companies as long as the ones in my portfolio are still attractive.Joe Frankenfield
Defining high-quality companies
[1:21:24] Tilman Versch: You’re also one of the investors who try to focus on high-quality companies. What is your definition of high quality?
[1:21:33] Joe Frankenfield: Yeah. To break that question down, the question is, why? It’s not a secret that high-quality companies do well. So, the question is, what makes a high-quality company, and I think even like, why do high-quality companies provide excess returns from an investment’s perspective? From a purely quantitative viewpoint, it’s a company that just is a cash cow. The return on invested capital is high. That’s the definition that people use for a high-quality company. It just spews cash. It can grow and also apply as cash for owners. And so, the question is why that is the case and why that’s a good investment.
A lot of times, it’s a good investment because the market is typically trying to discount those cash flows. It’s motivated by intelligent people trying to assess the future cash flow. So, in theory, it should value the price of the stock to that company to be pretty efficient to provide the nine or 10% annualized return the market will typically offer, but it doesn’t do as good of a job of that because these quality companies typically have a longer, I think Michael Mobis’ word for it is “capital advantage period” where the market might revert to a mean quicker than what the company does. So, it has a more durable competitive advantage where it can provide these excess cash flows for longer periods of time. But from more of a qualitative viewpoint, we view quality on a spectrum, where there are companies that are commodities. And then, some companies are monopolies, and that commodity is undifferentiated. Customers don’t care between widget A or B. A monopoly is there’s nowhere else to get this product or service. This is the only company that provides it.
And so, it gets to the question of what is the problem that companies are trying to solve? Why can’t other companies solve that problem today and far into the future? And if we can answer those questions, then there might be something interesting. I think Warren Buffett even writes about a franchise. That’s the question that he has because a franchise is a company that provides a product or service that is highly desired or needed. There are no close alternatives, and they are not regulated. So that way, they can have pricing power and price accordingly based on the demand.
And so, this creates a franchise, something that’s highly desired. There’s no cost alternative. And so, those qualitative analyses of understanding why is Amazon a quality company versus, let’s say, Walmart or Target, and why one company can do something better than another company? And so, that is what we look for in quality, right? We’re looking for natural monopolies. There aren’t close alternatives. Customers love the product and highly desire the product. That’s how we go about trying to analyze quality. But the thing is, what’s hard is the quantitative definition of a high return on invested capital. It has been debated the value investing of circles is like these companies.
Let’s say this Carvana is a high-quality company because if you use their return on invested capital, that obviously doesn’t have a return right now. After all, it’s absorbing so much cash. But there’s a huge difference between maintenance expenditures and growth expenditures in analyzing what we do. And so, you want to bifurcate the difference by actually trying to analyze the company that is investing their cash flows for growth because it’s an attractive investment for the company and seeing what the company from just a maintenance perspective is. Then you can kind of understand the unit economics of the business.
And so, the question is, can the company reinvest those cash flows and scale and grow, and eventually, if your analysis is correct and they are allocating capital well, then the company will grow fundamentally. And eventually, it will reach maturation, where then most of those operating expenditures will be maintenance. Then it should reflect an attractive return on invested capital if it’s a high-quality company. And so, that’s how we go about thinking it through. It gets into the conversation of, how long do you have to wait for the investment to pay off? It’s the same thing when someone looks at a portfolio manager investing in stocks. And like, how long do you give before you have to provide these outsized returns? That’s the goal of business and investments. And you don’t want to think short-term, quarterly, annually just because it’s random mainly, in our opinion. But eventually, you need to show the results.
So like if we’re investing in Japan, and they’re claiming to reinvest and acquire continually. Still, their sales or gross profits are stagnant, and you do not see any cash flow, so they’re not allocating appropriately over the long enough time period. You have to give them some slack in being able to invest, but if they’re investing all those cash and you’re not seeing it as owners, so you better hope that their earning power is also growing. And if it’s not, then they’re not investing appropriately. And the actual owner earnings of the business are probably much lower than what you think.
Similarly, Carvana is investing so much today. If they weren’t growing, where’s the cash flow going? It’s not to the owners. It’s not to the shareholders. And so, similarly, for a portfolio manager, we’re thinking 5-10-15 years out or continually, and that will always be the case. But in 10 years from now, the thoughts that we had in 2020 hopefully are paying off by the time it’s 2030. And if you’re not outperforming the market within a certain timeframe, then what are you doing? Right? What’s the value you’re adding? What would it take?
It’s possible that the market was crazy in 2013, and you are outperforming. Maybe we’re in a dot-com crash or bubble, so the market is crazy. That’s the argument a lot of people that underperformed for ten years make is that we’re at this point where we’re in this crazy bubble, which we aren’t, in my opinion. Still, valuations may be high, but they think that it’s going to crash, and then they’ll have that value investor excess returns from like, 2001-2004. That was like the traditional failing investors did well during that period after the dot-com crash, which was the late 90s. It was a crazy timeframe.
My point being is, eventually, you have to show results. We have to look at the track record. And so, there is a quote. I think it was on Twitter recently, where Buffett and his 92 Berkshire letter said that Alice from Alice in Wonderland was listening to the Queen discuss jam tomorrow. And then Alice eventually said, “Eventually, it has to be jam today.” Right? If you’re constantly thinking about the future, you have to show the results finally. Yes, that’s what I would think about thinking long-term and then investing in quality and reinvestments and growth. And eventually, you have to see the fundamental results for business and portfolio management.
Culture and team
[1:28:44] Tilman Versch: So, to put us in the question with the ten years framework, thinking about a high-quality company, it’s more about qualitative factor and culture than trust fundamentals. And maybe also understanding unit economics as a key ingredient.
[1:29:00] Joe Frankenfield: Exactly. I think about it from a sports team, a basketball team, or a football team. Your desired output, the quantitative output, is winning. You want to win the championship. But, how do you get there? It’s through the culture of the team—a winning culture of working together.
And so, when you’re looking at any match or game, you’re looking at the field, and you want to see how they are able to function. The best team in the world may sometimes lose, right? They may get sick, or something happens. It’s bound to happen. But you’re still hoping that they win the championship. And maybe they may not win one year, but they’ll win next year. And so, we need the quantitative results. Still, I think what’s more knowable are the qualitative factors that potentially are the inputs to the company that we can assess or give us the quantitative output. So, it’s like a passionate manager who’s aligned with shareholders that’s entrepreneurial. It’s this culture of winning and changing and providing this value. It’s all these different qualitative factors that potentially provide the quantitative outlook that we’re looking for.
Customize your approach to investing
[1:30:19] Tilman Versch: I have asked many questions. At the end of our interview, I want to give you the chance to add some that we haven’t discussed or inform us about any aspect that’s important to you. The floor is yours.
[1:30:31] Joe Frankenfield: Oh, thank you. Yeah, this has been a lot of fun. We spoke a lot about how I think about managing a portfolio and how I go about my investing process. And what I found, and I think what is important to think about, is that you have to do what’s makes sense for you, right? One approach doesn’t necessarily make sense for everyone. And you have to understand your specific suitability, or how you want to go.
So, I’m saying my approach doesn’t necessarily work for everybody that works for me. Those who understand what I’m doing and want to invest in Saga Partners, that works for them. We are making sure they understand how portfolios are managed. So there’s a lot of ways of going about investing. You don’t have to just invest in high-quality companies or have high growth outlooks. You can invest in low-quality companies that have high turnarounds or that you try to improve the quality, or they’re selling below their net asset value or things like that.
That’s not my game. But there are many different ways to go about investing and allocating capital. And so, you just have to do what makes the most sense for you and try to understand how the world works, and have your viewpoint and get to the right answers because everyone has their perspectives, opinions, background, and own way their brain is wired. All that matters is the real answer to how the world works.
I like to use the saying that says snakes and what they see in heatmaps. Bats see in sonar. Dogs see in black and white. We see in colour. All of those are different perspectives, but they’re all right. No one’s wrong. They just all have different interpretations of what the world looks like. And so, what’s important is it’s trying to get as accurate of a picture as possible by getting opinions and getting the information and the data, interpreting it, and trying to get to the right answer. And so, like you do that, and however you want to go about investing or managing capital or just thinking about how life works through mental models.
We see in colour. All of those are different perspectives, but they’re all right. No one’s wrong. They just all have different interpretations of what the world looks like. And so, what’s important is it’s trying to get as accurate of a picture as possible by getting opinions and getting the information and the data, interpreting it, and trying to get to the right answer.Joe Frankenfield
[1:32:37] Tilman Versch: Thank you very much for your insights and our great conversation. I hope you like my jokes.
[1:32:43] Joe Frankenfield: Thanks, Tilman. This was fun.
[1:32:45] Tilman Versch: Yeah. Thank you very much to the audience who have been listening to this podcast until now. I hope you all have a good week. Bye-bye.
[1:32:55] Joe Frankenfield: Bye. Thank you.
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