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WCM Investment Management | Insight | Beach Reads 6 - 9 | Welcome to Beach Reads. From social, health, and economic perspectives, these are some of the most unsettling and tumultuous times many of us can remember.
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Beach Reads

June 9, 2020

Welcome to Beach Reads. From social, health, and economic perspectives, these are some of the most unsettling and tumultuous times many of us can remember. Living through such flux can make it difficult, if not impossible, to assess what will lead to significant change and what will pass without consequence. In other words, as Howard Marks suggests in his recent memo, trying to predict future events can be a futile pursuit. A number of this week's articles therefore invite us to look at how we might look at things from a new perspective, while others suggest that learning from past experiences and being adaptable are likely to be key to navigating whatever the new normal turns out to be. Below, I outline the themes covered in this edition of Beach Reads.

  • Why bundles aren't actually bad, important differences between aggregators and platforms, and more
  • What businesses operating in the consumer economy look like before, during, and after COVID-19
  • Uncovering a Chinese fraud, a cannabis company no longer flying high, and Microsoft dusting off old business tactics
  • Debt as a threat and innovation as a solution as we move through the pandemic
  • Stacking up private equity versus public equity returns and impact

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Conor Deveney

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ABOUT Beach Reads

Welcome to Beach Reads, a collection of interesting links that we at WCM have come across and want to share. The goal of this publication is to engage with a broader audience in order to better ourselves and others. Feel free to email us at insights@wcminvest.com with any thoughts or feedback, and click here to subscribe!

01. Investing Philosophy

The Art and Science of the Bundle

In this fantastic Invest Like the Best podcast, host Patrick O'Shaughnessy talks with Coda founder Shishir Mehrotra about bundling. While griping about cable TV packages has long been a national pastime, Mehrotra thinks bundling is a powerful force in several markets and benefits both producers and consumers. Being chief executive of bundling productivity app Coda, a member of the Spotify board, and having worked at YouTube, it's a topic Mehrotra has significant expertise in. In the podcast, he discusses four common myths about bundling and how different classes of fans (super, casual, non) interact with bundled content. I normally give highlighted outtakes for podcasts, but this one should be listened to from beginning to end. You can find more about Mehrotra's bundling ideas here.

Platform, Ecosystems, and Aggregators

Sticking with Invest Like the Best, in this episode O'Shaughnessy talks to Ben Thompson, who focusses on tech and the media in his Stratechery blog. The subject that really caught my attention in this wide-ranging conversation is the difference between aggregators and platforms, which changes both how companies should operate and what metrics are important to watch for as a public investor. It's a topic I haven't given a ton of thought to, but am now convinced I should. Thompson, who is a well-regarded business thinker, also talks about Spotify and podcasting, which was touched on less positively in the last edition of Beach Reads. Finally, towards the end of the edition, the two talk about Epic Games, which was also featured in Beach Reads two weeks ago. Interestingly, Thompson highlights the "real world" nature of status symbols in a virtual world (see "Signaling as a Service" article here).

Moats Before (Gross) Margins

An article in the last edition of Beach Reads critiqued software as a service (SaaS) margins and the lack of human impact, specifically on employment, that these companies have (see "Don't Hate the Playa" article here). This piece, from the a16z blog, argues that future large, successful companies will have much lower margins than the SaaS companies of today and that moats are more important to understand than margins for investors. The authors outline four important moat sources: economies of scale, meaningfully differentiated technology, network effects, and direct brand power. They also point to metrics they track, many of which are unfortunately not available to public equity investors (e.g. customer acquisition cost). Some are more accessible, though: "Another sign of emerging economies of scale is if your business has a clear pathway to negotiating power over your suppliers and/or buyers. Again, Amazon is the classic example, but another interesting possibility is Spotify. Historically, music labels have commanded certain economics from streaming services, but if Spotify's existing large user base continues to gain share, the negotiation could flip, allowing Spotify to achieve meaningfully differentiated economics relative to the competition."

Uncertainty II

In a brief follow-up to the memo included in the last edition of Beach Reads, Oaktree Capital founder Howard Marks continues to wrestle with what the future may look like and how one can even attempt to predict it. "While we look to the past for guidance as to the 'worst case,' there's no reason why future experience should be limited to that of the past. But without reliance on the past to inform us regarding the worst case, we can't know much about how to invest our capital or live our lives." Both investing and living are fraught with risk and, by definition, uncertainty. Building a portfolio, or life, to suit one's risk preferences, through both good times and bad, is therefore the best way to be comfortable, day in and day out. But remember: with risk, comes reward. And ruin.

02. Consumer Business Strategy and the Sharing Economy

The Opportunity and Risks for Consumer Startups in a Social Distancing World

I've featured the work of Benchmark Capital partner Sarah Tavel on previous Beach Reads (podcast here), who, in this article, uses rock, sand and water as three substances to help illustrate a proposed new framework for thinking about consumer products during work from home (WFH). "Events that span bigger blocks of contiguous time (Rocks), micro events that take advantage of attention gaps between or during those blocks (Sand), and things that can overlay over the other two (Water)." During WFH, "rocks" are easier to come by than previously. However, when life returns to normal, this will no longer be the case. Tavel suggests that those building "rock" businesses have a plan to transition to more of a "sand" or "water" business eventually. I'm curious how to apply this framework to public investing - what companies do you think are going to have to evolve again when life goes back to normal?

The sharing economy will have to change

COVID-19 hit the sharing economy hard, although even before the pandemic many high-flying, non-profitable startups were being punished by investors as expectations about making money were pushed further into the future. As a result of the pandemic, some businesses have been forced to forgo adjacent projects and go back to basics, for example, "Uber has ditched several businesses, including a planned credit card for drivers and its e-bike service. It wants to concentrate on being the firm that 'moves people and things in cities', Dara Khosrowshahi, its chief executive, said recently." The author suggests this as a good thing, however I have to wonder if those that manage to muddle through with ancillary opportunities will come out stronger as they service more consumer needs than those who ditch adjacent opportunities.

03. Ups, Downs, and Competition

Behind the Fall of China's Luckin Coffee

For the uninitiated, Luckin Coffee was a Chinese unicorn, sometimes compared with Starbucks. Now exposed as a fraud, the Securities and Exchange Commission (SEC) is investigating a scheme that drew in and burned a number of big-name investment companies. "Luckin sold vouchers redeemable for tens of millions of cups of coffee to companies that had ties to Luckin's chairman and controlling shareholder, Charles Lu," the Wall Street Journal wrote. "Their purchases helped the company book sharply higher revenue than its coffee shops produced." The collapse is another cautionary tale that led in part to the SEC in April issuing "a renewed warning about the risks of investing in companies in China and other emerging markets."

How the 'Apple of Pot' Collapsed

Once rocking a billion-dollar plus valuation, cannabis retail pioneer MedMen has seen its stock price plunge 95% amid a slew of issues. These include ongoing litigation over its business practices and daunting structural hurdles, most significantly the Federal prohibition of marijuana, which "puts companies at the mercy of a patchwork of regulators" and led to less-than-ideal compromises such as a Canadian listing. This Politico article provides an entertaining insight into the nascent marijuana industry while charting the rise and fall of the "WeWork of weed, an overhyped startup whose sky-high valuation has come crashing back down to Earth."

Microsoft Takes On Zoom and Slack in a Battle for Your Work Computer

WFH has made productivity apps indispensable, with Zoom, Slack and others effectively serving as the connective tissue between individuals who can no longer work together, face to face. This booming market has made the landscape more competitive. Having added a significant number of customers to Teams during COVID-19, Microsoft is now a significant competitor to existing business productivity companies, leading to questions about how the Seattle giant is pushing the platform, according to the Wall Street Journal. Some of its methods may be reminiscent of "old" Microsoft, the one that went through an anti-trust case with the US government. "Officials working for House Antitrust Subcommittee Chairman David Cicilline, a Democrat from Rhode Island, have started asking Microsoft competitors about the software giant's business practices."

04. The Global Pandemic: Debt Going In, Innovation Coming Out?

Inside the $2.5T Debt Binge

A reckoning may be nigh for companies that took advantage of low interest rates over the past decade-plus to issue record amounts of debt to finance share-price-boosting dividend payments and share buybacks at the expense of innovation. A Forbes analysis of 455 companies in the S&P 500 Index — excluding banks and cash-rich tech giants such as Apple, Amazon, Google and Microsoft — found that for every dollar of revenue growth over the past decade, companies added almost a dollar of debt, nearly tripling their net debt by adding $2.5 trillion in leverage to their balance sheets. "Most S&P 500 firms entered the bull market with just 20 cents in net debt per dollar of annual revenue; today that figure has climbed to 38 cents." While Federal Reserve action amid COVID-19 has kept many of these levered firms afloat, a "prolonged recession" would be more problematic, and we're beginning to see the first wave of bankruptcies.

An Unlikely Hero for 1906, 1929...and Today

A recent WSJ article highlights the important role bank lending plays in helping small businesses to stay afloat during times of severe distress. During the Great Depression, Bank of America added significantly to the growth of regions it served by lending to struggling businesses. "During the depression years of 1929 to 1934, Bank of America reduced its lending by only 33%. On average, outside the biggest cities in California, other local banks tightened credit twice as much," the article says. "From 1929 to 1940, economic activity in smaller cities where [Bank of America] had a branch grew 25%, while it shrank by 3% in those without a Bank of America office." By contrast, the author posits that today, established banks are less likely to take such risk, which may create opportunities for the likes of Klarna, Affirm and others. "Innovation is bound to bubble up elsewhere in response to the coronavirus crisis, likely in overlooked and underserved corners of the market."

05. Private Equity versus Public Equity Investing

The 'Inconvenient Fact' Behind Private Equity Outperformance

Back to an old hobby of mine: comparing the real returns of different investment styles. Most current deliberations, at least in public markets, continue to center around value vs. growth. However, an old debate resurfaced in Institutional Investor recently: private equity vs. public equity. The article suggests that PE returns have matched those an investor would have earned by buying publicly traded stocks over the 13 years through 2019. Perhaps more importantly, it highlights that companies in PE portfolios are stretched thin to put up growth: "These companies are then stressed to the breaking point, because they have to generate returns large enough to overcome a total fee...that investors have to pay." I'm curious what the returns on PE companies are after their holding period - the article implies that they might slow after being strip mined. If this is the case, then certain PE practices might, over the long run, turn out to be value destructive (especially post disposition of an asset). This is fundamentally different than the nature of public investing.


 

Disclaimer: To the extent that Beach Reads discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. The companies and or securities referenced and discussed do not constitute an offer nor recommendation to buy, sell or hold such security, and the information may not be current. The companies identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the companies identified was or will be profitable. Beach Reads does not constitute a recommendation or a statement of opinion, or a report of either of those things and does not, and is not intended, to take into account the particular investment objectives, financial conditions, or needs of individual clients.

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