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Base Hits vs. Swinging for the Fences

I just got done reading Jeff Bezos’ annual letter to shareholders, which is outstanding as it always it. As I finished it, I spent a few minutes thinking about it. He references Amazon’s style of “portfolio management”. He doesn’t call it that of course, but this passage got me thinking about it. Since I wrote a post earlier in the week about portfolio management, I thought using Bezos’ letter would allow me to expand on a few other random thoughts. But here is just one clip from many valuable nuggets that are in the letter:

AMZN Bezos Letter 2015

Bezos has always gone for the home run ball at Amazon, and it’s worked out tremendously for him and for shareholders. Would this type of swinging for the fences work in investing?

I’ve always preferred trying to go for the easy bets in investing. Berkshire Hathaway is an easy bet. The problem though (or maybe it’s not a problem, but the reality) is that the easy bets rarely are the bets that become massive winners. Occasionally they do—Peter Lynch talked about how Walmart’s business model was already very well-known to investors in the mid 1980’s and it had already carved out significant advantages over the dominant incumbent, Sears. You could have bought Walmart years after it had already proven itself to be a dominant retailer but also when it still had a bright future and long runway ahead of it.

So sometimes the obvious bets can be huge winners. But this is usually much easier in hindsight. After all, Buffett himself couldn’t quite pull the trigger on Walmart in the mid 1980’s, a decision he would regret for decades. At the annual meeting in 2004, he mentioned how after nibbling at a few shares, he let it go after refusing to pay up:

“We bought a little and it moved up a little and I thought maybe it will come back a bit. That thumbsucking has cost us in the current area of $10 billion.”

So sometimes obvious bets can be huge winners. But many times, the most prolific results in business come from bets that are far from sure. Jeff Bezos has always had a so-called moonshot type approach to capital allocation. The idea is simple: there will be many failures, but no single failure will put a dent in Amazon’s armor, and if one of the experiments works, it can return many, many multiples of the initial investment and become a meaningful needle-mover in terms of overall revenue.

Amazon Web Services (AWS) was one such experiment that famously became a massive winner, set to do $10 billion of business this year, and getting to that level faster than Amazon itself did. The Fire phone was the opposite–it flopped. But the beauty of the failures at a firm like Amazon is that while they are maybe a little embarrassing at times, they are a mere blip on the radar. No one notices or cares about the Amazon phone. If AWS had failed in 2005, no one today would notice, remember, or care.

So this type of low probability, high payoff approach to business has paid huge dividends for Amazon. I think many businesses exist because of the success of a moonshot idea. Mark Zuckerberg probably could not have comprehended what he was creating in his dorm room in the fall of 2004. Mohnish Pabrai has talked about how Bill Gates made a bet when he founded Microsoft that had basically no downside–something like $40,000 is the total amount of capital that ever went into the firm.

“Moonshot” Strategy is Aided by Recurring Cash Flow

One reason why I think this approach works for businesses and not necessarily in portfolio management is simply due to the risk/reward dynamic of these bets. I think a lot of these bets that Google and Amazon are making have very little downside relative to the overall enterprise. Most stocks that have 5 to 1 upside also have a significant amount of downside.

I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow. Portfolios have a finite amount of cash that needs to be allocated to investment ideas. Portfolios can produce profits from winning investments, and then these profits can get allocated to other investment ideas, but there is no recurring cash flow coming in (other than dividends).

Employees, Ideas, and Human Capital

Not only do businesses have recurring cash flow, they also have human capital, which can produce great ideas that can become massive winners. Like Zuckerberg in his dorm room, Facebook didn’t start because of huge amounts of capital, it started because of a really good idea and the successful deployment of human capital (talented, smart, motivated people working on that good idea). Eventually, the business required some actual capital, but only after the idea combined with human capital had already catapulted the company into a valuation worth many millions of dollars.

There was essentially no financial risk to starting Facebook. If it didn’t work, Zuckerberg and his friends would have done just fine—we would have most likely never have heard of them, but they’d all be doing fine.

If AWS flopped, it’s likely we would have never noticed. There would be minor costs and human capital would be redeployed elsewhere, but for the most part, Amazon would exist as it does today—dominating the online retail world.

Google will still be making billions of dollars 10 years from now if they never make a dime from self-driving cars.

So I think this type of capital allocation approach works well with a corporate culture like Amazon’s. Bezos himself calls his company “inventive”. They like to experiment. They like to make a lot of bets. And they swing for the fences. But the cost of striking out on any of these bets is tiny. And you could argue that any human capital wasted on a bad idea wasn’t actually wasted. Amazon—like many people—probably learns a ton from failed bets. You could argue that these failures actually have a negative cost on balance—they do cost some capital, but this loss that shows up on the income statement (which again, is very small) ends up creating value somewhere else down the line due to increased knowledge and productive redeployment of human capital.

So I think there are advantages to this type of “moonshot bet” approach that works well within the confines of a business like Amazon or Google, but might not work as well within the confines of an investment portfolio. This isn’t always the case—I recently watched the Big Short (great movie, but not as good as the book) and the Cornwall Capital guys used these types of long-shot bets to great success. They used options (which inherently have this type of capped downside, unlimited upside risk/reward) and they turned $30,000 into $80 million. But I think this would be considered an exception, not the rule.

I think most investors have a tendency to arbitrarily tilt the odds of success (or the amount of the payoff) too much in their favor with these types of long-shot bets. They might think a situation has 6 to 1 upside potential when it only has 2 to 1. Or they might think that there is a 30% chance of success when there is only a 5% chance. It’s a subjective exercise—this isn’t poker or black jack where you can pinpoint probabilities based on a finite set of outcomes. So I think that many investors would be better off not trying to go for the long-shots, which in investing, unlike business, almost always carry real risk of capital destruction.

Berkshire Hathaway manages a business using a completely opposite style of capital allocation. Instead of moonshots, it goes for the sure money, the easy bets. It’s not going to create a business from scratch that can go from $0 to $10 billion in 10 years. But nor does it make many mistakes. There is no right or wrong approach. As Bezos says, it just depends on the culture of the business and the personalities involved.

I think certain businesses that possess large amounts of human capital combined with the right culture, the right leadership, and a collective mindset for the long-term can benefit from this type of moon-shot approach. They can and should use this style of capital allocation. Ironically, I think investing in such well-managed, high quality companies with great leadership and culture are often the sure bets that stock investors should be looking for.

Either way, from a portfolio management perspective, I think it’s easier to look for the low hanging fruit.

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

18 thoughts on “Base Hits vs. Swinging for the Fences

  1. Correct me if I’m wrong but I believe the key point is that investing is capital intensive, as are most businesses. Tech stands out because capital is not always the biggest constraint. That’s why moonshots work there. US Steel can’t do moonshots but Amazon can.

    1. Agree… thanks for the comment Ben. Yes, some businesses (especially ones with a dominant moat around a core business like AMZN or GOOG) have a better structure from which to launch moonshots.

      1. Thanks John. Always a pleasure to read your writing. Following this train of thought; how do you feel about funds (hedge, mutual, partnerships) etc as businesses? Would it be fair to say they are capital intensive businesses in a competitive industry with a lack of pricing power and lots of operational leverage?

  2. Thanks for the great article and blog. Do you have a recommendation or strategy with respect to allocation sizing within an individual’s investment portfolio perhaps contrasting when one has ongoing cash inflows vs beyond? Also, the discussion reminds me of Nassim Taleb’s discussion of a barbell strategy with majority of portfolio in very safe investments (treasuries, possibly 1 foot hurdles etc) and a minority in “moonshots”. My simple understanding is that he feels the long term cumulative outcome exceeds a more ‘balanced’ portfolio such as what might be considered in a value type portfolio. Would love to have your opinion.

    1. My idea is just to try and find good businesses that are undervalued, and hopefully along the way there will be the occasional big winner, so I don’t spend much time thinking about building a portfolio using a predefined set of criteria or categories (or barbells). I think big winners are often needed to pay for the inevitable losers, but my own approach is to try and first limit the losers. So I want home runs as much as the next guy, but I first try to locate investments where I feel the downside is protected. There are no certainties, and there always will be some losers, that’s just the nature of the game. But I find that too often people try to stretch their underwriting standards to mold a risky investment into one they can justify. I saw numerous writeups for Dex Media (now bankrupt for the third time) that said there was 10, 30, 50 and even 100 to 1 odds. Each analysis accurately stated the downside was a complete 100% loss (bankruptcy), but I think each vastly overstated the probability of success (which was probably 1-2%, not 10%). Those odds are very easy to manually adjust in your favor when you are desiring that type of outcome. It’s easier for me to just locate investments where I think there is a high likelihood of success. There will be plenty of big winners from that category too, so that’s the sandbox I choose to play in.

      There is no right or wrong way though… you can do very well investing in situations with 20 or 30% odds of success if you accurately handicap the situation (that’s what the Cornwall Capital guys have done). But it takes a very good ability to price risk properly, and it also takes someone who can be honest with themselves about the realistic probabilities.

      Thanks for the comment Harry.

  3. Thank you for another excellent post.
    Talking about situational odds of success, I highly recommend the book Thinking, slow and fast by Mikael Kahneman. The book describes, inter alia, about the tendencies of overevaluating the chancens of success when the chance of getting a home run is low, and underevaluating an almost certain base hit when the chace of getting a home run is close to a 100 %.

    1. Thanks Simon. Yes, a lot of people speak highly of the book, although it’s one I’ve never read. I’ll have to check it out. Thanks.

  4. I’d say tech is unique in that capital is not always the limiting factor. US Steel can’t make long tail bets, because like public market investing, there are few long shots that can make up for all the losses. This is inherent in the capital intensive nature of their models.

  5. John,
    Great post. I think you are also highlighting in a roundabout way the benefits of capital-light business models. For a Facebook or Amazon to embark on a new idea, like you point out, most of the initial capital is human. Because the upfront cost in financial terms is low in an absolute sense or relative to the recurring cash flows of the business, the consequence of failure is also minimal. Also, these types businesses usually don’t have large amount of financial leverage because they don’t need it in the first place. Contrast this with a capital-heavy business such as a mining company or even a company like Horsehead Holdings (which Monish invested in) which continually require large capital infusions. These cost of failure of a large project for this type of firm can be very high, especially when financial leverage is involved (which it often is for these type firms).
    I agree with your application to portfolio management. For a portfolio with no money flowing in, priority number one has to be avoiding large losses. On the other hand, for a portfolio with regular inflows (like a 401K for example) I think the risk profile is different. Recurring inflows give the investor the room to be a bit more aggressive, especially when it comes to doubling, even tripling down on positions that initially decline in price. It also gives the flexibility that comes with having money to invest when the market is declining, which is a great way to outperform over the long term. I think this is part of the reason why someone like Tom Gayner at Markel and Buffett have performed so well. They continually gets inflows into their portfolio to invest. They have constantly growing piles of permanent capital.

    1. I agree with “value investor” in that having strong or even growing cash flow can be extremely helpful in portfolio investment. In fact I’ve been wondering if I’ve been going about wealth building in the wrong way. I’ve been somewhat successful at investing in the stock market but I’m fairly certain I would have been better off investing in high cash flow control investments so that I have a base to stand on.

      Investing in companies like Amazon give the investor an occasional benefit of being able to buy the company at a fair price given its current operations and being able to buy future speculative business operations for free. This is the old Ben Graham-style analysis of growth companies.

    2. This is a good point regarding 401K or IRA inflows. A younger working person who has many years of possible contributions ahead of him or her might be in a different position to take a moonshot bet with say one year’s worth of contributions, since they have many more years of inflows coming. That said, it wouldn’t be my personal approach. I think regardless of how much capital you have coming in from a salary, business, etc… I think it’s best to view each investment situation on its own merit. I think taking a moonshot approach with personal capital can get too many investors into trouble–there is a tendency for many people to lower their standards and take greater risks. But from inside a well-managed business with a culture like Amazon’s, I think this type of risk taking and experimentation is both very low risk and high reward.

      Thanks for the comment.

  6. I think venture capital portfolios are essentially the portfolio equivalent of the moonshot style you describe. They place many bets and get involved in the venture they are funding. Many failures, but one huge success puts them way ahead.

  7. John,
    Thanks for another great post. Most of the time, investors have no competitive advantage to pick the technology trends or innovations. If they have, probably they should just set up a company because the risk/reward will be much better. Picking low hanging fruit is also playing to investors’ strengths.

  8. You answered your own question: “I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow”.
    The emotional and financial tolls of moonshot investing will nearly always lead to ruin. Not only that, but when you’ve finally landed a winner the urge to lock in profits could become overwhelming for many investors. Owning businesses outright will always always trump investing.

  9. I think Buffett’s best quote about this subject comes from the 1987 shareholder letter. This quote is in reference to Berkshire’s wholly-owned businesses:

    “There’s not a lot new to report about these businesses – and
    that’s good, not bad. Severe change and exceptional returns
    usually don’t mix. Most investors, of course, behave as if just
    the opposite were true. That is, they usually confer the highest
    price-earnings ratios on exotic-sounding businesses that hold out
    the promise of feverish change. That prospect lets investors
    fantasize about future profitability rather than face today’s
    business realities. For such investor-dreamers, any blind date
    is preferable to one with the girl next door, no matter how
    desirable she may be.”

  10. Beautifully written. Thanks for that.

    I love the ideas of taking risks but the risks will have to be calculated and assessed. Love Jeff’s annual letters. Just like Beffett’s letter it has very personal touch into it compared to letters that are sounded and written by bunch of robots. 🙂

    Cheers!

    BSR

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