How the Unimaginative Can Thrive in the Age of the Unicorn
“Do not let the brevity of these passages prevent you from savouring the profundity of the advice you are about to receive.”
-Donald Trump, author, politician and thinker, in How to get rich
I want to talk to you about Jesus. No, wait! I am not going to preach. Silicon Valley has this cult of the mission-driven founder. Jesus was a super talented, mission-driven founder. You know the expressions “he’s a miracle worker” or “he can walk on water”? For most people, this is hyperbole. But for Jesus, this was actually true. He could cure blindness, He could turn water into wine and bring people back from the dead. Jesus managed to get 12 disciples and many others to follow Him on His mission, without offering them a single stock option. He did all this before He was 33. Yet for all this talent, what was His fate? He got crucified! Literally.
My subject matter is investing — defined broadly. Almost all of life is investing, whether you devote money, time or effort. Let me start by proposing a very basic idea about investing: both potential and probability matter. If your brother-in-law tells you about a stock that will double, you would ask him: “How sure are you?” Most investment discourse leans toward potential. You often hear the expressions “reward to risk” or “asymmetrical payoff” . You might hear a stock is trading at half its God-ordained “intrinsic value”. A potential double! You hear about the fastest growing companies, the hottest industries or the most promising countries. Which seminar title would fill more seats: “The hottest emerging markets for the next 20 years” or “The surest emerging markets for the next 20 years”? Yet, if potential was all-determinative, the best investors on Earth would be lottery players.
The second general investment idea I want to propose is this: consider waiting. Wait and see. Here’s an analogy: you can bet on the Super Bowl before the game or at half-time. If you wait till half-time, the payoffs will change, but so will the probabilities. We have already agreed that both potential and probability matter, so the bettor waiting till half-time is not systematically disadvantaged. At half-time, you have more information and so you can make a more informed and intelligent decision with greater conviction. The person betting at half-time is the Second Mouse, he gets to study the lay of the land, before placing a bet on who will win.
Investing is essentially the art of balancing potential and probability. For example, merger arbitrageurs are able to convert very small, but highly certain potential into pretty good overall returns (especially back when that field was less competitive). Venture capitalists claim to transform low-probability but high potential situations into great returns — the opposite recipe of arbitrageurs. While in theory, this could work, in practice, I have some doubts. People who back or start early-stage companies are like people who place bets on the Super Bowl in September of the previous year. They make bets with far less information and are far more affected by blind luck.
The business of pioneering is dangerous. As it was said about conquering the American continent, pioneers got the arrows, settlers got the land. My favourite way of saying this is: “the second mouse gets the cheese”. Let other people blow their brains out trying to pioneer things. Patiently wait for the dust to settle and pounce on the winners that emerge from this destructive process. You don’t have to invent anything, you can make a lot of money capitalizing on the quality, proven creations of others. Today, the world is much more attuned to the opposite notion, ie “the early bird gets the worm”. But what about the early worm? This is a classic display of survivorship bias — talking about the winners without accounting for the losers. The earliest birds were dinosaurs.
Today, an economic sector I like to call the Industry of Hopes and Dreams is thriving. Innovation, creativity and disruption are in vogue. These notions are most notably exemplified in the person of Elon Musk, who is a pop culture celebrity as much as a CEO. His friend, admirer and fellow PayPal co-founder wrote a book called Zero to One which is all about conceiving and building valuable new businesses. Peter Thiel praises unicorn founders like Musk and Mark Zuckerberg. (Peter Thiel was also the first outside investor in Facebook, putting $500k.) His preface sets the theme:
Every time we create something new, we go from 0 to 1 — the act of creation. Unless they invest in the difficult task of creating new things, American companies will fail in the future no matter how big their profits remain today….Today’s “best practices” lead to dead ends; the best paths are new and untried….Zero to One is about how to build companies that create new things.
When a capitalist hears words like these, they should run in the other direction screaming. The “you must invest in the future” message is just a cliché all techies use. If you care about return on investment, I believe you should come in well after the “moment of creation”, you should not “invest in the difficult task of creating new things”. Many people don’t know this, but the word “entrepreneur” comes from a Middle French word for “person with a poor grasp of probability”.
This experiment has already been tried before. The 20th was marked by astounding technological change. It started with horse carriages and ended with reliable space flight. Name one investor who capitalized on a fraction of this transformation? Sure, you could name specific entrepreneurs like Henry Ford or Bill Gates, but where’s the diversified investment tech mogul of the 20th century? Let me illustrate my point with the tale of two investment moguls.
Arthur Rock was born in 1926. He is a Harvard MBA. Rock thus benefited from a superb education and network. He was among the very first venture capitalists — he coined the term venture capital. He had the field practically to himself. He was based in Silicon Valley and was behind the first venture-backed company, Fairchild Semiconductor. He then was an early investor in Intel, Apple and Teledyne. He played in a market that was much more inefficient than the stock market (especially back then). Presumably, he had the favourable carry fee arrangements typical of VC funds (at favourable tax rates). How much is Arthur Rock worth? Five billion dollars? 20 billion dollars? 17 trillion dollars? What if I told you that he’s not even on the Forbes billionaire list?
Contrast that with Warren Buffett. He is four years younger. He was turned down by Harvard. He is based in Omaha. He made his money running a hedge fund for a dozen years, with peak assets of $100m or so. Since 1969, he has simply been compounding his money in a tax-clumsy corporate structure while taking a fixed $100k salary. Buffett is currently worth $86 billion. How come the guy who invested in 19th century industries like insurance and chewing gum ended up on top? Think about that when people tell you that change is coming and you MUST invest in the future.
Charlie Munger said in early 2018 that large tech VC investments were in a bubble. CNBC interviewed veteran VC Alan Patricof to deliver a rebuttal. He is also one of the pioneers of VC, having started a fund in 1969. He was an early investor in America Online, Apple and Office Depot. How much is he worth? $7 billion? $36 trillion? A billion quadrillion? What if I told you I have seen estimates of a paltry $150 million? That’s not even enough money to buy a single month’s worth of Big Mac production.
If you can look into the seeds of time, and say which grain will grow and which will not, speak then to me.
VC returns — as a group — suck because they are fooled by potential and blind to probability. Look at wealth rankings and you will see this pattern: investment moguls related to private equity, real estate and public equities tend to be far wealthier. Private equity moguls invest in boring things like injection molding plants. As a group, pioneers of private equity are worth tens of billions. Why aren’t tech riches filtering to VC investors? Even the best VC investors are capital allocation pygmies in comparison to those who invest in what has proven tried, tested and true. Upon research, I could not find a single billionaire venture capitalist at the turn of the century. Today, there are a few. Korean-Japanese investor Masayoshi Son is today worth some $14 billion, which I have to admit is an impressive figure. Last time a tech bubble crashed, his net worth melted by 98%, so let’s withhold our judgement.
Most VCs operate on a build to flip mentality (whether to the public or to an acquirer). Both Peter Thiel and Jim Breyer, the luminary VCs on Facebook’s board at the time, were reportedly in favour of accepting Yahoo’s $1 billion bid, which in hindsight would have been a half-trillion dollars too early. Peter Thiel would sell far fewer books if Facebook had been a billion-dollar exit. VCs are eager to cash in their jackpot so that they can buy more lottery tickets. Many of these VCs would probably have performed better if they had sat on their winnings. Intel is now worth $240 billion. A $10k investment in Intel even at the IPO price would be worth $7.2 million. Co-founder Gordon Moore is worth $12 billion. VC Arthur Rock was there Day 1 — he wrote the business plan for Intel, his financing essentially put them in business. Where are Arthur Rock’s Intel billions? To be accurate, I have no doubt Arthur Rock is one of the best VCs. What I should really do is talk about terrible VCs, but that would be considered bullying. And to be fair, Arthur Rock, was not a pure VC investor. He also invested with Bernie Madoff. Alright, I have offended enough powerful Americans.
I think of Second Mouse investing as a unified theory of superior capital allocation. Whether your field is real estate, pharma, tech or Hollywood, there’s a risky way of succeeding and there’s a Second Mouse way. My favorite way to illustrate this contrast is the career of Michael Jackson. MJ made a lot of money thanks to his artistic talent, but no one would suggest trying your hand at pop music stardom as a reliable path to riches. MJ also blew through a lot of money — it’s expensive to raise a pet chimpanzee. For many years, what kept him afloat was not Thriller money, but an investment he made that is textbook Second Mouse.
The deal started one night over dinner with Paul McCartney. The Beatle showed MJ a binder with all the songs and publishing rights he owned of other artists. He said, “This is the way to make big money: every time someone plays these songs on the radio or live, I get paid ”. McCartney was at the time reportedly earning about $40m per year from other people’s music. MJ said: “Maybe someday, I’ll buy your songs.” In time, he would.
He started with less famous songs, but eventually set his sights on the prize: a catalogue of Beatles songs. In 1985, MJ paid $47.5 million for a catalogue of 4,000 songs, including many Beatles classics. All of that is very Second Mouse: first, mimicking a proven strategy in a proven asset class. Second, buying an asset that has already proven its quality. How much musical insight does it take to buy Beatles songs two decades after Beatlemania?
MJ had other ventures — shoes, a clothing line, video games. He had ideas for amusement parks and other entertainment ventures. Almost all these ventures were flops. I bet you don’t own MJ shoes, but directly or indirectly you have paid him for Beatles songs. No matter how creative he was, that was by far his best deal. By serving as collateral for loans, it saved him from financial disaster several times. Ironically, every time Paul McCartney sang Hey Jude in concert, he had to pay MJ, which annoyed him greatly. The catalogue was recently valued at $2 billion having thrown off hundreds of millions in royalties over the years. (His estate has since divested). An investment bank calculated the compound rate at 30% over 30 years. Extreme creative success, whether artistic or entrepreneurial is so much lightning in a bottle. So forget about ventures, being early or investing in tomorrow. Tomorrow may rain, invest in yesterday.
Part 2 of The Second Mouse Plan, called The Playbook, is the most important part. It discusses the three main strategies of the Second Mouse Plan along with tactics and numerous case studies. Read it here: The Second Mouse Plan Part 2.1 - The Playbook.