Capitalism and Hyperbolic Discounting

(Draft from 2013)

Capitalism is a way for society to determine how resources are used.  Say there exists some amount of raw material like wood.  And we determine how much wood is used for building houses vs. coffee tables in the marketplace.  If it was all used for houses, someone would find that if he made 1 coffee table, he would have an enormous margin/profit on that 1 table.  So he continues to make coffee tables until he can no longer keep these huge margins.  And thus, the wood goes to the highest bidder.  This is how in the long-run, capitalism will result to a close to optimal proportion of wood used for houses vs. coffee tables.

Hyperbolic discounting is the human tendency to overvalue the short-term.  We would rather have $100 today than $1000 in 34 yrs (7% discount rate).  We like to go party in our teens and college years, even though we know that an hour of work in our younger years can save us much more time in the future. ie, studying a little bit now might get us a higher GPA and lead us to a higher paying job, which greatly increases our expected life income.  Also, the higher the discount rate, the higher we weigh the short term.

Combining these ideas together, I think the world is likely to be consuming raw materials way too quickly.  In the grand scheme of things, is oil really worth 10x more today than 34 years from now?  Does capitalism help us allocate resources well over time?  There are arguments that prices will incentivize people to research new energy sources or discover more natural resources.  But discounting decreases our return on investment, and natural resources are finite while our population growth has thus far been exponential!  *Also, a high discount rate is a disincentive to researching new energy sources.

I guess my conclusion is that we live in a very peaceful state of the world in which there is very little competition over resources (at least for developed countries).  And that I might live to see a day where there will be increased competition or some sort of war over the limited resources of our planet.  

Decision Points

I was playing a board game yesterday called Ticket to Ride: Europe.  While we were learning the rules, my intelligent friend says "Okay, what can I do on my turn? What are my decision points?" It took me a little by surprise.  Instead of trying to learn all of the rules of the game (which were numerous), he was focused on his possible courses of action.  And the truth is, if you break the game down, you have 4 options over the course of maybe 40-60 turns.

In games, decision points are very important.  There is likely to be a random element, but the only things we can have influence is during a decision point.  A part of the random element may be influenced by other players, but that's where game theory also comes into play.

So what are the decision points in our lives?  Do we choose our values or do our parents and our society choose them for us?  Did you choose to go to college or not?  Did you choose your group of friends or were they the most available?  How did you choose your hobbies?  

What are the major decision points in life?  What are the range of possibilities and how do we come upon those possibilities?

Stonks go up

"Stonks go up" is today's meme phrase of what actually is a great strategy. The better sounding version goes like, "markets climb a wall of worry (and therefore you should stay invested)."

The best way to build wealth is to hold assets that compound wealth over time. Cash does not compound wealth over time. I too get drawn into thinking about rich valuations and near term risks and sometimes it doesn't feel great to be 100% invested in stocks. But the truth is that over the next 40-50 yrs, stocks will all certainly make thousands of new all time highs. If stocks return 9% a year for the next 40 yrs with a 2% dividend yield, then an investment in the sp500 today at 3270 should turn into 50,000 by 2060 and 100,000 with dividends reinvested. 

https://imgur.com/a/qXQm1W9

Stonks go up.  

Managers

For a long time, I had somewhat written off the power of a great manager. Of course I had known about great managers like Buffett, but when looking at most companies, I didn't necessarily focus on the management. And perhaps in some industries, management may matter less. But recently I've found a new appreciation for great managers. 

When I look at Amazon or Netflix, I see two CEO's with skin in the game that are honest, not afraid to experiment and keep and open mind, and focus on things that matter and things that work. 

I heard a quote recently that turned on a lightbulb in my head "I wouldn't bet against a man that led a Company to land two rockets safely back on earth, backwards!" I think you can look at Tesla and say, "this is a car company that will never its cost of capital because of its competition and continues to underdeliver on its promises." But the other way to look at it is that Elon is re-engineering capabilities in batteries, engines, cars, rockets and autonomous driving, why would you ever want to short the stock? He could invent or reengineer something that has other practical uses that could be turned into another product or Company.

Anyway, I'd like to own companies with managers who focus on the key variables of the business, who aren't focused on this years earnings and will reinvest for the future. 

  

Optionality in distribution

When VHS came out, Disney was able to distribute content like never before. Technology was a huge boon for Disney.

Fastenal created a distribution network for fasteners that provided amazing service to its customers and ultimately was then able to sell other products through the same network profitably. 

Facebook has such a big user base that it has huge embedded options in the company. Could it compete against PayPal? or Ebay? or Match.com? or Snapchat? The answer is yes, and I think Zuck has been reluctant to clone, but Facebook has the optionality to create new products. 

Tencent, Nestle, Ecolab and Netflix are also great distribution companies. And Apple App Store to some degree. 

A new hit game benefits Tencent because Tencent can distribute it to a billion users. When Ecolab or Nestle either acquires a new customer, or a new product, it can cross sell its products to help its customers scale. It's the AWS of physical restaurants! Netflix similarly benefits from better content creation over time.

It seems like some of the best businesses get better are getting and better over time and have additional optionality in selling new products. I hypothesize that the market may not do a great job at pricing in this type of optionality.  

 

Berkshire Hathaway

 I currently have a major investment in Berkshire Hathaway. I think it'll be tough for Berkshire to grow at much more than 8-10%/yr going forward, which may be in line with the market index. 

I do love the culture at Berkshire exemplified and prefer holding BRK over SPX at current prices. Management views shareholders as partners, sells stock when shares are overpriced, buys back shares when they are underpriced. Management compensation is more than fair and management is very price sensitive when it comes to acquisitions. I could go on, but in essence, Buffett and Munger were in the top 1% of managers and I think have established enough of a culture that future managers will adopt.

In terms of valuation, I think BRK can earn a 9% ROE and should trade at 1.4-1.6x book (though BV will be less valuable as BRK buys back shares). With BV ~$420B, and a MC of $500B, that it's worth closer to ~$630B and trading 15-25% cheap. BRK has grown BV by 6.9x over the last 20 yrs, which is a smidge over 10% (with a cash drag!) It's also hard very hard for me to believe that in 10 yrs BRK will  be worth less than its current $500B MC. In 2019, my estimate of normalized net income was $38B with $80-90B of excess capital. If it didn't reinvest any its cash in growth capex, it could likely pile up $500B in cash and securities in 10 yrs time.  

The downside to BRK is obviously that it does not have a large runway ahead of it and returns for the next 20 yrs should be lower than that of the last 20 yrs. There's also been the complaint that Buffett has been overly conservative with the balance sheet over this past 10 yr bull run. I actually like that he's ridiculously conservative given how levered most Fortune 500 companies are. 

In terms of the market, I think we can maybe get to $160-190 EPS in SPX by 2022. So at 3500 we're trading 20x 2022E. If I discount that back 2 yrs, we can call that close to 23.5x. Now SP does have a higher ROE, closer to 14% so it deserves a much higher multiple than BRK. But it's also much more leveraged. 

Starting to write thoughts again

 It's been quite a few years since I've written anything on this blog, but I want to start again. In part, I've been thinking more about investments and investing philosophy and wanted to write some things down to

1. make my thoughts clear

2. hold myself accountable to ideas

3. hammer in some lessons that I've learned

4. to have a record of my thoughts of the future!

I'll likely also be writing some philosophical ideas and some of the things I'm thinking about through life. Cheers!