August Memo – High Flows

Status Update

August 5, 2018

$\"Biz$

Written by James Esler

User Growth. User Growth. User Growth. It seems investors have forgotten that driving long term user growth is more important than short term user growth. In order to drive long term user growth, the company product must be sustainable and work out bugs. \”Debugging\” not only works to create a product that better serves the company\’s customers, but also typically drives higher long term net profitability. When a technology company these days says, \”new and improved\”, you can bet the bottom dollar that they have infinite data to support their pivot, rather than in many other industries (ie not tech) that have not caught on to the big data craze (some still use focus groups and customer surveys). Frankly, I believe harvesting data is the best thing for all corporations, and they should all adopt techniques. Companies that adopt the data techniques have at least three major advantages to traditional non-big data companies:

The vast amount of data points to truths in samples that allows for a valid prediction in customer preferences. Reviewing corporate techniques not only shows customers\’ current preferences, but also by ways of trend-based modeling, companies are now more able to see where the future of their products are.
The data the corporations use are real time and coming from dozens of sources. Data is becoming cheaper and is becoming increasingly commoditized. The take away is that any industry will soon very cheaply estimate the NPV effects of new expansion or replacement projects with perspectives that were never before available to them. These numerous NPV perspectives will be packaged for sale from analytics companies that synthesize such data for resale. Costs will come down.
The overhead is incredibly low to use machines and will become ever more economical. I am a huge fan of more competition in Processing Unit and semiconductor development. Research and Development costs should greatly come down over the coming years. Nearly every large tech company has decreased their R&D costs as a function of revenues over the last 3 years. This trend will continue… with vigor.

In the near future, I believe these companies will be able to tell us what we want (or even better what we need) before we even know it. If I had a round table with the greatest tech CEO\’s today, I\’m certain that this is the race they are trying to win. After all, the product of Facebook, Amazon, Netflix, Google, Twitter, Salesforce, etc. is not connecting people, an online shopping center, a virtual video library, a search engine, a news feed, or a CRM tool (respectively)… All of these companies have one product: data. So the goal of the companies is to garner the most attention overall to build more data and more predictive advertising revenues for their products and the products of 3rd parties. Reviewing their histories and MD&A briefings, this is quite obviously the mission of big tech.

The first movers in the data market will continue to thrive because they not only know what users want today, but they know what users will want tomorrow. I believe M&A at Facebook is not exactly predicated on the whims of CEO Mark Zuckerberg… I believe the acquisitions of Whatsapp, Instagram, and Oculus VR were incredibly motivated by infinite data of what types of technology users seem to like most. Thus, a fourthadvantage: Mergers and Acquisitions will be much more strategic for a company employing data techniques.

**None of the below issues should concern long term investors. Especially investors that employ margins of safety and disciplined investing techniques either themselves or with our firm. I stress that our clients have a long-term perspective at least 3 years. Overall, our portfolio\’s goal is to beat the market in down years and pace the market in good years. The goal of the below is for education of our clients and further perspective on entry/exit points in our positions.**

Back to markets.. While the long term view of these burgeoning industries is increbily strong, will the economy support their growth? Or will there be some form of austerity to solve the outrageous debt around the world? This question manifests in the markets weekly (if not daily) by an increasingly mercurial temperament of investors. Additionally, much of what I hear from other investors is irrational exuberance – simply looking to profit but doing so in vain. These investors are sure to have negative asymmetric risk/reward if there is not a margin of safety or intensely defined exit point. Without getting into political speculation, the second quarter earnings season is continuing incredible momentum. Attached you will find a record of the last 10 quarters\’ (including Q2 2018) earnings surprises. This chart (Wall Street Journal 8-3-2018) details how many (of the thousands of companies reporting earnings) have grown more than analysts expected since the previous quarter\’s report (ie Q1).

From my perspective, markets are mostly in sync. For instance, medicine prices are increasing, gas prices are increasing, and soon everything we buy from China will be more expensive due to Washington imposed trade tariffs. And those are only the normal goods. Luxury goods are increasing as well, as evidenced by the Personal Consumption growth number reported in the GDP figures late July. From a pragmatic perspective, people are mostly still going to buy overvalued consumer goods. Prices will rise until there is an event like a credit crunch. The economy is gaining traction quarter to quarter, and interest rates are considerably higher than they were two years ago (see attached chart). Money poured into American public companies in higher proportion than ever in June/July based on ETF reviews. This may be a flight to safety, or (more likely) simply a play on earnings season.

However, bond effective yields are getting narrower across treasury yield curves. An economist can interpret the narrowing spreads in many different ways: generally the long term bond is a function of a short term bond with an added premium for time of money (ie inflation). When spreads narrow, in theory, investors believe the economy will not grow much. If the long term (ie 10 year) becomes inverted, investors generally expect a recession. Thus, the narrowing spread is showing (at this point in time) that many investors think the economy will not be able to grow very much over the coming years.

P.S.

It is often good to understand the derivations of where things came from and compare that to where things are currently. Financial firms are moving toward profit and away from customer experience. Employees work for the companies we invest in. It\’s much more important to make sure those employees are working in your best interest than those of a financial firm. If, however, you have invested capital for direct ownership in the financial firm, and you do not have the financial firm responsible for any other part of your portfolio, at that point you should consider the employees of the financial firm you invested in. Clearly, any company (public or private) is dedicated to both customers and shareholders, with the goal to please both (the priority should be the customer). To reiterate, machines are much better employees theoretically than humans. Admin costs are lower and potential for error is virtually removed (given that the programmer hasn\’t made a mistake in code)… This is why blockchain, big data, AI are so amazing. However, if the goal of employing the machines is simply to reduce overhead (ie increase profitability) without providing a better user experience, this will eventually be bad for all parties. After all, with great power comes great responsibility. It is my belief that all financial advisors at larger banks will see their take home pay decimated in the next 5 to 10 years for the above reasons.

Most interestingly, I feel that over the past 20 years, the largest financial firms went from increasing the bottom line of their customers to presently increasing their own bottom lines. This paradox is evidenced at Wells Fargo savings bank and their \”Private Wealth Management\” department on an almost daily basis. Thus, I feel very good about the work that Capital Management Group is doing for our clients. We are trying to line your pockets, not ours – and this will most definitely continue. We currently pay \”machine employees\” (for lack of a better term) to take advantage of SEC\’s newest XBRL securities filings. The costs are extraordinarily low versus the benefit that we receive. In fact, we believe the benefit will outweigh costs by hundreds of times over the years. However, we are not replacing in-depth analysis with \”robo-advisors\” as of now. If we can find a way to provide clients with a net increase in wealth without having to overcharge, we will gladly participate in such an arbitrage event. I believe we are many years off of such an event at our current small scale.

To clarify: Robo-advisors are fantastic at helping manage wealth, but they are generally awful at security selection and discerning margins of safety/trends. The goal of a wealth manager is to create an allocation based on your age, risk tolerance, etc. This job should not include trying to beat the stock market. However, the ticker AIEQ shows how a robot can perform as far as security selection goes. I\’ve followed it since inception and the securities in the portfolio are absolutely baffling. Before I invest any money with a robot or anyone else, I\’ll need to know how I will be rewarded in the long term. At this point, humans still have the advantage.
$\"Yield$
$\"\"$

3065 Rosecrans Place #203

San Diego, CA 92110

Disclosure I Privacy Policy

Connect:

Linkedin

Twitter

Facebook