Curated Insights 2019.03.15

Buying into the timeshares Hilton Grand Vacations, Wyndham Destinations, and Marriott Vacations Worldwide

All of the timeshare companies offer some form of financing; in general, they offer consumer loans at low double digit interest rates. These are rather attractive loans, and they can generally be packaged up and sold into the ABS market at mid-single digit rates of returns. As of Q3’18, most of the timeshare companies had ~10% of their enterprise values invested into financing receivables that they hadn’t sold into the ABS market yet. I don’t think it’s appropriate to pull those receivable investments from the timeshare companies’ enterprise valuation calculations since they’re generally valued on an EBITDA calculation that includes earnings from those loans, but I could see an argument for why they should be deducted from their EV calculation (i.e. treated as a cash equivalent). Doing so would make the timeshare companies even cheaper.

The twenty craziest investing facts ever

Why am I using the Dow instead of the S&P 500? They’re effectively the same thing. The rolling one-year correlation since 1970 is .95.

If you had invested from 1960-1980 and beaten the market by 5% each year, you would have made less money than if you had invested from 1980-2000 and underperformed the market by 5% a year.
When you were born > almost everything else.

Dow earnings were cut in half in 1908. The index gained 46%.

Curated Insights 2019.03.08

The difference between the natural world and the investment world

You have to understand that there are no physical laws at work in investing. And the future is uncertain, and vague, and random. And psychology dominates.

Richard Feynman said, “Physics would be much harder if electrons had feelings.” You come in the room, you flip up the switch, and the lights go on. Every time! Why is that? Because the electrons flow from the switch to the lights. They never flow the other way. They never go on strike. They never fall asleep. They never say, ‘Ah today I don’t feel like flowing from the switch to the light.’ That’s physical science.

You have to understand the distinction between your field [architecture] and the field of investing, where there are no laws. There are only tendencies.

Facebook’s privacy cake

Why can Facebook deliver most of the value? Because they are still Facebook! They still have the core Facebook app, Instagram, ‘Like’-buttons scattered across the web — none of that is going away with this announcement. They can very much afford a privacy-centric messaging offering in a way that any would-be challenger could not. Privacy, it turns out, is a competitive advantage for Facebook, not the cudgel the company’s critics hoped it might be.

Why can Facebook deliver most of the value? Because they are still Facebook! They still have the core Facebook app, Instagram, ‘Like’-buttons scattered across the web — none of that is going away with this announcement. They can very much afford a privacy-centric messaging offering in a way that any would-be challenger could not. Privacy, it turns out, is a competitive advantage for Facebook, not the cudgel the company’s critics hoped it might be.


Zillow’s billion dollar seller lead opportunity

Here’s the kicker: Zillow claims about 45 percent of consumers that go through the Zillow Offers funnel end up listing their home. That’s a high conversion rate reflective of a high intent to sell; about 10 times higher than Opcity’s conversion rate. Assuming a 1 percent referral fee, a $250,000 home, and a conversion rate of 45 percent, those 19,800 leads are worth $22 million in revenue to Zillow, almost all profit. Compare that to the estimated profit of its iBuyer business (1.5 percent net profit), which, on 200 houses, is $750,000. The value of the seller leads is worth almost 30 times the profit from flipping houses!


Will Zillow Homes build a durable competitive advantage in the iBuyer market?

Let’s parse through these claims. The argument for Zillow to do their own mortgage lending sounds logical. A traditional home sale results in a 6% fee paid to the realtor. On the other hand, the typical iBuyer charges a seller fee of around 7-9%. However, if Zillow earns an additional 3% by attaching the mortgage, they can decrease their seller fee to be right in line with, or even cheaper than, the traditional realtor model. Home buyers have to get a mortgage anyway, so they shouldn’t care too much if it’s through Zillow—as long as the rates are competitive.

The combination of lower customer acquisition costs and increased monetization per customer could potentially be deadly. If both come to fruition, Zillow can underprice other iBuyers on their seller fee and/or pay more per house than their competitors can afford. It’s even possible that Zillow pays full market price for homes and earns enough just from selling the high-quality leads to agents. In this scenario, I’m not sure how others could compete. No one else owns almost 50% of all real estate web traffic that includes home buyers, home sellers, and real estate agents.

However, if Zillow is forced to pay for customers, or their competitors get enough local traffic organically, Zillow may not be able to earn high returns on capital in this new segment. If seller leads don’t pan out, or if those leads simply cannibalize Zillow’s traditional premier agent business, they may monetize customers at the same rate as other iBuyers. In this scenario, Zillow would simply be one of many in a commoditized industry.

How badly are we being ripped off on eyewear? Former industry execs tell all

When he was in the business, in the 1980s and ’90s, Dahan said it cost him between $10 and $16 to manufacture a pair of quality plastic or metal frames. Lenses, he said, might cost about $5 a pair to produce. With fancy coatings, that could boost the price all the way to $15. He said LensCrafters would turn around and charge $99 for completed glasses that cost $20 or $30 to make — and this was well below what many independent opticians charged. Nowadays, he said, those same glasses at LensCrafters might cost hundreds of dollars.

Butler said he recently visited factories in China where many glasses for the U.S. market are manufactured. Improved technology has made prices even lower than what Dahan recalled. “You can get amazingly good frames, with a Warby Parker level of quality, for $4 to $8,” Butler said. “For $15, you can get designer-quality frames, like what you’d get from Prada.” And lenses? “You can buy absolutely first-quality lenses for $1.25 apiece,” Butler said. Yet those same frames and lenses might sell in the United States for $800.

The Netflix of China might just be wishful thinking

Competition to attract new users means that subscription prices aren’t likely to go up any time soon. Pay television service in China isn’t much more expensive than an online video account, making it harder to encourage people to switch, Dai says. Netflix, charging about $10 a month, doesn’t face that challenge because pay TV in the U.S. costs about $90, he says. Over the past two years, revenue per user at iQIYI, the only one of the three publicly traded in the U.S., has fallen about 12.5% due to promotions to drive up subscriptions.

Although Chinese TV series are still much cheaper to make than U.S. shows—production costs for a top series are about $600,000 per hour, compared with $6-10 million for U.S. prime-time content, Daid wrote in his research note—content costs reached 84% of iQIYI’s revenue in 2018. The figure for Netflix is 48%.

Advertising revenue is destined to drop. That’s a function of the way the Chinese platforms work. Unlike Netflix, which has never had advertisements on its site, ad income makes up almost half of the revenue of Chinese online video platforms. Subscribers can skip ads shown to nonsubscribers before a show starts. If 85% of Chinese households signs up for online-video services—Dai’s assumption—only 15% will be left to watch the ads. At iQIYI, subscriptions have already surpassed ads as a source of revenue, accounting for 43% of the total in 2018, compared with 37% for advertising.

Tariff-Man Trump to preside over $100 billion jump in trade gap

The main long-term driver of persistent trade deficits since 1975 has been the gap between the U.S.’s low savings rate and its attractiveness as an investment destination, fueled partly by the dollar’s role as the world’s reserve currency. That in turn leads to a stronger dollar, which in itself helps increase the trade deficit by lowering the real cost of imports and increasing the local-currency cost of American goods in overseas markets.

Investors are losing millions on overpriced Chinese art

The art-purchase-and-lease offer is particularly appealing for people looking for a high-return alternative investment, but find the world of galleries, art fairs and auction houses intimidating. That’s where the model works, it preys on people by speaking to them in a vocabulary they understand and offering to be a trusted guide through this very opaque market, so buyers probably let their guard down,” says Edie Hu, art advisory specialist at Citi Private Bank in Hong Kong. “There is a mystique to the art market and all of a sudden you have someone who brings it down to your level. Nobody from galleries or auction houses talks about return on investment.”

AFG has set up a booth each year at the Asia Contemporary Art Show in Hong Kong alongside other galleries, and has held lucky draws to win a painting, according to d’Angelique, who said she was contacted by phone “in minutes” after filling out an online survey in 2012 to enter the contest.

She said she doesn’t believe her painting was ever rented out and AFG simply overcharged her and paid the lease premium from the sale proceeds. The leasing contract was drawn up between her and AFG, not a corporate renter. She said AFG wouldn’t tell her who would be leasing her painting.

Curated Insights 2019.03.01

The value chain constraint

To put conservation of attractive profits in generic terms, profit in a value chain flows to whatever company is able to successfully integrate different component pieces of that value chain; the other parts of the value chain then modularize and are driven into commodity competition.

In other words, what matters is not “technological innovation”; what matters is value chains and the point of integration on which a company’s sustainable differentiation is built; stray too far and even the most fearsome companies become also-rans.

The reality is that technology has an amplification effect on business models: it has raised the Internet giants to unprecedented heights, and their positions in their relevant markets — or, more accurately, value chains — are nearly impregnable. At the same time, I suspect their ability to extend out horizontally into entirely different ways of doing business — new value chains — even if those businesses rely on similar technology, are more limited than they appear.

What does work are (1) forward and backwards integrations into the value chain and (2) acquisitions. This makes sense: further integrations simply absorb more of the value chain, while acquisitions acquire not simply technology but businesses that are built from the ground-up for different value chains. And, by extension, if society at large wants to limit just how large these companies can be, limiting these two strategies is the obvious place to start.

The risk of low growth stocks

If a 5% growing business requires a 4% cash flow yield (a free cash flow multiple of 25x, the inverse of 4%) for investors to earn 9%, you can easily do the math to figure out what sort of cash flow yield a 3% growth business or a 1% growth business requires. While a 4% yield plus 5% growth gets you to 9% total return, if a business is only growing at 3%, it needs a 6% cash flow yield. If it is only going to grow at just 1% per year, it needs an 8% cash flow yield.

Now that’s scary. And seriously risky. Because an 8% cash flow yield means a stock is worth exactly half of what it would be worth if it was trading at a 4% cash flow yield. We’re talking about a $100 stock that needs to fall to $50 if the company is only going to grow at 1% rather than 5%. Even a small change, like a 5% business slowing to 4% (in perpetuity) requires the cash flow yield to jump from 4% to 5%. This means a change from 25x cash flow to 20x or a 20% decline in the price. Ouch.

That perpetual 5% growth rate? Remember it is descriptive of the market as a whole. But under the surface, individual companies are experiencing large swings in their growth rate. The market as a whole keeps returning to about 5% growth because that’s approximately the growth rate of the overall economy. But many companies find that while they might be able to reverse temporary periods of decline, once their ongoing growth rate slows down they hit what might be thought of as “stall speed”. In aerodynamics, the stall speed is the minimum speed at which an aircraft must travel to remain in flight. If it slows to a speed below this rate, it will stall and eventually crash.

Zillow is now the Netflix of homes

You already know how Netflix shows you stuff. When you browse, you see Netflix originals plus you see all the content other studios serve through Netflix. Going forward you’ll now see this on Zillow. Why? Because last April they started buying homes directly from sellers, and want to ramp up to buying 5,000 homes a month over the next 3-5 years. How? Fill out a form on their site, get an offer. If you accept, you close in days. If you decline, they pair you with a local non-Zillow agent who can list your home for you the traditional way.

Listing with an agent might be slightly cheaper than the 7% of sales price you might pay to sell to Zillow (or other instant offer firms like Opendoor), but it doesn’t have the same certainty or speed. Since 61% of you sellers are also buying a new home, you’ll need a new mortgage. Zillow bought a mortgage company last year so they can also do your loan—whether you buy your new home directly from them or through another real estate company.

So you might hit Zillow to look for a new home or ask them to buy your existing home. Either way, this is as close as the housing industry has gotten to a one-stop shop. Over time, they might prioritize Zillow listings over non-Zillow listings like Netflix prioritizes Originals, but our TV habits have gotten us used to that already.

Aligning business models to markets

USHG is a constellation of very different restaurants and chains. At one end it has michelin star fine dining restaurants like The Modern and Gramercy Tavern. While at the other end it has the large chain Shake Shack. And many restaurants in between those two ends of the spectrum of pricing and scale.

If you do well you could go on to run a restaurant in USHG’s portfolio. Or if you wanted to open your own restaurant, you could open one with Danny Meyer as part of USHG–or start your own restaurant and have USHG as an early investor. In fact, another possibility is what the three michelin star restaurant 11 Madison Park did. It was a USHG restaurant that they sold to its general manager and head chef, who’d both worked at USHG for years.

By having a portfolio of restaurants at different scales and price points, employees are able grow their careers while staying in the family. And USHG is able to have high retention and invest more in its employees.

Curated Insights 2019.02.22

“Hollywood is now irrelevant,” says IAC Chairman Barry Diller

“Netflix has won this game. I mean, short of some existential event, it is Netflix’s. No one can get, I believe, to their level of subscribers, which gives them real dominance.”

And that includes its closest rival Amazon Prime, which isn’t designed to bid as aggressively on tomorrow’s media stars as Netflix is. “Amazon’s model is saying, ‘If you join Prime, we’re giving you things,’” Diller said. “‘So our job is to get you to join Prime. If we can get you to do that by giving you Black Panther, or whatever, or The Marvelous Mrs. Maisel, then great.’ But that model, to people in the entertainment business, is like, ‘Oh my god, how did that happen?’”


Tollymore Investment Partners’ investment thesis on Trupanion

TRUP is vertically integrated; it owns its insurance subsidiary and is responsible for acquiring and servicing existing customers as well as underwriting their insurance. TRUP estimates this vertical integration has eliminated frictional costs of c. 20% of revenues. These economic savings have been donated to consumers in the form of higher claims payout ratios. TRUP’s strategy has therefore been to sacrifice the near-term margin upside of this cost advantage in the pursuit of a larger and stickier customer base and subscription revenue pool. This cost advantage does not manifest itself in lower prices, but rather the highest sustainable expenditure on vet invoices per dollar of premiums.

TRUP has built a database over 15 years using 7.5mn pet months of information and > 1mn claims; it has segmented the market into 1.2mn price categories in order to more accurately underwrite insurance costs for a given pet. Of course, determining the point at which the marginal returns on incremental data diminish is difficult, but according to the CEO it would take a competitor 13 years to replicate this data asset. Although Nationwide is larger by number of pets enrolled, its data are likely to be less comprehensive for two reasons: (1) a lack of data for conditions not covered by policies, such as hereditary and congenital diseases, and (2) pricing categories by state rather than zip code, even though the cost of vet care can vary widely within states. TRUP considers its ability to accurately estimate the costs of pet healthcare costs by granular sub- categories crucial to its leading value proposition. This allows for the provision of more relevant products for the customer.

The addressable market is large and underpenetrated relative to other developed markets. The differences in these other markets are not demographic, social or economic, but rather (1) the length of time comprehensive pet insurance has been available, (2) the value proposition in the form of higher claims payments as a ratio to premiums (higher loss ratios) and (3) vet vs. direct to consumer distribution models. Pet insurance companies in the US typically do not cover hereditary and congenital conditions, which are the forms of illness most likely to be suffered by cats and dogs, they increase rates when claims are made, they impose payout limits, and pay claims according to an estimated cost schedule rather than actual vet invoices. TRUP is different in all these respects and as such expects to grow the addressable market in North America to greater than 1% penetration. In any case, it appears to be the case that TRUP’s value proposition is driving adoption in North America.

The unit economics associated with the pursuit of this opportunity to grow the company’s assets are attractive. The cost to acquire a pet is c. $150, around 3x the average monthly ARPU. Assuming the current 10% discretionary margin and a six-year average pet life, the IRR on new pets is 30-40%. At a 15% discretionary margin the IRR would be double this. I estimate that both ARPUs and discretionary margins would need to decline by 20-25% to render reinvestment in pet acquisition a capital destructive pursuit. This would contradict the economic reality of a market in which pet healthcare costs are increasing mid-single digits as new technologies and treatments are ported over from human healthcare, and the scalability of the business model.

Purchases with plastic get costlier for merchants—and consumers

Merchants paid an estimated $64 billion in Visa and Mastercard credit and debit interchange fees last year, according to new data from an industry publication, the Nilson Report. That is up 12% from a year earlier and up 77% from 2012.

Other fees are on the rise, as well. Visa, the largest U.S. card network, is increasing several fees in April, according to people familiar with the matter. Unlike interchange fees that are paid to card issuers, these fees are collected by Visa.

Visa raised its “credit-card assessment fee” this year by 0.01% for most credit-card purchases made in the U.S. While seemingly small on a percentage or flat-fee basis, the increased fees that Visa will put in place during the first four months of the year are expected to cost U.S. merchants at least an additional $570 million through April 2020, according to estimates by merchants-payments consulting firm CMSPI.

But network fees aren’t the only additional charges merchants face. There are also other fees charged by firms that process merchants’ card transactions. Those, which include the network fees, totaled $14.8 billion on Visa and Mastercard debit and credit transactions in 2018, up 10% from a year earlier and 70% from 2012, according to the Nilson Report.


MSG says the Knicks aren’t for sale. It’s a good time to invest in sports either way.

That $5 billion is a big number, 25% higher than the recent $4 billion valuation by Forbes. And $5 billion amounts to more than $200 per share, or about 71% of MSG’s current stock price. Just because the number is large doesn’t mean it isn’t realistic. Don’t forget the Clippers were sold to former Microsoft (MSFT) CEO Steve Ballmer for $2 billion in 2014. That year, before the sale was announced, Forbes valued the Knicks at $1.4 billion and the Clippers didn’t crack Forbes top-10 most valuable NBA franchises.

Live TV content is part of the reason the value of sports franchises have swelled. Live content is becoming increasingly more valuable to media outlets like traditional networks and streaming companies. But other factors are also at play. Sports betting is another important avenue for franchise owners to generate brand-new streams of cash. “I think everyone who owns a top four professional sports team just basically saw the value of their team double” Dallas Mavericks owner Mark Cuban said in 2018, after the U.S. Supreme Court cleared the way for legalized sports betting in states other than Nevada.

If the Knicks are sold, MSG would be left with the New York Rangers, the WNBA’s New York Liberty, the Hartford Wolf Pack of the American Hockey League, and the Westchester Knicks of the NBA’s developmental league. In addition to Madison Square Garden itself, MSG also owns the Hulu Theater at Madison Square Garden, Radio City Music Hall, the Beacon Theatre, the Forum, the Chicago Theatre, and the Wang Theatre.

Curated Insights 2019.02.15

Even God couldn’t beat dollar-cost averaging

My point in all of this is that Buy the Dip, even with perfect information, typically underperforms DCA. So if you attempt to build up cash and buy at the next bottom, you will likely be worse off than if you had bought every month. Why? Because while you wait for the next dip, the market is likely to keep rising and leave you behind.

What makes the Buy the Dip strategy even more problematic is that we have always assumed that you would know when you were at every bottom (you won’t). I ran a variation of Buy the Dip where the strategy misses the bottom by 2 months, and guess what? Missing the bottom by just 2 months leads to underperforming DCA 97% of the time! So, even if you are somewhat decent at calling bottoms, you would still lose in the long run.

I wrote this post because sometimes I hear about friends who save up cash to “buy the dip” when they would be far better off if they just kept buying. My friends do not realize that their beloved dip may never come. And while they wait, they can miss out on months (or more) of continued compound growth. Because if God can’t beat dollar cost averaging, what chance do you have?

Miss the worst days, miss the best days

If you missed just the 25 strongest days in the stock market since 1990, you might as well have been in five year treasury notes. This remarkable data point is almost always followed by “time in the market beats timing the market.”

If by some miracle you managed to miss the 25 best days, you likely would have missed at least some of the worst days as well. You’ll notice a few things. The best days often follow the worst days, and the worst days occur in periods of above average volatility (red dotted line). These volatility spikes happen in lousy markets, so, if you can avoid the very best days, you will probably also avoid the very worst days, thereby avoiding lousy markets.

The chart below shows what happens if you were able to successfully avoid the 25 best and 25 worst days. This would have put you well ahead of the index. Of course this assumes perfect end of day execution, no transaction costs, and most importantly, no taxes.

Why time horizon works

When earnings compound but changes in valuation multiples don’t, the importance of the latter to your lifetime returns diminishes over time. Which is great, because changes in valuation multiples are the most unpredictable part of investing. Assuming earnings compound over time – an assumption, but a reasonable one – here’s what happens when valuation multiples go up or down by, say, 20% in a given year.

Valuation changes have a majority impact on your overall returns early on because company earnings are likely the same or marginally higher than when you made the investment. But as earnings compound over time, changes in any given year’s valuation multiples have less impact on the returns earned since you began investing. So as time goes on you have less reliance on unpredictable things (voting) and more on things you’re confident in (weighing).

Spotify’s podcast aggregation play

Anchor provides a way to capture new podcasters, leading them either to Spotify advertising or, in the case of rising stars, to Spotify exclusives. Critically, because Spotify has access to all of the data, they can likely bring those suppliers on board at a far lower rate than they have to pay for established creators like Gimlet Media.

Spotify Advertising, as I just suggested, makes a strong play to be the dominant provider for the entire podcasting industry. Spotify Advertising is already operating at a far larger scale than Midroll, the incumbent player, and Spotify has access to the data of the second largest podcast player in the market.

Gimlet Media becomes an umbrella brand for a growing stable of Spotify exclusive podcasts. Critically, as I noted above, the majority of these podcasts come to Spotify not because Spotify pays them millions of dollars but simply because Spotify is better at monetizing than anyone else.

Spotify doubles down on podcasts by acquiring Gimlet and Anchor

Spotify has acquired Gimlet Media and Anchor as it doubles down on its audio-first strategy. Gimlet is the podcast production house behind popular shows such as Reply All and The Cut. With Gimlet, Spotify has acquired a team with a proven record in original content production which should enhance its competitive position relative to Apple. Anchor provides easy-to-use software for podcast creation, ad insertion, and distribution, with more than 40% share of new podcasts produced. Anchor’s wealth of data should help Spotify identify and target original content, attracting more users to its ecosystem.

Podcasts should enable Spotify to differentiate its service and reduce its dependence on the music labels. Ever since Spotify’s initial public offering, the bear case has been that it never will deliver attractive returns because the labels will demand an ever-increasing share of its revenues. If its foray into original podcasts is successful, Spotify will convert some of its variable costs into fixed costs, improving its profit margins.

The ad-supported podcast business also is attractive. As shown above, podcast listener hours are roughly 12% those of radio but only 3% of the ad dollars. That gap should close with time. More important, as is the case with TV, traditional radio is in secular decline. A generation from now, podcasts could be the default format for spoken audio. If able to secure a leadership position, Spotify could enjoy a recurring revenue model with much higher margins in the years to come.

How DJI went from university dorm project to world’s biggest drone company

“In the very beginning, we had different competitors but they were small,” said Wang in a 2015 interview with Chinese-language news site of Guangzhou-based NetEase. “We made a lot of the right decisions to stand out in the industry … I think it is DJI’s success that made the drone industry attractive to investors and users.”

Chris Anderson, the chief executive of DJI’s major rival 3D Robotics, was quoted by US media as saying that the Chinese company has been “executing flawlessly” and “we just got beaten fair and square”.

“I do not see any strong competitor for DJI so far,” said Cao Zhongxiong, executive director of new technology studies at Shenzhen-based think tank China Development Institute. “The company can dominate the drone industry for some years to come.”

“We found success on the consumer side and are now leveraging the things we do very well into other industries. We are also expanding to serve different companies, operations and industries globally,” said Bill Chen, DJI’s enterprise partnership manager. He said the use of drones in agriculture will be a particular focus for the company.

DJI has rolled out a development kit so software developers can write applications for specific tasks, signalling the company’s shift from a hardware manufacturer to platform operator. “We aim to build a versatile platform that can be addressed by third-party developers as well,” Chen said.


Here’s what you need to know about Hikvision, the camera maker behind China’s mass surveillance system

The global video surveillance equipment market is expected to grow 10.2 per cent to US$18.5 billion in 2018 thanks to increasing demand for security cameras, according to a report by London-based market research firm IHS Markit in July. China’s professional video surveillance equipment market, which accounts for 44 per cent of all global revenue, grew by 14.7 per cent in 2017, outpacing the rest of the world, which grew by only 5.5 per cent, the report showed.

Around 42 per cent of the company is controlled by state-owned enterprises, with China Electronics Technology HIK Group owning 39.6 per cent of the company as the biggest shareholder. Hikvision had a leading share of 21.4 per cent for the global closed-circuit television and video surveillance equipment market in 2017, according to IHS Markit.

IHS Markit estimated that China had 176 million surveillance cameras in public and private areas in 2017, compared to only 50 million cameras in the US. The researcher expects China to install about 450 million new cameras by 2020. The researcher expects about 450 million new cameras to be shipped to the Chinese market by the end of 2020.

The global success of Marie Kondo -- Japan’s queen of tidying -- points to an important truth for Japan’s economy: there’s massive latent value still to be unlocked as women enter the labor force, research by Bloomberg Economics shows. Unpaid work in the home was worth as much as 138.5 trillion yen ($1.25 trillion) in 2016, or 25.7 percent of GDP, according to estimates by the Cabinet Office. If more women enter the labor force, and more domestic work is monetized, that could prove a double plus for Japan’s economy -- lifting the lackluster rate of growth.

Where big leaps happen

You can be great investor and still spend yourself broke. Ego is easier to develop and maintain than alpha, so good returns without the psychology necessary to hold onto those returns where money can continue compounding can be defeating. The math of compounding ensures that neither those who earn big returns but spend them quickly, or power savers who settle for low returns, will build meaningful wealth. There are many good investors. There are many good savers. It’s the intersection of both that compounding rules wild and big leaps are made.

The same mindset that allows visionaries to see things normal people can’t blinds them to realities normal people understand. If you’re staggeringly good at one thing, your mind probably has little bandwidth for other vital things necessary to make your skill work. Look around. There are a lot of people with crazy good ideas. But many people with crazy good ideas are crazy, and their idea is an outgrowth of a mind that has little patience for things like employee culture and appeasing investors, so their idea never stands a chance. A big leap happens when a visionary mixes with a sober operator who can tame the worst impulses of an otherwise great idea.


Will accountants become the weavers of the 21st century?

Intangible assets now make up 84 percent of the market value of the S&P 500. That’s up from just 17 percent in 1975. We investors clearly value things like investment in brands, new business processes, skills development for employees, R&D, etc., as drivers of future value. In other words, we believe these investments will create revenues in the future. But accounting can’t figure out how to value those non-tangible assets, so it treats those investments as expenses. That just doesn’t make sense.

Curated Insights 2019.02.01

One big thing

For years Seder measured everything on horses. Nostril size. Excrement weight. Fast-twitch muscle fiber density. And for years he came up empty-handed. Then, Seder got the idea to measure the size of a horse’s internal organs using a portable ultrasound. Bingo. He hit pay dirt. Seth Stephens-Davidowitz tells of Seder’s discovery in Everybody Lies: He found that the size of the heart, and particularly the size of the left ventricle, was a massive predictor of a horse’s success, the single most important variable. That was it. Heart size was a better predictor of horse racing ability than anything else. And this is what Seder knew when he convinced his buyer to purchase American Pharoah and disregard the other 151 horses at auction. The rest is history.

Hans Rosling echoes this sentiment in Factfulness when he discusses the importance of a single measure in understanding a country’s development—child mortality: Do you know I’m obsessed with the number for the child mortality rate? … Because children are very fragile. There are so many things that can kill them. When only 14 children die out of 1,000 in Malaysia, this means that the other 986 survive. Their parents and their society manage to protect them from all the dangers that could have killed them: germs, starvation, violence and so on. So this number 14 tells us that most families in Malaysia have enough food, their sewage systems don’t leak into their drinking water, they have good access to primary health care, and mothers can read and write. It doesn’t just tell us about the health of children. It measures the quality of the whole society.

Rosling’s use of childhood mortality and Seder’s use of heart size perfectly exemplify the power of heuristics. A heuristic is defined as “any approach to problem solving or self-discovery that employs a practical method, not guaranteed to be optimal, perfect, logical, or rational, but instead sufficient for reaching an immediate goal.” While Rosling and Seder don’t perfectly describe the systems they are studying with a single measure, they are able to gain important insights with little information. Sometimes it helps to have lots of variables/measures, but sometimes you only need to know one big thing.

Enhancing eBay: A letter to the Board of eBay

While surprising to many, only 10% of items sold on eBay today are sold via auction, and fewer than 20% of items sold are used goods. As a result of its ability to successfully evolve and grow with the broader e-commerce market, eBay today is the world’s second largest online retailer outside of mainland China, with #1 or #2 market positions in most major geographies. Furthermore, eBay owns two other leading franchises – the premier online secondary ticket marketplace (StubHub), and a portfolio of best-in-class international classifieds websites.

Online classifieds is a fast growing industry that has benefited from a stark shift from print to online channels. Against this positive macro backdrop, the usage of online classifieds platforms continues to grow rapidly. As with all network-driven businesses, online classifieds is an industry where scale matters and success is driven by establishing a strong leadership position. In any given geography and vertical, one to two competitors generally take the majority of the market and enjoy compelling economics. Many leading classifieds platforms operate with EBITDA margins in the 40% to 60% range, with some as high as 75%. Based on our review of comparable businesses, conversations with former employees and research on the sector, we believe that eBay Classifieds Group currently operates at a much higher level of profitability than the core Marketplace, with estimated EBITDA margins that should be in the range of 45% to 55%.

As a result of these strong market tailwinds, attractive economics and significant incumbency advantages, leading classifieds businesses garner extremely attractive valuations. The average publicly traded classifieds business trades at a mid-to-high-teens forward EBITDA multiple. Furthermore, there has recently been significant acquisition interest in this space from both strategic and financial acquirers, resulting in transactions all valued at more than 20x EBITDA over the past several years.

As the leading player in a high value business with competitive barriers to entry, StubHub enjoys an attractive economic model. Today, StubHub enables the transaction of more than $4.5 billion in ticket value, up roughly 50% over the past four years. Benefiting from its market-leading position, revenue growth has surpassed GMV growth with sales up nearly 70% over the same time. While StubHub is indeed a “marketplace” for tickets, the very nature of tickets makes this platform and the features required highly distinct from the core eBay Marketplace. Despite efforts over the years to better integrate the two platforms through initiatives such as cross-promoting tickets and merchandise, eBay has never succeeded in extracting meaningful strategic synergies.

StubHub is non-core to the eBay Marketplace but would command significant value as a market-leading, scale business. The second-largest player in StubHub’s market, VividSeats, has been acquired by private equity firms twice in the past three years. The most recent acquisition came in 2017, when it was acquired for ~16x EBITDA. The third-largest player is Ticketmaster, a competitor which is part of the larger LiveNation that conducts not only secondary ticket sales, but also primary ticketing and the production and promotion of live music events. While LiveNation’s other businesses have varying economic profiles, LiveNation currently trades at ~14.5x EBITDA.


Swiping right on InterActive Corp

Maslow’s hierarchy of needs suggests friendship/intimacy/family are far more important than entertainment (sub-set of self-actualization). Pricing for PayTV subscriptions are $80-$120/month, though PayTV is generally regarded as a melting ice cube as consumers shift online. While MTCH being able to command similar ARPUs as PayTV is not my base case, the wide disparity between the ARPUs and relative importance between the two indicates significant latent pricing power for MTCH.

As Tinder’s total addressable market (“TAM”) penetration remains low (est. 50m users vs 600m singles ex-China), TAM is potentially underestimated because of the exclusion of non-singles (as noted above, a significant portion of Tinder users are non-singles), and paid user penetration is low (~4.1m average subscribers vs est. 50m users; OkCupid 2015 paid user penetration was 5.7x that of 2012 while MAU doubled and Tinder’s first-year increase in paid user penetration post-monetization was greater than that of OkCupid in 2012, per MTCH S-1), MTCH can likely grow its Tinder’s subscriber base indefinitely.

Replication of MTCH’s core dating brands is difficult due to the need for network effects stemming from initial user liquidity. Capital is not the limiting factor – dating apps with high marketing spend (i.e. hard paywalls) tend to have inferior economics as a result whereas dating apps with the best economics tend to stem from viral adoption which requires little to no marketing spend (i.e. Tinder).

Risks of new dating apps usurping MTCH’s position is mitigated by user compartmentalization of different apps and a largely unsaturated market. Users tend to compartmentalize different dating apps for different sexual strategies. For example, Tinder/Bumble are geared towards casual sexual strategies whereas Match/Coffee Meets Bagel (“CMB”) are geared towards serious sexual strategies. As a result, the average user uses more than 3 different dating apps at one time – per 2Q18 earnings call.

ANGI is in the business of helping contractors improve job turnover/time utilization and helping consumers access quality home services at lower prices through its marketplaces. Its moat is derived from network effects between consumers and contractors and economies of scale in sales and marketing. Recreating ANGI requires significant and multi-year investments in a large sales force (to attract high-quality contractors) and marketing (to attract consumers) to initiate the flywheel. Matching a contractor with a consumer is incredibly hard as the marketplace needs to have the exact capacity available at the zip code level. In addition, matching algorithms are improved with experience and data, which favors incumbents like ANGI. Moreover, given ANGI is pricing at 3%-4% take rates (per IAC 1Q17 shareholder letter) which are far below any comparable marketplace business; any new competitor would likely need to sustain operating losses due to the relative difference in scale.

ANGI has a long reinvestment runway. 90% of discovery occurs offline for US home services; consumer awareness is the bottleneck – the company with the largest sales and marketing budget and lowest customer acquisition costs (i.e. ANGI) is highly likely to acquire the most mindshare over the long-term. Per IAC 2Q16 shareholder letter, an average household has 6-8 jobs per year, with ANGI taking ~1.5 jobs, implying significant room to grow its “job-share”.

While skeptics view Amazon HomeServices as potential existential threat, this is overblown given Amazon’s core advantages are in product e-commerce, not service. Even if Amazon were to significantly ramp up its home services business, the market remains heavily under-penetrated, allowing multiple long-term winners. Such a scenario would also likely be a net benefit to ANGI as it would raise consumer awareness and hasten the transition from offline to online. Furthermore, it takes many years to build a large network of high-quality service professionals and attract a large consumer base, as ANGI can attest to. At the current time, Amazon’s home service business remains nascent.

In my view, ANGI’s primary competitors are Frontdoor and HomeServe. Frontdoor’s primary market is the US whereas HomeServe is largely UK/EU with some US exposure. Whereas ANGI provides a marketplace connecting consumers and contractors, Frontdoor and HomeServe provide home service plans.

Platforms like YouTube can and do get a large portion of the economics of their creators’ content due to their market position. Vimeo provides content creators with better economics – YouTube and Dailymotion takes 50% and 30% of a content creator’s revenue while Vimeo, in addition to a 10% cut, makes money through content creators subscribing to its creator platform. It allows content creators to monetize their content much more profitably through transactional videos-on-demand (“VODs”) instead of advertisements despite the higher content creation costs of transactional VODs. Per IAC 2Q18 shareholder letter, average revenue per subscriber (“ARPS”) at Vimeo has grown 15% per year for the last 4 years (ARPS was ~$100 per IAC 2Q17 shareholder letter), and is accelerating.

Grainger eyes mid-size companies as it invests more in Zoro.com

Grainger is investing in Zoro—which caters to smaller businesses than the larger customers that tend to use Grainger.com—to further develop its staff, expand its number of available SKUs, improve its website features, and expand its web analytics and digital marketing. In effect, Grainger will help Zoro follow in MonotaRO’s growth curve, Macpherson said.

MonotaRO has “20 million items on their website, and we are making investments in Zoro to be able to expand our offering [on Zoro.com] dramatically over the next several years,” he said on the conference call, according to a transcript from Seeking Alpha. He added that he expects Zoro’s improvement projects to be completed by the end of this year, and that Zoro will “remain profitable through the transition.”

“Zoro continues to grow very strongly,” he continued. He added that Zoro currently has several million SKUs but will eventually expand to more than 10 million. Zoro operates internationally, with dedicated e-commerce sites in the United Kingdom and Germany as well as in the United States. It also maintains an online shop on the Zoro section of eBay Canada.

As it expands its available inventory and improves its website, Zoro is also expected to increase its number of mid-sized companies in its customer base, Macpherson said. But Grainger doesn’t expect it to cannibalize many mid-size company accounts from Grainger.com, which caters more to larger customers seeking its selection of industrial and maintenance, repair and operations (MRO) products and services, he said.

Grainger has also been working to increase its overall market share of mid-size companies for industrial supplies—now at about 2%, but down from prior share figures—both by “reengaging some” customers and acquiring new ones, Macpherson said. “I would say the new-customer acquisition has been very solid over the last quarter, and we expect that to continue,” he said, adding: “Most of that is acquiring new customers digitally, and then … building a relationship with those customers.”

Ruane, Cunniff & Goldfarb Q4 2018 investor letter: a2Milk

a2 is a New Zealand-based producer of premium milk and baby formula with an unusually long story behind it. Sometime around five to ten thousand years ago, scientists believe that a genetic mutation began to proliferate throughout certain global populations of cows, changing the protein with the exciting and original moniker A2. Cows that inherited the mutation, by contrast, started to produce milk containing a second protein labeled–you guessed it–A1. While this is far from settled science, some researchers and nutritionists believe that because people have only been drinking A1-bearing milk for a relatively short period by evolutionary standards, our bodies have a harder time digesting it than “pure” A2 milk.

A good analogy here is Greek yogurt, which is believed in some quarters to confer health benefits you can’t get from regular yogurt. While Greek yogurt, like A2 milk, is a commodity product, companies like Fage and Chobani have built big businesses by wrapping compelling brands around it. a2Milk is attempting to do the same thing, to great effect thus far. Riding powerful consumer trends favoring products perceived to be healthy and natural, a2 has become the leading premium milk brand in Australia while making rapid inroads into the massive and quality-obsessed infant formula market in China. An effort to penetrate the US milk market is also showing early promise. Notwithstanding its remarkable success to date, a2 remains a young company, and much will depend on whether management can navigate a thorny distribution landscape in China, solidify the positioning of an embryonic brand and exploit growth opportunities in new geographies and product lines. With good execution, particularly in China, we think a2 could become a much larger business than it is today, more than justifying the statistically high price-earnings ratio we paid for our shares.

NYSE, Nasdaq rival aims to shed light on fee profits

IEX, which itself pays the big exchanges’ fees for data and connectivity, estimated the big three’s charges are between 10 times and 19 times its own costs for market data and as much as 41 times its costs for physical connectivity. In dollar terms, IEX said that while its yearly cost of providing a type of market data feed to its firm customers is $12,000 each, it pays the NYSE $226,320 and Nasdaq $196,000 annually for a similar offering. IEX’s business model differs from that of the big exchanges because it doesn’t charge its customers annual subscription fees for data and connectivity. Instead, it charges based on the size of customers’ trades executed on the IEX venue.

Their industry group, the Securities Industry and Financial Markets Association, or Sifma, has been fighting the exchanges’ fee increases in the courts for years. In a letter to the SEC last fall, Sifma provided its own analysis of trading data and other costs. This analysis estimated that in 2018, firms paid about 10 times to 30 times more than they had in 2010 to receive the same market information. This is partly owing to the proliferation of charges incurred for the same basic data, the report noted.

The exchanges don’t disclose profit margins for these kinds of services. In the most recent quarter, Nasdaq said its information-services unit, which includes market data revenues, generated an operating-income profit margin of 65%.

Curated Insights 2019.01.25

Netflix flexes

Netflix has shows it owns completely, shows it own first-run rights to, hybrid shows like Hastings described, second-run shows — it runs the gamut. Critically, while some models are more profitable than others, all make the service more attractive to Netflix’s customers. This will be a particular challenge for a company like Disney: the company is staking a good portion of its future on its own streaming service driven by its own IP, but has not suggested a willingness to scale supply like Netflix has. That, by definition, will limit the company’s upside when it comes to consumer reach and also long-term pricing power.

T. Rowe Price’s Henry Ellenbogen on Gartner

Every company is trying to figure out how to use technology, internally and externally. One play on this is Gartner. Ninety percent of Gartner’s earnings before interest and taxes comes from its research business. It has two parts. Because of the demands that all companies have to use technology better and understand how their competitors are using it, the research product has transitioned from one that was nice to have to one you need to have. You can see it in Gartner’s numbers. Last year, it had over $2 billion of revenue and grew more than 13% organically. It’s a global business. We believe that it is going to continue to be a strong double-digit growth business.

The average customer spends $180,000 for Gartner research. They want to know what technology providers they should look at to answer their key questions. How are other people using technology and on-boarding it? How can they drive technology into a business line to get efficiency?

The other 20% of the research business is where the controversy has been. We have owned the stock since 2010. It has compounded at well over 20% since we’ve owned it. In the past two years, Gartner’s performance has been weaker, because it bought Corporate Executive Board, or CEB, a business best-practices consultant outside of technology that helps functional groups in a business understand issues in their areas.

Gartner instituted a turnaround at CEB. The product was fine, but it had to change the go-to market. They were selling by individual site license, as opposed to role-based pricing, and had to re-energize the sales force. A lot of costs have come into this division, with only modest improvement in growth; that’s where the controversy is. But Gartner now has an excellent franchise in an area that is becoming increasingly important globally.

In addition, Gartner has deleveraged. The leverage was about four times. It is now 2½ times, and the company is deleveraging at more than one time per year. They are back to buying back stock. We see low-$4 earnings per share in 2019. Free cash flow historically has been 130% or greater, because customers pay upfront. Next year, we see low-$5 EPS and close to $7 of free cash flow, and expect the company will return to trading at 20 to 25 times free cash flow, versus 18 times now.


T. Rowe Price’s Henry Ellenbogen on SS&C Technologies

When we think about compounders, the two key factors are ownership’s mentality and the durability of growth. My next pick, SS&C Technologies Holdings, came public for the second time in 2010, and we have been owners since the second IPO. Despite a mediocre 2018, the stock has compounded wealth at 24% since the IPO.

SS&C does fund accounting. It provides the pipes on the technology side and the service side for hedge funds. It’s the leading provider in the country; a lot of people in this room probably use them. And they are also the leader for private equity, and early last year, they bought DST Systems, which provides these services for mutual funds.

Bill Stone started the company in a classic American way, by getting a second mortgage on his house in 1986. He still owns 13% of it. Even in an industry where growth is neutral or negative, when you get into the plumbing, people can’t really take you out. You have a revenue stream, and you have pricing power. People worry about the health of their customers. But even under modest volume, Stone is going to have pricing power. If you change your back office and your accountants, you get all sorts of questions from your customers.

People are very concerned about the capital markets. But 10% of the company’s revenue is tied to market sensitivity; 90% isn’t. That’s about $50 million of Ebitda, if you assume a 30% correction, about 40% incremental margins. On the flip side, we believe that DST could yield an additional $50 million to $100 million of synergies beyond market expectations.

Another concern is that SS&C is 4.7 times leveraged, and the market doesn’t like leverage. This is the only highly levered name I am going to mention, and there are three reasons. First, Stone is investing his own money alongside other people’s, and he is very focused on paying down the debt. Second, the business is a very low capital-intensive one that is very sticky, and we think under normal operating situations, the leverage will be below four times by the end of this year. Third, when Stone bought DST, he got DST Health, which does $100 million of Ebitda and is a noncyclical business. If he wanted to, he could sell it at 12 to 15 times Ebitda, and that would instantly deleverage the company below three times. So he has another road out. We believe that SS&C Technologies will earn about $3.70 a share this year and $4 to $4.10 next year.


Rivulet Capital’s Oscar Schafer on Dollar Tree

Dollar Tree operates 15,000 stores under two distinct banners: Dollar Tree, a chain of variety stores selling a unique assortment of discount merchandise, all priced at a dollar, and Family Dollar, a chain of discount stores offering everyday goods and general merchandise. The Dollar Tree business is doing great, and it continues to execute on a growth model that has worked for three decades. The company acquired Family Dollar in 2015 and strove to really stabilize that business and turn it around. The reasons to be optimistic are that they have paid down debt and started ramping up investment in the Family Dollar stores. Most importantly, the stock price has declined to a point where I feel that I’m buying Dollar Tree for a fair price and getting Family Dollar for free. I like free options.

The Dollar Tree segment is a strong and stable business that will generate over 80% of consolidated operating income this year. A true “dollar” store, Dollar Tree employs a rapidly rotating assortment of merchandise to create a “treasure-hunt” experience. This format has proved to be largely insulated from e-commerce competition. The growth at Dollar Tree has been spectacular over the past 10 years, including during the financial crisis. Since 2006, the store count has more than doubled, from 3,200 to 6,900. Same-store sales growth has averaged 4.1%, and operating income is up by almost five times, with a compound annual growth rate of 15%.

Family Dollar’s business is different. A direct competitor is Dollar General. Family Dollar offers an assortment of everyday necessities in general merchandise, primarily to low-income consumers. Physical stores are much smaller; consumables make up almost 80% of the sales, and, over the past few years, the company has suffered from a litany of issues: food deflation, management turnover, and strategic operational business mishaps.

For many years, Dollar Tree was a stock-market darling, driving a 28% compound annual return from 2006 to 2014. Since acquiring Family Dollar in 2015, Dollar Tree shares have gone almost nowhere. This is due to dramatic multiple compression, not stagnating earnings. In fact, earnings were up by more than 60% in the past three years. On a combined basis, Dollar Tree is now trading at a relatively discounted valuation of less than 16 times forward earnings, and less than 10 times enterprise value to Ebitda.

We see multiple ways to win. First, we estimate that Dollar Tree can grow Ebitda at a mid-single-digit rate, even if we assume continued deterioration at Family Dollar. In this scenario, the company should still generate a billion dollars in excess free cash flow per year over the next few years. Having recently gained investment-grade status, the company can reallocate the cash flow from debt pay-down to share buybacks. This should drive double-digit earnings growth. Assuming a 16-times-earnings multiple on our estimate of 2021 earnings, I see 30% upside over the next two years.

Second, we see an opportunity for value-creating corporate action. In 2014, Dollar General attempted to buy Family Dollar for almost $10 billion. My research suggests that given the chance, Dollar General would again jump at the opportunity to consolidate its nearest rival. I estimate that the market is currently ascribing zero value to Family Dollar within Dollar Tree, so even if they sold Family Dollar at a discount to the 2015 purchase price, this would still unlock substantial value for Dollar Tree holders.

Serving the six-sided teeter totter: 2018 year in review — adventur.es

We often get asked by sellers, “What will adventur.es do for my company? What resources will you provide? What kind of growth can you promise?” Our answer is short and meant to be sweet — plan on adventur.es being a fair, long-term home for the business and its people, and nothing else. The response is almost always met with incredulity and usually leads to a great conversation.

What organizations do is overrated, while what organizations don’t do is highly underrated. It’s easy to make promises and we’ve certainly made plenty over the years that haven’t turned out well. What’s hard is following through — doing what you say you’ll do, when you said you’d do it, and under the terms agreed upon.

What’s even harder than doing what you say is intentionally not doing, and being transparent about it. Our first rule is “do no harm.” Humans are creatures of progress and crave shortcuts. We’ve learned that progress (almost) never comes by prescription, nor pill. Knowledge can light the path, but it can’t walk it for you. Often the right decision is to wait, gather more information, and reassess.

We ask that our sellers and company leadership have low expectations for us around everything except how we treat them. We’re not in the business of interventions, although we have paid for rehab a few times. If we intervene, we must see it through. It’s like a tree branch that is growing in the wrong direction. Merely pulling on it won’t solve the problem. The branch must be pulled and held, almost indefinitely. Sometimes we can help identify a poor direction, but leadership teams are the ones who pull and hold the branches.

The only other way to acquire a skill set is by hiring outside talent, a consultant, or a firm that can perform the difficult task. Again, there’s a nasty selection bias at play. If you’re excellent at a difficult-to-acquire and valuable skill, you typically don’t seek employment opportunities, or consulting gigs, or customers in small business, and especially in non-sexy industries.

Our goal is to find someone who has a range of experiences in successfully generating revenue through varied channels, building teams, and taking ownership of results. We know it’s humanly impossible for one individual to have deep experience in all the revenue disciplines. We expect this leader to build a team, both at the adventur.es level and within the portfolio companies, and draw on some stout resources already here.

Curated Insights 2019.01.18

10 years since BNSF

“It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex.”

One very important fact of this transaction, was his level of conviction. In November 2009, there were a ton of cheap opportunities. Buffett picked BNSF, and paid a 30% premium to gain full ownership. Also, 40% of the total consideration was paid with arguably deeply undervalued BRK shares. So, safe to say he really wanted BNSF. The $34bn paid for BNSF, represented almost 25% of Berkshire’s equity! It was a huge bet, with significant repercussions.

Applying similar numbers, we get to an Enterprise Value of $125bn and an equity value of $105bn for Berkshire´s railroad. Once again, Buffett paid $34bn, took out $31bn in dividends and is left with +$100bn in value…Good job Warren.

So we know returns for this massive investment have been impressive, but let´s get to a number. And the number is…~18%. That is massive for an investment many thought at the time would produce mediocre returns. Remember many experts thought he was overpaying for a capital-intensive, regulated and cyclical business.

18% is 1.5x the return of the S&P 500 during a bull market. But it gets better…At the time of the acquisition, Berkshire already owned ~20% of BNSF stock…so he didn´t have to pay the takeout premium on 100% of the shares outstanding. In reality, he had to pay ~$26bn for the shares he didn´t own. Also, Berkshire employed a bit of leverage to fund the acquisition. The company issued $8bn in bonds, so we get, leveraged returns. If we take into account the leverage and the shares of BNSF Berkshire already owned, then the return on the equity would go…way up. But I think we get the point.

Fund manager: Why Amazon could double

The market is not correctly conceptualizing normalized profitability. It seems that the market views AMZN’s profitability primarily through a legacy e-commerce lens, viewing AMZN as a single-digit-margin business. Piecing apart the business, I think this is wrong. First, AMZN has not known the meaning of the word “operating leverage” for the past 10 years, but it is showing through recently with beautiful impact. In Q3 18, fulfillment as a percentage of sales actually declined for the first time time in five years (having gone from 8.5% in 2010 to 15% of sales in 2018). This is a nascent signal, but suggests that the fulfillment infrastructure expansion is nearing its final stages. There are supplementary data points to support this notion, including the slowing in new DCs and headcount. As a result of this operating leverage, operating margins went from 0.8% in Q3 17 to 6.6% in Q3 18, with incremental margins of 26%. Second, there is a real mix shift going on at AMZN that benefits GMs and fundamentally changes the OM outlook for the combined business. Core e-commerce (lower margin) grew revenue only 10% in Q3, but third party seller services grew 31% and AWS grew 46%. As a result of this positive mix shift, gross margins went from 37% Q3 17 to 41.7% in Q3 18, with incremental gross margins coming in at 57.5%. Amazon effectively has a powerful combination of mix-driven GM expansion and operating leverage driven OM expansion in play here, and my view is that this dynamic will hold for at least a number of years to come.

PayPal quietly took over the checkout button

In 2013, PayPal bought Braintree Payment Solutions LLC, which processes the credit card transactions on the mobile apps of Uber, Airbnb, StubHub, and thousands of smaller businesses. The acquisition brought in an influx of programmers and designers, as well as Venmo, which Braintree had acquired the year before. Venmo is a way to quickly settle small debts between friends: a dinner check, a get-well present for a colleague. With Venmo, informal financial interactions formerly governed by social norms about reciprocity, forgiveness, and passive-aggressive hinting could be easily recorded and quickly paid. (“I only have a twenty” is no longer a viable excuse.) You could even “bill” your friends. The app—complete with a feed of the payments your friends have made to each other—has proved enormously popular with millennials.

Over the next six months, Schulman negotiated similar partnerships with Mastercard and Citibank, committing to make it as effortless as possible for customers to use Citibank-issued credit cards and Mastercard’s network. “When PayPal first spun out of EBay, there was a lot of competition and a lot of negative sentiment,” says Heath Terry, an analyst who covers the industry for Goldman Sachs Group Inc. “Basically, in 18 months on the job, Dan was able to completely change that narrative.” As with the Visa deal, PayPal was forgoing some profit but placating powerful and formerly antagonistic payments incumbents. Citi and Mastercard—along with Google, Apple, Amazon, and Samsung, each of which has an eponymous “pay” product—began steering customers to link their accounts with PayPal, seeing it not as a competitor but as a driver of transactions and the fees they generate. In short, as a pal.

The result has been a surge in growth. “It took us 14 years to go from 50 million subscribers to 250 million,” Schulman says. “I mean, it’s impressive, but it’s a long time. We went from 200 million to 250 million in about 18 months,” tripling the rate at which the company added users, or what it calls “net new actives.” PayPal’s stock is up more than 100 percent since the start of 2017. However, PayPal’s most impressive statistic may be its conversion rate. People who design online and mobile shopping apps are obsessed with smoothing and shortening the path from idle browsing to purchase—humans are acquisitive and impulsive creatures, but they’re also easily distracted and bad at remembering their credit card numbers. Too many options hurts conversion, and so does having to type out stuff or wait for a page to load. PayPal’s conversion rate is lights-out: Eighty-nine percent of the time a customer gets to its checkout page, he makes the purchase. For other online credit and debit card transactions, that number sits at about 50 percent.

This differential was cited by the hedge fund Third Point in an investor letter last July: “We see parallels between PayPal and other best-in-class internet platforms like Netflix and Amazon,” it read. It applauded PayPal’s $2.2 billion purchase in May of IZettle, a Swedish payments processor known as the “Square of Europe.” The praise was particularly striking coming from Third Point, whose billionaire founder Dan Loeb, like Icahn, is better known for publicly excoriating the leadership of the companies in which he invests. Built into PayPal’s high share price is the expectation that the company will figure out a way to turn Venmo’s popularity into profit. Third Point’s letter predicted that the app will be contributing $1 billion in additional annual revenue within three years. Disagreements over how to do that, or how much to even try, have led to the departures of two Venmo heads in two years. Employees who have left in recent months describe mounting mutual frustration. According to multiple people familiar with the company’s finances, the app is still losing hundreds of millions of dollars annually. In an interview after the announcement of Venmo’s latest leadership change in late September, Schulman’s deputy, PayPal Chief Operating Officer Bill Ready, downplayed any suggestion of turmoil. “Any startup that goes through rapid growth is going to experience this,” he says. “You evolve, and you have to bring in different skill sets for each stage of the journey.”

Cancer deaths decline 27% over 25 years

Deaths from cancer dropped 27% over a quarter century, meaning an estimated 2.6 million fewer people died of the disease during that period, according to a new report from researchers at the American Cancer Society.

For most of the 20th century, overall cancer deaths rose, driven mainly by men dying from lung cancer, researchers noted. But since the peak in 1991, the death rate has steadily dropped 1.5% a year through 2016, primarily because of long-running efforts to reduce smoking, as well as advances in detection and treatment of cancer at earlier stages, when prognosis for recovery is generally better.

Curated Insights 2019.01.11

Disney’s Bob Iger talks streaming, park plans, and learning from Kodak

In the case of Pixar, Marvel, and Lucas, none of them were for sale. We were the only ones. Us identifying them as acquisition targets and my going out and meeting with Steve Jobs and Ike Perlmutter and George Lucas one on one. Just alone. And broaching the subject and ultimately doing a deal. In looking back, particularly with Marvel and Lucas—Pixar was different—we had an ability to monetize those assets better than anyone else. If someone came along, we would have had a competitive advantage. You can argue that in the Comcast case with Fox, they’re probably the only other company out there that can monetize. Whether they monetize as well as we do, I don’t know. I don’t think they’re quite where we are.

What we looked at there was partly the result of the strategy we’re deploying, which is to be in the direct-to-consumer space in a very serious way. In order to do that, we needed a few things, and one of them, really the most important, was intellectual property. And when we looked at the Fox assets and brands—National Geographic, FX, Searchlight, the movie Avatar, the Marvel properties that they licensed, I could go on, The Simpsons—they had a lot that we could use to feed the beast that we’re taking to the market. And the board has been great at articulating this back to me. Had we not defined this strategy and gone for it, they would not have figured out how the Fox assets would have been of value to us. Because on the surface, you’re buying traditional businesses—cable channels and the like—and what do you need that for?

And then on top of that there was a global element to it that was very important to us. For instance, the Star assets in India. And they have a very successful business across Latin America. Sky was obviously attractive to us too, but it got less attractive as the price went up.

Wiedower Capital 2018 Annual Shareholder Letter: Trupanion

The vast majority of companies would take these increased efficiencies and let them drop to the bottom line. Not Trupanion. Their goal when the business is more mature in a few years is to have an adjusted operating margin of 15% (which equates to a net margin of around 5%). Once they achieve maturity, they want to then share all savings above that with their customers, basically capping their net margin at around 5%. Trupanion’s current loss ratio is ~70%, but their longer-term goal is to increase that to 80% (essentially giving 10% more value back to their customers).

To be clear, even if Trupanion does succeed with the scaled economies shared flywheel, it will not be as effective as Costco’s has been. An insurance company increasing loss ratios is a much less tangible benefit to the consumer vs a retailer decreasing prices. This is because retail prices can easily be compared at Costco vs Walmart or Amazon, whereas insurance policy prices are generally harder to compare apples-to-apples. However, I still believe this will make life harder on other pet insurers if Trupanion is slowly increasing their loss ratios on a yearly basis. That is tough to compete with. Very few companies are willing to pass up higher short-term profits every single year in the hopes that decreasing their prices will increase long-term customer loyalty.

For Healthy Paws (the #3 pet insurer, but the competitor I worry about the most) to have a meaningful effect on Trupanion’s customer acquisition strategy, they would have to hire and train a hundred salespeople all over the country and those people would have to spend years getting inroads into vets. And vets that already have Trupanion Express installed will have an even higher barrier to entry. Over 10% of vets in North America already have Express installed and that number is growing quickly (install growth was 42% in 2017 and over 50% in 2018).

Because of their customer acquisition cost, Trupanion loses money in the first year of all new pets they sign up. However, the average pet stays with Trupanion for over eight years, so that initial loss is made up over time. But because Trupanion is growing so fast, the cost of those new pets every year make the reported financials look worse than the progress of the underlying business. If customer acquisition costs are amortized over the life of a pet, the financials look much better.

This means that for every dollar spent on sales and marketing, Trupanion gets a 30-40% return on that invested capital. Very few businesses can maintain that return on capital for very long. Trupanion has been doing this for years and, given the industry penetration is just over 1%, they may be able to continue achieving this high return for many more years. Trupanion has the best unit economics of any company we own and, just as important, I believe these returns can continue because they are very defensible.

In addition to valuation, I believe the regulatory risks to Trupanion are overblown. The most touted regulatory risk is that many of Trupanion’s territory partners are not licensed to sell insurance—even though they don’t sell insurance and ideally never even interact with potential customers. There are fringe cases where this can be iffy though. For example, an unlicensed territory partner who talks to her friend about the benefits of Trupanion could potentially cross the line. Even in the scenario where regulators rule that all territory partners need to be licensed, I don’t believe the risk is large to Trupanion. From talking to insurance regulators about this, I expect a modest fine at worst.

The regulatory risk that I think is a bigger concern, but that gets discussed less often, is if veterinarians were required to get licensed. The veterinarians are the main conduit that connect pet owners to Trupanion. If veterinarians were required to get licensed, this would kill Trupanion’s current business model as very few vets would go through the effort of getting licensed. Here, it’s important to note that veterinarians who work with Trupanion do not explain the insurance specifics to their pet owner clients. The vets are allowed to recommend the concept of pet insurance broadly, and then discuss their personal experience with Trupanion, but that’s it. The vets do not get into insurance coverage details because that is when they would be required to get licensed.

Dureka Carrasquillo long Ferrari: Sohn London Conference

In 2017 the luxury car market was valued at $570bn. Estimates suggest it will grow at about 9% for the next 5 years. Ferrari sits in the category of luxury goods that is considered an ‘experience’ and that category is projected to grow at an even higher rate.

Special cars have historically been about 2% of sales but they will become a larger part of the business. She estimates that by 2022 special cars will represent 20% of revenues. These cars which are limited editions – often 500 cars – sell for more than $1m each and sometimes sell out on the day they go on sale. Gross margins on special cars are about 3x base cars. If the number of special cars is increased in the way that Carrasquillo predicts EBITDA margins for the whole group could increase from 33% to 38%.

Another hallmark of a luxury goods player is careful management of supply. Current product capacity is about 16,000 cars per year yet only 9000 are made. In comparison, Porsche sells 25,000 to 30,00 911s per year. Carrasquillo thinks that Ferrari could increase production to 16,000 cars per year and still sell them. Ferrari intends to launch 15 new models in the next 5 years – that’s a lot more than in the past. It takes about 40 months to produce and launch a new car.


Luke Newman long Rolls Royce: Sohn London Conference

At its heart Rolls Royce is a razor to razorblade business model – the razors – or the engines in this case – cost billions of dollars to design, deliver and install and come with an obligation to buy razorblades – service contracts – for the next 25 years. The gross margins on the service contracts are high between 50% to 70% but the engines are sold at a loss.

The secular trends in air travel are supportive driven by increasing wealth and emerging markets. Air passenger kilometres over the last 70 years have grown at 6% CAGR. If passenger growth continues at 4.5% and assuming planes have a 25-year life, 425 new wide body planes are required every year to keep up with demand. That’s 37 new wide-bodied planes every month. The production schedules for Boeing and Airbus for next year are slated at 34 per month creating positive pricing dynamics for all participants.

Over the last 20 years what was a 3-player market has become a duopoly. Pratt and Whitney took the rationale decision to concentrate on narrow body engines and ceded their market share to Rolls Royce. That did not come for free because Rolls Royce had to spend billions of dollars developing new engines to take the market share. The good news is that this year is the first year in which most of the revenue will come from the high margin aftermarket business. The company has reached a critical inflection point.

GE, the other member of the duopoly, has been in harvest mode, maintaining share and enjoying good aftermarket revenues. GE has lots of problems, but the engine business has not been one of them. GE’s engine margins have been consistently high.

Curated Insights 2019.01.04

The customer acquisition pricing parade

“One spectator, determined to get a better view, stands on their tiptoes. It works well initially until everyone else does the same. Then, the taxing effort of standing on your toes becomes table stakes to be able to see anything at all. Now, not only is any advantage squandered, but we’re all worse off than we were when we first started.”

“Marketing is increasingly cheap. Trust is increasingly expensive. Attracting eyeballs no longer sets you apart. Building trust among those who have their eyes on you, does. Getting people’s attention is no longer a skill. Keeping people’s attention is.”

To decrease spending and increase profitability, the holding companies of tomorrow will shift their attention from controlling supply to controlling demand — from building around industries to building around audiences.  

Re-marketing to an existing customer is significantly cheaper than trying to persuade a first time customer to buy your product — sometimes nearly 90% cheaper.

Companies who cater to the needs of passionate customers will benefit from lowered customer acquisition costs and higher lifetime value (LTV), reduced churn and increased loyalty. Once a paying customer is acquired, companies can cross-sell and up-sell them into different products, categories, and even brands. The fight to find that customer will be much easier leading to an increase in transaction volume. As they reduce friction in the payment process and increase customer loyalty, they’ll accrue data behind customer cohorts leading to a customer-centric experience.

Companies who cater to their customers and develop direct relationships with them, will own the future.

Working more magic at Disney

Walt Disney has in a sense become more Disney-like in how it earns its profits. After 20 years of being dominated by television, especially cable, the company is returning to its roots in films and theme parks. Seven years ago, for each $1 in operating profit that Disney made from its parks and studios, it generated $3 in TV. During the fiscal year ended September, parks and studios retook the lead.

The coming streaming platform will be reported to Wall Street as a separate Netflix-like division within Disney. Investors will see how much cash the unit is paying for content. New Disney, so to speak, will pay this money to Old Disney. “What I’ve discovered is, businesses in a traditional space that want to innovate and spend money to do so, they park the cost of innovation in their traditional businesses,” Iger says. “Those businesses all kind of suffer from the cost of that innovation, because it’s not typically monetized right away. You can get impatient to the point of losing interest and abandoning innovation, because you don’t have the patience to wait for it to really pay off.”

For decades, Disney was largely a moviemaker with theme parks, although television has long been part of the mix; The Mickey Mouse Club, which began on ABC in 1955, helped finance Disneyland, and the Disney Channel has been a cable mainstay since the 1980s. But in 1995, Disney surprised investors with a $19 billion acquisition of Capital Cities/ABC, gaining a prosperous TV network and a thriving ESPN. As cable spread service across the nation, and TV producers learned how to extract higher fees from cable operators for their content, the small screen became Disney’s big earner.

Iger planted the roots of Disney’s growth spurt in its traditional businesses when he rolled up major story-telling outfits that weren’t for sale. He did that by visiting their bosses one-on-one: Steve Jobs, culminating in the $7.4 billion purchase of Pixar in 2006; Isaac Perlmutter, for a $4 billion acquisition of Marvel Entertainment in 2009; and George Lucas, in a $4 billion deal for Lucasfilm in 2012. What has followed has been a film boom for the ages.

This year, Disney will again become the only studio in history to reap $7 billion in worldwide box office receipts: $4 billion internationally and $3 billion in the U.S. It also did so in 2016. And Disney makes eight to 10 films a year; some big studios make two dozen.

Box office results relate to return on invested capital the way dunking a basketball relates to winning a game: The former gets the crowd’s attention, but people with stakes care mostly about the latter. The broader film industry operates with a single-digit return, Iger says. Yet there are years when Disney’s film returns top 30%. As a result, studio operating income has multiplied more than fourfold since 2011, to nearly $3 billion during the fiscal year ended in September.

Does AI make strong tech companies stronger?

First, though you need a lot of data for machine learning, the data you use is very specific to the problem that you’re trying to solve. GE has lots of telemetry data from gas turbines, Google has lots of search data, and Amex has lots of credit card fraud data. You can’t use the turbine data as examples to spot fraudulent transactions, and you can’t use web searches to spot gas turbines that are about to fail. That is, ML is a generalizable technology – you can use it for fraud detection or face recognition – but applications that you build with it are not generalized. Each thing you build can only do one thing. This is much the same as all previous waves of automation: just as a washing machine can only wash clothes and not wash dishes or cook a meal, and a chess program cannot do your taxes, a machine learning translation system cannot recognise cats. Both the applications you build and the data sets you need are very specific to the task that you’re trying to solve (though again, this is a moving target and there is research to try to make learning more transferable across different data sets).

So: as an industrial company, do you keep your own data and build the ML systems to analyse it (or pay a contractor do do this for you)? Do you buy a finished product from a vendor that’s already trained on other people’s data? Do you co-mingle your data into that, or into the training derived from it? Does the vendor even need your data or do they already have enough? The answer will be different in different parts of your business, in different industries and for different use cases.

This takes me to a metaphor I’ve used elsewhere – we should compare machine learning to SQL. It’s an important building block that allowed new and important things, and will be part of everything. If you don’t use it and your competitors do, you will fall behind. Some people will create entirely new companies with this – part of Wal-Mart’s success came from using databases to manage inventory and logistics more efficiently. But today, if you started a retailer and said “…and we’re going to use databases”, that would not make you different or interesting – SQL became part of everything and then disappeared. The same will happen with machine learning.


One giant step for a chess-playing machine

Most unnerving was that AlphaZero seemed to express insight. It played like no computer ever has, intuitively and beautifully, with a romantic, attacking style. It played gambits and took risks. In some games it paralyzed Stockfish and toyed with it. While conducting its attack in Game 10, AlphaZero retreated its queen back into the corner of the board on its own side, far from Stockfish’s king, not normally where an attacking queen should be placed.

Yet this peculiar retreat was venomous: No matter how Stockfish replied, it was doomed. It was almost as if AlphaZero was waiting for Stockfish to realize, after billions of brutish calculations, how hopeless its position truly was, so that the beast could relax and expire peacefully, like a vanquished bull before a matador. Grandmasters had never seen anything like it. AlphaZero had the finesse of a virtuoso and the power of a machine. It was humankind’s first glimpse of an awesome new kind of intelligence.

Tellingly, AlphaZero won by thinking smarter, not faster; it examined only 60 thousand positions a second, compared to 60 million for Stockfish. It was wiser, knowing what to think about and what to ignore. By discovering the principles of chess on its own, AlphaZero developed a style of play that “reflects the truth” about the game rather than “the priorities and prejudices of programmers,” Mr. Kasparov wrote in a commentary accompanying the Science article.

What is frustrating about machine learning, however, is that the algorithms can’t articulate what they’re thinking. We don’t know why they work, so we don’t know if they can be trusted. AlphaZero gives every appearance of having discovered some important principles about chess, but it can’t share that understanding with us. Not yet, at least. As human beings, we want more than answers. We want insight. This is going to be a source of tension in our interactions with computers from now on.

Maybe eventually our lack of insight would no longer bother us. After all, AlphaInfinity could cure all our diseases, solve all our scientific problems and make all our other intellectual trains run on time. We did pretty well without much insight for the first 300,000 years or so of our existence as Homo sapiens. And we’ll have no shortage of memory: we will recall with pride the golden era of human insight, this glorious interlude, a few thousand years long, between our uncomprehending past and our incomprehensible future.


Evaluating early stage startups — The three metrics that matter

Defining “fast growth” depends on stage, but for early (Seed or Series A), growing 100% YoY is typically pretty solid. Paul Graham (PG) famously looks for 5–7% weekly growth for companies in Y Combinator, and his rationale is pretty simple: “a company that grows at 1% a week will grow 1.7x a year, whereas a company that grows at 5% a week will grow 12.6x.” When you consider the compounding effects of this growth, it means a company starting with $1,000 in revenue and growing at 1% will be at $7,900 per month four years later, whereas the company growing 5% per week will be bringing in more than $25 million per month.


The founder’s guide to understanding investors

When we dig deeper, the degree to which early-stage investing is a grand slam business is shocking. First, amongst early stage investors, the returns are disproportionately distributed. The Kauffman Foundation, an investor in many VC funds, found the top 20 VC firms (~3% of VC firms), generate 95% of all venture returns. Second, outside of the top 20 VC firms, most lose money! A study found the top 29 VC firms made a profit of $64B on $21B invested, while the rest of the VC universe lost $75B on $160B invested.

As early-stage investing operates on a power law, Paul Graham (founder of Y Combinator) mentions “You [as an investor] have to ignore the elephant in front of you, the likelihood they’ll [the startup] succeed, and focus instead on the separate and almost invisibly intangible question of whether they’ll succeed really big.” He highlights there are 10,000x variations (!) in startup investing returns, meaning top investors must have the mindset of willing to strike out in order to hit grand slams.

There needs to be room for your startup to capture a large share of this market. Elad Gil (early investor in Airbnb, Coinbase, Gusto, Instacart, Stripe), explains this means i) the market is structurally set up to support multiple winners, but ii) if the market only supports one winner and customers are currently not served well – there is an opportunity to dominate the market.

At the Series A stage, investors are mainly looking to see if PMF is achieved. This evaluation can be qualitative – Marc Andreessen (co-founder of Netscape and Andreessen Horowitz, an early investor in Facebook, Twitter, Wealthfront, Slack) notes, on the inside, “you can always feel product/market fit when it’s happening. The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling…”

When investors are evaluating for PMF, Rachleff notes that the best test is to see if the product is growing exponentially with no marketing, meaning the product is so good it grows through word of mouth. Top investors often don’t want to see marketing spend because it shows care for vanity metrics (things that don’t matter) rather than building an amazing product that people engage with (which does matter).

Not all buzzwords will fulfill their potential and result in a disruptive technology shift though. As a founder, you can reduce this risk by avoid starting a startup on that shift until the technology adoption is growing quickly and reaches a multi-hour per day level of usage. Sam Altman expands, “It’s very hard to differentiate between fake trends and real trends…If you think hard and you really pay attention, sometimes you can. The metric I use to differentiate between a real trend and a fake trend is similar to loving a product. It’s when there is a new platform that people are using many hours every day.”

To believe the startup can fulfill grand slam potential, investors want to see the startup has verified their assumptions on how users find the product in a repeatable and scalable manner. This is also called a go-to-market strategy (GTM).

Bill Gurley (major early investor in Uber, Stitch Fix, Zillow, etc.) called a unique GTM the most under-appreciated part about startups. It’s not about who did it first, but who did it right. Gurley looks to see if the startup has two things: (1) An interesting way to get into the market; (2) A way to establish themselves once in the market. The word ‘unique’ is important here. Replicating existing GTM strategies is often too costly because incumbents have already dried up the channel(s) to market and sell to customers. As a founder, you need to find a unique GTM that is repeatable and scalable. The good news here is that if you succeed, you’ll be able to keep out competitors by saturating the new channels.

Andy Rachleff has a second perspective on how startups can avoid competition. With his adaptation to Clayton Christensen’s (Harvard Business School Professor) disruption theory, startups can compete with reduced competition in either two ways. They can compete via new-market disruption – targeting a new set of users and competing on different characteristics (e.g. instead of price, focus on experience) than competitors, or they can compete via low-end disruption – targeting the same set of users as incumbents, but offering a greatly reduced product at a lower price point.

Along with the above quote, Bill Gurley tests if executives at the startup have a notion of insane curiosity – constantly learning new ways to win. To evaluate this, he asks questions on what information (e.g. books, podcasts) executives learn from, how they engage with it, and then probes if they are trying to use that information to majorly improve themselves or their business.

Curious folks tinker. Obsessively curious folks solve the hardest problems that require endless tinkering. If you are obsessively curious and fail with your original plan, odds are you will use your learnings and pivot into a big market that loves their product.

If a founder is obsessively curious, they can navigate the idea maze. By running a founder through the idea maze, investors evaluate if the founder understands all permutations of their idea, why their plan is superior to all other competitors, and which turns to lead to treasure versus which ones lead to certain death. It’s important for a founder to thoroughly know their idea maze, it can save years by not going down the wrong path, in addition to convincing investors you know can be a grand slam.

Rating citizens – can China’s social credit system fix its trust deficit?

In some Chinese cities, if you have wilfully defaulted on paying your debts, callers to your mobile phone will hear this message instead of the usual ringback tone: “This is a friendly reminder from the people’s court of XX city. The person you have just called has been declared a trust-breaker subject to enforcement by the court …”

Given that 80 per cent of respondents in a 2018 opinion poll conducted across China have approved of the social credit system, it seems that most Chinese, for now, do not consider the drastic surveillance scheme a violation of their privacy. Instead, most see the merit of the system in the perks they may enjoy and its potential in fostering trustworthiness in society.

However, the feasibility of this is highly questionable since the government is simultaneously the enforcer, the appraiser and the appraisee. For instance, many local governments in China have often failed to repay debt ranging from a few thousand to tens of million yuan, including loans, payment to contractors, and compensation for seized land. Since local governments are the ones that assess trustworthiness and mete out punishment, will they themselves be subject to the same penalties as other defaulters?

In this county, slandering others online will take 100 points off your social credit rating, while manufacturing and selling fake products will set you back by merely 35 points. Someone who may be rightfully seeking redress by occupying government offices may be slapped with a 50-point deduction, the same penalty as someone who has given or received bribes.