July 2023 - The Myth of Capitalism by Jonathan Tepper with Denise Hearn

We learn about the fun history of many monopolies and anti-trust! While I can’t recommend this book because its long and poorly written, it does reasonably critique aspects of antitrust and monopoly formation. Its repetitive and so aggressively one-sided that it loses credibility. The fact that the author used to advise and now runs a hedge fund that owns monopoly businesses tells you all you need to know.

Tech Themes

Consumer Welfare. Tepper’s fundamental argument is that since the 1980s, driven by Regan’s deregulation push, the government has allowed corporate mergers and abuses of market power, leading to more market concentration, higher prices, greater inequality, worse worker conditions, and stymied innovation. Influenced by the Chicago School’s free market ideas and Robert Bork’s popular 1978 book Antitrust Paradox, the standard for antitrust enforcement morphed from breaking up market-abusing companies to “consumer welfare.” With this shift, antitrust enforcement became: “Does this harm the consumer?” A lot of things do not harm consumers. Broadcast Music, Inc. v. CBS, Inc. (1979) is widely regarded as one of the first antitrust cases that shifted the Rule of reason towards consumer welfare. CBS had sued Broadcast Music, alleging that blanket licenses constituted price fixing. Broadcast Music represented copyright holders and would grant licenses to media companies to use artist’s music on air. These deals were negotiated on behalf of many artists, and did not allow CBS to negotiate for selected works. The court sided with BMI because the blanket license process was simpler, lowered transaction costs by reducing the number of negotiations, and allowed broadcasters greater access to works. They even admitted that the blanket license may be a form of price setting, but concluded that it didn’t necessarily harm consumers and was more efficient, so they allowed it. The consumer welfare ideology has recently come under fire around the big tech companies - Apple, Microsoft, Google, Meta, and Amazon. Lina Khan, Commissioner of the Federal Trade Commission (FTC) wrote a powerful and aptly titled article, Amazon’s Antitrust Paradox, highlighting why in her view consumer welfare was not a strong enough stance on antitrust. “This Note argues that the current framework in antitrust—specifically its pegging competition to “consumer welfare,” defined as short-term price effects—is unequipped to capture the architecture of market power in the modern economy.” The note argues that Amazon’s willingness to offer unsustainably low prices and their role as a marketplace platform and a seller on that marketplace allow it crush competition. Google is currently being sued by the Department of Justice over illegal monopolization of adtech and its dominance in the search engine market. The government is attempting to shift antitrust back to a more aggressive approach regarding monopolistic behavior. From a consumer welfare perspective, there is no doubt that all of these companies have created situations that benefit consumers (“free” services, low prices) and hurt competition. The question is: “Is it illegal?”
The ACTs - Sherman and Clayton. The Sherman Antitrust Act, passed in 1890, was the first major federal law aimed at curbing monopolies and promoting competition. The late 19th century, often referred to as the Gilded Age, saw the rise of powerful industrialists like J.P. Morgan, John D. Rockefeller, and Cornelius Vanderbilt, whose massive corporations threatened to dominate key sectors of the economy. Public outcry over the potential for these monopolies to stifle competition and exploit consumers led to the passage of the Sherman Act. Senator John Sherman, intended the law to protect the public from the negative consequences of concentrated economic power. The Sherman Act broadly prohibited anticompetitive agreements and monopolization, empowering the government to break up monopolies and prevent practices that restrained trade. However, the Sherman Act's broad language left it open to interpretation, and its early enforcement was inconsistent. President Theodore Roosevelt, a proponent of trust-busting, used the Sherman Act to challenge powerful monopolies, such as the Northern Securities Company, a railroad conglomerate controlled by J.P. Morgan. The Supreme Court's decision in the Standard Oil case in 1911 further shaped the interpretation of the Sherman Act, establishing the "rule of reason" as the standard for evaluating antitrust violations. This meant that not all restraints of trade were illegal, only those that were deemed "unreasonable" in their impact on competition. The Clayton Antitrust Act, passed in 1914, was designed to strengthen and clarify the Sherman Act. It specifically targeted practices not explicitly covered by the Sherman Act, such as mergers and acquisitions that could lessen competition, price discrimination, and interlocking directorates. The Clayton Act also sought to protect labor unions, which had been subject to antitrust prosecution under the Sherman Act. The passage of these acts led to a wave of significant antitrust cases. Prominent examples include: United States v. American Tobacco Co. (1911): This case resulted in the breakup of the American Tobacco Company, a dominant force in the tobacco industry, demonstrating the government's commitment to using antitrust laws to dismantle powerful monopolies. United States v. Paramount Pictures, Inc. (1948): This case challenged the vertical integration of the film industry, where major studios controlled production, distribution, and exhibition. The court's decision led to significant changes in the industry's structure. United States v. AT&T Co. (1982): This landmark case resulted in the breakup of AT&T, a telecommunications giant, into smaller, regional companies. This case marked a major victory for antitrust enforcement and had a lasting impact on the telecommunications industry.
Microsoft. The Microsoft antitrust case, initiated in October 1998, saw the U.S. government accusing Microsoft of abusing its monopoly power in the personal computer operating systems market. The government, represented by David Boies (yes, Theranos David Boies), argued that Microsoft, led by Bill Gates, had engaged in anti-competitive practices to stifle competition, particularly in the web browser market. Gates was famously deposed and shockingly (not really) came away from the deposition looking like an asshole. The government alleged that Microsoft violated the Sherman Act by: Bundling its Internet Explorer (IE) web browser with its Windows operating system, thereby hindering competing browsers like Netscape Navigator, manipulating application programming interfaces to favor IE, and enforcing restrictive licensing agreements with original equipment manufacturers, compelling them to include IE with Windows. Judge Thomas Jackson presided over the case at the United States District Court for the District of Columbia. In 1999, he ruled in favor of the government, finding that Microsoft held a monopoly and had acted to maintain it. He ordered Microsoft to be split into two units, one for operating systems and the other for software components. Microsoft appealed the decision. The Appeals Court overturned the breakup order, partly due to Judge Jackson's inappropriate discussions with the media. While upholding the finding of Microsoft's monopolistic practices, the court deemed traditional antitrust analysis unsuitable for software issues. The case was remanded to Judge Colleen Kollar-Kotelly, and ultimately, a settlement was reached in 2001. The settlement mandated Microsoft to share its application programming interfaces with third-party companies and grant a panel access to its systems for compliance monitoring. However, it did not require Microsoft to change its code or bar future software bundling with Windows. This led to criticism that the settlement was inadequate in curbing Microsoft's anti-competitive behavior. History doesn’t repeat itself, but it does rhyme and Microsoft is doing the exact same bundling strategy again with its Teams app.

Business Themes

Monopoly Markets. Tepper lays out all of the markets that he believes are monopoly, duopoly, or oligopoly markets. Cable/high speed internet (Comcast, Verizon, AT&T, Charter (Spectrum)) - pretty much the same, Computer Operating Systems (Microsoft) - pretty much the same but iOS and Linux are probably bigger, Social Networks (Facebook with 75% share). Since then Tiktok, Twitter, Pinterest, and Snap have all put a small dent in Facebook’s share. Search (Google), Milk (Dean Foods), Railroads (BNSF, NSC, CSX, Union Pacific, Kansas City Southern), Seeds (Bayer/Monsanto, Syngenta/ChemChina, Dow/DuPont), Microprocessors (Intel 80%, AMD 20%), Funeral Homes (Service Corporation International) all join the monopoly club. The duopoly club consists of Payment Systems (Visa, Mastercard), Beer (AB Inbev, Heineken), Phone Operating Systems (iOS, Android), Online Advertising (Google, Facebook), Kidney Dialysis (DaVita), and Glasses (Luxottica). The oligopoly club is Credit Reporting Bureaus (Transunion, Experian, FICO), Tax Preparation (H&R Block, Intuit), Airlines (American, Delta, United, Southwest, Alaska), Phone Companies (Verizon, Sprint, T-Mobile, AT&T), Banks (JP Morgan Chase, Bank of America, Citigroup, Wells Fargo), Health Insurance (UnitedHealthcare, Centene, Humana, Aetna), Medical Care (HCA, Encompass, Ascension, Universal Health), Group Purchasing Organizations (Vizient, Premier, HealthTrust, Intaler), Pharmacy Benefit Managers (Express Scripts, CVS Caremark, Optum/UnitedHealthcare), Drug Wholesalers (Cencora, McKesson, Cardinal Health), Agriculture (ADM, Bunge, Cargill, Louis Dreyfus), Media (Walt Disney, Time Warner, CBS, Viacom, NBC Universal, News Corp), Title Insurance (Fidelity National, First American, Stewart, and Old Republic). Since the book was published in 2018, there has been even more consolidation - Canadian Pacific bought Kansas City Southern for $31B, Essilor merged with Luxottica in 2018 in a $49B deal, Sprint merged with T-Mobile in a $26B deal, and CBS and Viacom merged in a $30B deal. Tepper’s anger towards lackadaisical enforcement of antitrust is palpable. He encourages greater antitrust speed and transparency, the unwinding of now clear market consolidating mergers, and the breakup of local monopolies.
Conglomeration and De-Conglomeration. Market Concentration. The conglomerate boom, primarily occurring in the 1960s, saw a surge in the formation of large corporations encompassing diverse, often unrelated businesses. This era was fueled by low interest rates and a fluctuating stock market, creating favorable conditions for leveraged buyouts. A key driver of this trend was the Celler-Kefauver Act of 1950, which, by prohibiting companies from acquiring their competitors or suppliers, pushed them towards diversification through acquiring businesses in unrelated fields. The prevailing motive was to achieve rapid growth, even if it meant prioritizing revenue growth over profit growth. Conglomerates were seen as a means to mitigate risk through diversification and achieve operational economies of scale. Many conglomerates formed that operated across completely different industries: Gulf and Western (Paramount Pictures, Simon & Schuster, Sega, Madison Square Garden), ITT (Telephone companies, Avis, Wonder Bread, Hartford Insurance, and Sheraton), and Henry Singleton’s Teledyne. However, the conglomerate era ultimately waned. The government took a more proactive approach to acquisitions in the late 1960s, curbing the aggressive approaches. The FTC sued Proctor & Gamble over its potential acquisition of Clorox and merger guidelines were revised in 1968, setting out more rules against market share and concentration. Rising interest rates in the 1970s strained these sprawling enterprises, forcing them to divest many of their acquisitions. The belief in the inherent efficiency of conglomerates was challenged as businesses increasingly favored specialization over sprawling, unwieldy structures. The concept of synergy, once touted as a key advantage of conglomerates, came under scrutiny. Ultimately, the conglomerate era was marked by performance dilution, value erosion, and the realization that strong performance in one business did not guarantee success in unrelated sectors.
Industry Concentration. A central pillar to Tepper’s argument that the capitalism game isn’t being played fairly or appropriately, is that rising industry concentration is worrisome and indicative of a broken market system. He uses the Herfindahl-Hirschman Index (HHI) to discuss levels of industry concentration. According to the Antitrust Division at the DOJ: “The HHI is calculated by squaring the market share of each firm competing in the market and then summing the resulting numbers. For example, for a market consisting of four firms with shares of 30, 30, 20, and 20 percent, the HHI is 2,600 (302 + 302 + 202 + 202 = 2,600). The agencies generally consider markets in which the HHI is between 1,000 and 1,800 points to be moderately concentrated, and consider markets in which the HHI is in excess of 1,800 points to be highly concentrated.” The HHI index is relatively straightforward to calculate. It can be a quick test to see if a potential merger creates a more significantly concentrated market. However, it still falls prey to some issues. For example, market definitions are extremely important in antitrust cases and a poorly or narrowly defined market can cause the HHI to look overly concentrated. In the ongoing Kroger-Albertson’s Merger case, the FTC is proposing a somewhat narrow definition of supermarkets, which excludes large supermarket players like Walmart, Costco, Aldi, and Whole Foods. If Whole Foods isn’t a super market, I’m not sure what is. And sure, maybe they narrowly define the market because Kroger and Albertsons serve a particular niche where substitutes are not easily available. Whole Foods may be more expensive, Aldi may have limited assortment, and Costco portion sizes may be too big. However, if you have a market that has Kroger, Walmart, Costco, Aldi, and Whole Foods serving a reasonable size population, I can almost guarantee the prices are likely to remain competitive. In some cases, high industry concentration does not mean monopolistic behavior. However, it can lead to monopolistic or monopsonistic behavior including: higher prices, lower worker’s wages, lower growth, and greater inequality.
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February 2022 - Cable Cowboy by Mark Robichaux

This month we jump into the history of the cable industry in the US with Cable Cowboy. The book follows cable’s main character for over 30 years, John Malone, the intense, deal-addicted CEO of Telecommunications International (TCI).

Tech Themes

Repurposed Infrastructure. Repurposed infrastructure is one of the incredible drivers of technological change covered in Carlota Perez’s Technology Revolutions and Financial Capital. When a new technology wave comes along, it builds on the backs of existing infrastructure to reach a massive scale. Railroads laid the foundation for oil transport pipelines. Later, telecommunications companies used the miles and miles of cleared railroad land to hang wires to provide phone service through the US. Cable systems were initially used to pull down broadcast signals and bring them to remote places. Over time, more and more content providers like CNN, TBS, BET started to produce shows with cable distribution in mind. Cable became a bigger and bigger presence, so when the internet began to gain steam in the early 1990s, Cable was ready to play a role. It just so happened that Cable was best positioned to provide internet service to individual homes because, unlike the phone companies’ copper wiring, Cable had made extensive use of coaxial fiber which provided much faster speeds. In 1997, after an extended period of underperformance for the Cable industry, Microsoft announced a $1B investment in Comcast. The size of the deal showed the importance of cable providers in the growth of the internet.
Pipes + Content. One of the major issues surrounding TCI as they faced anti-trust scrutiny was their ownership of multiple TV channels. Malone realized that the content companies could make significant profits, especially when content was shown across multiple cable systems. TCI enjoyed the same Scale Economies Power as Netflix. Once the cable channel produces content, any way to spread the content cost over more subscribers is a no-brainer. However, these content deals were worrisome given TCI’s massive cable presence (>8,000,000 subscribers). TCI would frequently demand that channels take an equity investment to access TCI’s cable system. “In exchange for getting on TCI systems, TCI drove a tough bargain. He demanded that cable networks either allow TCI to invest in them directly, or they had to give TCI discounts on price, since TCI bought in bulk. In return for most-favored-nation-status on price, TCI gave any programmer immediate access to nearly one-fifth of all US subscribers in a single stroke.” TCI would impose its dominant position - we can either carry your channel and make an investment, or you can miss out on 8 million subscribers. Channels would frequently choose the former. Malone tried to avoid anti-trust by creating Liberty Media. This spinoff featured all of TCI’s investments in cable providers, offering a pseudo-separation from the telecom giant (although John Malone would completely control liberty).
Early, Not Wrong. Several times in history, companies or people were early to an idea before it was feasible. Webvan formed the concept of an online grocery store that could deliver fresh groceries to your house. It raised $800M before flaming out in the public markets. Later, Instacart came along and is now worth over $30B. There are many examples: Napster/Spotify, MySpace/Facebook, Pets.com/Chewy, Go Corporation/iPad, and Loudcloud/AWS. The early idea in the telecom industry was the information superhighway. We’ve discussed this before, but the idea is that you would use your tv to access the outside world, including ordering Pizza, accessing bank info, video calling friends, watching shows, and on-demand movies. The first instantiation of this idea was the QUBE, an expensive set-top box that gave users a plethora of additional interactive services. The QUBE was the launch project of a joint venture between American Express and Warner Communications to launch a cable system in the late 1970s. The QUBE was introduced in 1982 but cost way too much money to produce. With steep losses and mounting debt, Warner Amex Cable “abandoned the QUBE because it was financially infeasible.” In 1992, Malone delivered a now-famous speech on the future of the television industry, predicting that TVs would offer 500 channels to subscribers, with movies, communications, and shopping. 10 years after the QUBE’s failure, Time Warner tried to fulfill Malone’s promise by launching the Full-Service Network (FSN) with the same idea - offering a ton of services to users through a specialized hardware + software approach. This box was still insanely expensive (>$1,000 per box) because the company had to develop all hardware and software. After significant losses, the project was closed. It wasn’t until recently that TV’s evolved to what so many people thought they might become during those exciting internet boom years of the late 1990s. In this example and several above, sometimes the idea is correct, but the medium or user experience is wrong. It turned out that people used a computer and the internet to access shop, order food, or chat with friends, not the TV. In 2015, Domino’s announced that you could now order Pizza from your TV.

Business Themes

Complicated Transactions. Perhaps the craziest deal in John Malone’s years of experience in complex deal-making was his spinoff of Liberty Media. Liberty represented the content arm of TCI and held positions in famous channels like CNN and BET. Malone was intrigued at structuring a deal that would evade taxes and give himself the most potential upside. To create this “artificial” upside, Malone engineered a rights offering, whereby existing TCI shareholders could purchase the right to swap 16 shares of TCI for 1 share of Liberty. Malone set the price to swap at a ridiculously high value of TCI shares - ~valuing Liberty at $300 per share. “It seemed like such a lopsided offer: 16 shares of TCI for just 1 share of Liberty? That valued Liberty at $3000 a share, for a total market value of more than $600M by Malone’s reckoning. How could that be, analysts asked, given that Liberty posed a loss on revenue fo a mere $52M for the pro-forma nine months? No one on Wall Street expected the stock to trade up to $300 anytime soon.” The complexity of the rights offering + spinoff made the transaction opaque enough that even seasoned investors were confused about how it all worked and declined to buy the rights. This deal meant Malone would have more control of the newly separate Liberty Media. At the same time, the stock spin had such low participation that shares were initially thinly traded. Once people realized the quality of the company’s assets, the stock price shot up, along with Malone’s net worth. Even crazier, Malone took a loan from the new Liberty Media to buy shares of the company, meaning he had just created a massive amount of value by putting up hardly any capital. For a man that loved complex deals, this deal is one of his most complex and most lucrative.
Deal Maker Extraordinaire / Levered Rollups. John Malone and TCI loved deals and hated taxes. When TCI was building out cable networks, they acquired a new cable system almost every two weeks. Malone popularized using EBITDA (earnings before interest, taxes, depreciation, and amortization) as a proxy for real cash flow relative to net income, which incorporates tax and interest payments. To Malone, debt could be used for acquisitions to limit paying taxes and build scale. Once banks got comfortable with EBITDA, Malone went on an acquisition tear. “From 1984 to 1987, Malone had spent nearly $3B for more than 150 cable companies, placing TCI wires into one out of nearly every five with cable in the country, a penetration that was twice that of its next largest rival.” Throughout his career, he rallied many different cable leaders to find a deal that worked for everyone. In 1986, when fellow industry titan Ted Turner ran into financial trouble, Malone reached out to Viacom leader Sumner Redstone, to avoid letting Time Inc (owner of HBO) buy Turner’s CNN. After a quick negotiation, 31 cable operators agreed to rescue Turner Broadcasting with a $550M investment, allowing Turner to maintain control and avoid a takeover. Later, Malone led an industry consortium that included TCI, Comcast, and Cox to create a high speed internet service called, At Home, in 1996. “At Home was responsible for designing the high-speed network and providing services such as e-mail, and a home page featuring news, entertainment, sports, and chat groups. Cable operators were required to upgrade their local systems to accommodate two-way transmission, as well as handle marketing, billing, and customer complaints, for which they would get 65% of the revenue.” At Home ended up buying early internet search company Excite in a famous $7.5B deal, that diluted cable owners and eventually led to bankruptcy for the combined companies. Malone’s instinct was always to try his best to work with a counterparty because he genuinely believed a deal between two competitors provided better outcomes to everyone.
Tracking Stocks. Malone popularized the use of tracking stocks, which are publicly traded companies that mirror the operating performance of the underlying asset owned by a company. John Malone loved tracking stocks because they could be used to issue equity to finance operations and give investors access to specific divisions of a conglomerate while allowing the parent to maintain full control. While tracking stocks have been out of favor (except for Liberty Media, LOL), they were once highly regarded and even featured in the original planning of AT&T’s $48B purchase of TCI in 1998. AT&T financed its TCI acquisition with debt and new AT&T stock, diluting existing shareholders. AT&T CEO Michael Armstrong had initially agreed to use tracking stocks to separate TCI’s business from the declining but cash-flowing telephone business but changed his mind after AT&T’s stock rocketed following the TCI deal announcement. Malone was angry with Armstrong’s actions, and the book includes an explanation: “heres why you should mess with it, Mike: You’ve just issued more than 400 million new shares of AT&T to buy a business that produces no earnings. It will be a huge money-loser for years, given how much you’ll spend on broadband. That’s going to sharply dilute your earnings per share, and your old shareholders like earnings. That will hurt your stock price, and then you can’t use stock to make more acquisitions, then you’re stuck. If you create a tracking stock to the performance of cable, you separate out the losses we produce and show better earnings for your main shareholders; and you can use the tracker to buy more cable interests in tax-free deals.” Tracking stocks all but faded from existence following the internet bubble and early 2000s due to their difficulty of implementation and complexity, which can confuse shareholders and cause the businesses to trade at a large discount. This all begs the question, though - which companies could use tracking stock today? Imagine an AWS tracker, a Youtube tracker, an Instagram tracker, or an Xbox tracker - all of these could allow cloud companies to attract new shareholders, do more specific tax-free mergers, and raise additional capital specific to a business unit.

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August 2021 - Hit Refresh by Satya Nadella, with Greg Shaw and Jill Tracie Nichols

This month we look at how Satya Nadella reignited Microsoft’s fire and attacked new spaces with a growth mindset. The book is loaded with excellent management philosophy and complex Microsoft history.

Tech Themes

Bing: The Other Search Engine. After starting at Microsoft as an engineer and rising through the ranks to lead Microsoft Dynamics (its CRM product), Nadella was handpicked to lead the re-launch of a brand new search engine, Microsoft Bing. Bing was one of Microsoft’s first “born-in-the-cloud” businesses and Nadella quickly recognized four core areas of focus: distributed systems, consumer product design, understanding the economics, of two-sided marketplaces, and AI. Microsoft had a troubled history with search engines and wanted to go big quickly, submitting an offer to buy Yahoo for $45B in February of 2008. Microsoft was rebuffed and thus Nadella found himself launching Search Checkpoint #1 in September of 2008 ahead of a June 2009 Bing launch. What are the odds that Microsoft’s future CEO would have early cloud, distributed systems, and advanced AI leadership experience? It was an almost prescient combination!
Red Dog to Azure. Microsoft started working on the cloud two years after Amazon launched AWS. In 2008, veteran software architects Ray Ozzie and Dave Cutler created a secret team inside Microsoft known as Red Dog, which was focused on building a cloud infrastructure product. Red Dog was stationed under Microsoft’s Servers and Tools business unit (STB), with products such as Windows Server and Microsoft’s powerful RDBMS, SQL Server. In 2010, Microsoft CEO Steve Ballmer asked Nadella to lead the STB business unit and set the vision for their then single-digit millions cloud infrastructure business. It was a precarious situation: “The server and tools business was at the peak of its commercial success and yet it was missing the future. The organizing was deeply divided over the importance of the cloud business. There was constant tension between diverging forces.” How did Nadella resolve this tension? It was simple - he made choices and rallied his team around those decisions. He focused the team on hybrid cloud, data, and ML capabilities where Microsoft could take advantage of its on-premise, large enterprise heritage while providing an on-ramp for customers eager to make the shift to the cloud. Microsoft has since surged to an estimated 20% worldwide market share making it one of the biggest and fastest-growing products in the world!
Re-Mixed Reality. Microsoft’s gaming portfolio is impressive: Xbox, Mojang (aka Minecraft), Zenimax Media (Maker of Fallout, Wolfenstein, and DOOM). Microsoft also owns the Hololens, a virtual reality headset that competes with Facebook’s Oculus. Many believe the future computing generations will take place in virtual reality, augmented, or mixed reality. Nadella doesn’t mince words - he believes that the future will not be in virtual reality (as Facebook is betting) but rather in mixed reality, a combination of augmented reality (AR) and virtual reality, where the user experiences an augmented experience but still maintains some semblance of the outside world. Nadella lays out the benefits: “HoloLens provides access to mixed reality in which the users can navigate both their current location - interact with people in the same room - and a remote environment while also manipulating holograms and other digital objects.” Virtual reality blocks out the outside world, but that can be an overwhelming experience and impractical particularly for enterprise users of AR/VR/MR technologies. One of the big users of the HoloLens is the US Army, which recently signed a rumored $22B deal with Microsoft. It is still early days, but the future needs a new medium of computing and it might just be mixed reality!

Business Themes

Leading with Empathy. Satya Nadella’s life changed with the birth of his son. “The arrival of our son, Zain, in August 1996 had been a watershed moment in Anu’s and my life together. His suffering from asphyxia in utero had changed our lives in ways we had not anticipated. We came to understand life as something that cannot always be solved in the manner we want. Instead, we had to learn to cope. When Zain came home from the intensive care unit, Anu internalized this understanding immediately. There were multiple therapies to be administered to him every day, not to mention quite a few surgeries he needed that called for strenuous follow-up care after nerve-racking ICU stays…My son’s condition requires that I draw daily upon the very same passion for ideas and empathy that I learned from my parents.” Nadella reiterates the importance of empathy throughout the book, and rightly so, empathy is viewed as the most important leadership skill, according to recent research. How does one increase empathy? It’s actually quite simple - talk to people! Satya understands this: “It is impossible to be an empathetic leader sitting in an office behind a computer screen all day. An empathetic leader needs to be out in the world, meeting people where they live, and seeing how the technology we create affects their daily activities.” Leadership requires empathy - hopefully, we see more of it from big technology soon!
Frenemies. One of the first things that Satya Nadella did after taking over the CEO role from Steve Ballmer in 2014 was reach out to Tim Cook. Apple and Microsoft had always had a love-hate relationship. In 1997, Microsoft saved Apple shortly after Steve Jobs returned by investing $150M in the company so that Apple could stave off potential bankruptcy. However, in 2014, Nadella called on Apple: “I decided we needed to get Office everywhere, including iOS and Android…I wanted unambiguously to declare, both internally and externally, that the strategy would be to center our innovation agenda around users’ needs and not simply their device.” Microsoft had tried to become a phone company with Windows Mobile in 2000, tried again with Windows Phone in 2010, and tried even harder at Windows Phone in 2013 with a $7.2B acquisition of Nokia’s mobile phone unit. Although Nadella voted ‘No’ on the deal before becoming CEO, he was forced to manage the company through a total write-off of the acquisition and the elimination of eighteen thousand jobs. So how could Nadella catch up to the mobile wave? “For me, partnerships - particularly with competitors - have to be about strengthening a company’s core businesses, which ultimately centers on creating additional value for the customer…We have to face reality. When we have a great product like Bing, Office, or Cortana but someone else has created a strong market position with their service or device, we can’t just sit on the sidelines. We have to find smart ways to partners so that our products can become available on each other's popular platforms.” Nobody knows platforms like Microsoft; Bill Gates wrote the definition of a platform: “A platform is when the economic value of everybody that uses it, exceeds the value of the company that creates it.” Nadella got over his predecessor’s worry and hatred of the competition to bring Microsoft’s software to other platforms to strengthen both of their leadership positions.
Regulation and Technology. Nadella devotes an entire chapter to the idea of trust in the digital age. Using three case studies - North Korea’s attack on Sony’s servers, Edward Snowden’s leaked documents (that were held on Microsoft’s servers), and the FBI’s lawsuit against Apple to unlock an iPhone that might contain criminal information - Nadella calls for increased(!) regulation, particularly around digital technology. Satya uses a simple equation for trust: “Empathy + Shared values + Safety and Reliability = Trust over time.” Don’t you love it when a company that the government sued over anti-trust practices calls on the government to develop better laws! You’d love it even more if you saw how they used the same tactics to launch Microsoft Teams! Regulation in technology has been a hot topic recently, and Nadella is right to call on the government to create new laws for our digital world: “We do not believe that courts should seek to resolve issues of twenty-first-century technology relying on law that was written in the era of the adding machine.” He goes further to suggest potential remedies, including an efficient system for government access to corporate data, stronger privacy protections, globalized digital evidence sharing, and transparency of corporate and government data. I imagine the trend will be toward more regulation, especially with the passage of recent data laws like GDPR or CCPA, but I’m not sure we will see any real sweeping changes.

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June 2021 - Letters to the Nomad Partnership 2001-2013 (Nick Sleep's and Qais Zakaria's Investor Letters)

This month we review a unique source of information - mysterious fund manager Nick Sleep’s investment letters. Sleep had an extremely successful run and identified several very interesting companies and characteristics of those companies which made for great investments. He was early to uncover Amazon, Costco, and others - riding their stocks into the stratosphere over the last 20 years. These letters cover the internet bubble, the 08/09 crisis, and all types of interesting businesses across the world.

Tech Themes

Scale Benefits Shared. Nick Sleep’s favored business model is what he calls Scale Benefits Shared. The idea is straight forward and appears across industries. Geico, Amazon, and Costco all have this business model. Its simple - companies start with low prices and spend only on the most important things. Over time as the company scales (more insured drivers, more online orders, more stores) they pass on the benefits of scale to the customer with even further lower prices. The consumer then buys more with the low-cost provider. This has a devastating effect on competition - it forces companies to exit the industry because the one sharing the scale benefits has to become hyper-efficient to continue to make the business model work. “In the case of Costco scale efficiency gains are passed back to the consumer in order to drive further revenue growth. That way customers at one of the first Costco stores (outside Seattle) benefit from the firm’s expansion (into say Ohio) as they also gain from the decline in supplier prices. This keeps the old stores growing too. The point is that having shared the cost savings, the customer reciprocates, with the result that revenues per foot of retailing space at Costco exceed that at the next highest rival (WalMart’s Sam’s Club) by about fifty percent.” Jeff Bezos was also very focused on this, his 2006 annual letter highlighted as much: “Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long-term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We have made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and – we believe – important and valuable in the long term.” So what companies today are returning scale efficiencies with customers? One recent example is Snowflake - which is a super expensive solution but is at least posturing correctly in favor of this model - the recent earnings call highlighted that they had figured out a better way to store data, resulting in a storage price decrease for customers. Fivetran’s recent cloud data warehouse comparison showed Snowflake was both cheaper and faster than competitors Redshift and Bigquery - a good spot to be in! Another example of this might be Cloudflare - they are lower cost than any other CDN in the market and have millions of free customers. Improvements made to the core security+CDN engine, threat graph, and POP locations result in better performance for all of their free users, which leads to more free users, more threats, vulnerabilities, and location/network demands - a very virtuous cycle!
The Miracle of Compound Growth & Its Obviousness. While appreciated in some circles, compounding is revered by Warren Buffett and Nick Sleep - it’s a miracle worth celebrating every day. Sleep takes this idea one step further, after discussing how the average hold period of stocks has fallen significantly over the past few decades: “The fund management industry has it that owning shares for a long time is futile as the future is unknowable and what is known is discounted. We respectfully disagree. Indeed, the evidence may suggest that investors rarely appropriately value truly great companies.” This is quite a natural phenomenon as well - when Google IPO’d in 2004 for a whopping $23bn, were investors really valuing the company appropriately? Were Visa ($18Bn valuation, largest US IPO in history) and Mastercard ($5.3Bn valuation) being valued appropriately? Even big companies like Apple in 2016 valued at $600Bn were arguably not valued appropriately. Hindsight is obvious, but the durability of compounding in great businesses is truly a myth to behold. That’s why Sleep and Zakaria wound down the partnership in 2014, opting to return LP money and only own Berkshire, Costco, and Amazon for the next decade (so far that’s been a great decision!). While frequently cited as a key investing principle, compounding in technology, experiences, art, and life are rarely discussed, maybe because they are too obvious. Examples of compounding (re-investing interest/dividends and waiting) abound: Moore’s Law, Picasso’s art training, Satya Nadella’s experience running Bing and Azure before becoming CEO, and Beatles playing clubs for years before breaking on the scene. Compounding is a universal law that applies to so much!
Information Overload. Sleep makes a very important but subtle point toward the end of his letters about the importance of reflective thinking:
BBC Interviewer: “David Attenborough, you visited the North and South Poles, you witnessed all of life in-between from the canopies of the tropical rainforest to giant earthworms in Australia, it must be true, must it not, and it is a quite staggering thought, that you have seen more of the world than anybody else who has ever lived?”
David Attenborough: “Well…I suppose so…but then on the other hand it is fairly salutary to remember that perhaps the greatest naturalist that ever lived and had more effect on our thinking than anybody, Charles Darwin, only spent four years travelling and the rest of the time thinking.”
Sleep: “Oh! David Attenborough’s modesty is delightful but notice also, if you will, the model of behaviour he observed in Charles Darwin: study intensely, go away, and really think.”
There is no doubt that the information age has ushered in a new normal for daily data flow and news. New information is constant and people have the ability to be up to date on everything, all the time. While there are benefits to an always-on world, the pace of information flow can be overwhelming and cause companies and individuals to lose sight of important strategic decisions. Bill Gates famously took a “think week” each year where he would lock himself in a cabin with no internet connection and scan over hundreds of investment proposals from Microsoft employees. A Harvard study showed that reflection can even improve job performance. Sometimes the constant data flow can be a distraction from what might be a very obvious decision given a set of circumstances. Remember to take some time to think!

Business Themes

Psychological Mistakes. Sleep touches on several different psychological problems and challenges within investing and business, including the role of Social Proof in decision making. Social proof occurs when individuals look to others to determine how to behave in a given situation. A classic example of Social Proof comes from an experiment done by Psychologist, Stanley Milgram, in which he had groups of people stare up at the sky on a crowded street corner in New York City. When five people were standing and looking up (as opposed to a single person), many more people also stopped to look up, driven by the group behavior. This principle shows up all the time in business and is a major proponent in financial bubbles. People see others making successful investments at high valuations and that drives them to do the same. It can also drive product and strategic decisions - companies launching dot-com names in the 90’s to drive their stock price up, companies launching corporate venture arms in rising markets, companies today deciding they need a down-market “product-led growth” engine. As famed investor Stan Druckenmiller notes, its hard to sit idly by while others (who may be less informed) crush certain types of investments: “I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basketcase and I couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”
Incentives, Psychology, and Ownership Mindset. Incentives are incredibly powerful in business and its surprisingly difficult to get people to do the right thing. Sleep spends a lot of time on incentives and the so-called Principal-Agent Conflict. Often times the Principal (Owner, Boss, Purchaser, etc.) may employ an Agent (Employee, Contractor, Service) to accomplish something. However the goals and priorities of the principal may not align with that agent. As an example, when your car breaks down and you need to go to a local mechanic to fix it, you (the principal) want to find someone to fix the car as well and as cheaply as possible. However, the agent (the mechanic) may be incentivized to create the biggest bill possible to drive business for their garage. Here we see the potential for misaligned incentives. After 5 years of really strong investment results, Sleep and Zakaria noticed a misaligned incentive of their own: “Which brings me to the subject of the existing performance fee. Eagle-eyed investors will not have failed but notice the near 200 basis point difference between gross and net performance this year, reflecting the performance fee earned. We are in this position because performance for all investors is in excess of 6% per annum compounded. But given historic performance, that may be the case for a very long time. Indeed, we are so far ahead of the hurdle that if the Partnership now earned pass-book rates of return, say 5% per annum, we would continue to “earn” 20% performance fees (1% of assets) for thirty years, that is, until the hurdle caught up with actual results. During those thirty years, which would see me through to retirement, we would have added no value over the money market rates you can earn yourself, but we would still have been paid a “performance fee”. We are only in this position because we have done so well, and one could argue that contractually we have earned the right by dint of performance, but just look at the conflicts!” They could have invested in treasury bonds and collected a performance fee for years to come but they knew that was unfair to limited partners. So the duo created a resetting fee structure, that allowed LPs to claw back performance fees if Nomad did not exceed the 6% hurdle rate for a given year. This kept the pair focused on driving continued strong results through the life of the partnership.
Discovery & Pace. Nick Sleep and Qais Zakaria looked for interesting companies in interesting situations. Their pace is simply astounding: “When Zak and I trawled through the detritus of the stock market these last eighteen months (around a thousand annual reports read and three hundred companies interviewed)…” Sleep and Zakaria put up numbers: 55 annual reports per month (~2 per day), 17 companies interviewed per month (meeting every other day)! That is so much reading. Its partially unsurprising that after a while they started to be able to find things in the annual reports that piqued their interest. Not only did they find retrospectively obvious gems like Amazon and Costco, they also looked all around the world for mispricings and interesting opportunities. One of their successful international investments took place in Zimbabwe, where they noticed significant mispricing involving the Harare Stock Exchange, which opened in 1896 but only started allowing foreign investment in 1993. While Nomad certainly made its name on the Scaled efficiencies shared investment model, Zimbabwe offered Sleep and Zakaria to prioritize their second model: “We have little more than a handful of distinct investment models, which overlap to some extent, and Zimcem is a good example of a second model namely, ‘deep discount to replacement cost with latent pricing power.’” Zimcem was the country’s second-largest cement producer, which traded at a massive discount to replacement cost due to terrible business conditions (inflation growing faster than the price of cement). Not only did Sleep find a weird, mispriced asset, he also employed a unique way of acquiring shares to further increase his margin of safety. “The official exchange rate at the time of writing is Z$9,100 to the U$1. The unofficial, street rate is around Z$17,000 to the U$1. In other words, the Central Bank values its own currency at over twice the price set by the public with the effect that money entering the country via the Central Bank buys approximately half as much as at the street rate. Fortunately, there is an alternative to the Central Bank for foreign investors, which is to purchase Old Mutual shares in Johannesburg, re-register the same shares in Harare and then sell the shares in Harare. This we have done.“ By doing this, Nomad was able to purchase shares at a discounted exchange rate (they would also face the exchange rate on sale, so not entirely increasing the margin of safety). The weird and off the beaten path investments and companies can offer rich rewards to those who are patient. This was the approach Warren Buffett employed early on in his career, until he started focusing on “wonderful businesses” at Charlie Munger’s recommendation.