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When I started this Substack, the idea was to look at past investments and to learn from them to make better decisions in the future. Revisiting past successes is proving both valuable and complimentary to one’s ego. However, it is the failures that are bound to teach the best lessons no matter how painful those might be. With this in mind, here is the story of my position in Chicago Bridge & Iron (CBI)…

By the time I invested in Chicago Bridge & Iron in early 2017, it had nothing to do with bridges or iron. Instead, CBI was one of the largest energy general contractors – companies charged with building projects such as nuclear and gas power plants, refineries, and LNG terminals.

The company operated globally and was credited with successfully delivering projects such as the Gorgon LNG plant in Australia, the Liwa petrochemicals plant in Oman, and the Nine Mile combined cycle power plant in Louisiana. These are multi-billion-dollar projects of extreme complexity, and CBI’s reputation for completing them was one of the factors that made it attractive.

The other was the company’s technology and fabrication divisions, which allowed CBI to earn higher profits than it would as a pure construction company. The technology division was especially valuable because it licensed process IP and sold proprietary consumables, such as catalysts, to the hydrocarbon complex. Both the technology and fabrication divisions delivered consistently strong profitability, while the construction business swung from profit to loss depending on which projects were being completed and how well the company estimated the costs to deliver them.

The setup in which a volatile or shrinking bad business hides a high-quality business is a favorite of value investors. One of the more famous cases is Ferrari, which, as a subsidiary of Fiat (now Stellantis), was being completely overlooked by the market. Sergio Marchionne stepped in as CEO and realized that Ferrari and Fiat shareholders were better off if it were a standalone company.

The decision was made to spin it out into a separate company, with Ferrari first selling 10% of the company to new shareholders and later spinning out the remaining stake to Fiat holders pro rata to their holdings in the larger company. Ten years later, the value of Ferrari is up 8x to over $60 billion, while the market cap of Fiat (now Stellantis) has barely changed from its 2016 level.

While I am not comparing CBI’s technology business to Ferrari, the fact is that similar licensing/consumables capital-light businesses with stable earnings were usually valued at double-digit EBITDA multiples, not 5.5x, where Chicago Bridge & Iron was trading at the time. If only the market would give CBI the credit for the two high-quality, stable businesses it had (technology and fabrication), the stock could benefit.

For the market cap of roughly $3.3 billion and enterprise value of $5 billion, you were getting two high-quality, stable businesses (fabrication and technology) that together generated between $300 and $400m of operating cash flow, and construction, which in an average year should have delivered another $150m or so. Just a year before the investment, in an admittedly great environment, with the company delivering projects initiated during the pre-2014 boom years, CBI generated over $900 million in free cash flow. Looking forward, I estimated the company’s free cash flow yield at around 15%1, which appeared attractive relative to its historical trading range and to the other opportunities in the stock market.

As it turned out, the problem with the above analysis was not recognizing the value of the technology division, but rather that I thought of the construction division in terms of “average” earnings, which fails to appreciate the risk assymetry. A good project could generate meaningful additional profit, but a bad project could wipe out years of profits and put the whole company in peril. There is an old joke about a hospital with an average patient temperature of 98.6°F, but half the patients are burning up, and the other half are stone cold. CBI’s construction division turned out to have similar characteristics.

Construction business made commitments to the customers to deliver a project within a certain budget. If, for one reason or another, project costs ended up significantly higher than initially estimated, the general contractor was on the hook. Historically, CBI did a reasonable job of estimating costs, and even when the company made a mistake, it did not have a significant impact on the overall business, since profits from technology and fabrication helped offset the shortfalls.

However, in 2017, CBI was hit by a commodity price rebound, which increased steel and cement prices by 15-20% or more over a couple of years. In 2017, CBI was delivering projects that had been signed in 2013-2014, at the tail end of the investment boom, when the management was likely making more aggressive assumptions while bidding on work to keep the backlog full and Wall Street happy. These bids did not take into account the possibility of a meaningful change in commodity prices, which is what got CBI into a fair bit of trouble.

In response to deteriorating fundamentals, in the summer of 2017 the company announced that it is looking for bids for its crown jewel – the technology division. While part of my thesis on the company was based on the technology division’s value crystallizing, this is not what I had in mind. Realizing that the company will likely be treated as a forced seller and that what will be left is a low-quality business, I decided to sell the position just six months after the initial investment.

As painful as it was to take a short-term loss, the subsequent deterioration of the business fundamentals reinforced the importance of revisiting the thesis when facts change. By the end of 2017 these construction projects were costing CBI hundreds of millions of dollars in cost overruns. Cash flow from operations went from a positive $400 million in 2016 to a negative $600 million in 2017.

Instead of selling the technology division, CBI shareholders approved a merger with another E&P general contractor, McDermott International. Two years later, McDermott filed for bankruptcy, blaming the projects it inherited from CBI and the ongoing cost overruns. While I felt bad for McDermott shareholders who got caught up in this mess, I was glad I was not one of them.

An investment manager I highly respect once noted that when we look back at the decisions we made as investors three to five years ago and don’t find any of them embarrassing, it indicates that we have stopped evolving as investors. The CBI experience definitely falls into the embarrassing category, but, hopefully I have “evolved” to the point where I don’t get too excited when poorly performing ones hide good businesses.

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In stark contrast to college or business school years, where you pay someone to acquire knowledge that later on proves more or less unnecessary (when was the last time you had to calculate the area under a curve?), one of the best things about an investment professional is that in some ways you get paid to learn things that prove useful time and time again.

One of the memorable “lessons” for me was the 2015 edition of the annual Graham & Dodd Breakfast, organized by Columbia Business School, where Phillippe Laffont from Coatue Management spoke about his investment philosophy. This event was so important because Mr Laffont’s investment style is so different from mine. He is one of the most successful growth investors, while my style is best described by my friend Vitaliy Katsenelson as that of a “Paranoid Russian (or Belorussian) Jew.”

The key message from Phillippe was to value the company using the company’s estimated earnings power five or ten years down the road, which he illustrated with the example of NFLX, which at the time was trading at a healthy 400x multiple of earnings. The company had roughly 75million subscribers and an average revenue per user of just over $8.

The question is whether a company like Netflix can have 400 million subscribers in ten years and an ARPU of $20. Given its fixed cost base, if the company got anywhere close to these numbers, then the multiple you were paying in 2015 on 2025 earnings was around 2-3x, which seemed a lot more attractive.

Netflix ended 20241 with roughly 300 million members and an estimated ARPU of $11.70, which was a bit off from Mr. Laffont’s hypothetical, but directionally his point proved correct since over the nine years Netflix earnings increased over 30x and the shares delivered a 25% annualized return.

A year or so after hearing Phillippe Laffont speak, I had a chance to apply that way of thinking to an investment that I was considering – Facebook. The company, at the time, had been listed for about 5 years and had delivered 9x revenue growth and 6x operating profit growth over that period. Despite (or maybe because of) the track record of success, the market was starting to get nervous about the sustainability of this growth, and the shares had sold off to a “value” multiple of just 20x EV to EBITDA.

Given that Facebook already had over 1.2 billion daily active users, concerns about the runway in user growth could have been justified. Still, the part that I felt the market was underappreciating is the pricing power that Facebook had.

In 2015, digital advertising accounted for roughly 30% of overall advertising expenditure. At the time, its average revenue per user was $20 in North America and just under $6 overall.

Digital advertising solves the fundamental problem of advertising best illustrated by John Wanamaker’s quote:

“Half the money I spend on advertising is wasted; the trouble is I don’t know which half.”

Merchants that are spending money on Facebook or Google or other digital platforms can track exactly how much sales are generated from these ad placements and calculate the return on investment. There was no reason why this superior product wouldn’t eventually reach a dominant share of advertising budgets.

In this case, the thesis largely played out, though not necessarily for all of the reasons that I had expected at the time. Over time, digital advertising gained share of the overall market, with total spend growing by 14.7% p.a. compared to just over 5% for the advertising market2. By 2025, more than 70% of total advertising spend is going to digital. Facebook/Meta has done even better with advertising revenues growing by 27% per annum.

The reason for Meta’s outperformance is the company’s careful nurturing of its ecosystem, which ensures that users continue to engage with Facebook, WhatsApp, and Instagram while advertisers get a return on their dollars spent. The fact that most people were already using one of these social networks was the draw for everyone else.

While the company has received its fair share of criticism for hosting viewpoints that foster extremism and allow external actors to influence domestic politics, Facebook, Instagram, and WhatsApp have also become the global townhalls that helped organize democratic movements or were used by volunteers helping people in various conflicts or calamities happening around the world. Moreover, Meta’s scale and billions spent on community relations (monitoring) probably led to less negative content online than otherwise would have been there.

Despite increasing competition from Snapchat, TikTok, Twitter (X), and other social media platforms, Facebook’s daily active users continued to grow. By 2023, it grew to over 2.1 billion (25% of the world’s population). By the end of 2025, over 3.5 billion people used at least one of Meta’s social media properties (Facebook, WhatsApp, Instagram, Threads, etc.)

Separately, in dealing with advertisers, Meta made a conscious decision to throttle its revenue growth and profitability. Given the high ROI digital advertising was generating, Meta could have easily increased ad prices whenever it wanted. Still, it seems to preserve pricing power during periods when impression growth slows. As a result, advertisers have been getting consistent value for the dollar spent, and the company has shown a smoother revenue stream that investors appreciate.

The revenue growth translated into strong profits and gains for shareholders. Between 2015 and 2025, revenue grew close to 11x, and cash flow from operations grew over13x3, thanks to a fixed cost base spread over higher revenues. The company achieved these results despite increasing spending on community relationships (monitoring) and R&D at a pace that outpaced revenue growth. Shareholder returns compounded and just over 20% over the same decade.

Predicting any company performance over a ten+ year period is usually a fool’s errand. As I discussed in earlier article over a decade, the company could become unrecognizable through changes to business model and/or M&A activity. That said, asking the right question about market potential can help uncover situations in which a company with existing competitive advantages can continue to thrive, benefiting both its employees and shareholders.

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If on January 1^st we had asked the following question – “What is your prediction of index performance assuming that 1) in the first six months of the year the top 10 S&P 500 companies are up 2% on average and 2) 20% of the world’s oil and gas output was disrupted by war?” – I doubt many people would answer – up 10%!

In the first half of this year, the performance leadership mantle passed from the largest companies to the companies making hardware for the AI arms race. While it is still uncertain whether the companies that are spending trillions of dollars on AI infrastructure will earn a return on that investment, the market has seemingly decided that the companies providing picks and shovels for this gold rush will. Out of the 10% gain for the S&P 500 this year, roughly 8% is explained by the gains in just 15 stocks1 which are up on average more than 200%.

As amazing as this performance is, it is not entirely undeserved. Taking 13 of these companies which were not members of the $1 trillion club already, their net income and free cash have gone up by 90% and 70% respectively since the beginning of the year. However, the market cap for this group is up by 170% and free cash flow yield declined from 2.3% to 1.5%. The market is seemingly getting increasingly confident that the planned investments in AI will take place and the boom will last longer than originally expected. Given that hyperscaler budgets have so far gone in one direction, upwards, it is hard to disagree.

The surprising thing about this year’s market performance is that the changeover in market leaders happened without a meaningful and lasting correction. Normally, one would expect purchases to be funded by sales of existing positions, but in this case, market participants chose to hold on to the positions they had and add new money to the market. This trend can be explained by the fact that retail investors are still increasing their participation in the stock market. Moreover, within retail, the fastest growth in equity ownership is coming from the poorest cohorts, which are getting more involved in the market than usual and are the likely source of new money.

New money coming into the market does not explain the huge moves in just a few stocks, but the way it is happening probably does. We are seeing significant growth in options, especially zero-day options which provide leverage and allow punters to benefit from a short-term upward move in stocks.2^[2] These options are mostly available for a few companies that capture investor imagination and are therefore driving the flows towards those select few.

Retail demand has grown throughout the year and so far, there are no signs that the market is running out of new money; in fact we are seeing the opposite. SpaceX record $75 billion listing was 5x oversubscribed and the shares jumped more than 20% on the open despite what was already a lofty valuation. Korean memory chip maker SK Hynix is currently raising $24B which would be a record for a foreign company, and this placement looks to be 7x oversubscribed as well.

It is tempting to look at these facts as signs of a bubble, however history suggests that even if it is a bubble it is not one in an imminent danger of bursting. Each period of irrational exuberance, in retrospect, had its defining moment, but probably it is not the one that we remember.

If we ask someone what they thought were obvious signs of irrational behavior back in the .com era, one would probably point to companies like Books-A-Million adding .com to their name and going up 10x in a few days after the event or Webvan which went bankrupt in 2001 listing at a multi-billion-dollar valuation and going up by 50%+ on the first day.

I would argue that a more likely signal for imminent market collapse was not when a company with .com in the name went up 10x, but when it didn’t. A company called BigStar Entertainment, which was an online retailer of DVDs, listed its shares in August 1999. Given its business model, the expectation was that this will be another company that will likely see its valuation expand dramatically on the first day of trading. However, it did not. The company listed its shares at $10 and finished its first day of trading slightly above $8 per share. The lack of an IPO pop suggested that markets were getting closer to the level where supply and demand for internet related stories was finally approaching equilibrium.

Even the failed BigStar IPO was not the moment when the bell was rung on the .com bubble. That happened six months later and at a level nearly double that of the day when BigStar Entertainment failed to pop.

Coming back to today, companies spending trillions of dollars on AI infrastructure are doing so with the expectation of a payback on this investment. In theory, the payback can come either from an acceleration in global economic growth (increasing the pie) or from a portion of existing economic activity being taken over by artificial intelligence and getting rewarded for it.

As large as a trillion dollars sounds, it’s a relatively small percentage of global GDP today which is estimated to be roughly $125 trillion. Based on current use cases, the capital invested in AI infrastructure is likely to be useful for at least five to seven years meaning that each trillion invested needs to generate roughly $150 to $200 billion of economic value per annum for the investment to make sense.

According to a 2011 McKinsey study, the internet contributed 0.4%-0.8% to economic growth of the mature economies between 1995 and 2009.3^[3] Given Artificial Intelligence usefulness, the assumption that it will contribute at least 0.5% to global economic growth is not a heroic one. For a $125 trillion global economy this means a contribution of $625 billion which is well above the $150 to $200 billion needed for the investments to make sense.

While the market appears to be pricing AI infrastructure companies as the likely be the winners of this investment boom, it is also hard at work figuring out the losers. The primary candidate so far has been the software sector which until recently has been one of the market darlings. The sector overall is down by more than 20% this year while some companies such as Intuit and Trade Desk have more than halved in value.

The reason why the market has decided that the software sector is at risk is similar to why retailers ended up the primary casualty of the internet. The internet made it easier for new retailers to reach customers and for consumers to compare prices, compressing margins across the industry. Likewise, AI has the potential to reduce the cost and complexity of building software, making it easier for new competitors to emerge and weakening the pricing power of established vendors. Technology dramatically lowers barriers to entry and is shifting bargaining power away from incumbents.

However, just like with the internet, incumbents that embrace the new technology have the potential to not just effectively defend themselves but also to benefit in the long run. Retailers such as Home Depot used the internet to improve inventory management, logistics, and omnichannel capabilities and ultimately came out stronger than they were before the internet. Home Depot’s operating margin today is well above that which it generated in the 1990’s.

In previous technology cycles market leadership has shifted from infrastructure, to hardware, to software as companies have adapted and learned how to utilize emerging technologies. We think that the AI cycle is going to be no different. While infrastructure is being built out most immediate beneficiaries are the picks and shovels providers, but over time companies that are enhancing their profitability must emerge to justify the technology investment in the first place. Time will tell but I believe that companies with an incumbent competitive advantage that are smart about learning and adapting new technologies early have the best chance of benefitting from new capabilities.

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I attend a few investing-oriented events per year. My favorites are the Intellectual Investor Conference in Vail (where I am heading right now) and the FatAlpha Value (Cyprus). These events are opportunities to reconnect with great people who have an uncanny ability to talk and think only about markets and companies we like, independent of how beautiful the surroundings are. These are weird gatherings, and I love them!

I go to these conferences for a few reasons. The primary one is for the ideas being pitched. Given that they are presented by talented people who’ve spent weeks, if not months, researching a particular topic, the companies presented are worth at the very least following up on and, on occasion, make it into the portfolio.

Just as important as the idea generation, I come away from these conferences with a network of friends who are experts in a particular industry who can be called upon when I come across an interesting company in that field. For a generalist, these connections are invaluable, as they can provide color and information about an industry and help you understand why a stock trades where it does.

The conferences, however, have one downside - they are mostly like-minded people “preaching to the choir.” We all read the same books, listen to the same interviews, and quite often hold similar views on the market’s general direction and perceived imbalances. That said, on occasion, a presentation stands out because it goes so far against the common wisdom of this crowd. I have learned that this is exactly the time to pay careful attention.

A few years ago in Vail, an attendee got up and confidently delivered a long thesis on Tesla. To call this presentation ballsy would be an understatement since the room included no less than three people who were actively and publicly short Tesla at the time. Also, the Tesla presentation was mostly a big-picture message that the company put out: a superior product that is a “computer on wheels” rather than an automobile. There was very little financial detail about how this product differentiation would translate into the company’s operating profitability. Needless to say, Tesla’s pitch stood out.

The reaction was polite but negative. Objections included the lack of the company’s profitability, Elon Musk’s tendency to overpromise and underdeliver, and other similarly salient points. The presenter responded to all of them with the rebuttal that can be summarized as “drive one, and you will know,” and that traditional car manufacturers are hopelessly outclassed. Throughout the discussion, my favorite moment was when Jonah, the conference organizer’s son, asked why the speaker delivered the pitch knowing he would likely get the reaction he did. The presenter was not ridiculed out of the room, but it was close.

Tesla shares are up more than 20x in the six years since the presentation.

Another similar situation occurred in 2022 in Cyprus, where a speaker from Lithuania pitched Bank of Cyprus (BOCH CY) to a room which had people from all over the world but a fair number of locals. To say that the reaction was negative would be an understatement. The local participants passionately detailed how poor customer service is and how incompetent the company management is. Their points, while valid, had very little to do with the company’s financial performance.

Bank of Cyprus operates in an oligopoly that is unlikely to be disrupted by competition. It also happened that its results at the time were extraordinarily leveraged to an increase in the interest rates. With the shares trading at 0.3x P/B, Bank of Cyprus’s valuation reflected all the negative points raised by the participants, and none of the potential upside from increases in European interest rates.

Once again, an overwhelmingly negative reaction should have been a buy signal to anyone listening. Thanks to euro interest rates rising from negative to 2-3%, the Bank of Cyprus’s earnings and share price have risen more than 8x over the four years since the presentation.

These two experiences show that, after a conference, it may be more important to look not at attendees’ favorites but at the ideas universally disliked. The audience, no matter how sophisticated or contrarian by nature, is a cross-section of the market. If a company is generally liked, there is a good chance that similar managers have already looked at it and decided whether to buy it or stay away. This means that the marginal money is already in the stock, and it is hard to see where new investors would come from to drive the shares higher.

On the other hand, a company that is dismissed is likely disliked by the market in general. Any change in sentiment is likely to be positive, which could drive the shares higher.

As I get ready for the next three days in Vail, CO, I look forward to reconnecting with old friends and talking about companies in obscure industries. Most importantly, I will be on the lookout for the idea that is universally hated, which might be the next great performer.

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Roughly half the books I read can be described as work-related. They would usually be either business biographies, such as Shoe Dog by Phil Knight, or investment process texts, such as Competition Demystified by Bruce Greenwald. Some books straddle both genres, with investment lessons drawn from the histories of the businesses analyzed. I think one of the better books from the latter category is The Outsiders by Will Thorndike.

The Outsiders argues that extraordinarily long-term shareholder returns are driven by exceptional capital allocation—how CEOs deploy cash through acquisitions, buybacks, dividends, debt, and reinvestment. By studying eight unconventional CEOs, The Outsiders shows that disciplined, rational capital allocation can create vastly more value than traditional management practices focused on growth, scale, or corporate prestige.

Given my focus on capital allocation, the central message of The Outsiders clearly resonates. Each of the cases presented in the book is a clear example where long-term returns have been enhanced through superior capital allocation. That said, a few years after I read the book, the part I remember is not the specific business story but a paragraph that was included almost in passing as a prediction (in 2012) near the end of the book:

The interesting thing about this comment is that at least one of the companies mentioned has been doing for years exactly what Thorndike has been recommending in the book published in 2012. In the five years between 2007 and 2012, Microsoft generated roughly $115 billion in free cash flow, of which over $70 billion was returned to shareholders via one of those means. In the process, shares outstanding declined by roughly 12%. Most of the shares were bought at free cash flow yield between 9 and 11% - well above the yields paid by the high-quality bonds, which can serve as the opportunity cost benchmark for sound capital allocation. This is textbook good capital allocation.

The buybacks, despite their hypothetical value, failed to yield significant returns to shareholders, with Microsoft shares delivering just 2% per year returns during the five years. The 5% per annum revenue growth, buybacks, dividends, and margin expansion were almost fully offset by multiple contraction during that period. Rapturous market response this wasn’t.

Now, if we contrast it with the performance in the next five-year period between 2012 and 2017, the picture is very different. While the fundamental factor contribution was identical at 14.1%, the total return was much more attractive at 19.6%. Multiple expansions added over 5% per annum, turning what would already be excellent shareholder returns into outstanding ones. So why the difference? It’s hard to attribute it to any one factor, but I think the following two matter:

First is the corporate management shift towards categories considered to be growing. In the five years in question, revenue growth accelerated from roughly 5% to 7%, an important data point but hardly sufficient to justify a major re-rating of the shares. However, in 2016, Satya Nadella, who had led the company since 2014, reorganized it into segments, taking the legacy Server & Tools segment and adding Azure cloud services, which were widely seen as a potential growth engine for the company.

The separation of the fast-growing division changed the rhetoric around Microsoft from a company milking its Windows and Office franchises to an entity that had potential for outsized growth. The market responded to the restructuring with an expansion in the P/E multiple. But another change was happening in the broader market.

Before 2008, Microsoft consistently delivered revenue growth of 10%+ p.a. It was one of the most recognized companies in the world and was likely part of almost every retail investor’s portfolio. Before 2008, retail investors were increasing their allocation to the stock market and more likely than not were buying shares of Microsoft. The 2008 financial crisis triggered a long period of retail outflows from the stock market that lasted, not coincidentally, until the summer of 2013 – the period in which Microsoft experienced the multiple contraction.

Since 2013, the share of individuals with money invested in the stock market has stopped falling and, in 2016, started growing again. As a result, retail investors moved from net sellers to holders to eventually net purchasers of Microsoft shares.

This change in retail sentiment towards the stock market benefited not just Microsoft but other companies that managed to capture and retain retail investor attention. Together with Microsoft, companies like Apple, Amazon, Facebook/Meta, and, later, Nvidia have all been recipients of increasing retail stock market flows. This trend is one of the more likely explanations for why the largest companies are outperforming the rest of the market and experiencing multiple expansion relative to the other businesses.

The example of Microsoft shows that share performance is driven as much by what is happening to the marginal dollar entering the market as by fundamental factors. No amount of correct corporate decisions will lead to investors’ immediate delight if the money is flowing out of the stock market for one reason or another.

Sensitivity to market flows is not an excuse for poor corporate governance or capital allocation. On the contrary, I think fickle investor sentiment makes sound capital allocation even more important, since the company is less likely to be at the mercy of market conditions if it needs to raise capital or access bond financing. The sensitivity is, however, a reminder that finding the right companies is only half the battle. The other half is understanding the factors that lead to long-term performance and having the intestinal fortitude to withstand periods of adversity.

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The fundamental investment process is naturally backward-looking, since it often begins with an analysis of historical financial statements. The main problem with relying on financial statements is that past performance may no longer be relevant. If the reason for extraordinary profits no longer exists (e.g., patent expiration) or if the business was disrupted by innovation or competition, then the last year’s numbers have little bearing on what the company will earn in the future.

With patents, it is very clear that the historical reason for the generation of excess returns no longer exists. As soon as it becomes legally permissible, competition swoops in and offers the same product at a lower price, which forces the former patent holder to lower its prices and profits. With other types of disruption, the catalyst for lower profitability is much less obvious and sudden. Competitive dynamics develop over time and can swing back and forth before ultimate outcome is obvious. Often enough the incumbents fight off the challengers and emerge with even stronger business fundamentals. Figuring out whether the business model can survive the challenge is one of the more interesting and rewarding exercises for the fundamental investors.

There is a category of investments that can be described as: “Company X is toast because Company Y will make their business uneconomic!” Given its status as the “Everything Store,” on more than one occasion, the company Y is Amazon.com. Jeff Bezos, founder of Amazon, is famous for coining the phrase “your margin is my opportunity,” and he means it.

The list of companies that fell victim to Amazon over the years is long. Borders, Toys R’ Us, Circuit City… None of them managed to adapt their business models to the online competition and eventually went bankrupt. Given the track record, when a headline comes out that Amazon is expanding into a new industry, the market takes notice, and valuations of existing players in that industry suffer.

That said, Amazon’s track record is not perfect. Over the years, it has attempted to expand into several industries where the effort ultimately proved futile. Does anyone remember Amazon Destinations (travel website), Amazon Restaurants, and Amazon Local? I don’t think so.

Given the wide range of outcomes, I’ve realized that the best way to assess whether a company is likely to be disrupted by Amazon (or anyone) is to apply the “10x better” framework. The idea is as follows: Is the challenger’s product 10x better than the existing solution because it delivers better results, is cheaper, more convenient, or some combination of the above?

Compared to brick-and-mortar retailers, Amazon offered more choice, better prices, and the convenience of shopping in your underwear. This was 10x better than going to a physical store, which is why old-line retailers trying to hold on to their historical profits failed to compete effectively.

On the other hand, compared to Booking.com or Expedia, Amazon’s travel website offered, at best, a product similar to what was already on the market and could not offer better prices, since hotel owners are often prohibited from price discrimination under the terms imposed by the OTAs. Amazon could not come up with a 10x better offer, which is why Booking.com and Expedia effectively fought off challenges from Amazon, Google, and other contenders that have come along up to this point.

Another example of a company challenged by Amazon is Etsy.com, an online marketplace for handmade goods. Etsy was listed in April 2015, and just six months later, Amazon launched Amazon Handmade – a marketplace for handmade goods. Etsy stock, already struggling with decelerating growth, took another leg lower, with the market understandably concerned about the viability of its business given the presence of such a large competitor.

To apply the 10x better framework to any business, it is important to understand who the real customers are. In the case of Etsy, it wasn’t the shoppers but the artisans producing the goods. These artisans had the option to (and often did) sell their goods on both Amazon and Etsy (and their own websites), and the question was which venue provided them with the easiest way to market their goods and would gain relative share.

This is where Etsy excelled. It worked on artisan engagement and added features such as a manufacturing assistance program (helping artisans find spare manufacturing capacity at other small-scale manufacturers), direct billing, and PayPal integration. For Amazon, a company with hundreds of billions in sales, going into the business of matching a curtain designer with a curtain manufacturer did not make sense – for Etsy, it did.

These services didn’t just increase seller captivity; they also generated significant revenue for Etsy, enabling the company to capture a higher share of each sale. In 2016, merchants paid roughly 9.5% of the sale price to Etsy for access to the marketplace and payment processing, and another 3.1% for additional services the company offered. The artisans were happy to pay the fees since it allowed them to focus on the part of the process they enjoyed the most – the creative one – while Etsy took care of all the boring bits.

By understanding the artisans better than Amazon did, Etsy became the 10x better option. Moreover, by making it easy to create, Etsy offered more people the opportunity to pursue their passion, thereby expanding the addressable market.

Between 2015 and 2023 Etsy grew the number of sellers at an average of 25% per year. Over the same period, revenues and operating cash flow grew at even faster rates of 33% and 60%, respectively. The stock price, thanks in large part to the COVID boom, went from below $10 in 2015 to over $200 in 2021. In 2023, even after the positive impact of the pandemic had faded for ETSY, its shares still traded above $80, providing a significant return for anyone who bet on the underdog against a much larger competitor.

Today, Etsy shares are trading at around $70, indicating flat or negative returns over the last couple of years. The reason for this is a lesson in itself. Etsy, especially after COVID, to maintain the growth rates, continued to take a larger share of the seller’s top-line revenues. At some point, the fees the company charges become too high, which starts to destroy the economics for its customers, which resulted in artisans leaving the ecosystem.

In 2023, Etsy’s total take rate exceeded 20%, coinciding with the platform’s peak in seller count. Since then, the take rate has continued to grow, but revenue growth has slowed dramatically. Ironically enough, if there ever were a chance for someone to challenge Etsy as the go-to marketplace for handmade goods, the time would be now when artisans are seemingly incentivized to look for alternatives, rather than when the company was young and hungry to win.1

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The average holding period for U.S. stocks has collapsed from roughly 7-8 years in the 1950-1960s to less than one year in the 2020s1. For a long-term investor, this fact should be both scary and exciting. The majority of the market operates on different timelines, and how one deals with it depends on the person’s comfort with looking foolish from time to time.

One example that comes to mind is Chipotle (CMG). The company started in 1993 from a single store near the University of Denver and created the “fast-casual” concept that spread across the country. By 2015, the company was operating over 2,000 stores, which were generating over $2m in sales per store and delivering 70%+ cash-on-cash annual returns on the opening costs. The market was putting a well-deserved premium on the company, with the shares trading at 50x earnings.

In August 2015, the norovirus outbreak linked to a Chipotle store in Simi Valley, CA, sickened over 200 customers and put a blemish on what had been, before this, a success story. Same-store sales growth fell from 10%+ in 2014 but remained positive, indicating that most customers were comfortable with a small side of risk accompanying their burrito. The Simi Valley incident was followed by a salmonella outbreak in Minnesota in August and an e. coli scare in Washington and Oregon in October. The second norovirus outbreak in Boston sickened another 150 customers. The continuous stream of bad news changed the risk calculation from the diners’ point of view, leading to double-digit declines in visits to shops.

While the market largely ignored the first norovirus incident, it definitely noticed the subsequent events. Chipotle’s shares fell by almost 50% between September 2015 and January 2016. Aside from obvious concerns for the health of the diners, one of the biggest questions being asked was whether Chipotle’s “food with integrity” concept, which relies on fresh ingredients cooked on site, could even be scaled to thousands of restaurants without triggering a stream of one-off incidents as the ones that plagued the company in the second half of 2015. For anyone considering investing in the company, the key question was whether the consumers will ever feel that a trip to Chipotle does not come with a slight risk of food poisoning.

The analysis of past incidents2 suggested that consumers’ affinity for their favorite type of fast food usually proves more enduring than the memory of past safety issues. The same turned out to be the case for Chipotle…or so it seemed.

By the second quarter of 2017, sales per store were recovering, and the company looked to be gaining back customer’s trust, when yet another norovirus outbreak, this time in Virginia, hit the company’s results. If you, as I did, invested in the company under the assumption that food safety issues are behind Chipotle, in July 2017 you looked rather silly. Being contrarian is only fun if you are proven right, and at the time, that looked like an increasingly unlikely outcome.

Thankfully, in addition to the review of past food safety incidents, the analysis of Chipotle’s business model and balance sheet suggested that it can survive even the latest calamity. The key to understanding it was to look at store-level economics and split costs into fixed and variable.

Labor, rent, utilities, and other similar costs were pretty much fixed and totaled roughly $1 million per store per annum. Food costs were variable and usually around 35% of sales. Putting the two together helped quantify the uncertainty and define the bet as follows: “Does one think that Chipotle sales per store are higher or lower than X?”

In 2016, with food safety concerns at their peak, Chipotle still delivered over $1.8 million per store, putting the company comfortably in the black and generating high enough returns to justify chain expansion. If sales per store return to $2.4 million (2014 levels), then profitability per store triples. An investor could construct a probability tree of possible outcomes and derive a weighted estimate of Chipotle’s earnings. Probabilistic thinking is one of the few advantages a long-term investor has in a market that seems to operate in short-term absolutes.

The curious thing about the calculations above is that even though the sell-side analysts were comfortable projecting a recovery in Chipotle’s sales, they were not considering the cost structure of the stores. Most reports I saw at the time kept margins at about the same level as the company delivered in 2017, when sales were still low.

One person who did make a personal bet on the company’s cost structure is Brian Niccol, formerly the head of the Taco Bell division of Yum Brands, who was brought in to “professionalize” Chipotle’s operations. Before agreeing to take the role, Mr. Niccol negotiated a pay package with specific awards for achieving restaurant-level cash flow margins set at levels that looked ambitious compared to recent results but were rather pedestrian when evaluated against pre-2015 levels.

Whether through skill or through good timing, Mr. Niccol delivered. In 2018, same-store sales grew to around $2m per store, triggering a recovery in margins, a new CEO’s pay package, and a 70% increase in the company’s valuation. This would seem like the time to declare a success for contrarianism, but unfortunately, this is exactly when my tendency to swim against the tide led me to a decision that would prove much costlier – selling too early.

Instead of celebrating that the company was finally doing well, I remembered that dreadful feeling of fearing the breaking news of yet another norovirus outbreak that could have ruined Chipotle’s reputation with diners for good. The flip side of looking for reasons to buy the companies that market hates is looking for reasons to sell the companies that market likes. In this case, Mr. Niccol’s decision to move Chipotle’s headquarters from Denver to his home in California looked like exactly the type of action that the CEO who cares about delivering the best returns to shareholders should not be doing. Following the announcement of headquarters move, I decided that the risk/reward was no longer in my favor and sold the stock.

Instead of looking for reasons to sell, the right thing to do would have been to focus on the company’s actions and consider the potential impact of management’s initiatives on store sales using the same probabilistic thinking that allowed me to invest in the company in the first place.

The key thing to consider should have been not the headquarter locations, but the Chipotle’s initiative to roll out second production lines in stores to service takeout and delivery orders. Anyone who spent time in Chipotle’s lunch rush line realized that the company’s problem was not demand but throughput. The second line allowed the capture of incremental orders and improved sales per store, while increasing fixed costs only slightly. The net effect of installing the second line was growth in revenue per store to over $2.6 million and a more than doubling of Chipotle’s free cash flow generation. The share price followed the results, with more than a 6x increase from the level at which I sold to the eventual peak in 2024, when same-store sales seemingly stabilized at a new, higher level.

The lesson from this situation proved expensive but valuable. It is always important to consider the levers the company controls – such as operational improvements and growth initiatives and their impact on results. It is just as likely that the market is underpricing them when the shares are doing well as when the shares are doing poorly.

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Takeaways:

- Probabilistic thinking helps with analyzing situations with wide range of outcomes

- When company finally starts doing well consider both the likelihood of results improving even further as well as the downside

Disclaimer3

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Each stock market bubble has its defining moment, when animal spirits driving capital towards a particular story begin to wane. Recognizing this signal may be easy in retrospect, but very difficult in real time while excitement about a particular investment theme is still at its peak. At the same time, the temptation to call the market top is there, even if the only reason is to brag about it at cocktail parties for years to come. The interesting thing is that, looking at recent bubbles, the events that signaled that the market is turning happened well before the actual peak.

In subprime lending, it was the collapse of the two Bear Stearns funds that invested in supposedly safe tranches of mortgage-backed securities and collateralized debt obligations. The funds in question, Bear Stearns High Grade Structured Credit Strategies, became the subject of margin calls in the summer of 2007, which forced them to sell assets into an illiquid market, leading to price declines that triggered more selling. After the initial attempts to save them, Bear Stearns, which evidently bet the firm on subprime lending but eventually lost, allowed the funds to liquidate.

While these events spooked the market, it did not reach the eventual peak until a few months later, in October of 2007. Even then, as the extent of the problem became more apparent with liquidity problems at Countrywide Financial (August 2007) and collapses of institutions abroad (Northern Rock in UK – September 2007), the market was still giving a chance to investors to sell out at prices which proved to be more than double that of the eventual bottom in early 2009.

The .com bubble, whose memory is invoked by those concerned about the pace of the AI infrastructure roll-out, also did not peak when clear signs of irrational exuberance were evident.

At the dawn of the internet, companies such as bookshop operator Books-A-Million jumped on the internet bandwagon by adding .com to their names. The market reaction – a 10x jump in a few days – seemingly irrational given no change to the actual business of selling books – would serve as a memorable signal that the market may be heading for the top. Except that November 1998, when this memorable event happened, was more than a year before the actual market peak.

A more real signal that demand for something may have been cracking is not when a company with .com in the name went up 10x, but when it didn’t. A company called BigStar Entertainment, which was an online retailer of DVDs, listed its shares in August 1999. A couple of my high school friends were working for BigStar at the time and were counting on a big payday, given that other companies were doubling and tripling on the day of the listing. There was even talk of borrowing money to participate in this “no-lose” proposition since they, as employees, had preferential access to the shares.

To everyone’s surprise, BigStar shares opened down, not up, from the IPO price of $10 and finished the first day of trading slightly above $8 per share1. As much as the lack of IPO-pop could have served as a warning that trouble was stirring beneath the market, the Nasdaq did not peak until six months later, at a level nearly double that of the summer of 1999.

This brings us to the present day and the event that captured the imagination a couple of weeks ago: a failed shoe retailer, Allbirds, deciding to pivot its business model into AI data centers. The similarity to the Books-A-Million story is apparent and is used by market commentators as an indicator of irrational exuberance regarding anything related to AI spending. I think they are missing a key distinction: pivots only signal a top when the market fails to reward them.

When companies make seemingly ridiculous business decisions in response to market conditions, this signals that interest in a particular story is still on the rise. It’s when a business pivots towards AI infrastructure that will fail to yield a positive market reaction that we may be concerned regarding the stock prices of the related companies. And even then, we would still likely be months away from the market top.

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As I mentioned in a previous post, I spend a lot of time looking at banks in Eastern Europe.

The main reason is that when a bank runs well, it’s a great business to be involved with. Customers deposit their spare cash in exchange for a certain interest rate. The bank then uses the same cash to lend to other customers at a higher interest rate. The difference between the deposit rate and the lending rate covers the cost of the beautiful branches, the technology infrastructure, and the risk that some customers will not repay the borrowed funds. If the bank is well-run, the difference between the interest rates is more than sufficient to cover all expenses and generate significant profits for the bank’s owners. It should be that simple…

Somehow, it’s not. Over the years, banks have become involved in all kinds of financial investments, such as trading and the creation of synthetic securities, which makes it very hard to understand what they own, who they lend to, and how much money they can make. This leads to situations like in 2008, when 100+ year-old institutions disappeared practically overnight. This is why most investors stay away from banks, which is the second reason why I like analyzing them. It’s much easier to find opportunities in areas that other smart people avoid for non-fundamental reasons.

One side effect of analyzing banks for twenty years is that sooner or later, you start seeing bank-like features in other businesses. When used appropriately, this is a good tool for identifying (or rejecting) investment opportunities. For example…

Sunrun (RUN) is a solar systems rental company. It offers homeowners interested in solar power a way to get the benefits of renewable energy without the upfront costs. Sunrun installs the panels and batteries and signs 20-to-25-year contracts with credit-worthy customers that guarantee the company a stream of income. The hardware is mostly financed through debt secured by the hardware and by special investment vehicles that the company sells to investors.

Sunrun is clearly successful in getting consumers to subscribe, with the number of customers and total installed energy capacity growing more than 4x since 2019. That, however, is not an indication of whether it is a good business.

Looking at it as a bank, we can consider the installed panels as a loan for which it earns a rental yield. In 2025, this rental yield was 11.4%, which, on the surface, is pretty good. The problem is that it pays for the panels by borrowing at about 7.7%. The spread, or Net Interest Margin (NIM), is only 3.7%, which Sunrun must finance to cover marketing, installation, maintenance, and other administrative costs. Most years, these costs are well above NIM, and the company reports negative operating income. While there may be other reasons to invest in Sunrun, viewed through a bank’s prism, it is not a good one.

Sunrun 2025 Revenues and Expenses:

Contrast it with AerCap (AER), one of the largest aircraft lessors. AerCap buys planes from Boeing and Airbus and rents them out to airlines (large and small) worldwide. As one of the largest buyers of airplanes in the world, it can secure significant discounts from the listed prices. It rents the airplanes to airlines that are unwilling or unable to make the same commitments to the manufacturers, which requires multi-year planning. As a result of acquiring assets at a low price, AerCap usually secures a hefty rental rate relative to the purchase price.

In 2025, this rental yield was 13.2%. Just like in Sunrun’s case, the assets are financed via asset-backed debt. However, unlike with solar panels, debt markets are willing to lend against airplanes at low rates. In 2025, AerCap paid only 4.4% interest on its outstanding debt. The Net Interest Margin for AerCap is almost $4.7 billion or 8.8% of the balance sheet value of airplanes.

The costs, including depreciation, marketing, leasing, and administrative expenses, total roughly $3.9 billion. In banking terms, the cost-to-net interest margin ratio is the cost-to-income ratio. For AerCap, it is 67%. To put this number in perspective, a well-run bank, like JP Morgan, usually achieves a cost/income ratio of 50 to 55%. A good regional bank would be at 60-70%. By this measure AerCap looks like a good regional bank, though not a great one.

AerCap 2005 Revenues and Expenses:

Another measure of the bank’s quality is Return on Equity (ROE). It looks at a ratio of net income to the shareholder equity required to run the bank. Net Income is a catch-all measure that includes both real earnings, such as the net interest margin, and adjustments banks can make to estimate the value of their assets. These adjustments can sometimes be significant and are one reason most investors feel uncomfortable owning banks. There is way too much faith in management’s ability to estimate all the inputs correctly.

That said, ROE is universally accepted as a measure of bank quality. A good bank would usually generate an ROE of around 16 to 20%. A less good one would deliver 8-12%. For AerCap, I am estimating the “book value” as the difference between the value of the flight equipment and the associated debt. For 2025, this difference was $13 billion, on which the company earned over $1.8 billion in real operating income, equivalent to 7% ROE1. Once again, as a bank, it looks like an average one. This raises the question of why bother with what looks like a mediocre business.

The answer is in the last, but not least, check in my investment process - whether the company adds value through capital allocation. We already know that spending money on new planes is a good idea since they are earning good spreads on renting them out. In fact, spending on incremental airplanes historically, except for COVID, generated returns of 20-30%2.

However, the need for airplanes is constrained by supply and demand. Boeing and Airbus together produce 1,500 to 1,700 airplanes per year, and this production is pre-sold for years in advance. Even if AerCap could add 1,000 planes in one year, it would not be easy to find customers willing to take them. Part of the reason AerCap is earning such good returns on incremental plane purchases is that it has a pretty good idea of what the market can handle.

This raises the question of what to do with the cash AerCap generates, which is not needed for fleet additions. One option is to pay down the debt secured by the aircraft, but the interest paid there is below 4.5%. The other option is to buy back shares. Most of the time, AerCap shares trade at a free cash flow yield3 of 10%+. The yield of 10% is much higher than the average for the S&P 500 and suggests that the market feels that AerCap earnings are not sustainable. Using the banking framework, we establish that AerCap business may not be fantastic but is not a bad one. By pricing company’s shares at high free cash flow yield, the market is giving the company an opportunity to create value through buybacks. Repurchasing shares that yield 10% is a better use of capital than paying down debt that yields 4.5%, and that’s exactly what AerCap does. Over the last three years, they bought back over 30% of the shares outstanding.

The returns to long-term shareholders at AerCap support the conclusion that AerCap, thanks to its capital allocation, is a good business to own. In the 10 years ending in December 2025, AerCap generated an IRR of almost 13%, delivering more than 3x return to the investors. Most of the return came from revenue growth, improved cash flow and profitability, and share buybacks.

An advantage of being a generalist (which I covered in detail in a previous post) is the ability to use frameworks from one industry to analyze businesses in another. Using frameworks from banking helped me identify and understand an investment opportunity that might otherwise have fallen into the “too difficult” pile.

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Takeaways:

- Applying frameworks from one industry can help understand businesses in another one

- When market offers a chance to a decent business at a great price, buybacks can add value and enhance shareholder returns.

Disclaimer4

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Coming into the year, it seemed that the only things that mattered for the global economy were the pace at which new data centers could be built and the impact of artificial intelligence on employment and productivity. The war in Iran and the subsequent disruption to global energy supplies served as a reminder that, while we may be transitioning to the world of electrons, our daily lives are still dominated by molecules.

For the better part of the last hundred years, this molecular world has been dependent on oil and gas. The hydrocarbons are extracted from the ground and used to power, heat, light, and outfit almost every aspect of our daily lives. Thanks to the rising living standards of a growing population, the demand for hydrocarbons is steadily increasing, even as alternatives are emerging that could replace/augment some current use cases.

Given the described dynamic and the importance of oil and gas to daily life, it is a wonder that the world has come to rely on an equilibrium in which spare production capacity is less than 3% of demand and hydrocarbon supply is delivered via long and complicated logistics chains. The war in the Middle East and the subsequent closure of the Strait of Hormuz, through which almost 20% of global oil production is transported, served as an unwelcome reminder of how fragile the equilibrium truly is.

The ultimate resolution of this conflict is still in question, but we think that, regardless of when and how quickly deliveries from the Gulf regions are restored, the world is unlikely to remain comfortable with the minimal spare capacity in hydrocarbon production and with reliance on any single region.

In a similar setting, the global economy was first shocked by the Arab oil embargo (1973-74) and then by the Iranian revolution in 1979, with each incident impacting roughly 7% of global oil production. Like today, before the disruptions, the supply and demand were evenly matched. What followed these events was a major investment period that more than doubled the amount of capital committed to finding new sources of hydrocarbons. As a result, several new sources of energy, such as the Gulf of Mexico, the North Sea, and Cantarell field in Mexico, were discovered.

Coming back to today, before the Iran war, oil and gas investments were at a low. Since 2014, volatility in oil prices and concerns about the sustainability of demand amid the push for renewable energy have led to a decline in interest in developing new projects. While investment has recovered a bit in recent years due to long-term oil prices stabilizing above $60, the total remains roughly 40% below 2014 levels in nominal terms.

The disruptions to shipping through the Strait of Hormuz affect roughly 20 million barrels of daily production. The current ceasefire raises hope that the problems will prove temporary, but oil-importing countries are becoming acutely aware of the danger of being overly dependent on any single hydrocarbon source, no matter how stable it may seem at the time. We think that, just as in the 1970s, the response will be to seek alternatives. There is some debate over whether they will come in the form of additional oil and gas sources or increased penetration of renewables, but the most likely scenario is that it will be both, and that investments in hydrocarbons will be well above 2014 peaks.

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Disclaimer1

I spend my days following and analyzing news about various companies and industries. Given the sheer amount of information being thrown at us, it is very easy to get caught up in narratives or stories. If there is one benefit to the twenty years of experience in public market investing, it is the understanding that, often, a news story that seems highly relevant one moment can be obsolete in just a couple of days. The ability to separate information that is meaningful to an investment case from mere noise is a fundamental skill that investors need to have any hope of delivering strong long-term returns.

To maximize my chances of success, I developed a few techniques that help filter the information as it comes in. The first one is color blindness. An experienced fund manager many years ago advised changing the Bloomberg terminal settings so all prices were yellow to avoid being triggered by red or green price changes on the screen. This technique is surprisingly effective and likely lowers blood pressure quite a bit for anyone who constantly glances at the price action on the screen.

The second technique is to identify two or three key parameters relevant to the company’s long-term performance. Focusing on these parameters helps filter incoming information, determining whether it is impactful to the company’s long-term competitive positioning. This point is probably best illustrated by a couple of examples.

Western Union (WU) is one of the companies I bought in 2012 when launching the strategy. This 100+ year old company has reinvented itself from a telegraph service provider to a leading global money transfer enabler with hundreds of thousands of agent-owned branches around the world.

I invested in this company knowing it faced disruption from emerging digital money transfer options. Two of those competitors, Transferwise and Remitly were founded in 2011 and offered customers a way to transfer cash abroad at a lower cost and more conveniently than going to a Western Union branch. Despite these alternatives, the number of consumers’ transactions going through the WU network continued to grow thanks to the underlying positive trend in international money transfers driven by migration and globalization. I felt that the number of transactions was one of the key data points to track to see whether Western Union’s network remains relevant to the consumers.

Throughout 2010s, the number of consumer transactions continued to grow at a rate of 2-5%, which was enough to offset revenue-per-transaction declines.. The growth also helped keep Western Union’s profitability at a level necessary for a generous dividend and value accretive share buybacks.. By 2020, the growth in consumer transactions had slowed to below 1% which changed the above calculus enough to negatively impact Western Union’s results. Tracking and understanding the dynamics between transaction volume, revenue per transaction, and their impact on overall results helped identify the underlying drivers of WU’s operating performance and, importantly, recognize the deterioration that emerged as growth slowed.

Another interesting case is World Wrestling Entertainment (WWE), which, from 2013 to 2015, underwent a business model transition. At the beginning of 2014, the company made a couple of announcements which gave the market reasons for concern – renewal of TV licensing deal at a lower than expected increase in average annual value and transition from pay-per-view events for which the company charged $45 to $60 per event to a subscription service named the WWE Network which at launch cost $9.99 per month. The WWE network looked like an especially risky endeavor given that it would require significant upfront investment in developing the technology and in getting customers to subscribe to the new offering.

Looking at the company’s economics, the key data point to track was the number of WWE Network subscribers. At 1.1 million monthly subscribers, WWE would generate similar profitability from subscription services as it normally did from selling PPV events individually. If the number of subscribers reaches that level or higher, the strategy shift would pay off; if it doesn’t, the economics would suffer.

Throughout 2014, subscriptions stagnated at around 700-800 thousand, with customer additions mostly offset by churn from existing subscribers. However, alongside the 2014 financials, WWE announced that the number of paid subscribers crossed 1 million early in 2015, as geographic expansion and free trial offers allowed more customers to sample and enjoy the WWE Network. Shares jumped more than 20% on the day these results were announced.

In situations like this, it is tempting to declare the opportunity missed and move on; however, several data points led me to conclude that even after a 20% move, the market did not fully appreciate the dynamics affecting WWE’s results.

First, engagement data from YouTube and social media showed that WWE’s popularity continued to trend upward, especially for online videos, which served as a form of advertising for the network. For the WWE Network to be value-additive, subscriptions had to stay at or above the levels already achieved, and that seemed like a solid bet given the engagement data.

Second, TV licensing revenues, which the company projected in 2014 to more than double based on the recently signed deals. If the company was correct in its forecasts, the same content licensed to the TV stations would generate as much as $150m in additional revenue and $60m or more in cash flow profits compared to 2014 levels. The $60 million was roughly the same as what the subscription network would generate with 1.2 million to 1.4 million subscribers. The market was mostly focused on the network while largely ignoring TV licensing, which was much more important to overall results.

Over the next four years, the number of network subscribers steadily increased to over 1.6 million while generating steady profits. The real star was the licensing revenues, which increased from $170 million in 2014 to over $500 million by 2020. In retrospect, early 2015 proved to be a positive inflection point for WWE, not because of how well the subscription business performed, but because of the licensing deals that were announced in 2014. Between 2015 and 2023, WWE’s EBITDA more than tripled, and eventually the company was taken private by the Endeavor Group.

In both the case of Western Union and WWE, the most important determinant of the company’s performance turned out to be not a change in analyst estimates or short-term forecast, but understanding which operating metrics drive longer-term results. Tracking these metrics and the factors that influence them can help identify positive and negative inflection points that could impact operating performance for years to come.1

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Takeaways:

- Market narrative sometimes focuses on metrics that are less important for company’s success which can create investment opportunity

- Tracking the right metrics helps ignore noise and improves decision making

When I was setting up the investment strategy, I thought two categories of investments would be unfit for the free cash flow-focused approach that I was envisioning.

One was biotech companies. Thanks to a pharma company I was on the board of in Eastern Europe, I had the opportunity to attend a discussion between a biotech company seeking capital and a well-regarded specialist biotech investment funds. Representing both sides were people with medical and/or chemical doctorates. The level of specialist knowledge involved about the molecule’s functionality, the competitive positioning, and the regulatory environment was so high that I immediately knew that the patsy at that proverbial poker table was clearly me. That realization, combined with the fact that these companies are often in the development stage and lack cash generation, made it clear that biotech companies are highly unlikely to fit my investment strategy.

The other category of companies was banks. Unlike the biotech companies, this area I felt reasonably comfortable with, given that over my 20 years as a portfolio manager and research analyst I’ve had the opportunity to research and invest in many Eastern European financial institutions. The banks in Eastern Europe are interesting because of their surprisingly simple business models – the best ones benefit from lower borrowing costs due to their perceived quality, can choose among the highest-quality borrowers in a growing economy, and are run efficiently, generating high returns on equity. In fact, we consider them the opposite of many Western institutions that have to contend with low net interest margins due to overly dovish central banks, high costs due to outdated infrastructure, and often generate a significant portion of their overall income from trading and the revaluation of complex assets.

For the above reasons, I felt that traditional banks, even the best-run ones, are unfit for my US equity strategy which is focused on companies generating free cash flows. However, over time, I found that a subset of financial institutions did fit, as they resemble Eastern European banks in the returns on invested capital they generate. The credit card companies.

Credit card loans, in theory, should be highly lucrative. Given the 20-25% annual interest rate, banks should be printing money, since they get money from customers for free or nearly so. The problem is that credit cards are the riskiest types of loans and do not have collateral that could be seized if the borrower is unable or unwilling to repay. It’s normal for even the well-run conservative to carry a cost of risk (losses) of 5%+, which rises much higher in times of economic distress. Given the riskier nature of the loans, underwriting experience, management conservatism, and knowledge of the customer base are often the difference between a high-quality business and a levered disaster.

To illustrate how difficult the credit card business is, it is useful to look at a couple of examples of when otherwise well-run financial institutions went outside of their circle of competence and tried to enter the consumer credit card market.

Goldman Sachs entered the market with the Apple Card – a tech-first, consumer-friendly card distributed via the Apple ecosystem. Given the presence of the premier investment bank and access to what should have been the most lucrative subset of customers (iPhone holders), this product was seemingly destined for success. In fact, the opposite happened: over the next four years, due to a combination of poor underwriting and misspent incentives, the consumer loans generated around $7 billion in losses for Goldman. Moreover, instead of building goodwill with customers, the partnership, due to mismatches between the two companies’ cultures and other operational problems, led to lawsuits and fines.1

The other cautionary tale is buried in the annual reports from one of the more dynamic fast-growing fintechs – Revolut. While they have been doing an amazing job disrupting some of the bank’s traditional fee sources, such as payments and transfers, they are still struggling with the lending products. Consumer loans were introduced in 2019 and were supposed to go, at first, only to their most creditworthy customers. Despite this, in 2023, the loan book, which primarily consisted of BNPL and credit card loans, generated over 8% of credit losses and only 10% of interest income. By 2025, the metrics have improved slightly to 9.7% interest income and 4% credit losses, but given marketing costs and other expenses such as interchange fees, it is unlikely that Revolut is making money on its credit products.

While new entrants are struggling to figure out how to make money in unsecured consumer credit, I found that most traditional pure-play credit card issuers have done an exceptional job and delivered significant value to shareholders over time.2

Discover Financial was born under the Sears umbrella, changed hands a few times, and eventually became a standalone public company in 2007. The company was a unique blend of proprietary payment networks (Discover and Pulse) and a credit card business aimed at middle-income consumers. Since its listing in 2007 through 2024, Discover has grown its loan book by 4.8x and its net income by 5x. By the time it was acquired by Capital One in 2025, Discover delivered double-digit returns to investors despite going public on what is likely one of the worst possible days on the eve of the financial crisis.

Synchrony Financial, which began as the consumer credit arm of GE Capital, was listed in 2014. Its core business is offering store-branded credit cards, which it does by partnering with dozens of retailers, including Lowe’s and Sam’s Club. The key differentiator for Synchrony is its retailer share arrangement (RSA), which allocates to retailers the income earned above a certain threshold on credit products. The RSA arrangement aligns incentives and creates customer loyalty. Synchrony shares have also delivered double-digit returns to investors since their listing.

Aside from a solid, differentiated business model and good underwriting, both Synchrony and Discover distinguished themselves by allocating most of the excess cash they generated to share buybacks. As I wrote earlier, share buybacks can be a great allocation of capital when done conservatively and deployed when shares are trading at high free cash flow yields. Both Synchrony and Discover used share buybacks to reduce shares outstanding when their shares were trading at attractive valuations amid macroeconomic concerns. Discover bought back half of the company between 2010 and 2024. Synchrony went even further, buying back over 55% of all outstanding shares between 2015 and 2025, including over 25% between 2021 and 2023, when shares traded at high-teens free cash flow yields.

One exception to the solid performance of the pure-play credit card companies is Bread Financial, formerly known as Alliance Data Systems (ADS). While, like Synchrony, it also offers store-branded credit cards, its business practices are quite different and can be described as more predatory. Bread Financial works with retailers such as Victoria’s Secret, Wayfair, and Ulta Beauty while targeting near-prime customers. Their net interest income is significantly higher than Synchrony’s or Discover’s, but so are the loss rates. A significant portion of income comes from late fees, with customers being charged $25 or more even if their credit balance is negligible. I believe predatory practices, such as high interest rates and late fees, combined with mismanagement, are the reason Bread Financial has seen a decline in its loan book since 2022, while Synchrony and Discover showed growth. The share performance tells the same story: since July 2014 (the date of Synchrony’s listing), Bread Financial’s total shareholder return is negative 60%.

Bread Financial is also a subject of one of the more curious conversations I had with a famous value investor with an amazing multi-decade track record of investing in high-quality companies with great managements. I noticed that in 2019, the new CEO who came up from the consumer credit side of the business was way too promotional and was not as forthcoming with information about regulatory changes as its direct competitors. I knew that this famous investor had Alliance Data Systems in his portfolio and asked him what he thought of the management. He responded that while he believes most of the companies in his portfolio have strong management, he can’t say the same about ADS. When I asked about the follow-up on why he owns it, he walked away.

The relative comparison of pure-play credit card companies and some of their wannabe competitors shows how difficult it can be to make money in the business of borrowing at low rates and lending at high ones. The best companies have decades of data on customer behavior that helps them avoid traps and deliver solid returns to their investors. The worst ones are at the mercy of economic cycles and occasionally become the subject of customer and regulator fury. A careful study of business practices and incentives should help find better ones while avoiding the value traps.

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Takeaways

- Levered business models can be highly lucrative but require strong, conservative management

- Specialized knowledge is institutional and is hard to replicate even for the best ran companies from adjacent industries

- Capital allocation is often the difference between solid and exceptional performance

Disclaimer3

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Several people are undisputedly among the pantheon of Value Investing Legends. Warren Buffett, Charlie Munger, and Benjamin Graham are the names that come to mind first, but a credible case can be made for a few others, including the subject of this post, John Malone.

John Malone’s story starts with Tele-Communications Inc. (TCI), which he ran from 1973 to 1998. This company, through a series of acquisitions, became the largest US Cable operator before being sold to AT&T for $32 billion in equity value, delivering 900x to the original investors. In addition to the money paid by AT&T, Malone’s investors over the years received several assets in spin-off transactions, including Liberty Media, Discovery Communications, QVC, Liberty Interactive, Liberty Broadband, and Liberty Global, all of which have gone on to deliver strong returns to investors in part due to additional spin-offs. In total, there were 40 or so different companies, of which twelve are public today, that can trace their roots to the original TCI.

Most of the companies that Malone invested in can be broadly defined as media companies. It’s a large tent that includes infrastructure (cable companies), traditional content (Discovery, Starz), online properties (Tripadvisor, Expedia), or some combination of the above (Sirius XM). The feature they share is that the companies can hold significant leverage due to their predictable cash flows. Malone often used debt to acquire additional assets, which were in turn leveraged to fund further acquisitions.

Given the reliance on debt funding, one of the keys to Malone’s success was that most of his career took place in a declining interest-rate environment. While he was in charge of TCI since 1973, the acquisition machine didn’t really get going until the 1980s when interest rates started falling, and additional funding sources became available, including the junk bonds popularized by Michael Milken.

To be clear, declining interest rates are not the only reason Malone achieved the success that he had. He proved to be a superior operator, willing to buy distressed assets when their future was far from certain. He also managed his companies religiously to generate as much cash as possible, in part by minimizing taxes so he could reinvest the money.1

The above factors were important for the success, but one data point suggests that none were as important as the interest rates. Looking at the performance of the Malone Index2 over the last twenty years, it seems that his returns stayed strong until 2020 but have stagnated since then, as borrowing rates rose after the Covid bottom. Moreover, there is a clear negative correlation: the Malone index underperformed in 2007 and 2018 – periods when interest rates were rising.

My takeaway from the above is as follows: even the best investors have difficulty delivering returns when they face macroeconomic headwinds that threaten the key elements of their strategy.

The second thing to consider is which companies were responsible for most of the value growth and why. Looking at the performance of various businesses over the last decade, the ones that have done best were those with steady or growing underlying demand and pricing power – Live Nation and Formula One. The ones that struggled are those being disrupted by new technologies that give their customers alternatives. Home Shopping Network operator Qurate Retail is having trouble staying relevant as smartphones provide endless entertainment and personalized shopping recommendations. SiriusXM’s paid subscription service is more expensive than Spotify, and you don’t get to choose your own music. Technological disruption combined with leverage rarely leads to good investment outcomes. At a risk of being accused of heresy, it is possible that John Malone, for all his prowess in buying and running companies, may not be as good at selling them when he should have.

As far as my involvement with Malone companies – it’s fair to say that I’ve dabbled… The investments included Tripadvisor from 2015 to 2018, SiriusXM from 2016 to 2019, and Discovery Communications from 2015 to 2022. Each one is an interesting example that shows both the benefits and the limitations of following anyone religiously, independent of how good their track record is.

With Tripadvisor, I was attracted by its status as the default source for anyone planning a vacation, strong relationship with hotels, and an emerging experiences business that was viewed as a liability, but I felt was a major potential source of value for the company. The operational thesis largely played out as expected, with the company’s EBITDA profitability improving by roughly 30% over the three years, but that did not lead to an improvement in valuation due to multiple contraction. I sold for various reasons, one of which was management’s comments that denigrated user-generated content, which I felt was the main feature that distinguished the company from many competitors. If the CEO didn’t appreciate all that content, why should I?

“If I’m going to London, the last thing I want to do is read 1,000 hotel reviews. I want inspiration.”

– Steven Kaufer, CEO of Tripadvisor, in a 2018 interview.

Sirius XM, by the time I invested in it, was the undisputed monopolist in satellite radio. The company was formed with Malone’s help by combining two companies – Sirius and XM Radio, which, before the combination, had competed to the brink of mutual insolvency. Once combined, the business became a cash-flow-generating machine, in part thanks to being automatically pre-installed in 75% of vehicles sold in the US, which significantly reduced their customer acquisition cost.

The company was using all the cash it generated to buy back shares, which effectively increased Malone’s controlling stake, since his company, Liberty Sirius, was not selling into the buybacks. The buybacks were a smart form of capital allocation because shares were trading at a higher yield than the company paid on its debt. As a shareholder, I appreciated both the value generated by the buybacks and the fact that they served as a natural source of demand for the company’s shares, thereby reducing potential downside.

Thanks to rising earnings driven by price increases and buybacks, Sirius XM shares delivered low double-digit returns between 2016 and 2019, but I felt there were signs of trouble on the horizon. The valuation the market was willing to pay for car manufacturers’ shares was coming down, which, to me, served as a clear sign of potential distress for Sirius XM, since new car sales were a key source of new subscribers for Sirius XM.

The story of Discovery Communications probably deserves its own post. For now, it is sufficient to say that i bought it when i thought the merger with Scripps network would bring significant benefits of scale due to similar content, and sold it when I thought that the merger with Warner Brothers brought significant risks precisely because the content of the two companies was very different.

The one thing in common for all three of my ventures into the Malone universe is that the companies were trading at attractive valuations at the time of the investment. These investments led to solid returns but nothing like the 30%+ IRRs that Malone generated for his investors in the 80s.

Counterintuitively, the attractive valuation could be the reason why outsized returns were not available. Malone’s track record is well known, and companies were optically cheap. This means that the market was pricing in the emerging disruption threats on the horizon and the limitations of Malone’s model in dealing with them.

There is an old joke that when someone is looking for something good, cheap, and fast, they must pick just two out of three. Investing equivalent is quality, value, and growth. More often than not, only two of the three attributes are available at any given time, and we, as investors, have to understand the trade-offs and their implications.3

Takeaways:

- Most exceptional investment returns are generated in a macro environment that is uniquely beneficial to a particular strategy. Different macro environment – different outcomes

- There is usually a good reason for why something is trading at a cheap price, especially when the company is run by a person known for superior investment returns.

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According to World Economic Forum estimates, as many as 92 million jobs may be lost over the next five years due to technological shifts. The same source states that 170 million jobs will be created and that the total number of people employed will increase by about 7%.

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The net gain, while promising for the world, may prove to be of little comfort to the hundreds of millions of people in white-collar jobs whose livelihoods is threatened by the ArtificialIntelligence. The anxiety related to this question was perfectly illustrated in the recent thought piece by Citrini Research.1 which painted a disturbingly realistic picture of AI impact on jobs currently employing millions of people. The market reacted to the publication by taking roughly $300 billion from the valuation of the sectors directly mentioned in the report.

In response, I’ve decided to look for “comfort” in the studies of the industrial revolution to see if anything from those two periods can help us understand and prepare for what’s coming.

The industrial revolution that took place between 1750 and 1850 started with inventions of machines that allowed for transfer of manufacturing from homes to factories. It also replaced human and animal muscle with inanimate force driven by steam engines. The machines generated significantly more power than any individual human or horse and harnessed that energy to increase the production of goods that had previously been made on a small scale by hand.

The innovations, such as the spinning jenny for weaving, were a clear improvement on existing methods. They also threatened artisans employed in the manufacture of various goods, who could not compete with the new technologies. At the time, nearly 10% of the British population was employed in hand-spinning, and the potential social and economic impact of their job losses was top of mind for both those affected and the country’s leadership.

Despite the threat to existing jobs, by the early 19th century, England provided an institutional framework for the entrepreneurs willing to risk their capital on the new, more productive machines. The initial attempts to hold the innovation back, either through regulatory means2 or through outright destruction (the Luddite movement) gave way to acceptance of the inevitability of progress.

In terms of its impact on workers, the Industrial Revolution can be divided into several phases. The initial stage, in which traditional at-home manufacturing methods became obsolete, led to stagnation in real wages and quality of life. This stage lasted from 1780’s until approximately the 1820s. Following that, once the labor pool had a chance to adjust to new means of production, wages grew rapidly while the cost of living decreased, leading to significant improvements in quality of life.3

France, at the same time, was undergoing the more traditional form of Revolution where the main innovation was the guillotine. Due to lack of established institutions it was unable (or unwilling) to create the same conditions for modernization. Incidents of machine destruction occurred much more frequently and with greater intensity.4 Due to lack of protection, enterpreneurs were less willing to risk capital on the new machines. The difference in approach led to urbanization and increased economic growth in England, with GDP and real wage growth accelerating throughout the 19^th century while France lagged in development.

The wage stagnation that accompanied the early stages of the industrial revolution came from conditions similar to those imagined by the Citrini Research paper: a replacement of existing form of production with a more efficient kind. Vast number of previously employed were being displaced by the innovation and forced to accept either lower wages or join the masses looking for jobs.

However, it’s the conditions that led to the acceleration in productivity in the second stage of the industrial revolution that give reason for optimism. A paper by two Harvard economists5 examines the evolution of manufacturing from artisanal shops to factories and later assembly lines. The period described in the Harvard paper (1910-1930) was one of rapid innovation that led to the mass availability of automobiles, airplanes, aluminium, appliances, and other things that start with the letter A.

The economists point out that while in the early stages demand for labor went down, factories, to get the most out of the capital spent on setting them up, needed highly skilled machine crews and craftsmen to maintain the machines. These new occupations, due to significantly higher production output, paid laborers more than they could have earned just a few decades earlier.

In exchange for higher earnings, employers expected employees to have skills that weren’t necessarily in demand earlier. Factory workers were expected to read manuals, understand chemistry and electricity, and use algebra to complete tasks. Schools adapted to these demands, and as a result, society as a whole benefited. All this came about thanks to capital investment and a highly trained workforce that was earning a return on the extra time spent in school.

I think the potential impact of the AI revolution is similar – technology is aiming to replace human cognition, which will affect the white-collar workplace and the jobs that are easiest to replicate. But as a result, service products that in prior years were only available to a select few will become much cheaper to produce. With lower costs, demand will skyrocket, and the systems producing these products will require skilled workers trained to get the most out of these machines.

Examples of France and England in the 19^th century show that stopping technological innovation is impossible. If one is unwilling or unable to adopt the new technology because of fear of disruption, the disruption will happen anyway, but someone else will benefit, and the party trying to hold on to the status quo will find itself in a long-term structural disadvantage.

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Takeaways:

- Industrial Revolution initially led to wage stagnation and job losses, but eventually created a higher-skilled labor class, benefiting from higher earnings and lower cost of goods

- Attempts to hold back innovation through regulation or outright hostility will likely lead to structural competitive disadvantage

Disclaimer6

1

Citrini Research

THE 2028 GLOBAL INTELLIGENCE CRISIS

Preface…

Read more

6 months ago · 8016 likes · 91 comments · Citrini and Alap Shah

For someone growing up outside of the USA, there were few things more American than Harley-Davidson. This company was synonymous with motorcycle culture and the spirit of adventure. Harleys, graffiti, and overstuffed supermarket shelves were pretty much how I imagined the U.S. before moving there in the early 90s. That is why when the company started popping up on the screen as one of the more attractive opportunities in the market in 2015, I didn’t hesitate to learn more.

It was the perfect setup… an iconic brand, a passionate customer base, a consumer discretionary business entering an economic upswing, messy financials due to a combination of a manufacturing and financing business, and a management team determined to take advantage of the shares trading at high free cash flow yields. It even got Warren Buffett’s stamp of approval through Berkshire’s bond investment in 2009.

What could go wrong?! It turns out – a few things.

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Harley-Davidson was founded in 1903 in Milwaukee, Wisconsin, and over the years became the dominant player in the cruiser segment, with its Fat Boy, Softail, and Sportster models usually accounting for around half of all large motorcycle sales in North America. Sales of new large motorcycles peaked just before the 2008 financial crisis, fuelled by disposable funds from home equity lending. Following the crisis, new motorcycle sales fell by almost half but slowly recovered throughout most of the 2010s. Harley’s sales followed a similar trajectory. Its market share fluctuated a bit but largely stayed within the historical 45-55% range, consistent with sales over the last couple of decades.

The market consensus at the time was that motorcycle ridership, especially the Harley type, was declining because younger people were less interested in risking their lives while wearing leather jackets. The actual data was suggesting otherwise. The number of motorcycle registrations, including the larger 601cc+ models, was going up.

Moreover, between 2007 and 2015, the average age of motorcycles on the road has risen from around 8 to over 11, suggesting that, sooner rather than later, riders will need to replace their aging cruisers if they want to keep riding into the sunset.

In addition to the registration data that was contrary to public opinion, Harley-Davidson had another feature that I found extremely attractive – Harley-Davidson Financial Corporation (HDFC), its wholly owned subsidiary, which provided financing for motorcycle purchases.

Unlike captive financing companies owned by car manufacturers, HDFC was not a marketing tool, but a highly profitable specialty finance company. Since very few banks were comfortable lending for motorcycle purchases, HDFC was often the only financing option available to customers looking to spread the cost of their new Harley. As a result, the company had high net interest margins, low costs, and generated double-digit return on equity (ROE), which would be the envy of most financial institutions.

Moreover, while it was conservatively financed with debt/equity of around 6-7x, compared to most banks’ ratio of 10x, the debt, which was included in Harley’s consolidated financials, was distorting the company’s overall leverage profile. Harley screened like a highly levered business with 5x debt/EBITDA, while all the debt was on HDFC, and the motorcycle business was in net cash and generating plenty of free cash flow.

In 2015, and a couple of years before that, the motorcycle and financing business combined were generating approximately $800 million of free cash flow per year. Harley was channelling most of this cash into dividends and buybacks, delivering an attractive yield to investors.

Based on the above, I felt that it was just a matter of time before new motorcycle sales rebounded to historical levels relative to total motorcycle usage, which would cause Harley’s profits and share price to rise dramatically. Ten years later – they still haven’t.

One important nuance that I missed was a technological shift that was causing an increase in average useful life of a motorcycle. The new engine types introduced in the late 1990s with electronic fuel injection eliminated several problems that were reducing the average useful life of the engine. Combined with material advancements (aluminium cylinders, forged steel components, etc.), the changes increased the expected life of an engine from 40 to 50 thousand miles to 50 to 100 thousand miles. For a rider putting only 3–4 thousand miles a year on a motorcycle, that changed the replacement cycle dramatically.

As a result, the average age of the motorcycles on the road continued to increase. By 2023, more than 60% of all registered motorcycles were more than 10 years old – up from less than 40% in 2012 and average age climbed to over 14 years old. The ratio of new motorcycle sales to total registrations fell from 10% in 2007 to around 5% in 2015, and to just over 4% in 2023. New motorcycle sales continued to fall and by 2024 were nearly 25% lower than in 2015 – the year I made the investments.

Throughout all of this, Harley performed surprisingly well. It cut costs, optimized its dealer relationships, and overall did what it had to do to perform even in a declining demand environment. Despite falling sales, free cash flow remained in the $600 to $900m range, and per-share figures, thanks to the buybacks, which reduced shares outstanding by about 1/3 over that time, were higher in 2024 than in 2015.

The share price also remained roughly the same, which could be considered a win given the headwinds that the company faced, but not compared to the overall market, which more than tripled over the same period. After years of waiting, I finally pulled the plug in early 2024, concluding that problems with the end market are unlikely to go away anytime soon.

The takeaway from the experience is that the success of the investment quite often is determined not by the factors that you have already considered, but by the ones that weren’t obvious from the start. Also, independent of how good and cheap the company is, it is very difficult for investors to make money in an environment where the demand for the core product is declining.

Takeaways:

- Consider all reasons for why the demand for the product may be changing, not just the most obvious ones

- Quality and Value are not enough to lead to a successful investment – growth is a must as well

- Ten years is a long time to wait for operating performance to improve

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Disclaimer1

Travelers Co (TRV) is a traditional regulated insurer. It stands out in the market by selling commercial and personal property/casualty insurance through a network of independent agents and brokers. While this approach may seem outdated to consumers accustomed to online comparison sites, as of 2023, it remained the dominant distribution channel for most insurance lines.

Commercial, workers’ compensation, and other lines are an area of strength for Travelers, which is 80%+ reliant on independent agents who sell insurance to small and middle-market businesses. These agents work with the businesses to understand each company’s unique situation and tailor the insurance offering to its needs.

In 2024, Travelers’ segment breakdown looks similar to that in 2013, with more than half of premiums coming from commercial insurance lines. Curiously, one area of outstanding growth has been personal auto insurance, where the company continues to compete effectively despite strong competition from DTC operators such as GEICO and Progressive.

Over the last decade, Traveler’s gross written premiums (GWP) grew by roughly 5% per year, in line with the growth of the overall P&C market. Underlying profitability also remained roughly the same, with the combined ratio, a key measure of insurance company profitability, fluctuating between 90% and 100% for most years.

The company’s solid yet admittedly unremarkable performance raises the question of whether it is a good investment and why. The answer, as usual, is in capital allocation. For the companies I am considering I try to understand what the drivers of returns have been and split them into fundamental (revenue growth and margin changes), capital allocation (dividends and buybacks) and market specific (multiple expansion). The reason for this exercise is that I believe returns are more sustainable when they come from fundamental or capital allocation factors while market multiple expansion at some point, in theory, will meet its mathematical constraints.

Over eleven years, Travelers generated $66 billion in operating cash flow, which is roughly equivalent to the company’s current market cap. Roughly half the amount contributed to the investment portfolio, which supports insurance operations and now stands at about $100 billion. At the same time, the other half was returned to shareholders as dividends and buybacks. Since 2012, the average dividend yield has been around 2% and repurchases reduced shares outstanding by over 30%.

Thanks to the smart capital allocation decisions, Travelers turned what would have been a solid 8% p.a. growth in intrinsic value into a 14% annualized increase. Curiously, in the market constantly in search of compounding machines, Travelers, despite its size and solid execution, has been largely overlooked, with a total shareholder return of 12% p.a., which lagged the intrinsic value creation.

The second insurance company, a holding since 2012, is Assurant Inc (AIZ). Assurant, a significantly smaller company with a market cap of around $11 billion compared to Travelers’ $65 billion, has a unique business model. It specializes in two niche insurance types – extended service contracts for consumer electronics and lender-placed home insurance. Despite their apparent differences, both businesses share a common trait: the separation between the decision-maker and the payer, a factor contributing to Assurant’s healthy profitability.

For extended service contracts, rates are negotiated with mobile service providers and paid by customers who choose to add this feature to their mobile plans. Mobile operators are encouraged to upsell this service through commissions and profit share arrangements.

Lenders force lender-placed home insurance on homeowners who need to obtain adequate coverage on their own. Lenders care only about the quality of the insurance provider, not about the cost of the insurance passed on to homeowners. Selling a product to a buyer who cares more about quality than price generally results in healthy profitability for the provider. Assurant’s lender-placed home insurance is no exception, with the margins from this business usually hovering around 10% — a very healthy level for an insurance company.

While Travelers Co. looks largely the same as it did ten years ago, the same cannot be said for Assurant Inc. (AIZ). Ten years ago, extended service contracts and lender-placed home insurance accounted for roughly 60% of premiums, with the remainder made up of health insurance, employee benefits, and pre-need funeral expense coverage. These other lines were sold off in a series of transactions for a total of around $2.3 billion. In exchange, Assurant purchased The Warranty Group for $2.5 billion in cash and shares. The acquired company had a significant presence in extended service contracts and automotive extended services coverage.

These transactions, which took place between 2016 and 2021, reshaped Assurant Inc. While revenues from premiums remain roughly the same, the company is now more concentrated in segments where it has clear competitive advantages and a healthier level of profitability. The combined expense ratio has improved, dropping from roughly 100% of premiums to around 95%, indicating a more efficient operation.

Regarding the shareholder return drivers which I’ve illustrated in the chart below, margin expansion and shareholder returns have been the primary source of value creation over the last decade. Growth in premiums is relatively pedestrian at 2%, but the M&A transactions obscure it. The core segments of extended warranty and global housing have grown steadily, averaging 4% per year since the acquisition of The Warranty Group. Capital allocation is once again value-accretive, with an average dividend yield of 2% and annualized share buybacks of around 3% since 2012.

Unlike with Travelers, shareholders of Assurant benefited from multiple expansion. Given improvements in the underlying business quality it is arguably warranted in this case. Even with multiple expansions, the AIZ is not particularly expensive,

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trading at a P/E of 11 and almost 10% FCF Yield.

The examples of Assurant and Travelers show that while good managements and companies may take different paths towards long-term value creation, truly exceptional results are unlikely without superior capital allocation, which can take the form of accretive M&A or appropriately sized buybacks conducted when the market offers the ability to buy high-quality businesses at high free cash flow yields.1

Takeaways:

- Very few companies look the same as they did a decade ago and it is reasonable to assume that they will look different ten years from now

- Companies that clearly understand their value proposition to clients benefit from focusing on it

- Good capital allocation is often the difference between good and great returns in the stock market

As I mentioned in an earlier post, one of the starting points for new idea generation is a screen that uses historical data on revenue, profit margins, and market multiples. This screen estimates what returns would be if future conditions were the same as in the past. The problem with taking these projections at face value is that the last ten years are rarely a good predictor of what the next ten years will look like.

To illustrate this point, the screen currently shows that some of the more attractive opportunities in the market are Xerox, Medifast, and GoGo Internet. The first question I ask when looking at a company is whether it will still be around in roughly the same form ten years from now. I think these three fail this test. For Xerox, the problem is a large amount of debt, combined with a steady decline in equipment and service sales, driven by declining use of office paper. For Medifast, it’s the GLP-1 drugs that make it easier to lose weight than company’s combination of supplements and coaching. For GoGo Internet, its the Starlink alternative, which can provide much faster internet to private jet customers. One of these companies may be able to overcome the difficulties and become a huge winner, but betting on that outcome feels like going to the casino and is probably less fun.

So why use the screen at all?

The answer is that, while past performance is not a good predictor of future performance, the screen does a reasonable job of identifying attractive companies in cyclical industries or those undergoing temporary difficulties. Each company popping up on the screen is an opportunity to dig deeper into the factors that led to the decline in value in the first place. Usually, the takeaway is that I either agree with market concerns or am completely outside of my depth in trying to figure them out. However, the analysis occasionally uncovers a situation that is not as dire as it seems, which could lead to a profitable investment opportunity.

Two types of companies that routinely show up at the top of the screen are retailers and restaurants. While the goods or services they offer may differ, the common feature is that they compete for the marginal dollar that a family has left over after paying for life’s necessities. The average family spends over $ 78,000 per year, but almost 80% of that goes to housing, transportation, healthcare, and other expenses.[1] Annually, roughly $ 11,000 per family is spend on things like apparel, restaurants, or entertainment.

Customers have a choice of whether to purchase a specific type of product and have plenty of options to choose from. Combined with competition from online alternatives, it is little wonder that investors can get nervous about the sustainability of these companies’ earnings. However, unlike the examples of GoGo Internet or Xerox, many of these restaurants and retailers are likely to be around ten years from now. There is competition from online options, but no one expects physical stores to disappear completely.

Since 2012, I have invested in retailers/restaurants on nineteen different occasions. The results are…mixed. Successes included Chipotle and Staples, which proved to be multi-year winners. Abercrombie & Fitch and Coach Inc. (now Tapestry) were losers during the holding period, but eventually became strong performers. Aeropostale and Bed Bath & Beyond were losers during the holding period and eventually went bankrupt. Sleep Number and Gamestop, which were held on two separate occasions, were both successes and failures. Hopefully, this summary is enough to keep you out of investing in consumer discretionary companies altogether.

But just in case it’s not…here are some takeaways from the experience:

Cheap is not a reason to buy a stock

Some of the companies that were purchased were trading at 20% or even 30% free cash flow yield. This ultimately did not serve as a predictor of eventual outcome.

Do not buy companies that are spending more than they earn on buybacks

For these companies, share buybacks are one potential use of capital. When the shares are trading at a high free cash flow yield, this option becomes especially tempting since they are a) deploying capital efficiently and b) signaling to the market that they are confident in the value of their business. I fully agree with this logic, and some of the companies are so good at buybacks that they have reduced their shares by more than half, benefiting the remaining shareholders.

One example from the retail world is Deckers, which between 2014 and 2020 invested in direct-to-consumer/omnichannel distribution for its key brands, UGG and Hoka. Over the six-year span, the company generated about $1.7 billion in cash flow from operations, spent roughly $400 million on its stores, and about $700 million on share buybacks, taking advantage of the fact that shares were trading at a free cash flow yield of 5-10%. Thanks to these purchases, shares outstanding fell by 17%, benefiting the remaining shareholders as investments in brands began to pay off. If you bought shares of Deckers in 2014 and held on to them until today, you made roughly 7x your money.

The problem comes when companies start buying back shares with money that they did not make – either using cash on the balance sheet or, even worse, borrowing. For a cyclical discretionary business, this is a bad idea because it reduces the company’s ability to survive a downturn, which is inevitable. Bed Bath & Beyond spent almost $1 billion on buybacks in 2021 and 2022, yet earned only $300 million. They went bankrupt in 2023. Sleep Number, which had disciplined itself to use only free cash flow for buybacks until 2017, spent over $1 billion on share repurchases between 2018 and 2023, causing debt to rise from $0 to $600 million. The resulting burden is proving to be a real problem for the company, which is dealing with a prolonged downturn in demand that could lead to bankruptcy.

Buy shares of companies when gross margins are rising, not falling.

Declining gross margins indicate the brand does not believe in itself and is discounting to move inventory. While this is happening, consumers are being conditioned to expect lower prices, creating a vicious cycle that requires further discounts. In such a cycle, it is highly unlikely that company shares will perform well. However, if a long-standing retailer is starting to show slow improvement in margins, this is an indication that brand health is recovering, which could lead to outsized gains. Good historical examples are Abercrombie & Fitch and Tapestry, which were not good investments until 2023 or so, when gross margins indicated a recovery in brand health.

Management is important

In consumer discretionary, more than in other sectors, management quality seems to be especially important. Warren Buffett is famous for saying that he prefers to invest in companies that even an idiot could run because sooner or later, one will.

Shareholders of Guess Inc. benefited from the return of Carlos Alberini, who was the company’s COO in the mid-2000s before leaving to run Restoration Hardware and Lucky Jeans. He was brought back in 2019 with a mandate and an incentive structure to improve the company’s operational performance, and he delivered nearly a 3x improvement. Similarly, Biran Niccol at Chipotle came in when the company was struggling with food safety scandals and successfully implemented an omnichannel strategy that delivered strong results for the company and its shareholders. He is now trying to do the same thing at Starbucks.

On the flip side, there is Nike Inc., which was led between 2020 and 2024 by John Donahoe, who took the company out of large sports stores while prioritizing its own physical and online stores. The company’s results suffered as other brands, like Hoka and OnCloud, took advantage of the space vacated by Nike, which held a 50% share of the athletic shoe market.

Reviewing the nineteen investments made in consumer discretionary goods mostly provides clues of situations to avoid, which is a good start. Cheapness is the symptom that indicates problems, not an investment thesis. Success often depends on factors outside the company’s control, such as fashion trends or the state of the economy. To some extent, for consumer discretionary companies, success comes from execution combined with being in the right place at the right time. This is extremely difficult to predict, but highly lucrative if you happen to get it right.

Takeaways:

· Consumer discretionary is a highly volatile segment that depends on marginal spending decisions in a highly competitive environment.

· Prudent use of capital is essential for a company to succeed in the long term.

· Management quality is more important than in other sectors due to intense competition.

The information contained in this post is provided solely for informational and educational purposes and should not be construed as investment advice, a recommendation, or an offer to buy or sell any security. Nothing herein should be interpreted as an offer to sell or a solicitation of an offer to purchase any interest in any fund, vehicle, or strategy. Any such offering may only be made pursuant to formal offering documents and only to persons who are “accredited investors” as defined under Regulation D, Rule 501 of the Securities Act of 1933, in connection with a private offering conducted under Rule 506(b), and who also meet the requirements of Section 3(c)(1) of the Investment Company Act of 1940 or any other applicable exemption.

The views expressed represent the author’s opinions as of the date of publication and are subject to change without notice. The author has no obligation to update, amend, or supplement the information contained herein. Certain statements may constitute forward‑looking statements, which are inherently uncertain and involve risks, assumptions, and factors that could cause actual outcomes to differ materially.

Any references to past performance, investment examples, or specific securities are for illustrative purposes only and do not indicate or guarantee future results. The discussion of any strategy, concept, or thesis is not a recommendation or endorsement and should not be relied upon when making investment decisions. All investments involve risk, including the potential loss of principal.

Readers should conduct their own independent analysis and consult with their own financial, legal, tax, or other professional advisors before making any investment decision.

[1] BLS 2024 Consumer Expenditure Survey

When I was building the initial portfolio, I thought that the strategy needed to have thirty more or less equally weighted positions to a) match my investment style and b) generate the strongest possible results. The theory behind thirty stocks comes from the 1987 work by Meir Statman[1] (What a last name for a statistician!) that shows that it takes this many holdings to have a well-diversified portfolio. But other studies[2] suggest that even a 10-stock portfolio is enough to eliminate most systemic risk, so why didn’t I try that?

As a generalist investor, I believe that I have certain advantages and disadvantages vis-à-vis other market participants. The disadvantage is that often the decisions I am making are based on inferior information relative to specialists trading the same stock. Pod shops, which are estimated to control over 30% of actively managed capital in the market, and probably a higher proportion of trading[3], hire sector specialists tasked with delivering returns of 1 to 2% per annum. To do well, they must know EVERYTHING about the companies they cover. These specialists live and breathe their industry, track real-time data, and are judged on small quarterly edges. With billions of dollars under management, they have almost unlimited resources to devote to paying for alternative data and expert calls.

The capital deployed by pod shops is often levered 10 times or more, which can deliver double-digit returns on investor capital but leaves minimal margin for error. The same people who will make millions of dollars if they succeed at generating the expected returns will get fired if they are down just 2% during the year. This job is not for the faint of heart. Even if I wanted to try to compete with professionals good enough at this job to be hired by one of the larger firms pursuing this strategy, I simply could not.

Fortunately, for fundamental investors like me, the question of whether a company has a long-term competitive advantage or is allocating capital smartly is nowhere on the pod shop agenda. This is where generalists like me can excel, leveraging pattern recognition and an outsider’s perspective to evaluate a company’s long-term strategic approach. This is assessed by determining whether a company is taking the proper steps to deliver better results, not in the next quarter, but in the next three years.

David Epstein, in the book “Range,” discusses the benefits of a generalist approach and gives several examples, including a comparison of Tiger Woods and Roger Federer, both of whom excelled in their fields but took different paths to get there. Golf is mostly about repeatable patterns where repetition, preferably from an early age, is key to success. If Tiger Woods had picked up a golf club when he was 12 rather than 2, he would still likely be an exceptional golfer, but would not be the dominant figure he was during his heyday. Tennis is more “wicked” – you must consider the opponent’s style of play, different surfaces, weather conditions, etc. Roger Federer grew up playing football, badminton, chess, skiing, and didn’t focus exclusively on tennis until the age of twelve. He credits his early experience in other sports for his superior vision, point planning, and creative use of his hands and wrists for finesse shots.[4]

To be good at predicting the next quarter, you must be like Tiger, with expertise built through repetition and in-depth analysis of one or two industries. To be good at figuring out what business will look like three to five years down the road, you must be like Roger.

One relevant example from the early days that comes to mind is an investment in Verisign (VRSN) made in the middle of 2014. Verisign is the company tasked by ICANN, the agency coordinating the internet’s naming system, with an essential duty of making sure that any .com, .net, or .gov address typed into your browser will take you to the web page you expect. At the time of the investment, there was some uncertainty about the renewal of Verisign’s license, which was due in 2016 and essential to Verisign’s core business.

It was believed that, technically speaking, ICANN could revoke Verisign’s license and grant it to another company, but realistically, the person who would make that decision would risk being personally responsible if the new licensee messed up and hundreds of millions of websites became inaccessible. Verisign, while it may not have been the cheapest option, was definitely the safest.

The investment was made not because there was intimate knowledge of how the renewal process works or who the other companies bidding for this lucrative monopoly were, but because there was a strong view of the decision-makers’ incentives, and they believed that Verisign was investing what it had to maximize its chances of getting the renewed contract. Between the initial investment and the ultimate renewal of the agreement, Verisign shares did well but still suffered multiple 20% drops when the likelihood of renewal was ever in question.

Over the subsequent years, I’ve been involved in many situations in which investment frameworks that focused more on the incentives of the parties involved than on industry fundamentals led to investments in particular companies. In some cases, such as Verisign, it led to success. In others, it led to failures.

Having 30 investments affords one the ability to be more experimental and take bets on situations that could lead to significant losses, but have the potential for outsized returns.

Takeaways

· Academic data suggests that a stock portfolio should have at least thirty holdings to be diversified, but ten stocks will give you most of the benefits of diversification

· Having a highly concentrated portfolio requires specialist knowledge and the ability to withstand the volatility that comes with it

· Generalists benefit from mental models developed through cross-industry pattern recognition and experiences

· Concentration is a function of edge and temperament. If your edge is long-term judgment (not near-term precision), you can’t size like a specialist — and you shouldn’t try.

The information contained in this post is provided solely for informational and educational purposes and should not be construed as investment advice, a recommendation, or an offer to buy or sell any security. Nothing herein should be interpreted as an offer to sell or a solicitation of an offer to purchase any interest in any fund, vehicle, or strategy. Any such offering may only be made pursuant to formal offering documents and only to persons who are “accredited investors” as defined under Regulation D, Rule 501 of the Securities Act of 1933, in connection with a private offering conducted under Rule 506(b), and who also meet the requirements of Section 3(c)(1) of the Investment Company Act of 1940 or any other applicable exemption.

The views expressed represent the author’s opinions as of the date of publication and are subject to change without notice. The author has no obligation to update, amend, or supplement the information contained herein. Certain statements may constitute forward‑looking statements, which are inherently uncertain and involve risks, assumptions, and factors that could cause actual outcomes to differ materially.

Any references to past performance, investment examples, or specific securities are for illustrative purposes only and do not indicate or guarantee future results. The discussion of any strategy, concept, or thesis is not a recommendation or endorsement and should not be relied upon when making investment decisions. All investments involve risk, including the potential loss of principal.

Readers should conduct their own independent analysis and consult with their own financial, legal, tax, or other professional advisors before making any investment decision.

[1] Statman M, “How Many Stocks Make a Diversified Portfolio”, The Journal of Financial and Quantitative Analysis, Vol. 22, No. 3 (Sep. 1987), pp. 353-363

[2] Evans, J. L., and S. H. Archer. “Diversification and the Reduction of Dispersion: An Empirical Analysis.” Journal of Finance, 23 (Dec. 1968), 761-767’

[3] https://www.trustnet.com/News/13451872/the-rise-of-pod-shop-trading-why-hedge-funds-like-citadel-and-millennium-are-redefining-wall-streets-approach-to-valuation/fund/sectors

[4] https://archive.nytimes.com/straightsets.blogs.nytimes.com/2009/05/29/not-just-tennis/

This is why, when I had a chance to build a portfolio from scratch, I felt that free cash flow yield was the most vital metric to consider. Using this premise as a guiding principle, I spent the summer of 2012 reviewing large US-listed companies to identify 30 that would become the inaugural holdings for the new strategy.

The initial portfolio below raises a few questions, the most important being “What was I thinking?!”

With the benefit of 13 years of hindsight, some of the companies that looked attractive at the time have proven to be in terminal decline, with 2011 free cash flows representing a high point on the way to bankruptcy and/or acquisition.

These companies seem to be a good illustration of why fund management experience matters. As an analyst, I developed scenarios and justifications for how Frontier Telecom could convert its status to an essential utility, generating enough cash to not only pay down debt but also increase dividends to shareholders. However, as a Portfolio Manager responsible not just for my own money but also for the funds of the family and friends that entrusted me with a portion of their savings, I truly felt the pain of being wrong.

On the other hand, I can also ask “What was Mr. Market thinking?!” allowing me to buy companies like Microsoft and Anthem (now Elevance) at double-digit free cash flow yields? The most egregious example of a mispriced company was Progressive, which was trading at an attractive price because of the concerns about increasing competition, slowing growth rates, earnings, and whether its business model would survive self-driving technology. Twelve years later, Progressive is generating more free cash flow in a year than its market cap was 12 years ago.

I guess we can call this one even.

The two investments mentioned above, Frontier Telecom and Progressive, shared one key uncertainty: whether technological changes threaten their business models and undermine their competitive advantage. What happened in the next few years helped me understand that the only thing that could be more important to the company’s long-term success than current cash flow generation is how it chooses to use this cash.

Competitors’ mobile phone and cable internet service were both superior alternatives to Frontier’s fixed-line phone service, which was responsible for the majority of Frontier’s revenues and profits. Despite technological inferiority, Frontier still had a significant advantage – its customer base. The company should have been investing in new technologies, such as fiber-optic cables, that could utilize the existing infrastructure and customer relationships, but it couldn’t do that at a fast enough pace because of the high debt burden stemming from outsized acquisitions and insistence on maintaining the dividend payment to shareholders until it was too late.

Consistent with the original thesis, Frontier did manage to maintain its operating cash flow at around 2011 levels but was still forced to declare bankruptcy in 2020 when refinancing markets seized up during COVID. A year later, Frontier emerged from bankruptcy with less debt and capital to invest in the fiber-optic rollout. The new structure didn’t generate free cash flow due to heavy investment needs but did illicit a bid from Verizon for essentially the same footprint it sold to Frontier a decade and a half earlier.

Talk about a circle of life!

Progressive, and the whole auto insurance industry, was trading at a low multiple of earnings that reflected similar uncertainties regarding the sustainability of its earnings, with one key difference that led to a very different outcome – a net cash balance sheet, which allowed the company to both continue investing in core business and take advantage of the depressed stock price to buy back shares. Progressive invested in digital advertising and data models that enabled more effective customer segmentation, helping them gain market share. It didn’t just survive the technological disruption – it profited from it. While I no longer hold it, Progressive shares are up more than 12x since the beginning of 2012.

The two examples above illustrate the point: ability and willingness to reinvest matter. A business that generates high enough returns to make it an attractive investment will undoubtedly attract competition seeking to displace it. The factors that led to incumbency will protect it for a time, but if the business does not invest in protecting or enhancing its competitive advantage, it is highly likely to become obsolete. However, if the leadership makes smart decisions, then the competitive advantage with relatively little investment compared to what the challengers have to spend can be extended and deliver extraordinary returns to investors.

Takeaways

· Unsurprisingly, some of the companies that looked cheap in 2012, over time proved expensive, others proved ridiculously cheap

· One of the factors leading to differentiated outcomes is the ability and willingness to reinvest in the extension of the competitive advantages

The information contained in this post is provided solely for informational and educational purposes and should not be construed as investment advice, a recommendation, or an offer to buy or sell any security. Nothing herein should be interpreted as an offer to sell or a solicitation of an offer to purchase any interest in any fund, vehicle, or strategy. Any such offering may only be made pursuant to formal offering documents and only to persons who are “accredited investors” as defined under Regulation D, Rule 501 of the Securities Act of 1933, in connection with a private offering conducted under Rule 506(b), and who also meet the requirements of Section 3(c)(1) of the Investment Company Act of 1940 or any other applicable exemption.

The views expressed represent the author’s opinions as of the date of publication and are subject to change without notice. The author has no obligation to update, amend, or supplement the information contained herein. Certain statements may constitute forward‑looking statements, which are inherently uncertain and involve risks, assumptions, and factors that could cause actual outcomes to differ materially.

Any references to past performance, investment examples, or specific securities are for illustrative purposes only and do not indicate or guarantee future results. The discussion of any strategy, concept, or thesis is not a recommendation or endorsement and should not be relied upon when making investment decisions. All investments involve risk, including the potential loss of principal.

Readers should conduct their own independent analysis and consult with their own financial, legal, tax, or other professional advisors before making any investment decision.

I am forever grateful to my parents, who took the risk to get me out of Belarus and to the United States. As a person who has seen the alternative, I firmly believe that the USA is and forever will be the best country in the world. The fact that the kid who barely spoke English at the age of twelve managed to attend one of the best universities in the world just five years later is as much a credit to the country’s social mobility as it is to the effort it took.

While at university, I got it into my head that I would end up in investment management at some point. This is the profession for which the theories crudely described in my Russian-language economics book made the most sense. Since I wasn’t at a school with direct links to many investment firms, it took a few years and another degree, but eventually I gained enough experience and knowledge to be helpful to companies like Firebird.

I’ve been with Firebird for over twenty years, but getting here was almost accidental. While at business school, one morning I was reading the Wall Street Journal and saw an article about Russia and a New York Investment Manager that invests in Eastern Europe. The fact that the article was titled “Investors in Russia Fear Gathering Storm” and the quote from Ian Hague, one of Firebird’s founders, referred to cow pies should have been a warning sign, but instead my takeaway was…this is the place where I must spend the rest of my professional life!

Firebird started with a deep focus on Eastern Europe, especially Russia and the former Soviet Union. As the region evolved, our opportunity set expanded with it, and the mandate gradually widened to include other Eastern European countries and a handful of nearby markets where we felt we could do the work properly.

It’s natural to ask why we didn’t keep going—why not add Latin America, Asia, Africa. The honest answer is that we understood the cost of doing it right. It took years to build the local knowledge, relationships, and judgment we relied on in Eastern Europe, and we weren’t interested in becoming “good enough” somewhere else at the expense of being excellent where we already had an edge.

That said, after a few years of internalizing Firebird’s methodology, I realized something important. The bottom-up part of our process — understanding how companies make money (competitive advantages) and how they spend it (capital allocation) — could be applied just as effectively in developed markets. There, the markets function in relative macro stability, and companies are protected by an established rule of law that renders them much less dependent on generational relationships that may be well known to locals but are a mystery to newcomers.

In summer 2012, with my wife and two kids (including a 1-year-old) away, my evenings were uncharacteristically free. To use the time wisely, I set a goal to review every company in the S&P 500 by the end of the summer, using an investment framework that leverages my experience in Eastern Europe. Emerging markets tend to have much quicker economic cycles, which are amplified by capital flows from abroad. As a result, specific metrics tend to be adjusted, such as revenue growth rates and profit margins, to see how the company looks in a more normal environment. I’ve applied similar methods to US companies to know whether I can build a portfolio of 30 stocks I would feel comfortable investing my personal funds in.

To my surprise, many companies were trading at valuations suggesting they could deliver double-digit returns over the long term. They included technology companies like Microsoft and Intel that were starting to use their massive cash hoards for share buybacks; well-known consumer brands; and service companies, some of which were household names. They also included names that looked attractive on a free cash flow basis but, over the years, proved to be in terminal decline. Overall, it looked like something that could work and was better than my existing approach to personal investing in the U.S. market.

When I embarked on the project, I didn’t think it was an especially opportune time to invest in U.S. equities. Still, the quality of the resulting portfolio and the fact that the expected returns I had derived were well in excess of the historical 7-8% average return of U.S. equities gave me confidence to approach my colleagues about starting a U.S. strategy.

In hindsight, the timing of the exercise could hardly have been better, given that U.S. markets were still recovering from the 2008 Global Financial Crisis. The market commentary was more concerned about the risk of a double-dip recession than about missing out on what turned out to be one of the greatest bull markets of the last century.

It’s possible that if I had been going through the same thought process over the last couple of years, with U.S. markets trading at very different valuations, the conclusion would have been entirely different. Still, as Daniel Kahneman says, success is where skill meets luck, so I’ll take it.

Takeaways:

· Successful investments in Emerging Markets depend on a favorable macroeconomic and political backdrop and an in-depth understanding of the incentives of the people involved, not just individual company economics. Developed markets like the U.S. are “easier” because the macro environment and the rule of law are usually much more stable.

· 2012 was a particularly good year to start investing in U.S. equities, with expected returns based on extrapolation of historical trends well above historical averages.

The information contained in this post is provided solely for informational and educational purposes and should not be construed as investment advice, a recommendation, or an offer to buy or sell any security. Nothing herein should be interpreted as an offer to sell or a solicitation of an offer to purchase any interest in any fund, vehicle, or strategy. Any such offering may only be made pursuant to formal offering documents and only to persons who are “accredited investors” as defined under Regulation D, Rule 501 of the Securities Act of 1933, in connection with a private offering conducted under Rule 506(b), and who also meet the requirements of Section 3(c)(1) of the Investment Company Act of 1940 or any other applicable exemption.

The views expressed represent the author’s opinions as of the date of publication and are subject to change without notice. The author has no obligation to update, amend, or supplement the information contained herein. Certain statements may constitute forward‑looking statements, which are inherently uncertain and involve risks, assumptions, and factors that could cause actual outcomes to differ materially.

Any references to past performance, investment examples, or specific securities are for illustrative purposes only and do not indicate or guarantee future results. The discussion of any strategy, concept, or thesis is not a recommendation or endorsement and should not be relied upon when making investment decisions. All investments involve risk, including the potential loss of principal.

Readers should conduct their own independent analysis and consult with their own financial, legal, tax, or other professional advisors before making any investment decision.