Where to play?

“How do you beat Bobby Fischer? Play him at any game but chess” – Warren Buffett

We all know that in investing, we should play where we have an edge. But which strategies have an edge? I think there are two major factors:

• Level of competitiveness / scarcity of capital – are you competing on an even playing field with many other smart investors or playing in a less competitive niche?

• Degree of control – do you have control over the company or investment outcome, or are you a passive player?

Duration of capital is also an important overlay, but I haven’t included it in this visual. Longer duration capital and ability to withstand volatility are positives.

Level of competitiveness

Everyone understands that of course you’d rather play where capital is scarce and you’re not competing against a lot of other really smart people – yet somehow, everyone in my peer group ends up gravitating towards early-stage venture, megafund buyout, or TMT public equities…

This is because the sexiness of an asset class and capital scarcity are orthogonal, and everyone wants to do what’s sexy. So, while the base rates are almost certainly better if you spend your time on microcap vertical SaaS in Australia, everyone wants to work at Blackstone or have the glory of finding the next Snowflake.

Nothing wrong with that, but there is a real superpower in being able to focus for a long time on something “boring”. Constellation Software, Transdigm, and Tyler Technologies are all examples of this.

Degree of control

Capital allocation

There are two software microcaps I’ve been studying recently. Both are growing nicely and trade around 5-6x EBIT and 3-4x forward EBIT. Insane!

But, the stocks have gone nowhere for years. The reason is that both these companies just pile up cash on the balance sheet and do nothing with it. The overcapitalization is so egregious that I estimate that if one of the companies just put all their cash into T-bills at 5%, they could increase earnings by 10%!

Unless this changes, these companies are not investable. With the right capital allocation, both are worth much more. The only solution is somebody needs to go activist or buy them out. Control over capital allocation would create massive value.

Outside of microcap land, even well-managed companies can degrade returns with poor capital allocation. Meta in 2021/2022, Apple before Icahn got involved, and the entire O&G sector for the past decade are all examples.

If you’re purely a massive minority equity investor, you have to find great companies, with great managements, who also have a capital allocation plan in place that makes sense. That’s not an easy combo to find, and the companies that do trade at premium prices. Having control lets you only worry about the first two, which is easier to find.

Operational benchmarking

On a recent BCG engagement, we were working with the mortgage division of a large bank to reduce costs. Since the mortgage market collapsed in ’22 due to rate increases, this division was running at a -50% operating margin, and internal projections were for losses through 2025!

It was obvious that they needed to right-size the cost structure but every member of senior management we talked to wanted to “be a hero” and save jobs within their team.

No senior manager, even one who owns sizeable amounts of stock, wants to be the one who does layoffs or cuts compensation. Morale drops, your teams don’t like you, you get bad Glassdoor ratings.

This dynamic can exist even at founder-led companies. The founder either might not own enough shares to care, or has already made enough money and cares more about legacy than shareholder returns. Either way, this will manifest in an unwillingness to do the right, but unpopular, things. Meta and Salesforce were recent examples until activists got involved, while Oportun is a similar on-going activist fight in small cap land.

You can’t hold underperforming management teams accountable if you don’t have control. You just have to sell at a loss, write in your LP letter how the experience reinforced in you the importance of good, shareholder-aligned management teams, and move on. That’s not a satisfactory outcome.

Mark to market

There are many examples of public companies that executed year in and year out and the stock didn’t move for years, until a narrative shift or something else caused a re-rate. Look at small caps and value stocks, which just continue to get cheaper and cheaper.

There’s a software microcap that I’ve owned for three years now. Growing ultra-fast, profitable, excellent software metrics. The company has been executing since I bought it, but the stock went nowhere for years. Then, they reported a good (but not blowout) quarter last month and the stock ripped 50%.

This is my PA so it’s fine, but if I’m running a fund and marked on quarterly performance, I can’t wait on dead money for 3 years. Marking to market is why public equity investors have such an obsession with “catalysts” and other short-term factors. You can’t blame them. Most LPs don’t have patience.

If I own enough of the company to consolidate it into my financial statements, I don’t have to mark to market but instead can mark to business performance. I know this sounds like accounting gimmickry, but I really believe it allows for investing with a longer-term focus.

Conclusion

You could argue that you can get control over capital allocation and operational benchmarking by being an activist – you don’t need control of the business.

That’s a fair point, and I think of degree of control as being on a spectrum, not binary. Being an activist, a large minority shareholder with the ear of management, or even having provided structured equity to a company gives you more control than being a passive minority equity holder.

So, where does this get us? My 2x2 above lays it out. The most structurally attractive strategies today are lower middle market buyout, micro/small cap investing, and niche consolidator models like Constellation with low deal sizes. Venture incubations are also interesting – if you can execute them correctly, which is hard.

What I’m bearish on is public markets TMT, late stage tech crossover, and early stage venture. Despite markets cooling, there is still an oversupply of capital and everyone is chasing the same few “great companies” with little differentiation. Certainly, a few firms and individuals will have big winners but they will be the exception, not the rule.