Electro Optic Systems (EOS) – a unique defense company

Years ago, when I worked as a hedge fund analyst, I dove deep into the satellite + space imaging industry.

The most interesting thing I learned was that space debris is a huge problem for humanity.

This scene from the movie Gravity demonstrates the problem pretty well.

Orbiting space debris travel 7x faster than bullets. And at that speed, even small paint chips can cause a lot of damage.

Every time we launch anything into space, debris naturally accumulates. And the problem grows exponentially.

EOS – a defense company working on the space debris problem

In 2014, I discovered Electro Optic Systems (EOS) via a news release that this tiny Australian company signed an agreement with Lockheed Martin—the giant US defense contractor—to tackle this issue.

EOS is listed on the Australian stock exchange. As of 9/30, it comprised 5% of my portfolio. Not only does the company track space debris, it also enables space communication,

However, both those items are a small portion of EOS’ business. Communications was 11% of first half 2020 revenue, while space debris tracking was a negligible 1%.

At its core, EOS is a defense business (88% of its revenue) at the forefront of modern warfare.

It sells Remote Weapons Systems (RWS) –automatic guns mounted on vehicles. And it sells Counter Unmanned Aircraft Systems (CUAS)— lasers that destroy drones.

Over the past 4 years. EOS’ Revenues have increased dramatically, driven almost entirely by the popularity of its remote weapons systems.

Geopolitical tailwinds that help EOS

EOS sells its products globally beyond Australia. They sell to the US and countries allied with Australia and US. 59% of 2019 revenue came from the US, and 27% came from the Middle East.

The company is fortunate to benefit from America’s changing geopolitical stance.

For better or worse, America’s allies are realizing that they need to fend for themselves and invest more in their own defense.

Whether Biden defeats Trump – now that the seal has been broken, the genie cannot be put back into the bottle.

This is quite the favorable trend for EOS—the national champion of Australia’s defense sector.

Risks

Of all the companies in my portfolio, EOS is the most dependent on advanced technology.

3 interesting assertions from the company:

  1. Its remote weapons systems and anti-drone systems are the best.
  2. It is reaping the reward of many years of R&D.
  3. Much of its leading technology is fueled by research derived from their space business.

Today, these statements are being proved out in their financial results.

However, it’s hard to get comfort on how durable their technology is.

On the other hand, your technology risk as an investor in EOS is mitigated by the nature of defense procurement procedures, which are quite onerous and result in a huge barrier to entry.

Governments can’t buy this stuff from just anyone. Not only are lives at stake, but the existence of the nation is also at stake.

Success in the defense sector requires trust, which can take decades to build. There is a lot of information-sharing that happens in order to design a cohesive product. Fortunately, EOS was founded nearly 40 years ago and it has those critical relationships in place.

A more pressing risk is EOS’s relatively small size. While the company is profitable, earlier this year, COVID wreaked havoc on production and deliveries. As a result, EOS faced a cash crunch and had to raise dilutive equity.

Valuation

The company has a sizable and growing backlog (A$570 million as of 6/30). Backlog generally means orders placed but not yet paid for because the orders either a) have not yet been produced or b) have been produced but not yet delivered to the customer.

The company is also tendering for A$3 billion of new orders. “Tendering” refers to the process by which EOS and other companies bid on new projects. If EOS wins the tender, then revenues move to the backlog. Petra Capital, a 3rd party research firm, indicates that historical tender win rates are around 25-40%.

I don’t think it is unreasonable that revenues can grow 50% a year for the next 3 years. And if you assume a 10% margin, you are paying $10 today for $1 of net income in year 3. That is slightly cheaper than the much larger US public defense companies.

What I like about EOS is that that you get a free call option on the space-related business – which is what first caught my attention years ago.

The flourishing defense side of the business reduces your risk and pays you to wait. EOS like a VC investment with a non-binary outcome. It’s a call option that does not expire. It aligns with my philosophy of upside optionality.

Lastly, beyond the standalone value of EOS, I like the company even more in a portfolio context.

EOS is a hedge against bad things happening in the world—(i.e. global conflict, or satellites exploding). And it is uncorrelated with the other stocks in my portfolio.

Parallels between space debris and COVID

For decades, just as experts have warned about a potential global pandemic, so too have other experts warned about the dangers of space debris.

It’s the same type of problem—simultaneously inevitable and unpredictable. And the problem will not be cheap to solve.

At the rate we shoot things into space, near-misses are now common place. The problem is growing exponentially, not linearly. And it’s just a matter of time before something disastrous happens.

There are several private companies, as well as a couple of large American defense contractors working on the problem. And I am optimistic that human ingenuity can solve this problem.

I’m betting that EOS will have a part to play in that solution and be rewarded for the value that they provide. But even if I’m wrong on that, I’ll have a profitable and rapidly growing defense business in my portfolio.

Why I write about my portfolio

I want you to challenge my beliefs. I’d love for you to tell me what I’m missing. I want you to tell me about public companies that I may not know about. And I’d love for you to teach me more about the companies that I already know.

Drop me a line if you have any questions / comments or just want to get in touch! yz@yishizuo.com

Disclaimer: I am not a registered investment advisor. Nothing I write should be construed as investment advice or the solicitation of investment.

Silvergate – Hidden Network Effect in the Crypto Industry

I have a decent grasp of the technology and utility of blockchains. I think that digital currencies add value to our world. And I think they will be here to stay.

If you can feel comfortable that the entire blockchain ecosystem isn’t a scam—a BIG IF given that Warren Buffett is convinced that Bitcoin is a Ponzi scheme – then Silvergate (NYSE:SI) is a great way to ride this trend.

I first heard about Silvergate nearly a year ago from the newsletter of my favorite journalist, Matt Levine.

On the surface, Silvergate is a bank. Their core business began by taking customer deposits and doing boring bank things like investing in municipal bonds.

Silvergate has actually been around for 40+ years, and they were one of the first banks to serve the digital currency industry 2013.

Since that time, Silvergate has pivoted to focus 100% on digital currency customers, carving out a nice niche for itself.

What makes Silvergate truly special is the Silvergate Exchange Network (SEN). SEN lets Silvergate’s customers transfer assets to one another instantly around the clock. It creates a classic network effect, and Silvergate has first-mover advantage.

Some of Silvergate’s core customers are the digital currency exchanges who actually handle crypto assets.

Think of it like this: SEN is an exchange for those exchanges. It also serves the broader ecosystem of crypto investors, developers, miners and more.

No other bank has the SEN. It would be difficult to replicate today, and that difficulty is only going to increase over time.

Imagine if JP Morgan owned the NYSE, and the NASDAQ didn’t exist. That would be a very powerful bank.

Silvergate is a bet on crypto without having to choose any specific currency. Silvergate has a strong brand in the digital currency world. They are headquartered in San Diego, and they generate real profits with real $USD.

Risks:

In general, the world of digital currency seems to attract a lot of young, sketchy, self-promoters. With Silvergate, however, management seems scrupulous. They have decades of experience and lots of gray hair.

Silvergate’s interest-yielding loan portfolio looks boringly vanilla which is what their depositers and investors should want. Plus, they have great relationships with banking regulators – with whom they’ve collaborated closely from the beginning.

The real risk is that the entire cryptocurrency ecosystem is a house of cards as Warren Buffett asserts. I disagree with the Oracle of Omaha here, but you must decide for yourself.

Valuation & why now:

Silvergate is profitable. But looking at the profits alone would obscure the underlying growth.

Here is the quarterly growth of activity on the SEN, as measured by the volume of cash transactions amongst the bank’s customers to one another.

And here is the associated fee income generated by digital currency customers.

One note: Q3 digital currency customer fee revenue has not yet been officially released (Earnings release on 10/26). $3.7M is my estimate based on Silvergate’s October 6th press release.

For comparison, Q2 net profit for the entire company was $5.5M, so ~$1.3M sequential growth in this revenue line item is very meaningful to the bottom line.

As fee revenues continue to grow, the market will be forced to realize that Silvergate is not just a bank. It has something that few banks have – a network effect.

As I write this, the stock has run up 30% this month and sits at an all-time high.

It’s still quite cheap. You are paying around $15 for $1 of net income today.

But if you think digital currency fee revenue can continue to grow 100%+ a year for the next few years, then you would be paying $5 today for $1 of net income in year 3.

(August 2020 Silvergate investor deck, Coindesk September 2020 Research Report on Silvergate)

Why I write about my portfolio

I want you to challenge my beliefs. I’d love for you to tell me what I’m missing. I want you to tell me about public companies that I may not know about. And I’d love for you to teach me more about the companies that I already know.

As of 9/30/2020, Silvergate was the 4th largest position in my personal portfolio.

I bucket the company as a “Hidden Gem”. Next time, I will dive deeper into another Hidden Gem – Electro Optic Systems.

Drop me a line if you have any questions / comments or just want to get in touch! yz@yishizuo.com

Disclaimer: I am not a registered investment advisor. Nothing I write should be construed as investment advice or the solicitation of investment.

Stock Bucket #2 – High Growth Beasts

These “High growth beasts” comprise 38% of my portfolio as of 9/30/2020.

These 6 companies are growing rapidly and are priced at a premium. I believe that the strengths of these businesses justify their valuations, but decide for yourself.

Atlassian – NASDAQ: TEAM – (15% of portfolio as of 9/30)

Atlassian makes collaboration tools—primarily for software development.

Their flagship product—JIRA—is as important to software development as Microsoft Excel is to financial analysis.

Just like with Excel, users start with JIRA because it’s the industry standard. Once they become familiar, there are few reasons to switch.

Atlassian products are priced via a freemium SaaS model. It’s easy to get started, and costs scale naturally with the customer’s success. As such, relative to its fast-growing SaaS peers, Atlassian spends very little on sales and marketing.

Founded in 2002, the Australian-headquartered company raised very little capital until their 2016 IPO, and the two co-founders own a shade under 50% of the company today—a rarity amongst tech companies at this stage

Key risk(s):

The enterprise collaboration / productivity space is extremely crowded. While Atlassian does have tools beyond JIRA, they haven’t made much progress outside of its core developer market.

They tried to compete against Slack, but they called it quits in 2018 and instead transferred some IP and cash to Slack in return for an equity stake.

I wouldn’t be surprised if Atlassian bought Slack one day. After all, the 800-lb gorilla in the room is Microsoft, which is starting to encroach upon Atlassian’s core.

Can Atlassian ever expand beyond its core software developer market? That would be nice, but I don’t think it needs to.

Valuation:

You are paying $17 today for $1 of gross profit 3 years from now. (I assumed 25% annual growth)

(Most recent Atlassian investor deck)

InMode – NASDAQ: INMD – (8%)

InMode is an Israeli-headquartered medical device company that makes products used in non-invasive, aesthetic procedures.

My friend Jay Vasantharajah wrote this sharp, much more detailed analysis of InMode a few months ago—I suggest you read it!

Consumer demand for InMode’s products is growing rapidly, and they have a superior distribution + pricing model relative to its competitors.

Not only that, but relative to those players, InMode has better product, better marketing, and overall better management.

In recent years, InMode has grown much faster than its competitors, just this week management announced that Q3 revenue increased by ~100% from Q2 (which to be fair, was depressed by COVID).

Key risk(s):

There are many players in this space—some standalone, some owned by private equity, some owned by larger medical device companies.

Valuation:

You are paying $4 today for $1 of gross profit 3 years from now. (I assumed 60% annual growth)

(Most recent InMode earnings release)

Match Group – NASDAQ: MTCH – (8%)

Match Group is the dominant global player in online dating.

These products fulfill a core human need and are not going away. The market is far from saturated and monetization will continue go up.

Online dating is a tough business to enter. Users naturally leave the service, and customer acquisition costs relative to lifetime value is very high.

Fortunately for me as an investor, Match Group has first mover advantage, brand recognition and economies of scale. They have the ability to buy companies for cheap, cross-advertise across their properties, and monetize where others cannot.

Key risk(s):

Facebook announced in 2019 that it would enter this space. While Facebook certainly has the userbase, its attempts have so far to penetrate the dating space not made a dent.

Valuation:

You are paying $13 today for $1 of gross profit 3 years from now. (I assumed 10% annual growth)

(Most recent Match earnings release)

Duck Creek Technologies- NASDAQ: DCT – (2%)

Duck Creek is a US-based vertical software provider similar to Constellation and Enghouse; however, unlike those companies, Duck Creek only operates in one vertical—property & casualty insurance.

Byrne Hobart, who publishes a paid newsletter that I subscribe to, wrote a great feature on Duck Creek in August.

The company is in the middle of a transition to SaaS. Looking at the financials alone, Duck Creek’s 70%+ SaaS annual recurring revenue growth is obscured by its legacy business.

On the SaaS front, returning customers spent $1.13 for every dollar that customers spent last year – and this includes the negative impact of customers who left.

And according to management, Duck Creek wins 2/3 of all potential new business opportunities (including ones they are not asked to bid on).

Key risk(s):

Insurance isn’t going away, but you are exposed to one industry.

Valuation:

You are paying $7 today for $1 of gross profit 3 years from now. (I assumed 20% annual growth)

(No deck – but here is the Duck Creek IPO prospectus)

Bill.com- NYSE: BILL – (2%)

Bill.com is a SaaS platform that helps small-to-midsize businesses (SMBs) collect and pay their bills.

As a leader at a small company, I’ve personally used this product and am familiar with the value that it provides. Collecting and paying bills can be a pain in the butt

Interestingly, I see parallels between this product and Zoom 2-3 years ago—the same people who were early adopters of Zoom’s video conferencing software are the same people I see first to use Bill.com.

Returning Bill.com customers spent $1.21 for every dollar that customers spent last year – and this includes the negative impact of customers who left.

Bill.com’s opportunity extends beyond SMBs. The most agile, and ultimately successful, large enterprises will empower their smaller team to choose their own tools. The Bill.com’s of the world will penetrate large enterprises at the grass roots level and expand upward.

Key risk(s):

Valuation is very high.

Valuation:

You are paying $27 today for $1 of gross profit 3 years from now. (I assumed 40% annual growth)

(Most recent Bill.com investor deck)

Adyen – Euronext: ADYEN – (2%)

Adyen is a Netherlands-headquartered payments platform.

They enable “unified commerce”. In other words, they make it easy for their customers to accept payments in different countries in different formats.

Behind the scenes, the world of payments is incredibly complex and constantly evolving. And that is great for this company. When complex systems change so quickly, customers need tools like Adyen to adapt.

Because Adyen owns the merchant relationship, it doesn’t matter whether Visa, Mastercard, Unionpay, Apple Pay, Google Pay, Wechatpay, Alipay, Grabpay, or anyone else will prevail on the consumer side–ultimately, Ayden wins.

Key risk(s):

Valuation is very high.

Adyen competes with Square, which is US focused, and to a lesser-extent – Stripe, which is focused on digital businesses.

Adyen’s forte is multi-channel payments, and its core market is retailers with a physical presence.

Right now, there appears to be enough room for all these players to coexist

Valuation:

You are paying $48 today for $1 of gross profit 3 years from now. (I assumed 25% annual growth)

(Most recent Adyen investor day presentation)

Why I write about my portfolio

I want you to challenge my beliefs. I’d love for you to tell me what I’m missing. I want you to tell me about public companies that I may not know about. And I’d love for you to teach me more about the companies that I already know.

Next article: Silvergate – Hidden Network Effect in the Crypto Industry

Drop me a line if you have any questions / comments or just want to get in touch! yz@yishizuo.com

Disclaimer: I am not a registered investment advisor. Nothing I write should be construed as investment advice or the solicitation of investment.

Yishi’s Stock Bucket #1 – Stable Cash Generators

These “stable cash generators” comprise 47% of my portfolio as of 9/30/2020.

These 4 companies aren’t growing particularly fast, but I like the risk-reward trade-off.

It is unlikely that any will double in 6 months. But the chance of permanent loss of capital is low.

In a downturn, these businesses should do fine.

Equinix – NASDAQ: EQIX – (26% of portfolio as of 9/30)

  • Equinix is a US company that operates global “Interconnection facilities”— locations where the internet physically connects
  • Imagine the pipes that carry data across the internet. These pipes come into an Equinix facility. Within each facility, enterprises can connect directly to one another
  • Enterprises have a lot of reasons to share data, and those reasons are growing
  • For these enterprises: latency matters, proximity matters, and having a one-stop shop matters.
  • As a result, Equinix is the dominant global provider and enjoys winner-take all network effects and customer lock-in

Key risk(s):

The internet is becoming multi-polar with increasing local regulations. In such a world, a global interconnection provider like Equinix could matter less.

Valuation

You are paying $23 today for $1 of adjusted funds from operations 3 years from now. (I assumed 10% annual growth)

(Most recent EQIX investor deck)

Slate Grocery REIT – TSE: SGR.UN – (11%)

  • Slate Grocery REIT (SGR) is a Canadian company that owns grocery-anchored real estate across US suburban areas
  • Their most recent rent collections through COVID have been relatively steady at 90%+
  • On the downside, the company’s cash flows are currently not growing
  • But they have plenty of liquidity
  • My hypothesis is that SGR will eventually recover to pre-pandemic levels, and their sizable dividend will remain reasonably steady and afford me time to wait

Key Risk(s):

While SGR doesn’t operate grocery stores, the more anchor tenants they have, the better. Amazon is a perpetual threat to the grocery industry given their Whole Foods acquisition + Amazon Fresh. And in the longer run, digital grocery delivery could disrupt the industry entirely.

Valuation

You are paying $8 today for $1 of adjusted funds from operations 3 years from now. (I conservatively assumed 0% annual growth)

(Most recent SGR investor deck)

Constellation Software – TSE: CSU – (5%)

  • Constellation Software is a Canadian-based company that acquires and grows vertical software businesses mostly in North America but expanding globally—especially Europe
  • Vertical software means selling software tailored to the needs of a specific industry (I.e. utilities, hospitals)
  • Generally, vertical software is a great business to be in given that the product, once installed, becomes critical for the customer. And switching costs become very high
  • As a result, you have predictable, recurring revenue with high margins and annual price increases. Costs are predictable too
  • Management is superb. For decades, Constellation has executed nearly flawlessly

Key Risk(s):

The company is expensive relative to its growth rate.

Valuation

You are paying $55 today for $1 of net income in Year 3. (I assumed 10% annual growth)

(No deck but CEO Mark Leonard has published annual letters that reflect his intellect and clarity)

 

Enghouse – TSE: ENGH – (3%)

  • Similar to Constellation, Enghouse is a Canadian-based company that acquires and grows vertical software businesses mostly in North America but expanding globally—especially Europe
  • Again, vertical software is a great business model
  • Management seems cut from similar cloth as that of Constellation
  • Relative to its larger “cousin”, Enghouse is less proven but the playbook seems similar
  • Relative to Constellation, Enghouse is growing faster, but priced more cheaply

Key Risk(s):

Can Enghouse continue to execute as it scales?

Valuation

You are paying $30 today for $1 of net income 3 years from now. (I conservatively assumed 10% annual growth)

(Most recent ENGH investor deck)

Disclaimer: I am not a registered investment advisor. Nothing I write should be construed as investment advice or the solicitation of investment.

Why I write about my portfolio and specific stocks

I want you to challenge my beliefs. I’d love for you to tell me what I’m missing. I want you to tell me about public companies that I may not know about. And I’d love for you to teach me more about the companies that I already know.

Next article: Stock bucket #2 – Fast growing beasts

Drop me a line if you have any questions / comments or just want to get in touch! yz@yishizuo.com

Yishi’s Stock Portfolio Q3 2020 Review

Here is an overview of my personal stock portfolio as of September 30th, 2020.

The 15 companies I own span a wide variety of industries.

  • US centric with global revenues: Most of my portfolio companies are headquartered in the US. The rest are all based in Western countries. However, much of the collective revenue is global.
  • Predominantly B2B: With the exception of Match Group, the entirety of my portfolio is B2B. A few others–InMode, Slate Grocery REIT– sell to businesses, but are closely driven by consumer spending.
  • Mission critical: Many of these companies are mission-critical businesses (Equinix, Kinder Morgan). Their customers would be in serious trouble if they disappeared.
  • Diverse value drivers: Some are riding unique, long-term trends (Silvergate, EOS). Some are cyclical (Schlumberger, Total).
  • Diverse stages: Some are in high growth mode and reinvesting capital back into the business (Bill.com, Ayden). Some are stable and spitting out double-digit dividend yields (Total, Slate Grocery REIT) or repurchasing large amounts of stock.
  • Software Focus: Much of this portfolio is software. Some sell across industries (Atlassian). Others are focused on specific industry verticals (Constellation, Enghouse, Duck Creek).
  • Understandable: Most of the tech companies in my portfolio depend less on any cutting-edge technology and more so on their integrations, ecosystems, customer lock-in & network effects.

I’ve bucketed my portfolio into 4 categories to reflect my thinking (More to come in a future article).

Why I’m publicizing my portfolio

Disclaimer: I am not a registered investment advisor. Nothing I write should be construed as investment advice or the solicitation of investment.

I used to be a professional hedge fund investor. I’ve been investing out of my personal portfolio for some time. I’ve done alright over the past few years, and I find the experience fun.

The reason I’m publicizing my portfolio is because I want you to be my thought partner.

I want you to challenge my beliefs and try to poke holes in my thesis. Please tell me what I’m missing.

I want you to tell me about public companies that I may not know about. And I want you to teach me more about the companies that I already know.

I think investing in public companies helps me become a better entrepreneur & vice versa.

In the coming months, expect to see a series of articles analyzing these companies and discussing my investment philosophy.

Welcome to the combination of value-investing + entrepreneurship.

Drop me a line if you have any questions / comments or just want to get in touch!  yz@yishizuo.com

Next post: Yishi’s Stock Bucket #1 – Stable Cash Generators

Warren Buffett, Charlie Munger, and the Principles of Entrepreneurship

Over the years, I’ve invested hundreds of hours in trying to absorb the worldly wisdom of Warren Buffett & Charlie Munger. (Saved here are the best Munger / Buffett materials that I have come across– please feel free to read, learn and share!)

The core tenets of Buffett and Munger have profoundly shaped the way that I approach life, and below are 4 of their key principles that I believe are most relevant to entrepreneurship.

 (Note, this is Part 2 of a 3 Part Series titled “My Personal Why”. Part 1 – Switching from Hedge Fund Investor to Software Entrepreneur. Part 3 – My Personal Mission & How I Arrived Here)

 

Principle #1: Circle of competence

“Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”   

– Warren Buffett, 1996 Berkshire Hathaway Annual Letter

For entrepreneurs, our circle of competence comprises of all the resources that we have available.

Within one’s own circle of resources – somewhere, there needs to be some advantage.  It doesn’t have to be a huge advantage. It could be as simple as one or two key insights – combined with your skills, your network, your reputation, and your energy.

Here is a concrete example from my personal experience — at DeepBench, the start-up that I co-founded in business school, we targeted an industry that we were very familiar with. We combined our insights, experience, and grit with the resources that MIT had to offer.

Over time, we built on those limited resources that our start-up possessed, and our circle of competence grew to where we are today.

Buffett uses the following baseball analogy to reiterate this concept:

“We try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

 . . . 

In investing, I’m in a no-called strike business, which is the best business you can be in. I can look at a thousand different companies, and I don’t have to be right on every one of them or even 50 of ’em so I can pick the ball I want to hit. And the trick in investing is just to sit there and watch pitch after pitch to go by and wait for the one right in your sweet spot

— (Paragraph #1 – 1997 Berkshire Hathaway Annual Letter, Paragraph #2 – Becoming Warren Buffett – 2017 HBO Documentary)

It’s clear to me that Buffet’s baseball analogy misses the mark for entrepreneurs, and it must be reinterpreted.

Where does a start-up’s circle of competence truly lie? There are so many rapidly moving pieces that make the boundaries of that circle very difficult to discern.

As entrepreneurs, we are forced to stretch the boundaries of our circle of competence far more frequently than investors are. Entrepreneurs don’t have the luxury of waiting for the perfect pitch in our sweet spot. A start-up must keep swinging and reaching for new opportunities. An entrepreneur must do things that do not feel comfortable.

I’ve personally learned to embrace the discomfort — that is the biggest mentality shift.

Entrepreneurs must sell our vision & capabilities to investors, the media, our customers and our employees. We must set stretch goals to motivate each of those constituents.

Unlike investors who are generally passive, entrepreneurs have the opportunity to create self-fulfilling prophecies. In fact, we must do so, otherwise we cannot grow.

 

Principle #2 Choose the right business model

Image credit: Garth von Ahnen http://www.artbygarth.com/

‘I always used to tell [Bill] Gates that a ham sandwich could run Coca-Cola. And it was a damn good thing, too, because we had a period there a couple years ago where, if it hadn’t been that great of a business, it might not have survived.” 

— Alice Schroeder quoting Warren Buffett in The Snowball (2008 Biography)

Note: Buffett disputes the context of this quote in a 2014 CNBC interview. However, I’m guessing that: 1) Buffett is backtracking in order to minimize offense and / or 2) The quote came from Charlie Munger if not Buffett, so I’ve decided to feature it with that caveat.

In any case, I think the sentiment is clear and makes logical sense. Buffett’s implicit advice is: Invest in businesses so good that morons can run them, so that you have an extra margin of safety.

To paraphrase another quote of Warren’s: When a great management team meets a tough business model, it’s the tough business model that wins. The business model is paramount.

The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

— Warren Buffett, 2011 interview with the Financial Crisis Inquiry Commission

As an entrepreneur, finding the right business model is easier said than done. Every market and every opportunity is slightly different. Micro-economics (i.e. customer acquisition costs, churn rates) matter. Customer personas matter.

You won’t know for sure whether your business model will work unless you invest resources to figure it out. A useful mental model to save some effort here is a concept from the investment world called “economic moats”.

Moats are essentially barriers to entry, and here are a few great examples.

If you think about it, the phrase “a start-up’s moat” is an oxymoron, given how vulnerable a young start-up is. However, to borrow a lesson from Peter Thiel’s book, From Zero to One : if you pick your market carefully, you can create your own tiny monopoly. Then over time, you use your monopolistic power within that niche to expand your moat and circle of competence.

Even if there are no barriers to entry today, a great start-up should have a credible path to creating barriers down the road.

Personally, with DeepBench, we’ve chosen a capital-efficient, network effect business model with SaaS and content components that should result in customer stickiness and a strong competitive moat in the long-run.

 

Principle #3 – Understand your edge and don’t be a sucker

Matt Damon’s quote above from Rounders is a poker aphorism that surfaced in the late 70’s and was used by Warren Buffett in the 80’s. This phrase has now become very popular in the investment world.

This concept is closely related to the circle of competence. The lesson here is that you have to understand what you are investing in. To bring up Buffett’s baseball analogy again: you don’t need to swing the bat unless a pitch is in your sweet spot.

Moreover, you need to know WHY the buying opportunity exists. If you think something is cheap, you better be able to explain why. Otherwise, you are the sucker at the table.

“If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.”

— Charlie Munger, Art of Stock Picking

As mentioned in my previous article, inefficiencies exist in both the entrepreneurial and stock market worlds.

In the stock market, for every buyer, there is a seller. When you take an action, you imply that you see something that the market does not.  As a stock market investor, it takes a dose of confidence bordering on arrogance to say that you are smarter than the market.

From a psychological perspective, this is the exact same “arrogance” that entrepreneurs must embrace when taking the plunge. You are more capable than the other entrepreneurs that have failed before you, and you are smarter than the incumbents in your industry that are somehow unable to act on this opportunity that you see. You are able to do something that people with more experience, connections, and capital cannot.

To determine where an entrepreneur sits along the boundary of calculated confidence vs. delusional arrogance, venture capitalists will often ask entrepreneurs some version of: “Why you? Why this team? Why now?”

I try my best to answer that question using the circle of competence framework. I strive to understand my own edge as well as Charlie & Warren do for themselves. And I aim not to be a sucker 😉

 

Principle #4 – Live a life that makes sense for yourself

Not too long ago, Warren Buffett was reading a 10-Q financial filing on a Saturday morning.

He then called the CEO of that company to ask a few questions.

The CEO replied to Warren, jokingly – “Is this what you do on Saturday mornings, read 10-Qs for fun?”

Warren replied matter-of-factly, “Yes”, and proceeded straight to his questioning.

I aspire to live a life such that my day-to-day business activities do not feel like “work”. I want my Saturday mornings to feel as equally enjoyable as my Tuesday afternoons.

I want to live life with a purpose. I want to voluntarily “work” weekends and evenings, even if I had enough resources to retire and live very comfortably for the rest of my life.

That is the life that I try to lead, as well as the mentality I look for in my current and future business partners.

Over the decades, Warren Buffett has carefully arranged his life in a way that is catered to his own peculiar strengths and needs – in other words–his own circle of competence. I think that this is one of the most critical pieces to his success.

As an example, Buffett has famously described his management style as “delegation to point of abdication”– where he will often go months or even years without talking to some of his portfolio CEOs.

The environment that Buffett has thoughtfully crafted for himself affords him the freedom to do what he does best and what he most enjoys doing: Warren Buffett has ample uninterrupted time to read, think, and make decisions.

On a related note, Jeff Bezos espouses a very similar concept called work-life harmony. Bezos states that the word “balance” in the conventional terminology of “work-life balance” implies a trade-off, and that is a limiting way to think.

I agree with him.

Personally, I’m still in the process of figuring out what my own work-life harmony looks like. I do think that it is a lifelong process that requires constant reflection and adjustments, and I feel like I’m closer than I’ve ever been.

The implications of Buffett & Bezos’ life approach for entrepreneurs are clear.

Every entrepreneur is different, and every start-up is unique. We must choose a path that fits us—a path that is uniquely tailored to our strengths and weaknesses. We must craft an environment that is authentic to our working style and our life goals.

You don’t need to be a billionaire to start making tweaks to your environment and shifting your mentality. Success won’t happen overnight, but that is no excuse to not try.

 

Conclusion

If there is anything I’ve learned from Buffett and Munger, it is that their tenets are best considered holistically.

You can’t have happiness without work-life harmony.

You can’t achieve work-life harmony unless you understand your life goals and circle of competence.

Your circle of competence defines a) your edge and b) what business models make sense for you to pursue.

If you want to get better at these things, and whether you are an entrepreneur or not, my only advice for you is to read and reflect—and Buffett and Munger’s writings are a great place to start.

If this type of thinking resonates with you, I’d like to invite you to join me on a life-long journey.

Next post, I’ll discuss my own long-term goals and how I hope to get there with your help!

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About the author: Yishi is a former hedge fund investor, current entrepreneur & recent MBA grad who enjoys thinking about businesses in his free time. He can be reached via yz [at] yishizuo.com

He is also a co-founder & CEO of DeepBench — We connect users with experts on any topic in any industry, and we also license our software to enterprises to better organize and monetize expertise. (Check us out if you are interested in joining our network or using our product!)

 

My Personal Why – Switching from Hedge Fund Investor to Software Entrepreneur (Part 1 of 3)

(Note, Part 2 has been published: “Warren Buffett, Charlie Munger, and the Principles of Entrepreneurship“)

I enjoyed my last job as a hedge fund investor. I found the work highly intellectually stimulating.

Being an investor aligned well with my lifelong desire to better understand how our world works

But I felt like something was missing.

 

Ultimately, I switched career paths and became an entrepreneur for 3 key reasons:

Reason #1 – I want to better understand business operations and the nuances of management in order to become a superior investor in the long-run.

Reason #2 – I am at the right stage of my life to take a risk. I have no kids, and my parents are doing OK financially and health-wise. From a personal perspective, I can afford a career reset if all goes south.

That is my personal Margin of Safety.  Nevertheless, I wouldn’t have made the career switch if I didn’t think that the decision would be positive Net Present Value (NPV) — which brings me to the last and most important reason.

Reason #3 – I believe that the long-term, risk-adjusted NPV of being an entrepreneur is higher than any other course of action I could have taken. This is somewhat of a contrarian view, so I will use this post to explain in detail.

 

I’m going where the market inefficiencies are.

As a former investor, I know that markets are inefficient for good reason. There are more unknowns, less liquidity, and more risks. But I firmly believe that if one is willing to do more legwork to address those risks, then the best returns can be found in the most inefficient markets.  

The above diagram illustrates my assertion that the best opportunities of all are found markets in which no company exists yet.  And the table below illustrates how I think about the similarities and differences between being an investor vs. entrepreneur.

Clearly, the critical process of execution is very different for an investor vs. an entrepreneur, as are the skills required to succeed. However, I assert that the high-level conceptual framework is the same.

After all, both entrepreneurs and investors look for market opportunities and capture them – the method of execution just varies, depending on how involved you want to be. Either you sit and wait (buy-and-hold hedge fund investor), or you actively build new products to serve customer needs and find more of those customers (entrepreneur). And there is everything in between (activist hedge funds, turnaround private equity shops, hands-on VCs).

Ultimately, just as hedge fund managers arbitrage market inefficiencies to generate “alpha”, so too do companies eliminate market inefficiencies by delivering value to customers. The way all companies (not only start-ups) generate “alpha” is to just keep a slice of that value created for themselves.  This is illustrated by the simplified diagram below, using Uber as an example.

Seeking like-minded people

In conclusion, I want to go where the most inefficient markets are, deliver enormous value to our customers, and capture a slice of that value for myself and my business partners, and I want to do it at scale.

Based on my conversations with other entrepreneurs and investors – I feel that very few people share my philosophical approach and see the same link between entrepreneurship and hedge fund investing as I do. If you are one of the few people in the world who thinks this way – please reach out to me!

(Part 2 – Warren Buffett’s influence on how I think about entrepreneurship, and To come: part 3 – Long-term goals and how I hope to get there (with your help!). Sign up for email updates at www.yishizuo.com)

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About the author: Yishi is a former hedge fund investor, current entrepreneur & recent MBA grad who enjoys thinking about businesses in his free time. To contact him about this article, or suggest new future topics – he can be reached via yz[at]yishizuo.com

He is also a co-founder & CEO of DeepBench – a company that 1) connects those who have expert insights with those who need them and 2) provides expert network software as a service. If you wish to organize knowledge within your enterprise as well as offer that expertise externally, DeepBench can provide the tools to do so!