Stuff I thought about last week 8-18-19

Greetings – We have a couple of longer posts this week: at the end of the main section I walk through our investment process, and apply it in detail to the recently announced ViacomCBS merger; then, at the top of the macro section I walk through some interesting demographic trends including the ramifications of the global population slowdown, the boomers exiting the labor force, and the interplay of AI and labor demand. Other topics this week: Mastercard and Visa are low “NZS” business models; cloud platforms will follow software pricing trends up instead of hardware trends down; and much more, as always, reply back with thoughts or grab me on Twitter.

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Stuff about Innovation and Technology

University of Missouri students have combined inexpensive digital cameras and infrared sensors to develop a system to monitor and adjust water levels for individual plants in fields. The system could one day be drone-based as well.

UPS has been using TuSimple’s self driving trucks between Phoenix and Tucson and is now investing in the company. “Self-driving trucks run consistently on predictable highway routes - in UPS’ case carrying large numbers of revenue-generating packages or goods - around the clock, including in the early hours of the morning when driving conditions are ideal.”

The NYT covers the rise of cloud kitchens as the restaurant industry is about to undergo a massive disruption. “No longer must restaurateurs rent space for a dining room. All they need is a kitchen — or even just part of one. Then they can hang a shingle inside a meal-delivery app and market their food to the app’s customers, without the hassle and expense of hiring waiters or paying for furniture and tablecloths. Diners who order from the apps may have no idea that the restaurant doesn’t physically exist.” I walked through some of the implications in SITALWeek #202 and #205. Another shift happening related to changing food habits is the rising demand for cold storage and delivery.

The Week discusses the Mastercard and Visa “tax” on the economy. I’ve always struggled with the valuation of these businesses, which both trade around 30x their fiscal 2020 consensus earnings estimates. They have been a deliberate, but unfortunate, omission in our portfolios at times in the past. Our adherence to our investment philosophy sometimes causes us to miss even long-term winners like these. The network effect platforms they run and the tailwinds to usage growth are obvious, but they rank very low in our non-zero-sum (NZS) framework for two reasons. First, I believe the tariff they collect is over-earning the value they provide; second, they enable an ecosystem of sometimes predatory credit tactics at card issuing banks. I think there is value in Visa and Mastercard’s risk models for transactions, but I think many companies could recreate this type of analysis (or already have it) given the availability of data and real-time cloud computing. Credit card networks seem to rely heavily on an Industrial Age “moat” that has the potential to become a vulnerability in the Information Age. I hold the very unpopular view that regulatory risk and the potential rise of a new transaction platform with higher non zero sum, or NZS characteristics (Facebook’s Libra for example), create a wider range of outcomes than the stocks contemplate with their current valuations. However, I also admit these can be great businesses for a long time if that doesn’t happen. It’s a situation where I’m comfortable saying “I don’t know,” and move on to the next idea. “There is no possible moral or economic justification for these fees. Credit card companies and their bank allies are just abusing their market power to soak the rest of society for easy fat profits.”

Microsoft’s head of gaming explains that streaming won’t be a reality for a long time. According to Spencer, the console is here to stay, and the phone will be the main streaming platform for games.

I listened to an interesting podcast on autonomous driving with Comma.ai founder George Hotz and host Lex Fridman. Comma.ai is an interesting concept that allows you to connect to your car's existing sensors and controls to run better autonomous software. George has a lot of unconventional views and outside takes that shed some light on the industry including: 1) Tesla is the iOS of autonomous while others, like Comma.ai’s Openpilot, are the Android version; 2) Tesla likely gets to Level 5 first – a really long time from now – with several others 2-3 years behind; 3) Mobileye (Intel) is rudimentary at best; 4) cameras and radar are enough, Lidar is not necessary; 5) Lidar can be used for local mapping, but overall mapping isn’t important; driver monitoring is much more important and can be expanded to include alcohol/drug impairment; 6) data value to insurance companies is huge. The discussion shifts to autonomous just before minute 27 of the podcast (if you’re not interested in the minutiae of programming languages skip to that point). An interesting concept would be if Lyft and Uber added Comma.ai tech to their existing drivers’ cars to improve safety, lower insurance costs, and bridge to autonomous cars 10 years from now.

Will cloud computing pricing at AWS, Azure, and GCP look more like software pricing over time than hardware pricing, i.e., will it rise instead of fall? The conventional wisdom is that cloud computing will become cheaper over time because of the price/performance improvements of the inputs such as semiconductors. Yet, we learned recently from Gartner that AWS hasn’t cut prices on it’s main compute service in 5 years. Large clouds are better buyers of chips and power, and they have clear scale advantages over individual companies running data centers. Customers of the big clouds are increasingly using their platform software and tools, which may make them increasingly locked in. Enterprises are increasingly exiting owned DCs, which gives clouds even more leverage. Microsoft is flexing its Azure platform by putting a new tax on running their apps on GCP and AWS. We’re generally wary of the term ‘pricing power’ because it’s a 1900’s view of customer lock-in that tends to becomes a vulnerability in the 21st century. However, that might be just what we are looking at with Azure, AWS, and GCP – sustainable economies of scale and pricing that can go up while still providing a large degree of NZS (win-win) for customers. Software is naturally becoming a much bigger part of the value of cloud computing beyond pure infrastructure, and the bundling of hardware and software in the cloud would suggest prices will go up over time rather than down while customers still benefit greatly from the transition.

NVIDIA recently discussed how they have increased the AI performance of their latest-generation Volta chips by 80% through software long after shipping the chips. Also of note from the company’s earnings this week was the continued pause in spending at the big cloud data centers. The company had previously called for an expected rebound, which has yet to materialize.

Here are a couple of articles on potential semiconductor wafer growth for GaN and SiC, which may provide better substrates for 5G and new growth areas for chips. Cree and Soitec are two companies focused on these materials.

The real estate broker Keller Williams has partnered with Offerpad in the hot iBuying market of Phoenix following the recent Redfin-Opendoor partnership as consumers are demanding options when they go to sell their houses.

The Investment Process at NZS Capital Applied
I don’t often walk through specific scenario analysis for companies or talk about what I think stocks might be worth in the future in this newsletter. There is a good reason for that – our process relies on not needing to narrowly predict the future. We don’t necessarily believe in popular investor concepts like mean reversion, intrinsic value, pattern recognition, growth investing, GARP (growth at a reasonable price), or what the market is currently infatuated with: QAAP (quality at any price). A more pejorative term for ‘mean reversion’ is ‘luck.’ Most market forces are governed by power laws with fat tails, not bell curves, so the idea that there is a mean to revert to is usually an illusion. Relying on an ability to use data and models to determine an actual intrinsic value for a stock is a good way for your brain to trick you into believing that you are exceptionally brilliant.

Instead, we try to find investments where we are likely to make money over the long term with as few predictions as possible. And, when we do make predictions, we want them to be broad. For example, we think electronics are pushing deeper into the world, and, therefore, we will have more need for semiconductors, sensors, and connectivity over time. This seems like a fairly safe long-term prediction. The narrower the prediction, or the bigger the parlay bet of predictions (this has to happen, then this has to happen, then this has to happen...), the smaller the position size will be in the portfolio.

We also try to get a sense for the duration of growth combined with a stock’s current free cash flow (FCF) yield (defined as FCF per share divided by stock price). A business with a safe set of wide predictions, long duration growth and a good FCF yield starting point can be the basis for a larger position size.

We seek Resilient cash flow streams with steady growth (a combination of positive feedback loops with negative feedback loop governors) and management teams with a long-term focus on innovation, adaptability, and creating Optionality around the business core. Lastly, we constantly absorb new information as objectively as possible and take a Bayesian logic approach to adjusting our credence up or down, while working as a team to identify when someone’s brain is tricking them so as to try like hell to avoid cognitive bias. This process built on elements of Quality, Growth, and Context of a business is the heart of our Complexity Investing framework.

As a case study of Complexity Investing and how to classify narrow and broad predictions, click here to read about this framework applied in detail to the announced merger of Viacom and CBS.ViacomCBS would not necessarily be a stock we would invest in for a technology strategy, but we have been historically successful investing in Disney as it transitions to a digital platform, so it’s an interesting exercise to go through (but, there’s that dangerous “pattern recognition” creeping in!).

Miscellaneous Stuff
Ergodicity, a favorite topic of ours, is covered in Aeon magazine this week. The path through time matters: most systems are non-ergodic, which means the average result over time does not reflect the path through time. Power laws and fat-tail events are good examples of why ergodicity matters and why expected utility theory and modern portfolio theory have no basis in reality. Just look at the 48% dropin the Argentina stock market this week if you need convincing!

The iron-60 isotope found in Antarctic snow is from an ancient star explosion known as a supernova.

I know things seem a little troubling in the world, but our slice of the multiverse can be fun sometimes too. In Mark Twain's Following the Equator it was stated: "Truth is stranger than fiction, but it is because Fiction is obliged to stick to possibilities; Truth isn’t." I couldn't help but think of this passage when I read that President Trump is interested in the U.S. buying Greenland. It turns out he is not the first president to propose the acquisition, and there are all sorts of good logic behind it as The Week explains.

Stuff about Geopolitics, Economics, and the Finance Industry
Demographics and the Economy
Regular readers should be more than familiar with my fondness for citing two key engines of capitalism: population growth and productive reinvestment of capital. The latter is a crucial part of Adam Smith’s Wealth of Nations, and the former is the driver of both labor growth and therefore consumption growth. In the past, I’ve covered the structural headwinds to the reinvestment of capital as a result of the transition to the tech-driven, Information Age. It’s an interesting exercise to dive deeper into the growing population conundrum, and how AI might invalidate the need for population growth to maintain growth in prosperity. In this post, I will walk through the three pillars of population growth – aging, births, and what’s going on in between – then will return to technology’s potential impact.

First, let’s focus on the aging population. “People are getting older” is an often-touted phrase, but that also means they are moving into retirement. Currently, about one third of Baby Boomers are in retirement, but the remaining two thirds will enter retirement over the next 10-15 years, with the youngest Boomers turning 65 in 2029. This creates the interesting phenomena where the number of Boomers are in declinein aggregate, yet the number of Americans over 65 will grow by ~15M over the next decade to ~70M (PDF). Thus, people are getting older, but that also means they are leaving the workforce (creating jobs openings for Millennials) and slowing consumption overall (but needing increased healthcare services). Behind the Boomers is Generation X, which is about 10% smaller (currently 66M), and thus will almost certainly have a smaller overall impact on the economy (vs. Boomers during their prime consumer years) between now and when Gen X begins to leave the workforce in a decade.

Second, life expectancy has dropped for three straight years in the U.S., primarily because of suicide and overdoses, which perhaps offers a difficult and heartbreaking early warning of the erosion of capitalism’s power to lift people up (this report from the CDC tabulates life expectancy by age). “We're seeing the drop in life expectancy not because we're hitting a cap [for lifespans of] people in their 80s, [but] because people are dying in their 20s [and] 30s.”

Third, let’s look at the birth situation. Globally, birth rates are declining dramatically to well below the replacement rate. The estimates people largely cite from the UN for a 2050 global population of 10B people have not adjusted to the new reality. It’s now much shorter to list the regions where birth rate remains above the replacement rate of 2.1: Sub Saharan Africa and a few smaller countries in the Middle East and South Asia – that’s it. Birth rate is now estimated at 1.73 in the U.S (there is reason to believe this number might be closer to two, but it has dropped from 3.6 when boomers were born). If you click on only one link this week, I recommend it be The Population Bust: Demographic Decline and the End of Capitalism as We Know It, which does a great job explaining the current population situation and includes some provocative predictions, e.g., could China’s population drop in half by the end of the century from a peak of 1.5B?

Now let’s get back to Adam Smith and the drivers of capitalism. Personal consumption is 68% of the US economy. Consumption jumps from $48k/year when people are 25-35 to a high of around $60k/year at age 45-54, and then falls to $34k at age 75 and older (source). The economy will need to contend with the consumption baton passing from Boomers, as they move into retirement, to the smaller Gen X, and then to Millennials, who are now a little larger in number than Boomers. As I covered back in SITALWeek #201, Millennials are delaying household and family formation for a variety of reasons including larger debt burdens; this supports the economic logic for eliminating student debt so this generation can offset the decline in Boomer spending.

We can’t have a complete discussion of demographics without a word on immigration. Historically, immigration has been a great offset to the dropping birth rate in the US and other developed nations, and it’s an important reason we’ve avoided a Japan-like stagnation in our economy. To save economies from these demographics, I think there could be a fight amongst wealthy nations to pay people from other countries to immigrate. That's a far cry from where the West currently sits on immigration! Late last year, Japan introduced legislation to encourage foreigners to move to the country to offset their 400k annual population decline.

There is a lot to think about as the population, a main engine of capitalism, begins losing its thrust. Rising inequality, nationalism, and other ugly problems are symptoms of traditional capitalism’s twilight. A digital rewrite of the economy is creating a new economic operating system with new engines of growth; it’s likely statistics such as GDP will fail to capture this transition. The increase in connected smart sensors and the use of artificial intelligence will fundamentally alter capitalism, hopefully for the better. Healthcare should see widespread impacts from technology; it’s not hard to imagine a near future when connected devices, like Apple watches, offer early diagnosis of a number of conditions, from heart failure to dementia, providing a longevity boost to the aging population. With the rise of AI, the relationship between population growth, labor demand, and GDP growth will be altered – growth in labor may no longer be required for economic growth. Lastly, a little bit slower population growth gives the planet a little break, which should increase the odds that our future AI overlords won’t see us as an existential threat. So, maybe we can avoid The Matrix outcome! I’m at best an armchair demographer, so please correct me on any of this analysis.
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There were a lot of folks jumping on this idea from Pimco that negative rates are a result of older people expecting to live longer, and therefore spending less today and saving more for tomorrow. However, I think the argument is sloppy and unsupported. If it were true that people are expecting to live longer, then they should be allocating to riskier assets that are likely to appreciate, like stocks, not government debt. As discussed in the section above, the large number of retiring Boomers who still have 1-2 decades ahead of them would not be well served by parking cash in negative-rate bonds.

AdvicePay is software financial advisors can use to charge clients on a fee basis instead of a percentage of assets managed. The company says they are on track to log $100M in billing transactions in 2020.

The Chinese government has removed the CEO of Cathay Pacific Airlines. Every company, including those based and listed in HK, should be considered state-controlled entities from an investment risk perspective. Related: there were calls to boycott Disney’s new live-action Mulan movie in the West after the star came out against the HK protesters. Trump smartly appointed a Uighur American as director for China on the National Security Council.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.