Sunday Finds + 3 Thoughts From Last Week

Podcast episodes on Wix and cloud computing this week

Jan 08, 2023

Welcome to Chit Chat Money’s Sunday Finds + 3 Thoughts From Last Week. In this newsletter you will find three topics I thought about last week, links to shows we’ve recently released, and links to some interesting articles, podcasts, and tweets. Check out the archive here.

Chit Chat Money Podcasts From Last Week:

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1. A mistake we made in 2022

I’ve been drafting up our annual client letter for 2022. We like to share our letters in public not just for marketing purposes but to help other people on their investing journey. The same goes for the podcast and this newsletter.

We made a few mistakes in 2022, but none bigger than sizing up positions in stocks that had identifiable short-term risks and traded at premium earnings multiples. As you may have guessed, that was a recipe for disaster (luckily for only a few holdings) that we want to try and avoid in the future. To do so, we want to add more scenario planning around what a stock might do over the next few quarters into our analysis while still focusing on a 3 - 5 year timeframe. This should help us avoid larger drawdowns on individual positions even if we think the stock looks attractive at current prices. In these scenarios, there is a high chance it might get much more attractive a few quarters from now which we don’t want to restrict ourselves from going after by taking too large of a position at a higher price.

Putting emphasis on the near term doesn’t mean becoming a hyperactive trader. But it can definitely help with the number one rule in investing: don’t lose money.

Obviously, nobody will be perfect in identifying short-term risks, but I think it can be foolish to completely ignore them.

2. Madoff documentary on Netflix

The new Bernie Madoff series on Netflix is solid. I watched it this week and came away very disappointed in the regulators of our financial markets, to say the least. Whether it is because of a lack of funding or a combination of reasons, the SEC does not have a strong track record of doing its job well.

If you already know a ton about his story, I doubt there will be anything new in the four-part series. But if you are someone like me who just knew that he ran a huge Ponzi scheme, it was super interesting to see the details of how it all played out.

The man swindled tens of billions of dollars from people over decades without getting caught until his own sons turned him in. There was malfeasance with the SEC, multiple deaths/suicides from the fallout, and a connection of investors/accomplices that spanned the globe.

And the fraud was pretty evident if you just had a look at his offering documents and called the trading floors. If it walks like a duck and quacks like a duck…

3. The Private Equity mark-to-market conundrum

There has been a big hullabaloo recently around private equity (PE) valuations amidst the current bear market.

Essentially, many people are complaining that PE firms are being dishonest with investors regarding the value of their assets.

PE funds market themselves as having lower risk because they don’t have to mark the value of their assets every day, which lowers the stated volatility given to investors. Allocators who want to lower the volatility in their portfolios love this and have been pouring money into these funds.

But by not marking down the value of these assets in a bear market (generally one would think the value of these assets, especially when the deals are funded through high amounts of leverage, would decrease in a rising rate environment), there are financial analysts who think there are major problems that could arise from this structure.

Here’s Cliff Asness in the Institutional Investor on the problems:

Second, it’s dangerous to understate risk. Many investors use PE to up their overall equity allocations while avoiding the occasional short-term excruciation that accompanies public equity market investing. The only way this increased risk can be justified without simply announcing, “We’re taking it up a notch” is to assume that this ever-growing PE allocation is relatively low-volatility and low-correlation. You can find many examples of these assumptions — people like to tweet them at me! — though whereas some managers are certainly honest or smart enough to avoid them, others lean in, shamelessly bragging that the assets they don’t mark to market outperform in a bear market. Some have taken to calling the understatement of PE risk “volatility laundering.” Okay, that’s mainly me, but it’s catching on, and volatility as a risk measure more generally gets a bad rap from those who erroneously think it means “short-term fluctuation that you definitely get back and shouldn’t worry about.”

I agree with Cliff and the others who believe there are major issues in how the PE industry works today. But here’s the thing: I don’t know how or why it needs to be fixed?

Everyone who gives money to these PE firms knows (I would guess) how the process works. And it’s not like these are individuals and widows who are potentially getting swindled like in the Madoff case. No, these are big-time allocators at big-time endowments, sovereign wealth funds, and other huge pools of capital. Sure, there might be some pension funds that could get hurt by a PE firm, but there’s always that risk when investing your money. The majority of the money that could get lost here is basically play-money from Yale and the Saudis.

Eventually, if there are chickens they will come home to roost, and the PE funds (and venture capital funds, for that matter) marking up asset values disingenuously will have to realize poor returns for their investors. The others, who act honestly, will do fine.

See you next week,

Brett

***Our fund, Arch Capital, may own securities discussed in this newsletter. Check our holdings page and read our full disclosure to learn more.***

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3 Good Reads

In Praise of Process - Invariant

A peculiar trait shared among many great artists is that they care little about preserving their work. Master painters have been known to scrape down canvases to use again or simply paint over completed compositions. Certain ceramicists pound down pieces and reform them before firing - or smash them afterward in radical protest. Even the legendary Michelangelo burnt many of his drawings.

Self Image - Mind Mine

What we see in ourselves, we see in the world—it is a canvas for our projection. To see this, just watch two different people process the same things, or consider how different versions of your past self would process the same inputs. A cloudy, rainy day might be “cozy, warm, delightful—a reason to stay inside and be with friends” or “dreary, dark, depressing, isolating and cold” depending on your state of mind, how you relate to yourself in that moment. Another easy example is alone time: some people cannot wait to hang out with themselves, while others cannot think of a more frightening way to spend their time.

Why Not Mars - Idle Words

The goal of this essay is to persuade you that we shouldn’t send human beings to Mars, at least not anytime soon. Landing on Mars with existing technology would be a destructive, wasteful stunt whose only legacy would be to ruin the greatest natural history experiment in the Solar System. It would no more open a new era of spaceflight than a Phoenician sailor crossing the Atlantic in 500 B.C. would have opened up the New World. And it wouldn’t even be that much fun.