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Now You’ll Get All the Jokes
We survived the holidays and are getting set to end our hiatus here at Permanent Equity’s Unqualified Opinions and kick off season three (“S3, huh?” indeed!) next week. To prepare for that, and in recognition of the fact that Brent’s shoutout in his annual letter garnered this humble daily email dozens of new subscribers who might not get the running jokes, here’s everything anyone needs to know to get up to speed:
First, as we were getting going, Emily made sure to tell me which ones of these were “not my best.”
Then we started referring to free cash flow as “beer money.”
Only to have the fiercely independent bakery here in town refuse to sell Brent all the biscuits.
But cholesterol may still be the biggest risk to our investment approach.
And I learn a lot from helping coach a u12 girls soccer team.
Now you’re in the know. So happy New Year, have a great weekend, and see you Monday!
-Tim
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Write Love Letters
When people ask, I tell them that I started Unqualified Opinions to challenge myself to say something interesting every day. And that’s still a true statement, and I hope I am achieving that objective. That said, meeting that challenge on a daily basis is difficult and sometimes stressful, so another question to ask is: Why?
Back in 2021, singer Billie Eilish released a film on Disney+ called Happier Than Ever: A Love Letter to Los Angeles. I thought that was an interesting title so I looked up why she called it that. The reason, she told Good Morning America, is because it “made me who I am…I owed Los Angeles some love.”
Of course, the thing about love letters is that while they are emotionally charged, they are not universally positive. They are also born out of anguish, conflict, fear, and all of the other feelings that might lead someone to do something out of the ordinary. And so it goes in the film, with some of Los Angeles’ shortcomings causing Eilish to change over time as a person.
It sounds funny to say it, but I feel the same way about the subjects of business and investing. Business and investing have framed how I think about the world, been the source of my best friendships, and even been why I moved my family to Missouri. But my experience in these areas has also not always been positive. I’ve lost money, fired people, failed and been wrong, and experienced shortcomings that have caused me to change over time as a person.
In other words, I owe the subjects of business and investing some love.
So these are my love letters. I'm energized to contribute to the discourse, and I hope that when it’s all said and done they form an interesting and coherent complete thought. Further, and generally speaking, I am going to bind these and hand them to my kids so they understand why I am such a weirdo.
But it’s not all said and done yet, and I know that’s the case because Sarah(!) already designed the logo for Season 3. That said, I've got a Turkey Trot to run and then will definitely need a break to recharge.
Have a joyous holiday season, see you in 2024, and write some love letters of your own.
-Tim
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The Person-to-Problem Ratio
One way to look at capital allocation is through fancy math such as return on invested capital (ROIC). This has you figure out how much money you spent on something and how much money you made as a result. It’s calculated in dollars and expressed as a percentage, and useful in evaluating and prioritizing work based on expected outcomes and also in thinking through how to get better outcomes by lowering the cost of achieving them.
A lesser-known framework (because maybe I’m the only one that uses it) is the person-to-problem ratio (P/P), which counts how many people are working on a problem. It’s useful in evaluating and prioritizing work based on the effort required to do it and also in thinking through how to get better outcomes by raising the cost of achieving them.
But why would anyone want to raise the cost of achievement?
Let’s say you make a New Year’s resolution to exercise more. Then the first week goes great and the second week ok, but by the third week you are back to your pre-resolution, couch potato self. If you tried to calculate a ROIC to justify investment to solve your problem, you’d get nowhere because it’s nearly impossible in this scenario to quantify an expected return in dollars. Further, a ROIC lens wouldn’t help you gain any insight into what or how much of an investment to make. You could buy weights, for example, but would that make you more likely to lift them?
Now apply the P/P ratio. Your problem (the fact that you’ve stopped exercising) exists because your P/P was 1, but what if you double it?
First, doubling anything is significant, so a forcing function here is that people are whole numbers and can’t be gradually allocated, so anytime you think about increasing your P/P ratio on something, you have to really consider whether doing so is worth it. Second, people are less faceless than money, so increasing the P/P ratio on something also forces you to consider specifically what that looks like. Going back to the exercise example, one way might be to hire a trainer. Another might be to get a running partner.
Or you could even push the P/P ratio to 10 by doing something like join a running club.
Of course, none of us have infinite resources, so another interesting aspect of the P/P ratio is thinking about how to increase it when warranted using lower-cost labor. After all, that’s exactly what the running group is.
Now, this is easier when it comes to personal rather than business problems due to networks of friends and relatives who are often willing to help on something, but it’s not impossible. Indeed, if you run a small business, it’s worth thinking about. After all, an unfortunate reality of small business is that the P/P ratio on many SMB problems is often less than one. In other words, there are lots of problems and limited resources.
But how might that work?
If you’re challenged for sales growth, for example, rather than bring on a salesperson, you might start a referral program that effectively turns customers into salespeople, increasing the P/P ratio without adding headcount. Or if you’re consistently out of stock, what might you do to delight a supplier to make sure they are focused on your access to raw materials as much as you are? Then there’s the idea of crowdsourcing, which was all the rage for a while, but seems to have fallen back down to earth aside from Wikipedia being near canonical.
At the end of the day, people solve problems, so it stands to reason that problems will get solved as the P/P ratio goes up. That said, the risk is that as P/P goes up, your ROIC goes down, which is bad news for running a profitable business. Further, there is risk in throwing too many people at a problem or assuming that if you overstaff a problem it will get solved well. This is the origin of Amazon’s Two-Pizza rule, which states that no team should ever be larger than can be fed by two pizzas because at some point you reach a point where the value of collaboration is diluted by having too many collaborators.
So the P/P ratio is not a panacea, but nothing is. Rather, it’s a different and – I think – interesting lens through which to analyze things, and I offer it up in that spirit.
– By Tim Hanson
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You Will Get Sued
The title of this Unqualified Opinion is what Brent told me when I signed up for this nutty gig (which I wouldn’t miss for the world). The reason is that while he used to think legal conflict was avoidable (“Just treat people well and everything will work out.”), the thing is that people get funny about money. Since it’s a way to keep score, sprinkle on top some ego, some “advisors” with strong opinions, and an attorney (who is probably looking for more work), it’s not hard to see how situations get volatile.
Said differently, you will get sued. And now I’ll turn it over to B…
“The first time I had legitimate legal action threatened against me was right after my first acquisition in 2009 and it involved an employee issue that was black-and-white. An at-will employee was let go for beyond good reasons after repeated attempts to salvage the relationship and many opportunities to make things right. The decision to end the relationship wasn’t a difficult one and the person knew it. But as I found out, this person had a history of being litigious with former employers and openly talked about getting “an exit bonus” based on getting lawyers involved, on contingency of course. This person looked at legal action as a game and knew how to play it.
So having just put all my chips on the line and borrowing a big sum from the SBA, I was faced with a lawsuit for about a third of the total purchase price. That got my attention. And, it kept my attention for months. I couldn’t sleep and struggled with depression. I obsessed about possible outcomes. I worried about affording a settlement or even the on-going legal costs of defending the claim. I stressed about what people would think and fretted about my reputation. I had little margin financially or emotionally and it showed.
Thankfully, the company I acquired had insurance that stepped in to cover the defense of the claim and they settled the claim for a fraction of the claimed damages. The process was brutal, but not because of what actually happened. My attitude and fear made it so. I learned never to meet a problem halfway, especially a legal problem. People will allege all kinds of things for all kinds of reasons. Almost always, very little comes from allegations where there’s little or no wrongdoing. And anyone who has been in business for very long doesn’t pay much attention to allegations, even ones that look bad.”
What’s the guidance?
Find a great lawyer.
Build trust when you don’t need it.
Do the right thing.
Government regulation is such that even if you desperately try to comply, you can’t operate successfully without inevitably running afoul of some rules, some of which conflict with other rules.
You will get sued.
Have a great weekend.
– By Tim Hanson
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Safe Ball, Make a Run
One paradigm that’s gained in popularity at Permanent Equity HQ is the barbell. This is the idea that there is no medium risk, so in investing you should either keep your money in safe assets or seek high returns that compensate you for taking any risk at all.
Yet the barbell can be elsewhere. When it comes to time management, for example, we’ve experimented with never spending 45 minutes on anything. Instead do something in 5 minutes or less if it’s that type of task or do it for as long as it takes to get it done right if it’s that type of task instead.
And at the risk of talking too much about my daughter’s soccer team in this space, the barbell is there as well. Here’s a recent example…
I was coaching a small group in a 3v3 tournament where when the ball goes out of bounds, you get a kick-in and not a throw-in. These kick-ins are real opportunities because it’s a small field and if you make a good pass, it can really break down a defense and lead to a scoring opportunity.
But the girls were getting frustrated by their kick-ins. First, you have limited time to kick the ball in and the ref is counting down that time, which is stressful. Second, as I said it’s a small field, so as the other two players moved around to get open, they’d often run into the same space, which makes it easy on the defense. Third, if the kick-in is not executed well and the other team intercepts it, well, it’s a small field, so now they have a scoring opportunity from what should have been your tremendous advantage.
So we huddled up to talk tactics and I said, “Hey, let’s try something. What if during a kick-in one player gives the kick taker a super safe ball and the other makes a really dangerous run? If the run is not there, play the safe ball. And if it is there, take the risk.”
They liked that because it was clarifying, solved for the time pressure, and also put us in a better position in case we turned it over. Moreover, it gave them a repeatable framework. Every time a ball went out of bounds one of our players would place the ball down to take the kick then point at one teammate and say “Safe ball” and point at the other teammate and say “Make a run!”
The point was to take a lot of risk if success meant making a material improvement to the status quo and to take no risk at all if it didn’t. And to do that over and over and over again. The reason that’s a recipe for success (they won the tournament, by the way) is because as you do it, your upside is increasing asymmetrically relative to your downside and if you can do that, do it all day everyday.
– By Tim Hanson
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What Can You Optimize
One of the reasons Permanent Equity invests in existing businesses that already have customers, suppliers, earnings, and employees is because we know that efforts to help optimize something that’s working are far more likely to be successful than those starting something from scratch. And there’s data to back that up. For example, of the 632 thousand businesses that started in the year ended March 2012, 132 thousand of them (20%) failed in their first year. But fast forward 10 years and of the 234 thousand survivors, just 13 thousand (5%) failed last year, their tenth year of operations. In other words, the Lindy effect is real.
What’s more, we believe this lesson to be true at the project level when it comes to working on a business as well. Yet instead of spending time optimizing strategies that are working reasonably well, we often see leaders get either bogged down in fixing something that’s broken or distracted by the glamor of inventing what to do next. Don’t get me wrong, there is a time, place, and circumstance to engage in both of these activities, but – and it’s a big but – our experience has taught us that the most significant returns come from leveling up parts of a business that are working well.
Here’s how that thinking can apply to several different areas of a business:
Now, I recognize that business and operations are hard and that things don’t always go your way or according to plan. When that happens, everyone needs to spend time fixing things. But know ahead of time that this work is a grind and it will be breakeven, at best. Many times, the best outcome from these efforts will be the status quo, i.e., the preservation of your reputation.
That’s nothing to sneeze at, of course, nor is a new idea that works brilliantly. But if you want to be able to consistently and sustainably level up, regularly ask and answer, “What can I optimize?”
– By Tim Hanson
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Insanity and Inflection Points
I went to a college that didn’t play FBS football, so when we moved to Missouri we logically thought we’d adopt Mizzou as a rooting interest. But don’t do it, I was told by the locals, because the program is doomed and nothing good ever happens to us.
The track record to date is that mostly that’s true except that this year has captured most everyone’s interest. What’s more, ahead of the game at number one ranked Georgia in early November (which the Tigers ended up almost pulling out), pretty much everything was on the table.
As for why that was, you could trace it back to Coach Eli Drinkwitz’s decision to fake a punt against Kentucky down 14-0 and facing fourth and 10 in week 7. See, Mizzou had lost to LSU the previous week and was on the verge of getting blown out. But instead Missouri scored, changed the momentum, and went on to win 38-21. And then the team carried that momentum into homecoming against South Carolina and blew the Gamecocks off the field. In other words, the fake punt was an inflection point in the sense that it leveled up the baseline of what was possible and the team took full advantage.
Author Malcolm Gladwell is famous for calling these “tipping points” and his so-titled first book is full of case studies of small, niche products that had a few things go right and “tipped” into becoming cultural phenomenons, leveling up the baseline of what was possible. And it seems correct that if you do something in football or business that creates a massive opportunity, you go ahead and take it. But is it?
Now that I’ve broken the seal on talking about the foibles of mid-Missouri dining establishments, I have no shortage of stories and this one is about the fiercely independent local juice bar (if you know, you know) that decided to expand its breakfast menu. On its face, this was a sound strategic decision. Breakfast is a logical complement to juice and capturing more wallet-share from a customer is good business. What’s more, we heard that the addition to the menu, some blueberry wheatcakes, were delicious. So delicious, in fact, that Mizzou students camped out to get them and customers came from as far away as St. Louis and Kansas City with lines out the door.
When we went to try them, however, we were told they were no longer being served. They’d gotten too popular and the lines were disruptive, stressful to the staff, and inconvenient for the cold-pressed-juice-drinking regulars. (Befuddled, Brent offered to buy the recipe, but the juice bar demurred.)
Faced with an inflection point that could level up the baseline of what was possible, the fiercely independent local juice bar walked back. So a fair question to ask is: Is that insane?
Whether you agree with the decision to stop selling delicious blueberry wheatcakes or not, the juice bar in making it was practicing risk management. See, the thing about inflection points is that they create variance, and the thing about variance is that while it’s great, it also makes a lot of people uncomfortable. Facing an onslaught of new customers demanding blueberry wheatcakes, the juice bar might need to hire more employees, upgrade its kitchen, lease new space, or maybe even stop selling cold-pressed juice to cold-pressed-juice-drinking regulars in order to take advantage of the opportunity. There’s reward to be had from this, sure, but it could also not work out and maybe it’s not why the juice bar got into business in the first place.
To me, creating an advantage with significant upside and then not pressing it is, yes, insane, but you could also argue insanity is doing something you don’t want to do because someone else thinks it’s insane not to. Still, they should have sold Brent the recipe.
– By Tim Hanson
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Why Small Business
Our COO Mark and I both moved to mid-Missouri from the Washington, DC area to join the Permanent Equity team. Before doing so, we both worked for a company that invested in large public companies, so making the move was a big change both personally and professionally. The east coast to the midwest; big companies with audited financials to small companies that in some cases are lucky to have financials. You might ask why we did it?
The simple answer is our shared observation that one’s opportunity for growth is directly correlated with the number of problems one has the opportunity to solve. It’s a strange epiphany, but if you have an infinite number of problems, you can achieve exponential growth. That’s because each problem, once solved, now means something is being done better/faster/cheaper, with those gains dropping straight to the bottom line and compounding over time.
By those measures, there is no higher growth opportunity than operating small businesses. So while it’s frustrating to get punched in the proverbial face over and over again, it’s a first-class problem to have so many problems.
The other aspect is agency. It’s a cold truth that the ability to influence something is inversely related to its size. If you were an investor in Amazon, is there a website optimization you could think of that they haven’t thought of yet? And if you could, how long might it take you to get Amazon to test it, let alone implement it? And if it did get implemented, would the benefits have a noticeable impact on the company’s bottom line?
Yes, breakthrough, trajectory-changing improvements can happen at large companies, but the odds don’t tilt that way. The introduction of something like a lead-scoring system to focus limited resources on the best prospects for a small business, on the other hand, can lead to exponential improvement almost overnight.
Of course, it doesn’t always feel that way with what can often feel like an unending parade of problems and new challenges constantly emerging alongside solved issues unsolving themselves. But when you take a step back to appreciate the chaos, you see that when it comes to having chances to solve problems to great results, there is no better opportunity set in the world.
– By Tim Hanson
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They Blew Up the Bridge…Again
Of all of the lessons we learned from blowing up the bridge, the one I keep thinking about is Robbie’s observation that the rebuilt thing is also not forever. Not only is he right, but God willing, you’ll get a note from me 60 years from now titled “They Blew Up the Bridge…Again” and it will really be about that (and not about the fact that they accidentally did blow up a part of the new bridge already). Because that’s the hard thing about growth. Not only does it create new problems, it also causes solved problems to become unsolved.
Take, for example, the problem of keeping track of the financial performance of Permanent Equity’s companies. When I arrived in 2018, there were basically seven businesses to keep an eye on. So I made a spreadsheet that listed the expected performance of the different metrics we wanted to track at each company and asked our financial partners to input the actual performance when they received it, and we went on our merry way. The system worked...for a while.
Now we have 17 or so businesses to keep an eye on and that spreadsheet and process have gotten unwieldy and inefficient, so Mark and Nikki are thinking about investing in some software to replace it. Am I sad to see my spreadsheet go? Yes. Am I sad I spent time building a solution that ultimately didn’t work? Absolutely not; I’m pumped that we outgrew it.
I wrote previously that one thing that’s undefeated is the ability to raise unlimited capital. Another is entropy.
If you're a homeowner, you know entropy well. It’s the thing that causes you to say “Didn’t we just pay for that?”
Like risk of loss and risk of gain, entropy and growth are kind of the same thing just reversed. Except growth causes entropy and entropy causes growth. In other words, by trying to grow, you will create problems, but solving problems will also cause you to grow. And if you think about it that way, acknowledging nothing is forever, then all of those problems unsolving themselves all of the time will become a source of delight rather than frustration.
Or not. But have a great weekend and the next time they nuke the Rocheport Bridge (not by accident, great job guys), you are all invited on the boat.
– By Tim Hanson
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Now That’s Pessimistic
When we last saw my friend with the not sufficiently pessimistic financial model, he was going to go back to forecast higher levels of volatility in the commodity business he was thinking about buying in order to determine if the deal he had on the table made sense. He did that, and the answer was that if revenue declined by 20%, he wouldn’t be able to service the debt he proposed to put on the balance sheet.
Could that happen?
Well, since the relative standard deviation of the commodity price that drove sales at this business was 26%, the potential for a 20% decline in sales was very much on the table. He could hedge, of course, but that didn’t seem practical for a business of this size, so the question was “What next?”
If you’re ever in a position where you need to predict how a business will behave, the thing to look at is its capital structure. In other words, is it funded by debt or equity, how much of each, who are the actors, and what are the terms? In this case, my friend wanted to buy a business and reinvest in capabilities in order to grow, but his cap table with far more debt than equity would never enable him to do that even after leaving aside the potential for top line volatility.
So I said, “You’re already raising money from investors to do this deal. Can you raise more and swap out some of the debt with equity?”
“I could,” he responded, “but then the returns will be lower.”
And that’s a true fact. Equity capital is more expensive than debt with its cost borne directly by other equity holders. Yet what selling equity won’t do is bankrupt you.
Or here’s how Stripe cofounder John Collison phrased it on Patrick O’Shaughnessy’s Invest Like the Best podcast recently: “Credit financing is fixed cost to the borrower…[but] has the unbounded risk of destroying your business. Equity capital has unbounded costs, but does not come with the embedded risk of possibly blowing up your business.”
That’s a great way to look at it. So a question to ask of your cap table is what is the risk of it blowing up my business and how much is it worth to me not to?
Given that my friend was personally guaranteeing this loan, relocating his family, and staking his savings and employment in the deal, when he thought about it, not blowing up turned out to be really valuable to him. Further, when he went out to raise additional equity and explained why, he found that his investors now wanted to give him more money despite the lower return profile because lowering the risk of their losing their investment was valuable to them as well.
In other words, it can pay to be pessimistic, particularly if your pessimism is realistic, and helps you align the funding of your business with the funding it needs.
– By Tim Hanson
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Risk of Gain
Not all of Permanent Equity’s employees have finance or investing backgrounds, so we do what we can from time to time to help everyone gain a shared understanding of how this sick, sad world works. A little while back, it was a Lunch & Learn about personal finance and investing. More recently, it was a note explaining how our investors might react to news of a loss in our portfolio.
In that note, I said this: “Our partners are sophisticated investors who know that equity investing involves the risk of loss. The reason they, or anyone, take this risk is because equity investing also involves the risk of gain.”
“Risk of gain,” I heard back, was a curious term. What did I mean by that?
Volatility, variance, beta…whatever jargon you want to use (and among professional investors there is a lot), one way to think about gains is they are the same as losses, just reversed. In other words, both are what happens when an asset you purchase changes in value or price…just don’t get a professional investor started on the difference between the meaning of “price” and “value.”
But if you think this way about gains and losses, then a key to investing successfully is to only traffic in transactions where the risk of gain is greater than the risk of loss i.e., if your thesis is correct, you stand to make more than you stand to lose if you’re wrong.
Provided you don’t use leverage, since the most you can lose is all of your money, this is why making a portfolio of equity investments and holding them for a long period of time mathematically makes sense. Some will go to zero, but that’s a bounded loss, while others will increase exponentially in value, creating boundless upside. So if you own a group of them and you’re only, or more than, or even less than coin-flip talented, your risk of gain is more than your risk of loss.
The same reasoning helps explain why if you own a home, you should absolutely have homeowner’s insurance. You only have one home, it’s only going to appreciate in value (on average) a few percentage points per year, but one catastrophic event such as a fire could zero it out in a blink, leaving you without shelter and owing a bank a lot of money. That's an unbounded downside in my view, so pay to insure against it.
The point is when a party and a counterparty are transacting, both are assuming a risk of gain and a risk of loss. If that’s you and your risk of gain is greater than your risk of loss, that’s a good investment. If they are equal, then hopefully the transaction makes sense for some other reason. And if your risk of gain is less than your risk of loss, then hopefully the transaction makes sense for some other reason, but also buy insurance.
– By Tim Hanson
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In Defense of Micromanagement
Here’s what Jerry Seinfeld had to say to the Harvard Business Review about why Seinfeld was such a success:
“If you’re efficient, you’re doing it the wrong way. The right way is the hard way. The show was successful because I micromanaged it – every word, every line, every take, every edit.”
This very well may have offended the HBR professionals (or at least made them cringe), as they have published a deep catalog of content writing against micromanagement as a viable business philosophy:
February 2008: Micromanage at Your Peril
September 2011: Stop Being Micromanaged
November 2014: Signs That You’re a Micromanager
August 2015: How to Stop Micromanaging Your Team
August 2017: To Get Your Boss to Stop Micromanaging, Clarify Expectations
December 2019: 3 Ways to Kick Your Micromanaging Habit for Good
December 2020: Stop Micromanaging and Give People the Help They Really Need
January 2021: How to Help (Without Micromanaging)
September 2022: How to Stop Micromanaging and Start Empowering
You get the point. Conventional wisdom doesn’t have a lot of nice things to say about micromanagement. And yet, we see it happening – and often working – all the time
The reason is that small businesses tend to struggle to hire talent and not have time or resources to invest in building training programs. Absent those factors it’s almost impossible to run a business without micromanaging.
What’s more, micromanagement is an effective way to manage risk. If nothing can happen without an owner’s approval, it’s nearly impossible to stumble into a problem that might destroy your business.
There is, however, a cost to micromanaging, which is that a micromanaged business can’t grow sustainably and its equity is worthless to anyone but the micromanager. This is why Seinfeld stopped running after nine years even though NBC would have loved to keep it on the air. You couldn’t just bring in John Goodman or Nathan Lane and keep rolling.
But that’s also one way to do it. Not every enterprise needs to have a plan to grow for decades and go public. It’s okay for something to exist successfully for a period of time and then stop existing. That’s not nihilism, it’s reality, and it happens all the time.
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You Can’t Buy All the Biscuits
Our founder and CEO Brent can be a magnanimous guy and so he stopped into a local bakery the other morning (which will remain nameless, but any denizen of Columbia, Missouri, will know the one I am talking about) to buy breakfast sandwiches for everyone in the office. When he got his turn at the register, the following dialogue ensued:
Brent: 15 breakfast biscuits, please.
Fiercely Independent Bakery Employee: 15 biscuits?
Brent: Please.
F.I.B.E.: That’s all of them.
Brent: Is it?
F.I.B.E.: You can’t buy all the biscuits.
Brent: There are 15 people at my office.
F.I.B.E.: What if someone else wants a biscuit?
Brent: What if someone doesn’t?
F.I.B.E.: You can’t buy all the biscuits.
Brent: How many biscuits can I buy?
F.I.B.E.: Not all of them.
Brent: 14?
F.I.B.E.: Probably not.
Brent: 13?
F.I.B.E: Uh.
Brent: I can’t not bring biscuits for everyone.
F.I.B.E.: Sorry.
And I don’t think he has been back since. But why couldn’t Brent buy all the biscuits? Let’s apply stakeholder theory…
Brent here was a Customer, and while the Customer is not always right, he was right to try to buy 15 biscuits. The F.I.B.E. here needs to sell 15 biscuits, so it would seem like the interests of the Customer and Employee are aligned. It’s also obviously good for the Capital behind the bakery to sell all of its biscuits.
Ergo it seems like a no-brainer to let Brent buy all the biscuits.
Unless you think the world is losing out by the bakery not having any more biscuits to sell that day. Or perhaps the F.I.B.E. did some math in her head on behalf of the Capital and realized that the incremental increase in earnings would be negative to the equity value of the bakery due to an increase to its cost of capital given risks associated with customer concentration.
While I can’t say for certain exactly what reasoning took place, to me it is not good business to not sell your biscuits to a customer you’ve already acquired. We have a saying around the office that small businesses don’t stay small on purpose, but sometimes I guess they do.
– By Tim Hanson
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What Blowing Up the Bridge Taught Us
Back when I shared the video of the Rocheport Bridge blowing up (and here it is again), I said that if you were able to find a business, finance, or investing lesson in the carnage to let me know what it is. And you didn’t let me down! So here’s all of the wisdom watching the bridge blow up imparted:
“If something isn’t working out, a vendor, customer, employee, or investment, sometimes it’s better to just blow it up.”
–Casey
“You have to be willing to destroy things you work hard to build if they stand in the way of something new and better, because if you don’t, your competitors will.”
–Mark
“It’s fun to watch things blow up because it teaches you how to build it better.”
–Augusto
“That rebuilt thing is also not forever.”
–Robbie
“The explosion happened before anyone heard it. If you’re not actively looking for risk, you may be in for quite the surprise.”
“The synchronicity of the explosions stood out to me. As leaders, we focus on being aligned when we are building, but we also need to be aligned when it’s time to break things down (or blow them up).”
–Joe
“Reputations are like bridges. Years to build, but seconds to blow up.”
–Russell
“Any year that passes in which you don’t destroy one of your best-loved ideas is a wasted year.”
“When you blow up a bridge, which you need to do sometimes, do so in an artfully controlled manner so you don’t get collateral damage.”
–Kieran
“Economic progress, in capitalist society, means turmoil.”
Not bad learnings from a 13-second video. Have a great weekend.
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Negotiate No-Brainers
The Investing team had a pleasant conversation at lunch the other day about how much we enjoy investing and our jobs, but then turned to the topic of how many of our fellow investors seem stressed out by and even adversarial with their chosen profession. We wondered how anyone can not enjoy doing this for a living?
Now, I don’t think any investor starts off hating his or her job. After all, it’s a white collar affair with upside and glamor if you do it well. But it can become challenging if there’s underperformance as self-doubt creeps in and customers start asking hard questions or even for their money back. But every investor will experience periods of underperformance, so how might that happen without that person hating it or calling it quits?
I think the secret comes down to two factors: 1) Who do you invest with and (2) How do you define success?
As we’ve talked about in the past, other people’s money (OPM) can come with lots of baggage that can make life less fun. So choose partners wisely and only be in business with people whose names you’ll be excited to see pop up on your cell phone when things aren’t going well (which is a great litmus test).
As for success, defining it needs to happen along several vectors: magnitude, frequency, timeline, and measurability. Further, you need to be on the same page with your customers about that definition before ever deploying a dollar.
That said, a wrinkle here is that good partners aren’t people who don’t hold you accountable and success isn’t something that can only be measured after a 30-year period. As I’ve said before, one of the best things someone can do for you is tell you you’re wrong and be right and also that the long-term is a series of short-terms. In other words, to love investing you need to be able to have hard conversations about things that aren’t working right now.
But then what?
This is where terms come into play i.e., the rules of engagement between an investor and his or her capital. For example, if you manage a typical public company mutual fund or ETF and you have a bad day, all of your investors could ask for their money back. That’s stressful! And it’s also why that industry suffers from sleights of hand like window dressing and closet indexing.
Yet while the best investing strategies should only get better with time, an investor also can’t lock up capital forever because if you’re doing a bad job, there needs to be redress. But it’s also true that investing outcomes aren’t always controllable. So the question is how can you be held accountable for results that aren’t linear or predictable?
One approach to negotiation is that a good agreement has been reached when both sides feel a little aggrieved. In other words, no one got exactly what they wanted, so the compromise was probably fair. That doesn’t work in investing because being able to take back some of your money when performance is meh really isn’t great for anyone.
So this is where a different approach to negotiation comes into play: to only agree to no-brainers. In other words, terms that are so obvious that if the other side exercises one, it’s exactly what you would have done had you been in their shoes.
At Permanent Equity, one way that takes shape is that if our performance isn’t good, our investors pay no fees. Another is that if we take fees we end up not being entitled to, we give them back.
If either one of those scenarios happens (and we hope it doesn’t), the consequences are both predictable and reasonable. And that, I think, is among the reasons why we love our jobs. We have great partners, understand what success looks like, and know that no matter what happens, we will be treated fairly and treat others fairly along the way.
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Tornado Traffic
My daughter and I were parking the other day at a soccer complex in Illinois that is susceptible to severe traffic jams when everyone tries to leave at the same time. Some relevant information here is that the last time we were at this soccer complex, her game got blown dead due to a tornado warning and then no one could escape as the sky turned green and the sirens started wailing because we were all waiting to merge into one lane of traffic and make a right on red.
“Eff this,” I finally said and drove up over the curb and onto a bike path that took us to safer ground.
The reason this is relevant information is that as we were parking this time I said to my daughter, “Do you want to park near the field and risk getting stuck in traffic when the tornado hits or should we park near the exit and have to walk a ways to the field?”
I, of course, would prefer to park near the exit and walk because (1) optionality and (2) I’m an Apple Watch psychopath.
But she said, “I don’t think a tornado is likely, so let’s park near the field. That way we’re sure of getting something good.”
So I said, “I love that you’re thinking about risk and reward and you’re probably right about a tornado, but I think you’re overvaluing the reward of parking close and undervaluing the risk of getting stuck in traffic.”
And she turned and looked at me funny, so I parked near the field because (1) I know I’m crazy and (2) I didn’t want her to be late.
Yet I still think I was right (even after leaving out the benefit of getting more steps in, which admittedly has more value for the geezer about to sit and watch a soccer game than it does the young person about to run a handful of miles playing in one). The reason is that earning gains of one magnitude without being cognizant of the potential magnitude of losses said gains expose you to regardless of the infinitesimal likelihood of said losses materializing is a good way to eventually end up on the wrong side of a bet.
In other words, getting a great parking spot is not worth being stuck in your SUV when it’s sucked up by an F5. While that seems obvious in this context, I can assure you it is not in the real world. People look at you funny after 10,000 instances of being angry, tired, and behind schedule because you parked out in left field when you keep suggesting you park there to escape from a tornado that has never materialized.
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From Here to There
One saying we have around our office is that what got you here won’t necessarily get you there. What this is in recognition of is that projects, businesses, and people are all works in progress. In other words, what you did to get where you are today may not scale and, in fact, may be working against you with regards to getting where you want to go next.
For example, after years of thinking about it, we finally (now that we have a qualified CFO) implemented Expensify in our own office to better track, reimburse, and manage expenses that employees were incurring on behalf of Permanent Equity as well as promulgate an official expense reimbursement policy. Previously, this process was manual and we trusted the judgment of individual employees to decide what was an appropriate amount to spend on something. With 10 employees, that was fine. With 15, it started being a hassle. As we approached 20, it became a pain point.
Process and policies, of course, mean less flexibility, which might be irksome to some, but also enables faster scaling. The reason that’s so is because fast, decentralized decision-making relies on trust. Absent process and policies, the only way to build trust is through careful hiring and relationship building over long periods of time. And that’s one way to do it. But if you want to go faster, you need process and policy so that new folks can understand what success looks like and what is expected of them. But also everyone needs to abide by the same rules because having two (or more) classes of employees will never beget a strong culture.
Here’s another example: We saw another business that had scaled to high heights and promoted several long-tenured employees into leadership roles. Normally, this would be a massive success story and a desirable situation. The problem was that these employees were hired before the business had to document their immigration status and no one knew what that status was.
For a small, closely-held business that may remain an unasked question one can live with. But for a large business taking outside capital, it’s a non-negotiable.
This isn’t to judge anything anyone has done to build their business. Decisions are always made in context and looking back, most that I’ve encountered have been defensible. But some decisions have half-lives and others get outgrown. That’s important to remember and revisit because scaling on top of a shaky foundation is a good way to sow the seeds of your own destruction.
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Risk and Recovery
I know I’m repeating myself when I say that one of the benefits of writing daily about things that interest you is that other people read about the things that interest you and then curate the internet on your behalf by sending you things they think might interest you, but it really is a nice perk. So it went the other day as I opened my email while drinking my morning coffee to find a note from Johnny that said “From James Clear…Seems like something that would be of interest to you…”
And it was!
If you don’t know James Clear, he’s an author and authority on habits and decision-making. He has books and a newsletter, and it was from his newsletter than Johnny passed along this:
One filter I use for making decisions: How much can I influence the outcome after the initial choice is made?
When I can do a lot to influence the outcome, I’m less worried about risk. Even if the choice appears risky on the surface, I can likely create a good outcome with effort.
When I can’t do much to influence the outcome, I’m more risk averse. Even my best effort won’t move the needle. Your ability to influence the outcome after a decision is made is a crucial thing to consider.
On its face, this seems like sound advice. If you have more agency, try to do more, because (1) your ability can make good things happen and (2) if good things don’t happen, it was your fault anyway.
But what this advice ignores is how consistently (1) people overestimate their ability to influence outcomes and (2) how often the world conspires against our best efforts.
I try to avoid politics in this space, but I don’t think it’s political to point out that when Russia invaded Ukraine in February 2022, it thought the war would be over in 10 days! There’s really no situation where someone can think they have more agency than a global superpower choosing to invade another country, but here we are.
Taking it down a notch, our COO Mark feigns offense whenever I tell someone that when we underwrite an investment, we don’t assume that we can do anything to make the business better. But it’s true (and no, that’s not me disrespecting our Ops team). Rather, it’s acknowledgment that even when you think you have 100% agency, you probably don’t and further that making any prediction come true is an incredibly difficult task.
Does this mean you shouldn’t take risks? Heck no. But I think the better framework for thinking about them is: Can you recover if they materialize or will there be permanent damage done? In other words, if I were to revise James Clear’s advice, I’d put it this way:
One filter I use for making decisions: If my choice is a bad one, can I recover from the consequences of it?
When I can recover from the consequences, I’m less worried about risk.
When I can’t recover from the consequences, I’m more risk averse. Your ability to recover from the risk you are taking after a decision is made is a crucial thing to consider.
– By Tim Hanson
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The Most Dangerous Danger
Our managing editor Sarah pinged me recently because she realized I had to update my bio on our website. I was no longer CFO, she pointed out, and she asked if anything else had changed.
Reading it again, that brief bio from when I started way back in 2018 said that I enjoyed “running, gardening, biking, paddling, and soccer-ing.” So I wrote her back and said that she could delete biking and paddling because I really don’t do those any longer.
“What happened?” she asked.
“As I age, I streamline my activity set,” I responded.
And it’s true. When it comes to physical activity, I know I’m one wrong foot away from a debilitating injury at this point so I only try to do things that I’m willing to risk being crippled by. Just as in finance, there is no medium risk, so try to traffic only in activities that give you upside.
The analog to this is that it’s the unintended bets that will get you, because they’re the bets you don’t know you’re making. For example, if you recently picked up pickleball because it seemed fun and you didn’t think it could cripple you, well, you’re wrong. Pickleball is expected to cause $400M worth of injuries this year. And that’s surprising because pickleball, on its face, doesn’t seem as violent as something like football or hockey.
But that’s what makes it so dangerous!
The Wall Street Journal reported recently on this study, which found that on the job accidents “are most likely to occur under moderately hazardous work conditions.” In other words, as measured by likelihood of injury, safe jobs are safe and really dangerous jobs are safe, but kinda dangerous jobs are really dangerous. And that makes perfect sense when you put these ideas together and realize that if you take any risk, you are taking catastrophic risk, and if you don’t realize the risk you’re taking, you make it more likely that that risk will materialize.
That’s the most dangerous danger, so stretch before you play pickleball and have a great weekend.
– By Tim Hanson
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How to Hold Cash
We are fortunate at Permanent Equity to have a strong balance sheet, and we prefer to keep it that way. Of course, the downside of holding “excess” cash, particularly in an inflationary environment, is that you have to find something to do with it.
Or do you?
Our founder and CEO Brent dropped by my desk not long ago and asked what we were doing with our cash and if nothing, should we buy treasuries to take advantage of the high interest rate environment? The cash was sitting in some safe bank products earning reasonable (but not great) rates, so he was right that if we bought six-month or one-year treasuries we could earn quite a bit more. The question was did we want to take the duration risk?
I’ll be honest here: Duration risk terrifies me. Having money and not being able to use it or being forced into taking a loss because it’s today and not tomorrow seems like it would be both painful and humiliating. Further, this is the kind of risk you don’t realize you’re taking that can blow you up – as duration risk did to Silicon Valley Bank. That said, it’s also painful to watch the value of our money get eroded, so how might one balance these two suboptimal outcomes?
I’ve talked before about The Four Important Roles, and one of those is the person who’s constantly creating opportunities for an organization to take risk. At Permanent Equity, that’s Brent, and he’s great at it. What he’s not great at though – and the reason he’s not great at this is because he’s so great at creating opportunities – is predicting when he will create said opportunities.
So after thinking about it, what I said to Brent was, “I don’t think the incremental interest income is worth being handcuffed if we get the opportunity to make a really big investment we don’t even know about yet.” Yes, I know we could borrow against treasuries and so on and so forth, but then you are also bringing in other decision-makers and risks, and we like to keep things in house.
He ultimately agreed so we continue to keep more capital on the sidelines today than we probably should. But we think that’s because what we’re not earning today will be more than made up for when we get that opportunity to finally do something with the money.
As for how much cash you should keep on the sidelines, that answer will be different for everyone depending on the risk-free rate of return and your ability to create high-returning opportunities. If you don’t think any big opportunities are on the horizon, lock it all up in treasuries. But if something big might happen, you’ll want your cash to be ready to go.
That being said, no matter how big an opportunity there is, never go to no cash because you’ll always want three-or-more months of operating expenses on your balance sheet just in case there’s a pandemic or something.
– By Tim Hanson