Still Working on that White Paper
When it comes to thinking about how much capital to put behind an individual investment, one universal truth and three considerations apply. The universal truth is that anything can go to zero, so never invest an amount that if that amount did go to zero, it would prevent you from making additional investments. That specific amount will be different for different actors, but one way to know that you haven’t sized your bets too big is if you always live to fight another day.
And while that advice can help one avoid catastrophic blow-ups (which is something we should all strive to avoid), a bigger challenge when it comes to generating above-average long-term return streams is betting too small. That’s because the more bets you make, the more likely you are to achieve average results, which are then likely to become below average over time due to the increasing frictional costs of trying to keep up with so many bets at once. Ergo the three considerations:
1. How big can this bet get if it goes well?
2. If this bet goes well, what is the net impact on returns if everything else in the portfolio doesn’t go well?
3. If this bet goes poorly, what is the net impact on returns if everything else in the portfolio does fine?
Asking and answering these three questions can help size the opportunity and scope the influence on the rest of the portfolio. The reason that’s important is because you want to be thoughtful about not making investments that are too small to matter, but also avoid making investments that are so big nothing else matters.
For example, one of the smallest investments in our Permanent Equity portfolio is a 3% position. Now, it’s expected to punch above its weight this year and contribute 4% of our total return, but run the numbers and that’s only 73 basis points of that return. So a fair question to ask is: Was it worth it to make and now maintain an investment that contributes less than 1% to our returns and that would still be relatively inconsequential in the scheme of things if it only doubles or triples?
Indeed, we asked that very question at the time we made this investment and our answer was yes because the total addressable market for this business is significant and the operating leverage inherent in the model meaningful, so we thought it had multiples more potential. This doesn’t mean it will achieve that potential, but by virtue of having it, this is a small position size that’s worth it. To put it the context of the considerations:
1. If this bet goes well, it could grow into a 10% to 20% position.
2.As a 10% to 20% position, this bet could be a meaningful positive contributor and make up for one or two bad bets.
3.If this bet goes poorly, it will be a 1% to 2% annual drag on returns.
Now contrast that profile with one of our larger positions, which is 20% of the portfolio and will contribute 30% of this year’s return. We’re happy with that, but don’t necessarily expect the company’s return contribution to grow significantly over time. To put it in the context of the considerations:
1.If this bet goes well, it should remain approximately 20% of the portfolio.
2.As a 20% position, this bet will immediately be a significant contributor to our returns if it goes well.
3.If this bet goes poorly, it will be an 8% to 10% annual drag on returns.
Given that profile, we wanted to take a big enough position now so that the investment would be a material contributor to the portfolio both now and in the future when other companies had grown at higher rates. But in order to take that upfront risk in light of consideration 3, we needed to be compensated for doing so, which we believe we were and are by the valuation we paid and also by being invested via a preferential share class that gives us favorable economics if the business significantly retrenches. So while there is concentration risk, it is mitigated in the near-term by the terms of our investment and in the long-term as our other investing decisions play out.
Having said that, I recognize that none of our investing decisions will play out according to plan. But that’s exactly why we should all try to build a thoughtful portfolio of some number of them sized accordingly.
-Tim
