Book review: Black Edge

Black Edge: Inside Information, Dirty Money, and the Quest to Bring Down the Most Wanted Man on Wall Street. (Sheelah Kolhatkar)

Stevie Cohen’s SAC Capital Advisors had delivered c. 30% returns for two decades. He was The Man, when hedge funds were still the new kings of Wall Street. Sheehan Kolhatkar has successfully woven together the tale of how the government tried (and plot reveal – failed) to put Stevie in the can. You should read this book, but you will be disgusted by: (1) How crooked some hedge fund managers (and their enablers) are; and (2) The fact the big fish got away.

The book also gives a small peek into the lifestyles of the rich and famous. The anecdote involving casino mogul Steve Wynn accidentally putting an elbow through his Picasso after he had sold it to Stevie Cohen for US$139m is particularly amusing.

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Head to the “Books” page to see a collection of other books you may enjoy.

Investing exponentially

The article “Soft Bank CEO Masayoshi Son Banks on Exponential Growth”  by Vitaliy Katsenelson (Contrarian Edge) really made me think about how I invest. Soft Bank has been in the news recently for its US$32bn investment in Arm Holdings (at 48x earnings!) and its US$100bn technology investment fund. The CEO has proven a master at placing bets on companies in rapidly accelerating industries.

A younger Masayoshi Son

Source: Wikipedia

Before discussing Masayoshi Son’s investment approach further, I’ll provide a bit of background about my own investment philosophy. I believe an investment philosophy is crucial for those interested in personal finance and financial independence. As a non-professional investor, I’m a huge fan of using index ETFs for cheap and low hassle exposure to equities. However, I also think I’m a smart guy, who occasionally comes up with a good investment idea, so I like to do some non-index investing. I know I will struggle to beat the index over-time, but don’t care. In summary, my philosophy is “mostly use low cost ETFs, but leave room in the portfolio for some small bets”.

My view of the market at the moment is:

  • P/E multiples (particularly in the US) are outrageous, particularly for many low growth businesses
  • However, money has no-where else to go if people are seeking real returns
  • The low interest rate environment could last for decades. Government and corporate debt levels make significant interest rate increases unlikely (but not impossible)
  • For those with a long-term horizon, investing in equities remains a no-brainer
  • But, you have to accept the risk of multiple contraction which will reduce your portfolio’s value

I’ve been doing a lot of thinking about what types of investments I should pursue with my non-index fund allocation. Here is where I am at:

  • Making investment in individual companies which are unlikely to perform substantially better than the market is more expensive and higher risk than index ETFs – it is pointless
  • Macro investing at times of significant volatility is attractive, but often difficult to execute for non-professional investors (e.g. profiting from the oil price crash has proved difficult, Oil ETFs tracking of the price recovery has been dismal)
  • The growth of PE/VC means getting early access to fast growing companies is increasingly difficult for retail investors

Now back to Masayoshi Son. Vitaliy Katsenelson’s article summarises Son’s investment approach, which is based on exponential (non-linear) thinking:

To understand this acquisition [purchase of Arm Holding for US$32bn], we need to come to terms with Son’s investment strategy and his mental models that have made him the richest person in Japan. Son is a master of exponential (nonlinear) thinking. Examine his past investments and you’ll find that he identifies industries about to go from high but linear growth into the exponential phase — where the rate of growth is accelerating.

Son has done this over and over again during the past 40 years. It started with PCs in the ’70s, when he built a software distribution business in Japan to capitalize on PC growth entering the accelerating phase. He saw the inflection point of Internet growth in the ’90s, bet on Yahoo and created Yahoo Japan (a joint venture with Yahoo).

In the early 2000s he saw e-commerce and the Internet taking off in China and purchased a stake in Alibaba, turning his $20 million investment into $60 billion today…

Identifying industries that are entering an exponential growth phase is hard enough, but acting on the insight is even more challenging. I remember looking at a report on Apple in 2009, analyzing smartphones’ potential market size, assigning a conservative market share to the iPhone and basically saying that over the next several years Apple’s sales could accelerate (or continue at the then-current rate of 30 percent or so) and reach $100 billion from less than $20 billion that year. I saw the logic in the analysis, but it was difficult for me (and, I think, for most people) to mentally process a high growth rate going exponential. By the way, iPhone annual sales reached $155 billion in 2015.

Investing at the pivot point when growth rates accelerate is especially tough for value investors (present company included). As revenue growth accelerates, costs usually don’t rise as quickly, and therefore earnings increase at an even faster rate than revenue — now earnings growth is truly exponential. This dynamic creates a lot of value, which our linear brains may or may not process…

Son believes we are at the inflection point when the Internet of Things (IoT) market is about to enter the exponential growth phase. There are 7 billion people in the world today. In 2015, ARM sold 15 billion processors — about 2 processors per person. By 2020, ARM expects to sell 75 billion processors a year — a fivefold increase.

Do read the whole article, available here.

This is a more operational and nuanced approach than typical big picture thematic investing. After all, Son is running companies. He is buying for the medium to long term. He’s not just chasing momentum or short-term returns.

This article has made me realise I need to refine my framework for making my “small bets”. I should be looking for both shorter-term macro bets, and bolder longer-term exponential growth bets. As discussed above, identifying, timing and executing exponential growth bets is very difficult. I won’t be placing many of these bets over the years, but will remain on the look-out.