Yen Liow’s Game Within the Game.
Here are a few ideas I took away from this wonderful presentation by Liow. I would recommend it for all to take a listen.
Business Stages
Liow breaks up the lifecycle of companies into Proof of Concept (POC), Replication, and Maturation. POCs are determined as the venture-type investing where the business model is being proven out. Replication is after the company has won its niche and is scaling the monopoly (i.e. growth equity).
Though POCs are often considered to be micro-cap companies or small private start-ups, there are large public companies that are still in that stage. The reverse is true for companies in the replication stage. Not all companies that are scaling a monopoly are large-cap public companies. This replication stage can last 10+ years for some companies. What companies you invest in, find interesting, want to understand, etc. should influence how you invest. The question is: What game will you play?
Game Selection
It’s a combination of your skillset, time horizon, capital, liquidity constraints, psychology, and a whole lot of factors that require introspection that should inform the kind of game you want to play as an investor.
Large companies have more eyeballs on them. The inefficiency in large markets will come from temporal while small markets will come from structural. Most funds can’t invest in low-volume companies (i.e. most of the small caps). Consider your advantage as an investor in such an environment.
I have small amounts of capital and the ability to size up large positions easily is an advantage I have that funds don’t. My structure as an independent investor with small sums gives me an advantage in the market of small companies. But most in those markets are POC so finding the rare ones that are in the replication stage would work well for my investing strategy.
Something else Liow points out is a strategy going for 100x or 10x investments. Those seeking 100-baggers will need to invest in POCs for the most part since they need to get in at a low price. But a business that goes 10x can be found when it’s in the replication stage.
Let’s assume you have a 50 stock portfolio using a POC strategy. Let’s say each investment is equally weighted 2% each. Companies that return 100x are extremely rare–despite how everyone today thinks they are the next Amazon, there still is only one Amazon. The same result can be achieved with a 20% position that 10x. It’s a different game, both are easier said than done. It’s about selecting the game you want to play, while assessing the realities of your situation.
Liow’s Moat Checklist
The three things that show the existence of a moat.
High competitive win rates (i.e. unfair fights). Remember that competition is good for the customers but not so for the capitalist. Liow looks for the business’s ability to win and retain (continue winning) customers.
Persistence in gross margins over time. It shows pricing power.
High return in incremental invested capital (ROIIC). Ability to deploy capital at continued high ROIC. Can’t have competitors erode the opportunity.
If the three are observable for a long period of time, there’s an indication of a great business that may be an oligopoly or monopoly. Just doesn’t tell you the source/root of it. But it presents the business as something worth looking into.
Base rates
...of Volatility
You are going to have to face high volatility. Know what to expect:
…of businesses
If you are investing in companies that are supposed to provide outlier results, they need to defy the base rates. They are fighting to be the exception, not the norm.
…of management
Elite management teams will find a way to win and poor management isn’t priced into the business. You need to invest in people who you like, trust and admire because when you experience the volatility, you will be tested.
There is upside optionality from elite management team. Looking for aligned, capable, hungry and ethical management team. Remember that a great business that achieved proof of concept will need a great management team for it to be able to scale the monopoly after winning their niche (What Liow calls the replication phase).
Price
How much you pay for the investment is an indicator of how much you could hope to make. Price volatility is the friend of those investing in highly predictable businesses.