AcquiredComplexity Investing & Semiconductors with NZS Capital (Extended Cut)
EVERY SPOKEN WORD
130 min read · 25,697 words- 0:00 – 0:29
Intro
- BGBen Gilbert
excitement, fun, brevity. [laughing]
- DRDavid Rosenthal
[upbeat music] I love it.
- BGBen Gilbert
For brevity is the soul of wit.
- SPSpeaker
Who got the truth? Is it you? Is it you? Is it you? Who got the truth now? Is it you? Is it you? Is it you? Sit me down, say it straight. Another story on the way. Who got the truth?
- 0:29 – 2:07
Show setup: why NZS Capital + semiconductors deserved an extended cut
- BGBen Gilbert
Welcome to this special episode of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert, and I'm the co-founder and managing director of Seattle-based Pioneer Square Labs, and our venture fund, PSL Ventures.
- DRDavid Rosenthal
And I'm David Rosenthal, and I am an angel investor based in San Francisco.
- BGBen Gilbert
And we are your hosts. On our TSMC episode, one of the sixty-five sources that we used was an episode of The Knowledge Project with Brinton Johns and Jon Bathgate. Brinton and Jon are public equities investors at a hedge fund called NZS Capital, and they spend a lot of their time researching semis. It was packed so full of great content that I actually watched it twice to make sure that I understood everything.
- DRDavid Rosenthal
It was so good.
- BGBen Gilbert
It was awesome. And then, in a wild coincidence, the very next week, even before we shipped the TSMC episode, David and I were at Capital Camp, great event organized by Patrick O'Shaughnessy and Brent Beshore, and we ran into Brinton in person, and I was like: "I recognize that guy. Where do I recognize him from?"
- DRDavid Rosenthal
It's like the Spider-Man, uh, gif. It's like, "You! No, wait, you!" [chuckles]
- BGBen Gilbert
[chuckles] V- very, very much so. So after, like, nerding out the whole rest of the event on TSMC, geopolitics, semis, we decided to have Brinton and Jon on Acquired. And on this episode, we actually didn't even get into semiconductors for the first hour, since it was so fascinating to hear about their investment principles at NZS, which are just a real treat to learn about and, uh, and think through. And, uh, I've said this many times on the show, but yet again, new frameworks that have totally changed the way-
- DRDavid Rosenthal
Yeah
- BGBen Gilbert
... that I think about the world.
- DRDavid Rosenthal
It's frameworks all the way down, Ben.
- 2:07 – 6:15
Sponsor interview: Banco Inter’s transformation into a Brazilian digital bank and super app
- BGBen Gilbert
It is. Well, for our presenting sponsorship on this special episode, we have the SoftBank Latin America Fund. As many of you know from other specials this year, SoftBank LatAm is deploying huge amounts of capital into the burgeoning Latin America start-up ecosystem, and they just announced they have another three billion to invest in addition to their initial five billion.
- DRDavid Rosenthal
Ooh.
- BGBen Gilbert
We are talking today with the CEO of one of their portfolio companies, João Menin, CEO of Banco Inter, which is now a publicly traded digital bank based in Brazil.
- DRDavid Rosenthal
João, welcome to Acquired. You have taken a publicly traded traditional bank and wholesale transformed it first into a digital bank and now into one of Brazil and Latin America's leading super apps. We're so excited to have you here, and tell a little bit about the story. And the bank, it was a traditional bank when you stepped in as CEO?
- SPSpeaker
Yes, that's a very good question. Banco Inter was founded back in nineteen ninety-four. We like to say that we are everything but a start-up. We're not a start-up. And I also like to say that we're not a fintech. We changed the course of the business when I stepped in, because from nineteen ninety-four until two thousand and fourteen, fifteen, we're just a local commercial bank just doing some SME business. We didn't have retail, just wholesale. We're very focused in one big city in Brazil, at Belo Horizonte, where we're still headquartered today. I decided to really try to launch a retail banking unit from scratch, and I realized that in order to at least have a chance to succeed, we need to do something different. In Brazil, we have five big banks that control maybe eighty-five percent of the market, and in order to compete with them, they still have, like, twenty, twenty-five thousand plus bank branches. We need to took a different approach, and that's what we did. We decided to say: "Look, let's launch a hundred percent digital, free, and full-service checking account within the smartphones, and let's try to get as many clients as possible." So this is what the change in the mindset, and if you fast-forward to two thousand and twenty-one, it really happened. We actually just achieved fourteen million clients yesterday, so, I mean, from zero to fourteen million in, I would say, in a short period of time. So after that, we also decided: "Look, we already have a retail bank. Why not to put some non-banking products as well?" The first one we launched was our marketplace, and today we have many other products, non-financial products. And then I would say that we transformed ourselves into a super app here in Brazil.
- DRDavid Rosenthal
That's amazing. Do you look to folks in China, like Meituan or like Grab in Southeast Asia, as inspiration, or was this a vision that came homegrown in Brazil?
- SPSpeaker
Yes, I would say that we don't have these guys as a benchmark for us, but we started to say: "Look, let's build the digital banking unit," and to say, "Yes, what else can we add? So let's add some investments. Okay, and what else? Let's add insurance. And what else? Let's add shopping. What else? Let's add effects." And so we start just to keep evolving the business, but, I mean, we're really trying to see, what else can we put in order to help our clients? How can we make their lives easier? And we like to say that everything ends up with banking, which stands for payment and credit. Everything you do in your life, if you want to travel, if you want to give a call to your girlfriend, whatever, it's always about banking.
- BGBen Gilbert
... Our thanks to the SoftBank Latin America Fund, to João and Banco Inter. If you wanna get in touch with SoftBank, you can do so at latinamericafund.com. Or if you wanna learn about Inter, there are ways to do that in the show notes, too. Now, as always, this is not investment advice. We almost certainly hold, uh, stocks-
- DRDavid Rosenthal
Something discussed in this episode. [chuckles]
- BGBen Gilbert
We talk about a lot, uh.
- DRDavid Rosenthal
[chuckles]
- 6:15 – 12:24
NZS’s starting point: complexity theory and admitting you can’t predict the future
- BGBen Gilbert
So do your own research, make your own decisions, but, uh, love the frameworks that, uh, we dive into with Brinton and Jon. So without further ado, onto our conversation. All right, well, listeners, we initially thought that this was going to be purely a semiconductors follow-up, but we decided after digging in further with Brinton and Jon, that we wanna introduce you to NZS Capital, their investing philosophy, and partially because, uh, we think they're a fascinating firm, similar to Ho Nam of Altos or Hamilton Helmer of Strategy Capital. Uh, but also, uh, the deeper David and I have, have dove down the rabbit hole the last week of, of reading all the papers they've published, like, we feel like we've gotten a lot smarter. And so we basically just wanna expose the world to, uh, um, more and more of that. So Brinton and Jon, welcome.
- BJBrinton Johns
Thank you.
- SPSpeaker
Thanks for having us.
- BJBrinton Johns
Thanks for having us.
- BGBen Gilbert
Well, I think f-first, let's start with complexity theory, which is a concept that your whole firm is based on, and you've published a forty-seven-page paper on that, uh, it is just like, A, full of fun little graphics, but, but, B, I think probably has five to eight kinda mind-blowing concepts in them. And the first one is, you, you you come right out and admit that you don't know the future. What's going on with that?
- DRDavid Rosenthal
[chuckles] You, you would be, uh, uh, you would be bad, uh, uh, marketers as VCs. [chuckles]
- BGBen Gilbert
Oh, right. [chuckles]
- BJBrinton Johns
[chuckles]
- DRDavid Rosenthal
Everybody claims to know the future. [chuckles]
- BJBrinton Johns
No, I mean, look, the whole investing philosophy comes out of a lot of pain, right? So we, we were investors for a long time. We are wrong a lot, like, [chuckles] oh, like all investors, are wrong a lot on a consistent basis, and we are just looking for a better way to think about things. And so, um, sort of early in the day, uh, somebody suggested this book to me called The Origin of Wealth by Eric Beinhocker, and sort of serendipitously, a- around the same time, someone suggested Complexity by Mitch Waldrop to Brad. And we both, uh, read those books and, you know, um, Origin of Wealth was a slog. I think it took me six months to really get through it. [chuckles] Um, and then, and then swapped books and, and started thinking about sort of a different philosophy.
- DRDavid Rosenthal
I'd heard a little bit about, um, complexity theory and, and the Santa Fe Institute, which I wanna get into. I think, uh, Bill Gurley talks about this, uh, uh, fairly frequently and, uh, Michael Mauvison, and, uh, that's how I kinda originally got turned onto it. But, um, but, but tell us a little bit more about, like, what, what is it? Uh, 'cause, you know, it's, it's not, it's not at all about investing, [chuckles] it's about the world.
- BJBrinton Johns
That's right. Um, yeah, in fact, I think it was Bill Gurley that recommended Complexity to Brad. Um, so, you know, complex adaptive systems are all around us, right? That's what governs the world. That's how the world works. The- we don't know how the future is gonna unfold because these system is interacting together, and it creates what's called emergent behavior. And emergent behavior makes predicting useless in most cases, and we can have guidelines and heuristics, and those are all helpful. But as far as exact, you know, sort of outcomes and what's gonna happen in the future, those are, [chuckles] those are a lot more difficult. Um, Santa Fe Institute started with a group of scientists from the Los Alamos National Labs, and they came together, and they- they were mostly physicists, and they started talking to economists. It was sort of hard sciences and soft sciences. And the physicists were like: Hey, economist guys, you guys seem really smart, um, but, you know, your theories, like, they don't work. [laughing] Like, your, all your math doesn't work.
- BGBen Gilbert
[laughing]
- BJBrinton Johns
Like, so, so what's, so what's up with that? Like, you know, with, with our math, like, it's, it's extremely precise. In fact, you know, when the math is off just a little bit, Einstein's like: "Oh, your math is off. The Pluto-
- DRDavid Rosenthal
Yeah
- BJBrinton Johns
... should really be here," and comes up with the theory of relativity, right?
- DRDavid Rosenthal
We- it's like, we, we literally made the atomic bomb, like it works. [chuckles]
- BJBrinton Johns
Yeah, it works. Um, and so, so they started coming together around this idea of complexity. What is complexity? How do we define complexity? Where does it sit? And because we are living in this complex adaptive system, how do we think about the future? How do we think about life? How do we think about going forward? And for us, uh, this sort of, like, sparked an interest in biological systems, and we found the, this sort of biology vein much more interesting than the traditional economics vein and much more applicable to investing than the traditional economics vein.
- DRDavid Rosenthal
Well, that's so cool. And am I right that, that y'all actually went, uh, to the Santa Fe Institute and, and, and took courses there? Like, like, how deep did you go in this? [chuckles]
- BJBrinton Johns
We did. Um, you know, like, like a lot of rabbit holes, we go down very deep. Uh, we, we quickly became members of the Santa Fe Institute. They call it the Action Group. It's, uh, this group of non-scientists that are allowed to sit in on a lot of the, the science. And, and so then we took this complexity course over a weekend, Brad and I did, at, at Stanford. Um, and, and that was just a ton of fun actually. Jon and Joe, uh, the two other investors on our teams, they took a longer course. They actually had to do real work. [chuckles] Brad and I didn't have to do homework. Um, but, but we just learned so much. And, and I remember sitting outside of this café in Palo Alto with Brad, and, and we'd just sort of been at this course with Deborah Moore, this lady that teaches at Stanford and who studies ants. And I thought, "Man, this concept of resilience is really fascinating." You know, it's really more about resilience than it is about predicting the future, and, and it's about adaptability. Like, biology doesn't really care that much about the future.
- DRDavid Rosenthal
[chuckles]
- BJBrinton Johns
They care about, they care about adapting to this wide range of futures, right? Like, my bees don't really care if it's gonna snow tomorrow. They can adapt to snow. They've learned how to do that over millions of years. And what if we looked at companies like that? And so then, you know, of course-... We kept reading, we kept writing. This was probably twenty eleven, twenty twelve, and in twenty thirteen, we published this long paper [chuckles] that you referenced, which is super geeky, but it's got a lot of pictures, um, because that's the way we think. And, and-
- DRDavid Rosenthal
You've got the Back to the Future DeLorean in there, so [chuckles] -
- BJBrinton Johns
It's got the DeLorean. Like, what more could you want, right? We're really hoping for a DeLorean for the office. That's our dream, like, office furniture.
- DRDavid Rosenthal
Oh, amazing. [chuckles]
- 12:24 – 14:30
Resilience as the goal: the ant colony lesson and founder-like time horizons
- BGBen Gilbert
Well, on, on the note of ants, uh, this is, like, probably the f-first and, uh, best example of an extreme version of resilience in an organization. Can you share the insight you had there?
- BJBrinton Johns
Yeah. So we attended this class by Deborah Gordon, and sh- she has been studying this group of ants for thirty years in New Mexico. So, like, they obsess over this group of ants, right? And they know what every ant is doing at all times. And what they found was really fascinating. They found that about half the ants in the colony weren't doing anything. They were just sort of sitting around, and then they had half the ants doing these defined jobs, and that's very counterintuitive. We think of ants as sort of the ultimate productivity machines. Um, but it turns out ants aren't optimized around productivity. They're optimized around longevity. They're optimized around resilience, around living as long as possible. Let's say it that way. Um, so, so that was really insightful for us. We thought, man, all these companies are optimized around productivity, and Wall Street only makes it worse 'cause we're obsessed over quarterly earnings. And so what if companies were really optimized around this long-term thinking? Of course, we see that with lots of companies. Most of them tend to be run by founders, 'cause founders have a lot of skin in the game, and they think long term. Um, but there are CEOs that think that way also. We know that the average tenure of a CEO in the S&P 500 is less than five years, so this is not- [chuckles] they're not optimized like ants are. They're, they're trying to get, uh, a lot of return really quickly. Um, but, but companies that take this long-term view are so much more interesting.
- DRDavid Rosenthal
When I read that in your paper, that is, like, the thing that, like, hit me over the head. I was like, "Oh, this is Warren and Charlie's, you know, laziness bordering on sloth." Like, [chuckles]
- BJBrinton Johns
That's exactly it.
- DRDavid Rosenthal
The goal is not productivity. The goal is long-term, you know, steady returns and resilience.
- BJBrinton Johns
I think Warren and Charlie grokked this very early, and, you know, there's a lot of science behind it and math, but they don't need that. They're so good with folksy wisdom, and especially once Warren sort of gropped-- grokked, uh, Phil Fisher, um, you know, and this became their MO, it really, uh... They're great at this. [chuckles]
- 14:30 – 16:51
Slow compounding beats hypergrowth: durable growers and capital allocators (e.g., TI)
- BGBen Gilbert
I like the-- So then the thing that hit me, of course, I'm like, well, a company's not gonna have half their employees sitting around doing nothing. Um, but, like, just as a fun thought experiment, w-what if a company only was growing at, you know, half the growth rate of a high-growth company, and, but they could do that-- You know, it's a marathon, not a sprint. They could do that over, you know, forty, fifty years instead of thinking in these, these, you know, five- and ten-year time horizons. Uh, do you have any good, like, anecdotes on... I know you have this firm belief that, uh, hypergrowth is bad, and actually slow, very long-term compounding growth is the, the, the real holy grail.
- SPSpeaker
Yeah, I mean, I, I think what we're, we're generally looking for is, uh... I mean, we, we kinda use Groupon as, as an example, whether that's fair or unfair, of like, we're not looking for the next company to hit X, you know, revenue run rate in the shortest period of time or whatever it is. Like, we're really looking for this durable, resilient growth, and I think the, the way, um, you've, you framed it, Ben, that, you know, if a company does have employees, you know, n- that are, that aren't driving the, I guess, level of growth that, um, you know, you'd be seeing in a hypergrowth firm, that's okay if, as long as it's, it's hyper-durable. And so you could look at, um, I mean, look at Danaher or kind of like some of the classic, iconic, you know, growth companies that have compounded for, um, for decades. Um, and that, that's generally where, where you see the, the compounding is, is obviously, you know, you compound it ten to twelve percent a year or in the teens, but you can do it for ten, twenty, thirty, forty years, um, you can just get tremendous value creation. So, I mean, some, I guess, some companies in the portfolio we admire that, that do that, uh, would be someone like Texas Instruments, where, um, they have a really decentralized, um, culture, and, and they actually push responsibility and decision-making down into kind of the, the deeper parts of the organization. And so the, um, you know, the, the CEO is not a, um, really a, a manager. He's a capital allocator. He almost, uh, thinks- has to think more like an investor, I think, than, um, and, and a portfolio manager than, you know, an operator. And so I think that's what we really look for, is, is companies that can, um, you know, provide this durable growth. Again, it's very, it's very Buffett-like, where we're hopefully finding companies where you can just set it, forget, set it and forget it, and they're gonna put up, you know, moderate to healthy growth for, you know, ten, twenty, thirty years. And in our, our framework, which we can talk about around resilience and optionality, that's what we're looking for in the resilient bucket of the portfolio, is these companies that can really, you know, compound at a, um, at a healthy rate for, for a very long time.
- 16:51 – 20:44
Defining NZS portfolio halves: resilience vs. optionality (and why ‘moats’ can be dangerous)
- DRDavid Rosenthal
Yeah, so you guys have these, um, two concepts and then one kind of super concept that combines both of them, of, uh, resilience and optionality that you look for, uh, in investing. And, um, you know, neither of those are terms that, uh, uh, most investors are, are familiar with. Uh, can you, uh, can you define what you mean by both of them and maybe, maybe give a few examples of companies?
- SPSpeaker
Sure, yeah. On, on the resilient half of the portfolio, um, I mean, we, we kind of say, "You know it when you see it," which I think is, is kind of an unsatisfying answer. But generally, what we're looking for are companies that are further along, kind of in their S-curve, in their growth trajectory. Um, and so this would be a company-- like, companies we own in the head of the portfolio would be someone like a Microsoft or a TSMC, where we're not, we're not looking for, like, value stocks or kind of like cheap companies. We're looking for companies that are healthy growers that we think can durably grow for the next, you know, twenty years.... thirty years, and our, our turnover in this half of our portfolio is around ten percent. So this is, uh, really kind of like the hopefully set it and forget it part of the portfolio. And so, um, you know, a few characteristics we tend to see in that part of the portfolio are, are kind of like mission criticality and switching costs, which I know you guys cover well, um, in, in some of the, the deep dives you've done. Um, I mean, just scale, like TSMC, we, we can talk about in, in more detail. Just like a classic scale company where, um, you know, we, we talk about power laws in our, our investing framework and kind of like, you know, pockets of industries where one company can take ninety to ninety-five percent of the profits in a given industry, and TSMC is a great example of that. And then you-- exactly the way you guys laid it out so well on your episode on TSMC, is you really get the flywheel going, right? Uh, where, where the more scale you have, the more you can reinvest, the more you can impact your customers, and it just becomes this beautiful compounding machine. Um, and, and then the, the last bucket we probably would see, um, in the, the resilient part of our portfolio is just network effects. There are network effects based, um, you know, competitive advantages, where you see companies that really hit their inflection point. And again, especially in, in digital markets, you'll tend to see, you know, a handful of companies or potentially, you know, one or two companies take most of the economics in a given market, like digital advertising or, um, you know, smartphones or... There, there are just so many markets where there's, you know, one or two players that have, um, eighty to ninety-five percent of the profits. And so, uh, we tend to see those in the resilient part of the portfolio.
- DRDavid Rosenthal
Well, and one thing, uh, just to on, on resilient is that, um, I think what's really counterintuitive, uh, that about how you guys think is y- you're actually not looking for moats, right? In these comp-- 'cause like a lot... You know, the companies you just described, and I think a lot of investors would think about like, "Oh, wow, well, like, they've got, like, really deep moats." And so like, yeah, that's a-- of course, you want those as your, you know, long-term compounding holds. But y- you guys have a little different perspective on this, right?
- SPSpeaker
Yeah, we have a little bit of a different take, and so I, I don't, I don't wanna offend anyone that uses the term moats. I think it's a great term, and it's a great, you know, part of anyone's kind of investing toolkit. But I, I guess one of the things that we're careful about is, like, looking for companies where, you know, part of their moat is kind of, um, you inserting themselves into the value chain or into their, um, you know, their customers', you know, share of wallet, basically, where they put themselves in a position to extract as much economics as possible. And so I, I think that can be viewed as especially in kind of a, uh, more of like an industrial age v- view of how competitive, competitive advantage, um, you know, has evolved. Is, is that something that, that we, we try to avoid? Like, we're not trying to look for a company where they feel like they have customer lock-in, and then all of a sudden, they can raise price, you know, three to five percent for the next ten years. I think that's, you know, part of our, our framework and the reason, uh, we named the firm NZS Capital, is we're looking for non-zero sumness, so looking for a win-win outcome for all constituencies across kind of the value chain. That includes the company's employee- employees and their customers, and also kind of society and the environment, um, at large. And so if we, we-- we're just careful looking for companies where, like, all of a sudden, if I have this moat, then I can, like, screw my com-- my customers over the next ten years, right? I think that's what we're careful about.
- 20:44 – 25:44
Non-zero-sumness in practice: Apple as a cautionary case, TSMC as the counterexample
- DRDavid Rosenthal
Yeah. Like, I noticed, uh, in your latest 13F, like, um, I don't think you guys hold Apple, right? Uh, but you do some of the other, you know, large tech companies, and this feels like a perfect example to me of like, every, you know, oh, Apple, like, incredible moats, right? But like-
- BGBen Gilbert
They're getting pretty good at value capture over there. [chuckles]
- DRDavid Rosenthal
Yeah.
- SPSpeaker
Yes, that's a, a very nice, uh, polite way of putting it. I think, um, you, you obviously see it with, with Spotify in the EU and, and Epic here and all the new-- Epic here in the, in, in the US and, um, you know, all the- being in the news flow constantly. I, I just think when you get to a point where you're taking so much economics for your, your business, which, um, already has the market- the largest market cap in the world, that your, um, your key partners on your platform are, you know, are, are taking you to court or, like, taking you up to re- various regulatory bodies or writing white papers on how you're screwing your customers, that- that's just what we're trying to avoid. And, um, who knows? It might work out perfectly for Apple over the next ten years.
- DRDavid Rosenthal
It makes you less resilient, right? Like... [chuckles]
- SPSpeaker
Yes, exactly.
- BGBen Gilbert
Is that the idea that if there's consumer surplus, y- you know, if there's money left on the table for, for consumers, where they're not getting every dollar extracted that they could by the company, that that company is more resilient over time, even if they're not making every profit dollar and growing as quickly as they could today?
- SPSpeaker
I agree with that, especially if you're-- I mean, if you really have a management team that's thinking really long term, I don't know why you wouldn't give up a little bit of extra economics for your key partners, whether that's suppliers or developers on your platform or your customers, um, to really solidify your trajectory over the next, you know, ten to twenty years, versus... I don't wanna pick on Apple too much, but, like, what's the gross profit impact if they cut their App Store, um, you know, take rate from thirty percent to fifteen percent, you know, a- across the board? What is that, like, five percent of gross profits? It's, like, meaningless to them, and it would create so much value for, uh, all the-- and there, there's obviously knock-on effects of that. But, um, anyway, I, I think that's what we're, we're looking for, is companies that are paying it forward. Like, again, back to the TSMC example, 'cause you guys covered it so well, like, TSMC has lower margins than most of their- gross margins than most of their customers. And so at any point, they could, they could probably take their margins from fifty percent to sixty percent and say, "Hey, um, obviously, [chuckles] I have a monopoly in this market." But the way, you know, Morris Chang architected the culture there, um, is, is on, you know, long-term value creation and really creating a platform for, for their customers to, you know, create massive, you know, amazing businesses, and so I think that's, that's the way we, we think about it.
- BGBen Gilbert
Yeah, and just for listeners, to put some numbers behind this concept, which I think is, is just great from this NZS white paper, "Fifteen percent growth over ten years would deliver more than a three hundred percent return. Not bad, but fifteen percent growth over fifteen years would almost double the ten-year return. If we could populate our top twenty positions with these types of resilient companies, we'd only trim and add around periods of volatib- [chuckles] of volatility and sip mai tais while reading a good book the rest of the time." Which, yeah, that, that, that kind of stuff is what makes the paper quite readable. But it, it, it is this, uh, you know, the, all, all the, all the, the real absolute dollar value of compounding shows up in the out years, so you just wanna make sure that you're still compounding in the out years.
- BJBrinton Johns
... That's right. And, and it's sort of where we take issue with Porter, 'cause i- if, if we think about, like, a cynical view of Porter, I'm not saying this is what-
- BGBen Gilbert
This is, of course, like Michael Porter, competitive strategy, Porter's five forces.
- BJBrinton Johns
Thank you. Yes. Um, i- if we take a cynical view of Porter, he- a lot of people have interpreted it of, "Hey, build a moat around your business and then stick it to your customers on price," right? [chuckles] I'm not saying that's what he said, I'm just saying that's the way it's interpreted. And, and that's a terrible way to build a business, because eventually someone will undercut that and offer actually a be- better value prop to the customers. And because all of this value are in the out years, it, it is really not a value-maximizing way to run the business either. So we think this concept of creating more value than you take is, is really important. And, and Porter agrees. He actually revised his thinking, and in, in 2019, wrote a paper in, in, uh, Institutional Investor called "Where SG- Where ESG Fails," where he talked about this concept of shared value.
- BGBen Gilbert
And that's, like, not him trying to say that i- purely because it's good for the world to care about all your constituencies, you know, not just your shareholders, but also your customers and partners. Like, he's literally making an economic argument for shareholders that that's the long-term value maximizing thing to do, right?
- BJBrinton Johns
I think that's right. And, and, you know, he was a consultant for Intel, um, back when, uh, ARM processors were starting to come out-
- BGBen Gilbert
Oh!
- BJBrinton Johns
... and actually dominate the mobile space. And they came out with this sort of dumbed-down processor, uh, right? Sort of-
- BGBen Gilbert
The Atom?
- BJBrinton Johns
Yeah, exactly. Um, but, but even before that, I think they came out with another one, and Jon, I'm blanking on the name of it. Um, but, but, uh, it was a-- it's in the paper, it's in the footnotes. I'm sorry, I forgot it. [chuckles] But they came down- they came out with a, a cheaper version of it. But, in reality, that's not what they should have done. They should have, a- you know, actually embraced a totally different business model, like ARM did, where just- they were just selling I- IP and, and enabling a whole ecosystem instead of trying to take all the profits for themselves.
- 25:44 – 31:15
Optionality and ‘Root MOS’: designing asymmetric upside into a public equities portfolio
- DRDavid Rosenthal
Okay, so that's the resilience kind of side of, you know, the, uh, NZS thinking and, and, and the portfolio. Then you also marry that with something very different, [chuckles] which is optionality. [chuckles] Uh, uh, tell us a little bit about optionality and how you think about that.
- BJBrinton Johns
Yeah, really, when we're thinking about the future, we're just thinking about how broad and safe is the prediction we're making? So we can make these very broad, safe predictions, like we think electronics are gonna push deeper into the world, right? I think in nine out of 10 copies of the multiverse, that's happening, right? Um, but there are other predictions, like we think EVs are gonna, uh, dominate the world, and, and Tesla is gonna be the power law winner inside of EVs. That may only happen in two out of 10 copies of the multiverse. [chuckles] You know, it's certainly not 10 out of 10. So these predictions are, are, are much narrower, and the range of outcomes is much broader. And so that doesn't mean we can't invest there, because it's incredibly asymmetric if we end up being in that copy of the multiverse. But if we're not, and it's a zero, it also doesn't torpedo the portfolio. So I feel like, actually, you guys could give the master class here since you're such great venture capital investors. Um, but that's really what we're trying to expose ourselves to in these earlier-stage public equity companies.
- BGBen Gilbert
And so how do you actually then, um, apply both of these very different principles inside the same portfolio? Like, are you picking some stocks because you're maximizing for, uh, resilience, and you say that, "Look, this is a great compounding, slow growth, but durable company," and then there's other stocks that you're, you're-- other companies that you're investing in because you say, "Oh, my gosh," like, "if this, if this thing's right, it's gonna be really right," like venture capital, you know, uh, asymmetric upside right? Or do you... Is it blended in some of the same companies?
- BJBrinton Johns
No, you're right. Um, it tends to be these two portfolios in one. So we, we concentrate resilience. That's about 15 names and then just over half the portfolio, and then we distribute optionality, so that's about 40 names, also just under half the portfolio. Max position size, one and a half, and in the middle of this, between one and a half, two and a half, one and a half, three, we don't own anything.
- BGBen Gilbert
And that's percent of the portfolio?
- BJBrinton Johns
Thank you very much.
- BGBen Gilbert
Okay.
- BJBrinton Johns
Percent of the portfolio. I say this stuff so much, sometimes I, I don't complete the sentences. Um, and then sometimes we find these very resilient companies that are actually layering on optionality to the business, uh, where-- so they have both. They have this resilient base, but then they have optionality on top of that.
- DRDavid Rosenthal
And you call those companies root MOS? [laughing]
- BJBrinton Johns
[chuckles] Yeah. We're such geeks. Um-
- DRDavid Rosenthal
Oh, we love it!
- BJBrinton Johns
... uh, it's so, so bad. Uh, it stands for resilience with out-of-the-money optionality. It's just a shortcut on the team that we use.
- DRDavid Rosenthal
So great. Okay, so what's an example? And, and those are the companies that, like, you bump up to seven, eight percent of the portfolio-
- BJBrinton Johns
Yeah
- DRDavid Rosenthal
... right? What are, what are some examples of those?
- BJBrinton Johns
Well, I mean, sort of there's a couple, right? The classic example would be Amazon in, in '97, when they went public. You know, I think around a billion-dollar valuation, nobody could have foreseen AWS, right? That wasn't in anybody's DCF. "Oh, yeah, they're gonna also create infrastructure that everybody in the world is gonna use to create businesses." [chuckles]
- DRDavid Rosenthal
[chuckles]
- BJBrinton Johns
It sounds so silly, right? But, uh, another one that we had in the portfolio years back was, was eBay. Um, I don't know if you guys remember, the marketplace business was struggling. Uh, they brought in-
- DRDavid Rosenthal
Yep
- BJBrinton Johns
... a new CEO, John Donahoe.
- DRDavid Rosenthal
Yep.
- BJBrinton Johns
Um, they had PayPal, uh, and really, you weren't paying for any of PayPal. I- i- if the marketplace business would recover, that was-- that would more than cover the cost of, of entry. So, um, of course, you know, marketplaces did recover. PayPal ended up being great. John Donahoe is an amazing leader, um, and, and that was a classic root MOS stock.
- BGBen Gilbert
So in that situation, you've got a fairly resilient business, or, or the, the hope is that the marketplace is a resilient business, and then the, uh, PayPal is the out-of-the-money option that you sort of have that's being valued at zero, but clearly is a, uh, a very valuable business.
- BJBrinton Johns
That's exactly right.
- DRDavid Rosenthal
... Well, and I think what's cool about this, a- a- and you, you, you know, you guys talk about it, is like yeah, right, th- this makes a lot of sense in investing. This also makes a lot of sense in how you should run your company. [laughing]
- BJBrinton Johns
Yeah.
- DRDavid Rosenthal
Uh, and that the best CEOs think this way, uh, as in, you know, "How do I create resiliency in my core business? But then what are the options that I'm, you know, [chuckles] investing in for the future on top of it?" You know, A- Amazon- like, there's-- to my mind, there's no better example than Amazon, you know, of just con- like, this is the whole, like, operating philosophy of the company, right?
- BJBrinton Johns
So we love this concept because we think it's true in the universe, and so therefore, the slight-- the, the narrow slice of investing that we're using it for, we're pretty sure is also true. But it works really for everything. I mean, it works for parenting. So, of course- [laughing] ... you wanna have, you wanna have love for your kids and to provide this, like-
- DRDavid Rosenthal
Oh, that's great. I'm expecting-- we're, Jenny and I are expecting our first baby in, like, a month, so-
- BJBrinton Johns
[chuckles]
- 31:15 – 40:06
Power laws, non-ergodicity, and why traditional risk models fail in the real world
- BGBen Gilbert
All right, I'm gonna take us in a totally different direction. Um, I wanna talk about the difference between normal distributions and power law distributions. And listeners of the show who are in venture capital or in startups and have tried to raise venture capital or successfully raised venture capital will know, you know, they get this answer from VCs all the time that, "Our, our portfolio construction is really a power law. You know, we fully expect a third of the portfolio to go to zero, a third to return capital, and really only, like, one or two companies at the sort of head of the curve are gonna, you know, be this, this, uh, hopefully ten, fifty, hundred X for... that, that, that sort of gets us a great return regardless of what else, you know, happens in the portfolio." Uh, you guys, interestingly, are sort of applying that thinking at much later-stage companies, hopefully ones that aren't going to zero, you know, the way that, that a frail, you know, ten million dollar valuation startup could. Uh, h- how does that work, and what was the insight that made you realize, "Hey, the world is not normally distributed. Actually, in certain scenarios, it's very power law distributed?"
- BJBrinton Johns
Right. Well, once you accept the fact that, uh, all of life is governed by complex adaptive systems, and the markets are also governed by complex adapt syb- systems, which means emergent behavior, you can't predict the future, you focus on adaptability, then, of course, that- those complex adaptive systems tend to be governed by power laws, so it's sort of a natural follow-on. But the, the insight here is, you know, all risk models are based on these Gaussian, these normal distributions, right? Um, but in fact, the world doesn't work that way, and so there's [chuckles] a really fascinating economist named Ole Peters, who, who's done a lot of work here and said, "Wait a second, uh, your risk models are sort of like airbags that go off at stop signs, but not when you get in a crash," right? [laughing]
- DRDavid Rosenthal
[laughing] Huh. Uh, which actually does sound like... You know, this has always been my beef, you know, when I was in business school, so with, um, economics as applied to, like, business and investing in the real world is like, you just-- like, you study this stuff, and you're like: "Wait a minute, I actually work in the industry, and this is not how it works," like [chuckles]
- BJBrinton Johns
Right. Exactly, and, and being venture capital investors, you see this all the time. Um, with public companies, it's also true. There are a few big power law winners. We see them in the market today. They're driving the entire market, right? Uh, this is our, this is our reality.
- DRDavid Rosenthal
There's a great study that you, you guys reference in the paper that, um, I'm wondering if you could just talk a little bit more about it. The, the toy example of a coin flip, a coin-flipping contest, where you, when you win, uh, you essentially, you, you win-- let's say you win fifty, you know, dollars or whatever. When you lose, you lose forty. Uh, th- that sounds like, you know, investing to me, like there's an expected return of ten percent. Um, what, uh, what actually happens when you run that contest?
- BGBen Gilbert
Wait, real quick, before you answer. Is, is it that? Is it win fifty dollars, lose forty, or is it you win fifty perc-- like, it's a fifty percent-
- BJBrinton Johns
Percent, right.
- BGBen Gilbert
Oh, okay.
- BJBrinton Johns
Lose forty percent.
- BGBen Gilbert
Okay.
- BJBrinton Johns
Yep.
- BGBen Gilbert
Yeah.
- BJBrinton Johns
So if it's a hundred-- if it's a hundred dollars, then yeah, you're right, David. It's, uh... Yeah, up fifty percent, down forty percent.
- BGBen Gilbert
Got it. Okay, cool. I, I just didn't know if, I didn't know if that would a- affect the math.
- BJBrinton Johns
Yeah, um, the, the concept is, uh, it gets to the heart of modern portfolio theory and expected utility theory and, and the flaws of that. So back to the multiverse, right? If, if- the, the way this works is if you had a hundred people flipping coins, you would a- and they did it for enough time, you would actually see a nice, steady, positive return, right? And that looks like, on average, the, the experience of the participant is winning, but that's not really true. What you get is a lot of people going bankrupt and a few massive winners, sort of the Buffetts and the Soroses of the investing world, right? So the average is not average. And, and in modern portfolio theory, you're taking an ensemble of all these, but that doesn't really make sense because I don't really care about your outcome, David, or Ben, your outcome. I care about my outcome, and I, I only get to live in this one universe. I don't get to live in yours. You know, I don't get to live in the multiverse. So, so my outcome, on average, is that of loss. It's that of bankruptcy. Um, so when the time average does not equal the ensemble average, that is called a non-ergodic system. And, and then you guys can put in the show notes, Ole Peters works on this. It's super geeky, but really fascinating.
- DRDavid Rosenthal
Oh, it's so cool. Well, this is so counterintuitive. You would think, like, if you presented that game to me, I would be like: "Oh, for sure, I wanna play that game." [chuckles] Like, the odds are stacked in my favor. But-... the actual, like, most people who play that game will lose, and then a few will win really, really, really big. Uh, and, like, that, that just blew my mind reading that. [chuckles]
- BJBrinton Johns
Yeah, the distribution set is not normally distributed, it's, it's power law distributed, and so that changes everything. And that's true- that's why all these risk models are like airbags that go off at stop signs, right? It's, it's because, uh, it turns out the world doesn't work that way. So, you know, we hear on a regular basis, "Oh, this was a three standard deviation event," you know? Which, if you understand the math of three standard deviation events, you expect, "Oh, wow, I'm so lucky to have seen one of these in my lifetime," right? [chuckles]
- BGBen Gilbert
Right. It's like, what if, if i- one out of a thousand days should contain one of those?
- BJBrinton Johns
[chuckles] But we see them a lot according to, you know, uh, just the media, and so then it's sort of ridiculous.
- BGBen Gilbert
Oh, wait. Th- is it... What is it? It's three out of 10,000 days should contain a-
- BJBrinton Johns
Yeah, it's bigger-
- BGBen Gilbert
Or six out of-
- BJBrinton Johns
It's bigger than 1,000, uh, in fact. So 99.9- nine- 99.73% of all events should fall within three standard deviations, is the way the, the math works.
- SPSpeaker
Meanwhile, I mean, I've been in this business for 13 years, and already been through two r- recessions that are way outside of three standard deviations. Brinton, uh, has as well. And so it is just kind of a funny, kind of common sense, saying that when you're practicing this stuff, that the norm- the normal distribution doesn't really make that much sense. And then it, it is... I mean, I, I, Brinton mentioned I took this, uh, course at this, the Santa Fe Institute. It was actually around this time last year, and like, I mean, just, just power laws are just, like, so cool. It's amazing. I mean, one of, one of the examples we use, um, in the white paper is, um, if you, if you plot, like, earthquakes by frequency and intensity, that, that just, like, in nature, naturally forms a power law, which actually makes a lot of sense. You're gonna get, you know, one or two or three, um, you know, heavy magnitude earthquakes a year, and then, then a lot, then a lot of small ones. But also, if you plot, like, the, the frequency of every word in the book Moby-Dick, um, that actually also forms a power law. So like, "the" is mentioned 15,000 times, and then the next word is "and," and that's, like, 7,000 times. And then there's, like, this super long tail of words that are only, you know, used, you know, a handful of times. And so it's just like... It's, again, it's one of these things, once you, once you see it, uh, and it's amazing for starting companies, obviously, like we mentioned, especially in, um, kind of digital markets, because I, I, I just think, you know, the world is going towards more markets where a winner can take all, and then, um, you know, it becomes mu- much more of a power law dynamic. And so that, that's why we just always have our kind of antennas up for, um, these power law dynamics. That's honestly a big part of when we're looking for optionality, that's what we think about, is like, is this a company that is relatively, you know, earlier stage in, in public markets that has the opportunity to power law, you know, a large market?
- BGBen Gilbert
Which is why, of course, you're making 40 diversified optionality bets here. Because, you know, it's, it's funny to think about this, but the, the statement of, um... Let's go back to the stop sign example. Like, yeah, the vast majority of the time, the fact that these airbags don't work is, like, totally not an issue. Like, that's totally fine. But it's a massive issue the moment that you need them the most. Very similarly, like, all, all of the gigantic, outsized economic value is created from the three, four, five, six, seven sigma events in the world. And so it's, it's, like, kind of ludicrous to be like, "Well, the vast majority of the time, this investment philosophy is, is very sound." And you're like, "Yeah, but we're not really trying to index on how, how many days out of the year it's sound. We're trying to index on, like, how much value can get created at the end of the portfolio, 50 years from now, and that's gonna be driven by the outliers." So we have to be prepared and fully optimized around the outliers, not close our eyes to the few days that they might exist.
- SPSpeaker
That's such a good point, I'm, I'm really glad you, you brought it up, because what we're, we're really playing for in the optionality, half the portfolio is asymmetry, and, and really, it's not about batting average. Like, it's okay if we're only right 30% of the time, which is not intuitive at all for public markets investors, I think. I think everyone wants to be right 55% of the time, 60, whatever. It doesn't have to be that high to have good long-term returns. But, um, you know, we're playing for slugging percentage, where even if only one out of three work, but, you know, those are, are multi-baggers and can really create a lot of value over a long period of time. Then that's, that's, like, the beauty in that half of the portfolio. And we, and we've seen it, we've been doing this for, for years now, and it is amazing how you see these companies, um, emerge as, as, you know, value creators and, and generate a lot of value for the portfolio, um, out of relatively small starting position sizes.
- 40:06 – 47:32
Anti-conviction culture: documenting theses, calling out bias, and playing for slugging %
- DRDavid Rosenthal
It gets back to this whole idea of, like, you don't know what's gonna happen. [chuckles] And so if you do- if you, if you, like... If you set everything up with the idea that you don't know-- You know, and it's funny, I, uh, I think in a lot of ways, most venture capitalists grok this idea and set up their portfolios in this way. But even still, I don't think it's like... I think lots of people, myself included in the past, didn't fully understand this. Like, um, you know, y- you say in the paper, uh, I think you use nicer language than this, but I'll, I'll, I'll [chuckles] use my own language. This is my quote: Uh, that conviction, this idea of conviction that so many people in venture talk about, and entrepreneurs are like, "I have conviction, I'm convicted." Which convicted means you're convicted of a crime, but anyway. [laughing] Um, I have conviction that, uh, that this, uh, in this company, I'm gonna lead this investment. Conviction is kind of stupid. Uh, conviction is saying, "I think my view of the future is gonna be right." Uh, and really what you want is optionality. And, like, you need people to have conviction, 'cause otherwise, you, there would be no entrepreneurs, right? Like, the, that, that example of the, um, uh, of the coin-flipping contest, that is exactly the dynamics of becoming an entrepreneur. The expected value is positive, and yet the vast majority of people who start down that path go bankrupt, and then a few people win really, really, really big. [chuckles] But when you're constructing a portfolio, what you actually want is a lot of those bets. You guys have, you know, 30, 40 optionality names in your portfolio. As a venture fund, you want 30, 40 [chuckles] na- quote, unquote, "names in your portfolio." Venture portfolios with five or 10 are very non-resilient. [chuckles]
- BJBrinton Johns
Yeah, that's right. I mean, we use, uh, conviction as a synonym for overconfidence.... I think that's what really is the right way to [chuckles] that's the right way to think about it. Conviction for us means, "Hey, I've done a ton of work, so I've got a lot of sunk costs, which means I've got bias, and I think that my view of the future is better than yours."
- DRDavid Rosenthal
That is literally what you're saying when you say that. [chuckles]
- BJBrinton Johns
Yeah, right? Um, so who knows, right? What we're trying to do with the tail of the portfolio, and I think what you guys are trying to do in venture capital investing, is maximize the probability that we get lucky, right? So that's- this is, um... I just ripped that off from Balbason. He's ve- he's very good at, at calling it what it is. Um, and we're just trying to maximize the probability that we get lucky.
- SPSpeaker
I also think-- I mean, just change- changing your mind is the hardest thing to do as an investor when you're wrong. And I think if you kind of stand in a row and say, "This is my highest conviction idea," it just makes it that much harder, to Brinton's point, on just, like, introducing bias into the equation. And so... And I also think if you kind of invert it, like, I think it's fine to have an optionality position that you actually don't have that high of conviction on. Like, to Brinton's example on Tesla, like, I don't think that we have super high conviction that Tesla is going to power law the, the EV market, but is there some probability where they do that, and it's, you know, worth, you know, multiples of what it is today? Sure, you know. And so I think that's, um, that- that's the way that we kind of think about conviction. And again, I don't want to piss anyone off that uses the word conviction, similar to moats. Like, it's fine. Everyone has their own process, and we're not trying to, like, push what we do on anyone else. Um, this is just what has worked for us over time, and so one, one thing we're very careful about is just introducing bias into our process, and luckily, we all-- everyone on our team knows each other well and can call each other out. But, um, that, that's-- I, I do want to be a little careful.
- BGBen Gilbert
Well, I have two points to make. The- this, uh, this cultural one, I think, is the second, but let me start first with, at the end of the day, this is a Buffett concept. This idea that it's better to be approximately right than exactly wrong. Like, that's another way to describe this optionality phenomenon here, where, you know, it, it- it doesn't sound nearly as strong to stand up in front of an investment partnership and say, "I have very little conviction in this, but, um, it, it could totally work, and if it does, it'll be really big. That's about the best I can tell you right now." Like, that is not-- that does not get everyone around the table excited to like: "Let's do it! Let's go," but, but, like, in a very Buffett sense, you know, you're like: "Look, this thing is... If, if, if it works, it's gonna be so freaking successful that this is a great price to own it at." And like: Do I know if this is the right price to own it at? Not at all.
- BJBrinton Johns
That's exact- I mean, how many versions of the multiverse do we have railroads? Like, all of them, right? [chuckles]
- BGBen Gilbert
[chuckles]
- BJBrinton Johns
And h- and they're important. Um, you know, and, and where can we-- how can we recreate that? We can't. It's impossible. Those, those are in the ground. And so I think you're right. Buffett a- and Munger say this so easily, so naturally, and we're just saying it in a much more complicated way.
- BGBen Gilbert
That's the second point I'm curious about, is like, how do you... W- what, what are some guardrails that you have in the internal culture to, to reward non-conviction? [chuckles] You know, to, to reward, like, "Yeah, I don't know, but, uh, it, it could work, and if it does, it could be really big, and here's why it could be really big."
- BJBrinton Johns
Well, the funny thing is, um, the way we view team-- So we think investing is inherently a team sport. It's a terrible solo sport for the most part. Um, and the way we view team is our role is calling out bias in each other. Now, these are uncomfortable conversations, 'cause nobody likes to get their bias called out, but we all know that bias is really easy to identify in other people and really difficult to identify in yourself. And so by opening yourself up to having-- being called out, um, then your probabilities go up as an investor. So it feels unnatural to us at this point to say, "I have super huge conviction that this, you know, microcap stock is gonna rule the world one day," right? It's like, that would feel really odd. Everybody would be like: "Are you okay? You feeling all right?" [chuckles]
- SPSpeaker
[chuckles] I think the way we've also, um, just, like, set it up with our, our framework is, is we just, like, inherently expect failure, I think, more than other public markets investors might. Like, if we put something in the optionality tail of the portfolio... And by the way, that, that half of the portfolio turns over a lot more quickly than, than the resilient part of the portfolio, which, which makes sense. Like, we are going to be wrong a lot. Um, and luckily, there's-- these are smaller positions, and so you're not going to torpedo the portfolio, as long as the most important thing to do is just admit you're wrong and move on. And so I think building that into the culture where, um, you know, it's, it's okay to be wrong and move on and, and fail quickly versus, like, stringing ourselves along on a three-year journey on a tough position. And so that- that's, that's one, um, I think, cultural way that, that we've architected the way that the team works together that, that has really helped with, um... It basically gives yourself a license to take some risks that maybe you otherwise wouldn't, um, you know, take if you were sitting on a different team or within a different organization.
- BGBen Gilbert
And do you try and document any of the, like: "Here's the reasons why I'm making this optionality bet," so you know you can, like, decide to rotate it out of the portfolio if those reasons are no longer true?
- BJBrinton Johns
Yes. Yeah, the- everything's written down. And actually, Brad, uh, which is, a, an investor on the team, is, is amazing at pulling this stuff back up and saying, "You said, blah, blah, blah." [laughing]
- DRDavid Rosenthal
He must be really popular on the team. [laughing]
- BJBrinton Johns
Oh, yeah, he's great.
- DRDavid Rosenthal
[laughing]
- BJBrinton Johns
No, we love Brad. He's just-
- BGBen Gilbert
Oh
- BJBrinton Johns
... he's just very good at, like, remembering and then, and pulling the source data and saying, "Hey, look, you've drifted," you know?
- SPSpeaker
And then to, to your guys' points, too, like, it's not like, is their operating margin exactly twenty-two percent this year, or, like, is the revenue exactly at this runway we thought it'd be? It's like, are we, are we approximately right on the thesis, right? Um, it- it's not like we feel like we can predict the future, but you can certainly have checkpoints along the way, and we, we call those... Usually, with, with any stock, I think there's usually, usually three or four things that really move the stock, and so we call those key leverage points on any position. And so you can generally check in on those and make sure that, um, you know, we're, we're, we're on track.
- 47:32 – 53:51
Managing the optionality tail: trimming winners, crossing into resilience, and valuation as a ‘forced prediction’
- DRDavid Rosenthal
So, well, one of my big, um, questions, or things that didn't quite make sense to me in reading your paper and how you work, is, um... Well, first, can you talk about what you do, uh, with your, uh, optionality part of the portfolio as things evolve in it, um, and, and how you, uh, ma- you know, you, you start an optionality position?... There are two copies of the multiverse where this works, and then X amount of time passes, and you start to have more of a view of which copies [chuckles] you know, two out of ten, and now, you know, maybe it's, like, two out of five or two out of three. Or like, you know, a- as it evolves, what do you do?
- SPSpeaker
There's, like, kind of two scenarios that you can really see this happening. Like, a good example is being Peloton before the pandemic. You know, and the stock obviously went parabolic. Like, they were a huge beneficiary of work from home. But it's also still just a really dynam- dynamic company, you know, that's early in its life cycle, building a brand and a platform. And so with a company like that, you know, I think it's still early days to call that business resilient for, for many reasons, both just, like, the, the context of the company of we're going through a digestion after, you know, a, the twenty twenty kind of a, a record year for, for them, an off-the-charts year, I should say. So for a position like that, we'll actually, we'll just trim it, and, you know, we have this cap of how big in the portfolio we allow optionality positions to get. And so I think that, that it's generally pretty clear, like, how much of this is something that's a really durable inflection in the business. And sometimes, like I said, it's both. Like, I think Peloton is definitely a different company in this version of the universe [chuckles] versus the, the non-COVID version of the, of the, of the metaverse, right? But, um, I, I think we, we can't cross it over.
- DRDavid Rosenthal
Well, this is so different, you know, that you trim it. You know, the canonical VC wisdom is ride your winners [chuckles] as long as possible. You know, the things that are working are likely to continue to work, so don't sell. [chuckles] Uh, but that's not the approach you guys take. Uh, and, and I'm curious, like, why? Have you thought about this, like-
- SPSpeaker
Yeah, it's a, it's a really good question. We, we talk about it a lot 'cause we're certainly, in some cases, leaving money on the table, I think, if we're not letting our compounders really express themselves over time. And so there are stocks we will let them- we'll own them earlier in their life cycle and let them cross over in the resilient head of the portfolio. And so we'll do that a few times a year, and I think it does kind of force us to, um, kind of like average up if the company, you know, and actually buy more stock, potentially at multiples higher than our initial purchase.
- BGBen Gilbert
Oh, it's so hard to do. [chuckles]
- SPSpeaker
It's so hard to do, but I think it's actually... I've thought about this a lot. This is actually kind of part of our process, where we're kind of forced to do it, which is really helpful, 'cause otherwise it's harder to just, like, look at the stock and buy more. But we're saying we're making this explicit decision that we're gonna take this from a hundred fifty basis point position to two hundred and fifty basis points. And so, um, we're gonna add capital because this business has structurally changed and actually be- belongs in the resilient bucket of the portfolio. And so that, um, I think there, there are companies where we've done that, where they, they're honestly just more mature or they're becoming, like, more of a platform. You can actually see, like, the network effect starting to, to hit. And honestly, um, it's... Some of that is a valuation conversation also, that there are, there are plenty of, like, platform-like companies we might wanna own in the resilient part of the portfolio, but in, you know, the current market environment, they're trading at valuations that we would not consider resilient, and so that's another reason we would own them, um, as optional positions. But it's, it's a really good question, and I think w- well, not, not to ramble on too much here, but what we try to do is not make sure that an optional position ends up in the head of the portfolio, because that's something we've just learned the hard way, that, you know, if you have a stock that can have a fifty to seventy percent drawdown, you know, and it's-- the starting point is a five percent position, not only does it crush your performance, but then you're also probably hamstrung where you've got a stock that's still a relatively big position, and you don't, you don't really want to add to it, and then you just kind of have to [chuckles] take your licking. And so that's something that we've learned, um, through experience.
- DRDavid Rosenthal
Yeah. Well, I'm wondering if even just thinking about this past year... Well, two-year cycle, but the past year of this two-year COVID cycle, uh, you've kind of seen this happen, right? Like, um, you know, the stocks, uh, that had huge, um, were huge, uh, multiverse winners in the beginning, the Pelotons, the Zooms, you know, and the like. I'm thinking Zoom. Uh, you know, Zoom went from, I don't know, what, seventy, eighty dollars a share to six hundred dollars a share, and then back down to [chuckles] you know, the, I think it's at, like, two eighty right now. Uh, so you've kind of seen this happen, right? Like, the optionality played out. That was correct. But then returns pulled back. [chuckles]
- BJBrinton Johns
We're always looking at, like, what's happening to the range of outcomes? Is it widening? Is it getting broader? Is the prediction becoming safer, or is it getting narrow- or is it remaining narrow? And so with a, a company like Zoom, which we never owned, 'cause, you know, I don't know, just bad call, um, [chuckles] uh, it, it, it looks a lot to us like a feature, and, and then so now the question is: Can it become a product and eventually maybe a platform? Can it develop an ecosystem around it? We don't know. Um, but let's say, to take your example, let's say in the middle of the pandemic, it, it was just sort of a cool feature. It was better than everything else out in the market. Still is. And, uh, and then this big ecosystem came around it, and it became a full-blown platform. Well, then the range of predictions actually w- would, uh, the, the range of outcomes would narrow, and the prediction would get safer, right? And so then that would warrant that becoming a bigger portion of the portfolio. Valuation is a key piece, and this is the piece that we get every day as public investors. And valuations, expensive valuations, force predictions. I have to believe a lot more at ten times sales than I do at ten times earnings, right? So we're seeing, okay, what is the prediction of the company, and what is the prediction the market is forcing us into, and are we comfortable with that?
- BGBen Gilbert
So we are in an unprecedented investment climate, where everything on a, you know, whatever basis you wanna b- revenue multiples, earnings multiples, uh, unprecedented highs. So the whole... Like, any asset you could invest in, be it stocks or farms or crypto, is forcing you to make predictions. And, uh, what I've heard this whole podcast so far is y- you actively avoid trying to make predictions. So how do you respond in an environment th- where the- there's very little resilience [chuckles] in your ability to, uh, to, to invest without making a prediction and have a margin of safety there?
- BJBrinton Johns
It's really difficult. Um-
- SPSpeaker
You just inserted yourself into the weekly NZS meeting, investment meeting-
- BJBrinton Johns
That's right [chuckles]
- SPSpeaker
... I think with that question.
- BJBrinton Johns
That's right.
- SPSpeaker
This is, this is-
- BGBen Gilbert
Oh, just dial us in anytime. [laughing]
- BJBrinton Johns
[chuckles]
- 53:51 – 1:15:27
Why semiconductors now: ‘ten out of ten multiverses’ need chips, and where NZS invests across the stack
- BJBrinton Johns
Yeah, part of this is interest rates, right? We've never had negative interest rates, and w- and then stimulus, and so those effects on, on, on all assets, which, which are unprecedented. We, we think about this a lot. We don't know the answer. Um, we-... Exactly. But, you know, this could get us into our topic of, of semiconductors, because there's a few building blocks of the information age. Um, and we are in an epic shift. We're still early days from the industrial age to the information age, and semiconductors are the new oxygen in this environment. And so we look at some of these companies, we think the valuations are actually quite reasonable, and, and we choose to sort of, um, bring the portfolio more towards resilience, and these are one of the ways we do it. We do it multiple ways.
- DRDavid Rosenthal
Yeah. Like you used the railroad example, right? Like the, uh, there are ten out of ten copies of the multiverse in the future, uh, going forward, where railroads are important.
- BJBrinton Johns
Right. [chuckles]
- DRDavid Rosenthal
There are probably also ten out of ten copies of the multiverse where semiconductors are important.
- BJBrinton Johns
Exactly.
- BGBen Gilbert
Well, that's an amazing way to transition to semiconductors. I mean, I was looking for the right hook, and, uh, you know, Brinton, I think you bringing that up, uh, [chuckles] I was prepared to make some joke like, "Wait, you guys know something about semiconductors?"
- BJBrinton Johns
[laughing]
- BGBen Gilbert
I think TSMC is, like, a top three position for you guys. I think your other top positions, uh, Amazon, Microsoft, like, they use a lot of semiconductors. A- a- and I think Salesforce is probably up there too.
- DRDavid Rosenthal
And TI is one of your top positions, right?
- SPSpeaker
Yes, that's right.
- BGBen Gilbert
So let's, uh, uh ... Maybe even before getting into some of the nerdier semiconductor topics, let's stick with an investment one. W- what semiconductor companies do you own right now th- in the name of resilience, and which in the name of optionality?
- BJBrinton Johns
Let's start with the two different versions of semiconductors, right? So there's a lot of semiconductor makers that are on the digital space, on the leading edge, right? They're, they're making, uh, you know, three nanometers and, and, and on, and these are the high compute functions. And there's other semiconductor makers that aren't really dependent on that leading edge. They're more dependent on having the breadth of a catalog. That would be like a Texas Instruments that has 100,000 parts or a Microchip. And so in our top positions, we're more heavily weighted towards the catalog names, these names that the lifetime of a part is 30 or 40 years. Um, you know, the, the, the margins are high, the, the growth is pretty good. There's clear NZS in the business. They're definitely creating more value than they take. And they're very hard to replicate, not because what they're doing is so technically hard. It's hard, but it's because the breadth of what they have would take you decades to recreate.
- SPSpeaker
Those are like I- I've always kind of hoped that, uh, that Buffett would buy, uh, a catalog semiconductor business. I just feel like those are, like, just classic Buffett businesses, where they're, they're probably not gonna look, honestly, that different in 20 years than they do now. They'll have higher margins and be bigger, and they'll be selling into, you know, cool electronics that we don't even know about, but they're also still selling into, like, water meters and coffee makers and just, like, you know, everything in your household or, or in a factory or, um, you know, anywhere you look, it just has, um, kind of these, these cheap but high-margin chips in them. So and I, I guess to maybe answer your quest- answer your question a little bit just on, um, the kinda like semiconductor impact on the portfolio, we, we have about a third of the portfolio in, in semis, um, and that goes across, like, the whole value chain. Like, to Brinton's point, we invest in kinda like the catalog, analog microcontroller companies. We'll invest in a digital company like NVIDIA that's actually, um, in the optionality tail of the portfolio right now, um, just because for, for valuation and context reasons. Uh, we're, we're big investors in semiconductor capital equipment, um, and those actually are, are in the head of the portfolio. We view those as resilient. TSMC is a resilient position, and then, um, kind of the broader ecosystem, like Cadence Design Systems, which you guys brought up in the TSMC episode, that's kind of the key, one of the two key kind of CAD software platforms for designing a chip, um, is also a position. And so, um, there are also, there are kind of more, you know, less household name type positions we own as optional, um, positions, like a company like Cree, which is early in silicon carbide, which is an alternative technology to silicon that's going to be, um ... That's, that's used in electric vehicles, including the Tesla Model 3. And so that's a classic example where, like, you know, there is some version of the [chuckles] metaverse where, where it's, it's a massive platform, and then this, and silicon carbide, the market goes from being a $1 billion market to a $30 billion market, but it, it ... You know, I don't know if that's a, there's a 50% chance of happening or 20 or that kind of thing. And so that's, that's like a little bit of a walk around the, um, the portfolio in terms of, uh, of semis.
- BGBen Gilbert
That silicon carbide thing is the first I'm sort of hearing of it. Is that, like, changing the substrate, uh, of the, of the wafer?
- SPSpeaker
That's exactly right. Yeah, instead of using a silicon, like a bulk silicon wafer, you use a silicon carbide wafer, which is actually ... The, the wafer itself is much more expensive, and it's very hard. It's kind of- there's kind of like, it's one of these classic semiconductor processes where there's some black magic that goes into it. Um, and honestly, most of the people that know how to do this are, are all in, like, the Research Triangle in, um, in North Carolina. Um, and so there, there's, Cree is the one company that has two-thirds of the market for the substrate itself. Then they will sell the chips-
- DRDavid Rosenthal
They're the ASML of, uh, of, uh, [chuckles] silicon carbide.
- SPSpeaker
So po- potentially, then that- that's a classic optionality, right? We honestly don't know, but there's a chance where either this stuff isn't that hard to do, and they have a two-year lead on their competitors, or it's incredibly hard to do, and they do become one of these companies where they're doing something that, that no one else in the world can do. Um, and so that, that is kind of classic optionality for us. But it, it does, it makes electric vehicles and charging and also, like, renewable energy and really high-voltage applications much more efficient. Um, and so it's, it's like really one of these companies where their core competency has just, like, all of a sudden, the market really needs what they can offer, and so the market is growing, um, extremely quickly. You're seeing a lot of, um, activity around, from other companies trying to get into the market as well.
- DRDavid Rosenthal
All right, listeners, you know what time it is. We've been, we've been joking, uh, all season that, uh, that Modern Treasury is the worldwide leader in payment operations. I'm gonna borrow a little bit from the ESPN sports theme. You know, on, like, college selection day, when all the athletes get their hats out, I've got-
- BGBen Gilbert
Boom!
- DRDavid Rosenthal
... Modern Treasury hat here for people [laughing] watching on the video version. So great. We are so pumped for our friends over there. They just, uh, a little while ago now, but, uh, just as we are recording this, announced a $80 million dollar Series C at a $2 billion valuation led by existing investors, Altimeter Capital and Benchmark Capital. Modern Treasury is the best, and-... Ben and I are now small investors as well, which we're so excited about. So for customers like Gusto, Pipe, ClassPass, Marqeta, anybody who manages complex payment flows, which is basically every company out there these days, Modern Treasury automates the full cycle of money movement, from payments, to approvals, to reports, to reconciliations. All the things that your finance teams did manually by hand in the past, now it is all done in software by A- with APIs from Modern Treasury. They are just the best.
- BGBen Gilbert
You're invoicing people to get money. If you're sending money, and if this isn't straightforward in any way, like, if there's any complexity or multiple people that need to collaborate on this, Modern Treasury is for you.
- DRDavid Rosenthal
Uh, indeed, it is. We actually used the product ourselves for the first time this season, at Acquired. It was just mind-blowing, like, how, how much better this was than the old, you know, bill.com, and invoicing, and reconciliation. So much better.
- BGBen Gilbert
And for those of you who are wondering, like, "Is it working?" Like, you know, this is a cool idea, but here's a, a pretty crazy stat: in twenty twenty-one, they had twenty X volume growth to two billion dollars a month in payment volume, which was accelerating from ten X growth already in twenty twenty.
- DRDavid Rosenthal
Yeah.
- BGBen Gilbert
So just an unbelievable, unbelievable company.
- DRDavid Rosenthal
And as we've been saying all season, if you haven't checked it out yet, the only thing that the Modern Treasury team is more nerdy about than payment operations is, of course, Acquired. We had such a blast a few months ago, interviewing the whole company, which is now about two or three X bigger than it was then, uh, on the LP show. They have made that LP episode available to everybody to listen to. You can go check it out at moderntreasury.com/acquired, or click the link in the show notes. Let's do a little sidebar if, if, if you guys are game, um, uh, that I just thought of, that I think this could be a really cool case study if you're, if you're willing to talk about it, about, um, the, the NZS process. So you mentioned, Jon, that you own, uh, Cadence as a resilient position in the portfolio, having just done our TSMC episode and got a deep dive on the whole semi, you know, industry infrastructure. You know, you mentioned they also have a competitor, Synopsys, uh, and the two of them, it's like a duopoly in the EDA, uh, space. How did you desi-- How did you decide to own Cadence, and I'm assuming not Synopsys, or do you hold both?
- SPSpeaker
Yeah, that's, I mean, it's a really good question. We've talked a lot about both of them over the years. We've owned Cadence for nine or ten years, back to our, our days at our, our previous, um, portfolio, um, or our, our previous, um, employer. Um, I think on, on Cadence, it's a, it's a few things. I mean, it's actually kind of a cool story, of just kinda like how we even kind of got into the idea of investing in, in EDA. As part of our kind of process for finding new ideas and, and just kind of being up to speed on what's going on in the industries we follow, is going to, like, industry trade shows instead of investor conferences. Like, we don't generally go to a lot of, like, big investor conferences. And so in, like, early last decade, I used to go to all these, um, chip conferences, and, like, every presentation, it was, like, someone from TSMC and someone from Arm, and then someone from either Cadence or Synopsys. And at the time, Cadence and Synopsys were viewed as these, like, sleepy, crappy companies. And, um, it was just kinda like this, like: "Well, we, we love TSMC and we love Arm, so let's, like, let's do some work on Cadence," you know? And then we-- The more work we did... I mean, both, both companies are amazing. Like, they deserve a lot of credit. I think what, what steered us towards Cadence, um, one is the management team. So Lip- Lip-Bu Tan, at the time, was the CEO. He's actually moving into the executive chair role this year. Um, I think he, he just is, like, one of the iconic leaders in the SEMI industry over the last, um, eleven years. He was actually a, a VC previous to being, um, the CEO of Cadence, and he was just on the board and had to come in and basically turn around the company. But he was just so focused on, on the culture of the company. I mean, he hon- he told us what we wanted to hear, [chuckles] you know, which, which helped. Um, but, um, in terms of turning around the culture and really taking a company that was in a very difficult position in the, in the financial crisis, um, and really, like, re-architecting the, um, you know, the, the product positioning of the, of the company, and he's so customer-centric. That was how we kind of first got involved with Cadence. And then they, they actually- we, we do think they're taking market share, especially in digital markets, like where they would be selling to an Intel, or an Apple, or an NVIDIA. Uh, we think they're the share gainer. But both, but both companies, it's like an extremely high-quality duopoly, and so y- I think you, you've been fine either way.
- BGBen Gilbert
And do you end up doing like, like, one-on-one meetings with the CEO at the, the level of capital that you're deploying?
- SPSpeaker
Yeah. So this was back to our previous firm, where we were, um, you know, there was, like, more than a hundred billion dollars of, of AUM to deploy, um, and, and technology was a decent chunk of that. And so, like, uh, Cadence is a great example. We were actually their biggest shareholder for, for multiple years. And so at that point, we had, you know, a really strong dialogue with them, and I honestly would just bump into the CEO in airports and at conferences [chuckles] because everyone... Semis aren't that big of a universe. Everyone's kind of going to the same, the same things, you know?
- DRDavid Rosenthal
And he's very tall. He's very tall, too, so he's easy to spot.
- 1:15:27 – 1:28:12
TSMC vs. Samsung, vertical integration tradeoffs, and TSMC’s geopolitical ‘company-ending’ risk
- BJBrinton Johns
Yeah, well, Samsung is, is an amazing company, um, probably not super well understood, maybe like TSMC, and people know them for consumer electronics and phones, obviously, but they have 50% of the market share in DRAM and about a third of the market share in NAND. So, of course, as we do compute, we need more memory. We need a lot more DRAM, which is the fast memory on your phone or device or whatever. They queue stuff up, it's like a funnel, right? If you think of the funnel, you've got solid state or stuff sitting there in NAND flash. Um, the, it moves into DRAM, then actually goes onto the chip with SRAM, which is a really fast funnel, and then it go... and then it goes into logic to get processed. So Samsung is very good at making memory, and like I said, they have over half [chuckles] of, of the market share in DRAM, which is incredible. There's really only three major companies in the world, that make DRAM, two are in Korea, and one's uh, Micron in the US. Uh, and, and then in flash, they're big. They also have a decent logic business, um, or, sorry, foundry business. It's about 17% of the total foundry pie, so not as big. But DRAM and NAND are easier to make than, than logic.
- BGBen Gilbert
And are these branded Samsung project, uh, products, or are they manufacturing them as a contract manufacturer?
- BJBrinton Johns
The DRAM and NAND is all branded Samsung, but of course, everybody uses Samsung. So, uh, so, you know, it'd be next to impossible for Apple to get all the memory they needed without having a massive relationship with Samsung. So they're frenemies.
- SPSpeaker
So the, you know, four or eight gigabytes of memory in your iPhone, that's coming from Samsung?
- BJBrinton Johns
That's coming from Samsung. Yeah, exactly. And so these, these are easier to make. They have fewer steps, but still, they're, they're very hard. So DRAM takes around 400 steps and, you know, over a month in the fab working 24/7 to, to make, and NAND has a little bit fewer steps than that, but actually, NAND is getting more difficult because they're stacking it into 3D. So as you get more layers, it's actually getting more complex. But logic is still the hardest stuff to make, these, you know, system on chips that TSMC makes, and of course, it's just imagine, um, you know, making one thing over and over versus making, like, a menu of what if you had to be a restaurant that made every kind of food on the planet, [chuckles] right? Like, it'd be really hard to be good at all these foods, and that's what TSMC is doing. So that's some of the difference. Samsung is also doing logic, but, but it's- they have a different business model, right? They compete with their customers, so it's harder for their customers to trust them, um, whereas TSMC doesn't have that conflict.
- BGBen Gilbert
What do you think makes for a more resilient company? Being, uh, playing at multiple spots in the value chain, such that you compete with your customers and have optionality, or being super pure-play so that you have no strategy conflicts?
- SPSpeaker
I mean, I think it depends. I mean, if you're talking about something in, in semiconductors, and I mean, like, Intel is the classic example of this, where they're more vertically integrated. I mean, the, the hard thing about doing that is you have to fight multiple fronts, um, or battles on multiple fronts, right? Like, Intel has to fight TSMC on process technology, which, like, in itself is one of the hardest things, you know, any technology company's had to do over the last 20 years, and that's why Intel has been surpassed by TSMC, right? But they also have to fight AMD, um, in their core, kinda like, chip design market, where AMD, enabled by TSMC, is, um, innovating, you know, faster than they have in the last 20 years and, and, like, really delighting customers and, and, um, you know, taking share from, from Intel kind of real-time. Or, you know, NVIDIA, where they're trying to just basically marginalize the CPU and make the CPU less relevant, so Intel's less relevant. So I think that's the hard thing about-... being vertically integrated in, in semis versus being more of just like a horizontal pure play, is the, the needs of Moore's Law are just so difficult that, like, it's hard enough to just do one of these things well [chuckles] and doing multiple of them well, um, makes it, uh, makes it harder. So I, I generally, I think Brinton's point on, on just, like, the business model difference between Samsung and TSMC is so spot on, because, I mean, TSMC is, like, the neutral party that will never, ever compete with their customers. And if you think about the amount of trust that, like, a company has to put in TSMC because they're betting their entire company on TSMC's ability to make this chip for them and to have capacity for them when they need it, um, just, like, the amount of, like, trust, and this has kind of been Morris, you know, Chang's hallmark since he founded TSMC, that that's just something that Samsung can't quite offer because they, um, they just have a different business model, and they're not willing to... Um, not that they're not willing, they just don't have the capacity to build kind of a massive foundry.
- DRDavid Rosenthal
They can't change, right? Like, they're not gonna shut down two-thirds of the company.
- SPSpeaker
Yes, exactly.
- DRDavid Rosenthal
How do y'all think about, especially since TSMC is such a large position in the portfolio, um, how do you, how do you think about the, the geopolitical risk? Like, is that, uh... I mean, 'cause we did this whole big, long episode, and it kinda our, you know, the conclusion I think we came to was, like, [chuckles] "This company's amazing. There's, like, no fault we can find in this, except that-
- SPSpeaker
[laughing]
- DRDavid Rosenthal
... you know, China might wanna, like, you know, take over the land that they sit on."
- BJBrinton Johns
Except this enormous-
- DRDavid Rosenthal
Yeah
- BJBrinton Johns
... company-ending risk. [chuckles]
- SPSpeaker
Right.
- DRDavid Rosenthal
Yeah.
- SPSpeaker
Yeah, on TSMC, on TSMC's last earnings call, someone asked them, like, what they thought about Taiwan's sovereignty, and I'm just like, "What a world we live in," that, like, that's an open question-
- DRDavid Rosenthal
Yeah
- SPSpeaker
... that an analyst can ask about an earnings call. Like, "What do you think about China invading your country?"
- DRDavid Rosenthal
[chuckles]
- SPSpeaker
Um, so yeah, I mean, I, I, I would start- G- Brinton and I are not, like, geopolitical experts at all. I think we're- we, we spend a lot of time thinking about just the importance of TSMC to the world, and I'm not- I do think TSMC is top five most important technology platforms to the world. Like, I think TSMC is more important than Apple. Like, if Apple disappeared off the face of the Earth, I actually think it would be painful for everyone that, you know, loves iMessage and FaceTime, but, like, it really would not be as big of a deal versus if, if for some reason, you know, China moved to, um, to seize Taiwan or, or however, you know, it went into play, and all of a sudden, TSMC's fabs were shut down, then you really- the Western world would be, you know, set back at least five years, if not 10, just in terms of, like, technology progress. And by the way, technology progress is driving most of GDP right now. And so you do read about, like, what's happening with the auto sector and shortages, and it's like you've seen nothing. If you think, you know, shortages kind of from the way the auto, auto guys manage their inventory, um, and kind of just like the classic post-recession semiconductor shortages you always get, um, you go from there to, um, you know, what would happen if, if TSMC, you know, was really... If Taiwan's sovereignty was in question, and TSMC, that stopped making wafers for some period of time. It would- I just think the, the impact on the global economy would be extremely painful, so then that brings you to the logical conclusion of, you know, hopefully, um, the US and kind of the West would, would move to protect TSMC at all costs, or at least get the people out of there. [chuckles] We were- I mean, I guess I, I shouldn't joke about it, but it wouldn't be totally dissimilar to what's happening in Afghanistan, where I think you would just airlift as many TSMC folks out of there as possible in a short period of time. But then you have no fabs, um, you know, there to produce. I mean, TSMC fabs a quarter of the digital chips made in the world right now, and so, um, it, it would be a lag of multiple years between when, um, you know, when you get those people out and when you can actually start making wafers again. So it's a very complex topic.
- BJBrinton Johns
I think another way to think about this is just an ecosystem perspective. So, like, TSMC as a company is very valuable, but it's not super valuable without ASML and Lam and AMAT and KLA, right? So, um, when you think about the ecosystem of semiconductors, and ASML, of course, is not valuable at all without TSMC and Samsung, um, there are this handful of companies, it's called 15-ish, maybe more, that if you think of them as one super company, which is kind of what they are, it's like a super organism, [chuckles] right? Um, um, kinda like my bees are a super organism.
- DRDavid Rosenthal
It's like a ecosystem, you mean?
- BJBrinton Johns
It's like a ecosystem.
- DRDavid Rosenthal
Like, maybe like a complex adaptive system, like-
- BJBrinton Johns
Like a- it's like a complex adaptive... Yeah, so predicting the future is really hard.
- DRDavid Rosenthal
[chuckles]
- BJBrinton Johns
Um, so anyway, yeah, if you think of it as a super organism, this is probably the most super, uh, like, important super organism on the planet. If it's not, it's cert- certainly one of the top, uh, most important. So, you know, could you recreate that elsewhere in the world? You absolutely could, um, if you had access to, to the rest of these pieces, which in the West, uh, we do. It would just take, to Jon's point, a long time, and that's why people are sort of saying [chuckles] , "Maybe we should, like, take some risk out of this place." And, and, um, you know, ASML calls this semiconductor sovereignty. Uh, we're building this fab, of course, in Arizona, this five-nanometer u- TSMC fab. Um, but it wouldn't be a stretch to think that they will be built again in Europe. W- you know, th- this happened before, but of course, when, when technology reaches a fairly stable state, you know, you, you wanna optimize around efficiency, and so you get these horizontal-type models, right? I remember when Apple bought PA Semiconductor, I was on the record going, "Oh, this is the stupidest thing ever. Like, Qualcomm makes these really good semiconductors. Broadcom makes them. You know, like, TI makes a great application processor."
- DRDavid Rosenthal
And this is the origin of you deciding that you don't know the future-
- 1:28:12 – 1:36:16
Moore’s Law today: EUV runway, chiplets, advanced packaging, and system-level scaling
- BGBen Gilbert
Yeah, makes sense. Um, well, I wanna come back to, uh, some more technical questions. Another thing that I think we kind of glazed over in our TSMC episode is the current state of Moore's Law from a, from a, like, literal perspective, but then probably more interesting, the current state of the spirit of Moore's Law. And I was wondering, maybe Jon, let's, uh, let's go to you. Could you give us a little bit of a download on, like, does Moore's Law still work, at least spiritually?
- SPSpeaker
Yeah, I'm, I'm glad the way you've, you framed it that way, 'cause it is kinda like a religious debate, and people much smarter than me in the semi industry are on, like, both sides of, like: Is, like, the true Gordon Moore, um, Moore's Law still, um, holding up? I think, I think just, like, for the spirit of Moore's Law, we still have... We have visibility probably for the next ten to fifteen years. And to be honest, that's like, the industry never has more than ten to fifteen years of visibility. I think, obviously, the death of Moore's Law has been pronounced for a very long time, but I think that's one thing to keep in mind, is, like, there, there are a lot of things out there that's gonna keep us driving down Moore's Law. And so, I mean, one, one thing that you guys covered well, um, in the TSMC episode is, is the, um, implementation of EUV systems, um, from, from ASML, and they actually are al- allowing us to shrink the transistor, um, kind of the fundamental building block, um, you know, two-dimensionally. So they've actually put more, you know, transistors into a chip. And so ASML is kind of on record saying they think that, that EUV will last about fifteen years.
- BGBen Gilbert
In terms of they'll, they'll allow us to keep doubling the number of transistors on a chip every eighteen months for fifteen years, or just, like, it will be an effective way of getting any performance?
- SPSpeaker
Yeah, I think it will be an effective way to, to drive performance and, like, drive, drive shrink, basically, is the way the industry kind of frames it, is you'll, you'll be shrinking the transistor to pack more, you know, performance in, into a, uh, you know, in- into a chip. But I think the, the broader point you hear from the industry a lot is this concept of, of more than more, um, which is kind of, you know, a cheeky pun-
- BGBen Gilbert
Ayo!
- SPSpeaker
But, uh, yeah, there you go. [laughing]
- BGBen Gilbert
[laughing]
- SPSpeaker
But, um, the, the, the point is, it's, it's really it's not just about the-
- DRDavid Rosenthal
Those semi guys, they're real- [laughing]
- SPSpeaker
[laughing] That's-
- DRDavid Rosenthal
Yeah, a real hoot. [chuckles]
- SPSpeaker
Exactly. [laughing]
- BJBrinton Johns
[laughing] So geeky. Um-
- SPSpeaker
But so the, the broader point around, um, you know, where, where Moore's Law is going now, is it's not just about the transistor, it's really about kind of the, um, the package. And so you're seeing a lot more, um, innovation, not just in, like, can we put, like, more transistors onto one, you know, gigantic chip to drive more performance? You can actually split up, um, you know, chips into multiple chips called chiplets, um, which AMD is, is doing, and this is a big part of Intel's future strategy, actually, also. And so having, like, you know, one gigantic, like, GPU that you buy from Nvidia, you can have four smaller chips, um, and you can kind of like stitch them together to drive more performance. And so that's another way, um, that, that we're gonna get a lot of, um, benefit from, um, from Moore's Law. And then, actually, I- one thing I skipped over on the transistor side is we are moving to a new, um, transistor architecture, um, either a two nanometer or three nanometer, depending on which company you're, you're talking about, um, to a gate-all-around architecture. Um, previously, we were on, on FinFET, which, which, um, has been around since-... I guess for the last seven or eight years, I don't know the exact numbers, um, maybe ten. Um, but so I, I think like having, you know, there's line of sight into from here, um, more gate architectures, different materials, and then when we get to, like, the mid-twenty thirties, we'll kind of see how it goes. But it's just, it is amazing. I was actually at a virtual, um, chip design conference this week, earlier in the week, and there's so much focus, not just I guess, on this, like, packaging idea, but even, like, if you abstract that one more layer from that, it's about system-level performance. And if you look at what NVIDIA or AMD and kinda like the leading, um, you know, digital companies are talking about, it's can you make more processors and actually, like, stitch them together into a cluster with some sort of proprietary interconnect? Um, so you actually are just getting- they're, they're really thinking more like computing companies than just like chip companies now, and so that, that's a big change. But all, but all of these, like, transistor-level innovation, package-level innovation, and then system-level innovation, I think we've got pretty good line of sight into, um, you know, the, the spirit of Moore's Law, um, continuing at least through kind of the mid-twenty thirties.
- BGBen Gilbert
And so it seems like with the sort of creation of the system on a chip, that, uh, mm, at least let's, let's just talk about the iPhone, 'cause it's the one I understand the best. Like, Apple became the, um, aggregator. Like, th- rather than the old days of I'm gonna go build my computer, and I'm gonna go buy a motherboard, and I'm gonna buy a GPU, and I'm gonna slot it in the PCI slot, and blah, blah, blah. Like, Apple basically says, "Uh, well, we've designed this logic board, and we've designed every single chip, or most of the chips, the important chips, and we've, we've situated them together. TSMC manufactures it. They do all the packaging, so you have, like, metal, like the bare metal to bare metal, um, uh, packaging of these things, so we don't need to run it through these buses that have low bandwidth to get information from one piece to another." Like, let's, let's keep playing that out a little bit based on everything you know. W- who, w- where in the value chain do you think the point of aggregation shifts to over time, where th- who gets to own, uh... Where do we put all this stuff together, and I get to capture a lot of extra margin because I'm the one putting it all together?
- BJBrinton Johns
I think the interesting thing about the semiconductor ecosystem is actually there's a lot of people catching, capturing margin, and they're capturing really high margin. So we don't d- this is the sign of a healthy ecosystem, right? There's not one company that's making all the money. Um, throughout the whole chain, we've seen margins come up. And, you know, here's a good trivia question. Who has higher operating margins, Texas Instruments or Microsoft? Right? Because I asked it, you know the answer-
- BGBen Gilbert
Ooh! [chuckles]
- BJBrinton Johns
... it's TI. [chuckles]
- BGBen Gilbert
Wow!
- BJBrinton Johns
But, but, you know, it's not-
- BGBen Gilbert
Wow
- BJBrinton Johns
... really appreciated how good these businesses are.
- BGBen Gilbert
That's shocking. [chuckles]
- BJBrinton Johns
Right?
- BGBen Gilbert
Yeah.
- BJBrinton Johns
Yeah.
- DRDavid Rosenthal
Especially 'cause TI, i- i- their main, uh, the, the, the core business is not the, like, the leading edge, uh, you know, uh, digital processors that TSMC is doing. It's the, it's the commodity stuff, right?
- BJBrinton Johns
I think this was Rich's key insight. You know, he said, "Okay, we're doing all this leading-edge stuff. We're fabbing at TSMC, and, um, what if we just trickle that business down to zero?" They tried to sell it, no one wanted to buy it. Um, and, and boring is beautiful. And so, you know, you look at TI's end markets, two-thirds of which are industrial and auto, and I guess it's a tech company. You know, they make chips, but, man, it seems a lot like an industrial company too, right? Um, so, so yeah, uh, Jon makes a really good point on this. I- I... Why don't you finish, Jon, 'cause you're better at it? [chuckles]
- SPSpeaker
Yeah, but I- well, I think you can make the same point that you made on TI, on NVIDIA, like, the, the fabless business model, um, really, I mean, it's like a software company. It's like NVIDIA's got close to seventy percent gross margins and, like, you know, low forties operating margins. And it really, with, with very little cyclicality because TSMC offloaded all that cyclicality, right? So it is just, like, one of the best business models besides, I would say, [chuckles] enterprise software. It's one of the best business models, um, you know, in, in the world, and so TSMC is the enabler of that. But I, I think Brinton's point is spot on. You're gonna see, and kind of in this future world, like, one of the things that's kind of cool is it takes the whole ecosystem to really drive kind of the future of Moore's Law. Like, it used to be just about ASML needed better litho tools, and, like, Intel would use them and, like, shrink the transistors, and we'd just kinda like brute force ourselves down Moore's Law. And now, like, all this advanced packaging needs, it needs litho advancement from ASML, but it also needs, um, improvements from the other equipment guys, like Lam Research or Applied Materials or Tokyo Electron, 'cause you need dep- dep- deposition and etch steps to, um, to build these, um, advanced packaging and, and, and, yeah, multi-die packages for, um, you know, for, for kinda the advanced packaging applications. And so, um, and then the- you also have all this off-the-shelf IP they're getting from companies like Arm or from Cadence or Synopsys, that... I mean, part of what Apple does, to your point, Ben, is they're really just an aggregator. Like, they buy, you know, IP blocks off the shelf. A lot of what designing a chip is about is just, is just buying a lot of individual IP blocks and, and aggregating them. And so the, the great thing about it is, like, since Moore's Law is really fricking hard, everyone in the ecosystem does really well. And then I think TSMC, sitting in the middle of it, will obviously do very well because they, um, you know, they're, they're driving a lot of the innovation also and, and obviously are the key partner for a lot of this.
- 1:36:16 – 1:59:57
Ecosystem orchestration: TSMC’s Open Innovation Platform, ASML/Trumpf/Zeiss ‘fractal’ dependencies, and why growth governors create durability
- DRDavid Rosenthal
Real quick on, um, TSMC. We- w- I think we glossed over this on the episode 'cause we didn't, we weren't deep enough to understand it. Um, my sense is that the open innovation platform that they've created is really important and is kind of the, what orchestrates all of what you're talking about here, that, like, it really takes, [chuckles] it takes the village of the whole industry to push things forward now. Is that true? Like, is, uh, uh... Yeah, like, what, w- w- what is that, and how, how central is TSMC's open innovation platform to all this?
- BJBrinton Johns
That's exactly what I was gonna say. I think it's, it's really true, and there is no GitHub to the semiconductor IP ecosystem, right? Um, the closest you get is kind of the TSMC Open Alliance, um, and there's pockets of it elsewhere. The EDA guys have a, a ton of IP as well. Um, and of course, as you make these chips, you need to emulate them to see if they actually work, uh, hopefully before you put them in the fab, because that's really expensive. Um, so-... All of these things really play together. And so when you think about how Intel was doing this for a long time, it was a closed system. It was Intel's way, Intel's process flow. And TSMC said, "Oh, wait, let's form an alliance with everyone, because this is really gonna take everyone [chuckles] to keep driving this forward." And this open architecture, um, or this open approach, uh, has really won over.
- BGBen Gilbert
One thing that's always hard for me to understand is how hard it is to do each layer of the, the stack. And by that I mean, ah, wow, it seems like the ASML guys create a pretty unbelievable machine, and they have a lot of services associated with that machine. Like, they're even in the TSMC factory helping to assemble and operate these things. And then I sort of sc- was scratching my head thinking, "Well, could ASML just kind of like become TSMC? Like, could they just operate their own equipment?" And then I dove down the other side of the, the slope, and I was like, "Well, who makes the stuff that's important to the ASML machines?" And I was like, "What is this Trumpf company? "
- SPSpeaker
[chuckles]
- BGBen Gilbert
And then, of course, you go on the Trumpf website, which let's just let the name lie for a moment here-
- BJBrinton Johns
[laughing]
- BGBen Gilbert
... And, uh, they make this unbelievable laser. And like, they've got this crazy video on their website that shows off their laser, and I'm pretty sure what they're showing me is actually the magic of the, ah, ASML EUV machine. And I'm like: Well, shoot, why can't the Trumpf company just do what ASML does and then also do what TSMC does if they are the only ones in the world who can make this unbelievable laser? Like, can you guys shed any light on, like, [chuckles] what value... Like, is that ever gonna happen? Is this really, is- could it ever, like, vertically integrate?
- SPSpeaker
Yeah, I mean, I think it-- first of all, the, the videos of the, of the, um, like the simulations of the laser in, um, an EUV system on the Trumpf website are, like, so freaking cool.
- BGBen Gilbert
[laughing]
- SPSpeaker
Like, they're really-
- BJBrinton Johns
They're amazing. [chuckles]
- SPSpeaker
Um, especially... I actually, I hadn't seen them until recently, and I've heard so many times that, like, fifty thousand pulses a second, you know, drops of molten tin, the whole spiel from ASML, which, Ben, by the way, you did a very good job on the, uh, on the TSMC episode.
- BGBen Gilbert
I was doing my best-
- SPSpeaker
Like-
- BGBen Gilbert
... My best Jon Bathgate impression. [chuckles]
- SPSpeaker
I could tell you were excited to do it, I think-
- BGBen Gilbert
[laughing]
- SPSpeaker
... like, multiple times. You were like: "Can I do the ASML thing now?"
- BJBrinton Johns
[laughing]
- SPSpeaker
But anyway, we, um, we, uh... I, I think a few things to, to think about. One is there, there's so much innovation around... I mean, so the laser itself actually is ten tons, but an EUV system is a hundred and eighty tons. So there's a lot of other equipment in there that's not just the laser. And actually, I was trying to find this from a dollar value, and I didn't track it down, but I'm sure that, that, that number is out there. Uh, I mean, ASML's partnership with Zeiss, the lens company, is also, like, really special. And I guess, like, Trumpf and Zeiss could try to partner to... I don't think they have any ambitions to do this, but they could try to partner together to kind of circumvent ASML. But like, the, you know, the lenses that Zeiss is coming up with are literally the most uniform lenses designed, you know, in the history of the world. And so some of the metrics that they throw out on that are incredible. And I think, um, on, on- with one of the things that's unique about ASML is, you know, they shipped the first EUV tool in twenty ten to TSMC, and EUV didn't even really start high volume. And this was after, you know, a decade of R&D already. But then they didn't start high-volume manufacturing on EUV until twenty nineteen. So they had, like, almost a decade of learnings in TSMC's fabs on, like, how to get these things to actually work, how to get the, um, you know, the throughput to levels where the economics actually make sense. And so there's actually, like, this really cool conference called SPIE every February, where all of ASML's customers come together and basically give feedback on EUV and, and, um, and kind of give the updates on, on where they're at. And so TSMC lived through ten of the... or ASML lived through ten of those, um, with all the fe- the, um, feedback, not just from, um, TSMC, but from all their ecosystem partners, right? And so I just feel like the, the learning cycle that ASML has been through, there's just so much more innovation besid- um, in addition to the laser, um, and, and the, um, the lenses. But it is... I mean, the lens is a really critical component. I mean, ASML actually bought a laser company in twenty twelve called Cymer, and I think they actually had, like, an internal laser bake-off between Cymer and Trumpf, and I think Trumpf won for, um, EUV, which is also kind of a funny-
- BJBrinton Johns
Wow
- SPSpeaker
... you know, trivia question. [chuckles]
- BGBen Gilbert
Wow!
- BJBrinton Johns
Oh.
- BGBen Gilbert
Fascinating. Okay, so the answer is they all add a ton of value on top of, [chuckles] uh, the previous layer of the stack.
- BJBrinton Johns
A- And like a lot of things in the tech ecosystems, there's fractals on fractals, right? It's like you say, "Okay, well, what's the most important part of this ASML tool," right? And there's a fractal down, and then, like, what... You know, you keep going. But it's really this ecosystem approach that makes sense. No one can do all of this. It's just way too hard. It really does take a village.
- SPSpeaker
All right, listeners, for our final sponsor of the episode, we are here to tell you about Fundrise. And as we've been saying all season now, everybody knows Ben and I collaborate not just on Acquired, but on a massive [chuckles] and growing-by-the-day spreadsheet with, uh, uh... It's basically like, you know, the intention of this was like: How do we recreate, like, the infrastructure of a family office in Excel for our personal investing and collaborate on it? [chuckles]
- BGBen Gilbert
David, when you say growing, primarily growing in the number of tabs [chuckles] in the spreadsheet-
- SPSpeaker
Yes. Yeah, yeah, yeah
- BGBen Gilbert
... that we're adding. [laughing]
Episode duration: 1:59:57
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