Asking the Best Questions
Plus: Is AR stupid? Is the Fed stupid? Is NFT insider trading stupid?
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The Build: Asking the Best Questions
“The most intelligent people don't have the best answers—they ask the best questions.”
The most intelligent people do ask the best questions.
Many of the best questions are simple and persistent. You don’t have to be super intelligent to come up with these questions. You just have to be willing to ask and honest in your assessment of the answers.
There are three big questions that I always come back to when investing in companies big or small, public or private.
Does this solve a time, money, or meaning problem?
How long until this company generates its valuation in free cash flow?
Would I work for this company or this founder?
Does this solve a time, money, or meaning problem?
From a first principles standpoint, time, money, and meaning are the only problems we humans have. Thus, every company at its core must solve a time problem, a money problem, or a meaning problem for its customers.
Google’s a time company. Ask it a question. It gives you the right answer faster than anything else.
Zoom is a time company. Don’t fly three hours to see someone. Just click a link that works more reliably than anyone else’s (so you aren’t wasting time trying to get the tech to work).
Costco is a money company. Buy more for less.
For Tesla to win big, it needs to be a money company. Transportation that’s cheaper per mile than anyone else. Robots that are cheaper than human labor.
Saving the environment is not a foundation for a company. See my last post.
LVHM is a meaning company. Same for any company that bestows a powerful identity on its users.
It’s usually obvious what problem a great company solves. The stark association with the problem is what makes the company great.
Google was notorious for limiting the amount of words on its homepage. No distractions that take up time. Costco has always avoided taking more margin on its retail business because it would erode its ability to win on the money problem. They still sell $1.50 hot dogs, even in this time of inflation.
A great company’s solution to the core problem is always its moat. Google’s threat was never Facebook. It’s not Apple. Nor do I believe is it Amazon. The threat to Google is that some other company or technology solves the information/time problem better than Google. None of those companies do, nor are they really trying. They’re solving different problems.
Asking the time, money, or meaning question and getting a clear answer tells you most of the important things you need to know about a company.
How long until this company generate its valuation in free cash flow?
If the value of an asset is the sum of its discounted future cash flows, then a great investment must generate far more future cash flow than is priced in at the time of investment.
A simple heuristic for investing in growth companies is to ask how long it might take to generate its valuation in free cash flow. The question requires some simple assumptions on sustained rate of growth and long-term margins.
Forget discounting. If a growth company pays you back on a free cash flow basis in 10 years, I can almost guarantee it will be a good investment. Facebook, Google, and Amazon have all done this in various periods. Even shorter in some cases.
Few growth companies ever achieve this level of payback.
The power of the question extends even better to what not to invest in. As a general rule, if there’s no reasonable scenario where a company is even paying close to half its valuation back in free cash flow over the next decade, it probably won’t be a good investment. The stock might go up but it won’t be for sustainable fundamental reasons.
Side note: To do free cash flow right, don’t exclude stock-based comp from the calculation. Third Point’s Dan Loeb demands growth investors give up that comfort in the current non-bubble regime. He’s right.
Would I work for this company or founder?
Investors rely on management to understand where opportunity exists to drive sustained growth. This requires management build effective strategy to capture the opportunity and to excite and retain talent to go execute on the strategy. The longer your investment horizon, the more important this dynamic.
Asking whether you would work for the company or founder is the most instinctual way to attack this problem. Competence may be measurable on track record, but trust, believability, likability — all these things are intangible. Your gut will answer you best.
If you’d quit your job and go into the trenches with some founder, there’s a good chance other smart people would too. The most intelligent of those make sure they ask all three of these questions.
Notes and Quotes
Staying with the theme of questions for this Deload, here are a few more:
Are virtual and augmented reality stupid?
Big firms, led by Apple and Facebook (I still can’t call it Meta), have invested heavily in creating VR and AR headsets. The influence and resources of these firms makes it possible they will the new technology into existence, but that doesn’t mean people want it.
From Galloway’s piece “Big Stupid”:
“VR is a decade-long experiment that has cost tens of billions of dollars to prove nobody wants it. Consumers putting something on their face designed by Stanford and Harvard engineering graduates who live in Redmond or San Jose is less likely than the next great SaaS company emerging from Florence.”
I’ve long disagreed with some of my partners at Loup about VR and AR. I think meaningful VR will take way longer than anyone realizes, and I have a growing skepticism toward AR headsets. Both beliefs are built on what Galloway describes: nobody really wants either.
Current VR experiences just aren’t that compelling. VR doesn’t save time, nor does it enhance content with significant incremental meaning. It’s arguably worse because you’re stuck in a lo-fi immersive world that you can’t escape by aimlessly scrolling your smartphone.
That said, I am bullish on the far-future version of VR that’s delivered via brain computer interface. We’ve invested a lot in the space. The brain is ultimately how we experience the world, and direct connection to the brain to create hi-fi, life-like experiences is a step-function change in meaning. You won’t want to scroll in that world.
As for AR, it’s already a real and usable technology in a 2D context. It’s likely this continues and evolves. The problem with an AR headset is that it too misses on the time and meaning question. Like VR, I’d argue that having a persistent stream of notifications piped to your eyes is a severe net negative on time and mental well-being.
Imagine seeing every notification from your iPhone flash on your glasses?
Unless something demands and deserves full immersion, AR is best delivered on short bursts through devices that aren’t always worn. It’s hard to imagine many broad-serving use cases that fit the former.
An Apple AR headset is coming, but it’s more likely the next Newton than the next iPhone.
Does the Fed want to avoid recession or beat inflation?
Fed watching is a mostly stupid game of trying to interpret statements by the various governors. Instead of parsing statements, we should listen and use logic.
The Fed has told us that they will be data driven, and that’s worth believing. The economic and inflation situation could change and they might ease up. The situation could change and they might need to be more aggressive. We’re going to get 50 bps the next two months, and then we’ll see. That’s the reality of policy.
Here’s the other thing I know: Everyone in America is feeling inflation right now. It’s top of mind when filling your car with gas costs $80-100 when it used to cost $40-50. My Loup partner Gene, a lover of Subway sandwiches, was dismayed that a foot long now costs $10.99. Five-dollar foot longs are long gone.
Continued strong inflation is the least politically tenable outcome. And it’s worth noting that the Fed is still a political body.
“Now we have President Biden holding a rare Oval Office meeting with the Fed Chairman. No one believes they are simply going to have tea, chit-chat, and catch up on their weekend plans. President Biden is likely to deliver a message to Powell that he has to get inflation and economic growth in the right place.
So much for the central bank being independent.
This is equivalent to a teacher being called to the principal’s office. The teacher has all the control and leadership in their classroom, but that disappears in the principal’s office. Chairman Powell….welcome to Principal Biden’s office.”
If we’re logically handicapping the tradeoffs between recession and persistent inflation, I’d bet on the Fed erring toward recession over inflation. Prior to this week, I thought that was becoming the consensus view. Now I’m not so sure. Bearishness is consensus, sure, but there seems to be a solid belief amongst many that the Fed will blink at a weakening economy. There also seems a growing belief that the Fed will take the foot off the gas in September.
As long as foot longs keep getting more expensive, they can’t. Every American feels that and every politician knows it.
Is NFT insider trading wrong?
Morality is a fraught topic. One would hope that right and wrong are universal principles, but it’s more often the case that haziness clouds simple binary views of morality. That’s the basis of so much of our political discord.
Here’s one of the few things that does seem clearly wrong: insider trading.
Insider trading has plagued the crypto world since the beginning. The issue made waves in the NFT community last year regarding an OpenSea employee. The employee was discovered to have been using information about NFT projects that would be promoted on OpenSea’s homepage, buying those NFTs before the promotion, and selling them after at a profit. OpenSea fired him shortly thereafter.
Last week, the NY AG and FBI unsealed an indictment against the former OpenSea employee, charging him with wire fraud.
Matt Levine broke down the case well, specifically securities fraud vs wire fraud.
“A famous fact of US securities law is that there is no law against insider trading. What there is is a law against securities fraud: It is illegal “to employ any device, scheme, or artifice to defraud” someone in connection with a securities trade […]
Now, insider trading is a type of securities fraud. But there is another federal statute that makes it a crime to use “any scheme or artifice to defraud” someone using a phone or the internet. 2 This crime is generally called “wire fraud,” and it is much broader than securities fraud. Securities fraud is doing fraud about securities. Wire fraud is doing fraud about absolutely anything, as long as you do the fraud using email or the phone or text messages or a chat app, and in 2022 you certainly do. So every fraud is wire fraud.”
For all his trouble, he supposedly only made about $40,000.
Scummy things usually feel scummy to do. It’s hard to imagine this person didn’t think to some degree that what he was doing was wrong.
When you ask yourself, “Does this feel wrong,” and the answer might be yes, don’t do it. Certainly not for $40k. That’s just stupid.
Thanks for reading, and see you next week.
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I share your skepticism on VR goggles, and your trouble with the name Meta for the same reason. Immersive 3D experiences are a niche market and definitely not a new Metaverse.
The console game market serves as a proxy for TAM. It could be expanded to sports and rock concert viewing. But even these and other niches remain marginal, limited by age, gender, and affordability. Since VR goggles are not do-all products like SmartPhones or SmartWatches, the cost cannot be amortized across other end-user benefits.
Ironically, Apple has the best, by a wide margin, chip and software technology plus 23 million developers in their ecosystem. But will they release such a non-mainstream device?
Pretty sure Tesla is a meaning company as well. Evidence: public awareness of its mission, its social media following, its brand strength, its attractiveness to employees and customer loyalty. All of which have been quantified.