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Hayden Capital 3Q17: Tech Investing in the Midst of Disruptions & IBKR

Hayden Capital 3Q17 Letter, November 5, 2017

  • Portfolio gained 1% during 3Q17 and 14.9% YTD; this compares to 14.2% and 17.6% for S&P 500 and MSCI World Indices YTD

Let’s Talk About Tech, Baby

  • Traditional value investing teachings have long encouraged investors to shun this category, putting it in the “too hard” pile due to the nature of rapid change
    • Warren Buffett is the most famous example for this – avoiding the first tech bubble of the late 90’s by following this advice
  • It is time the narrative is re-examined or at the very least not taken at face value without further thought. In today’s world, change is a given, not an outlier
  • The question is how can we spot these inflection points in change, and ensure our investments themselves won’t be disrupted?
  • Take an idea from Amazon. Jeff Bezos has famously said to focus on the very few things that won’t change – customers’ preference for low prices for instance – and assume everything else will. This is also applicable to investing
  • When the value investing school of thought was being born in the 1950’s and 60’s, the business environment was much different – companies derived their competitive advantages from their vertical integration, which led to scale benefits, which almost always required large amounts of capital investment
    • This vertical integration / conglomerate culture gave them cost savings and manufacturing capabilities that smaller companies couldn’t achieve
    • Physical moat, based on size, prevented them from being pushed around
    • Only hard assets could achieve this type of scale. Products were still being sold the old-fashioned way
  • Fortune 500 list from 1960: Companies like GM, Exxon Mobil, Ford, GE, and US Steel, which owned virtually their entire supply chain led the way – vertical integration was the name of the game
  • These types of growth activities take time – a single factory could take years to get up and running and were expensive. You simply couldn’t afford to grow your sales 10x in a year like many of the explosive technology start-ups today. Growing revenues meant increasing sales force and hiring 10x as many people while ensuring uniform culture and productivity was almost impossible
    • Many of the best-in-class companies of this era tended to grow at steady and predictable rates over long periods of time. Change was slow and competition was even slower to react
  • Today, change happens very fast and innovative business models can gain traction seemingly overnight. As investors, there are two paths to take:
    • Concede that predicting change is too hard, happens too rapidly, and only look for industries that are change resistant and hard to disrupt
    • Recognize this shift in business environment, and find out how to take advantage
  • Even products as simple and low tech as shaving razors are being disrupted: P&G’s North American razor business declined from 71% to 59% market share in just 5 years, with almost all of the gains going to a faster-moving startup
    • If a $220Bn company with all the resources in the world missed the trend, how can we?
  • It’s important to understand that there are two types of innovation:
    • Innovation of new products themselves, which people may or may not want (say, a Self-Twirling Spaghetti Fork)
    • Innovation of business models for existing products / services, which already have a proven market need (i.e. selling a TV online vs. selling the exact same model in brick & mortar retail or renting a car vs. owning a car)
  • Key difference is that I’m not betting on what the customer wants. Demand is already proven for the end product. Rather, I’m betting on customers wanting the same products or service, but getting it in a better way, and are willing to change their habits to do so
  • Dollar Shave club didn’t become a billion dollar company by reinventing the razor blade. Instead, they simply reinvented the business model to sell razors for a fraction of the price. Customers thought razors were too expensive after P&G abused their pricing power for decades
    • Customers will always want the lowest price
  • Amazon, JD.com, Zooplus, Baidu, Cimpress, Interactive Brokers – end product that these companies deliver to their customers are the same. However, they’ve all found to so cheaper and are rapidly gaining market share because of it
    • I would argue these aren’t “tech” companies. Fundamentals of these companies are based on old school industries – retail, logistics, information, printing services, or finance
  • To do it successfully, you need to consume a vast amount of information and always be on the lookout for a new business model that threatens your thesis
  • Best way to prevent being “disrupted” is voracious studying of competitors – not just in your backyard, but across different industries and geographies. You have to be paranoid

Interactive Brokers (IBKR)

  • Leading provider of brokerage services to professional investment advisors, hedge funds, traders, and individual investors
  • Brokerage services are largely commoditized where the primary concerns are price and service
  • Company’s pricing is unparalleled, although there is room for many improvements on the service side
  • By replacing a traditionally labor-intensive business with software, company has maintained ability to charge far lower commissions versus competitors
  • Many emerging advisory firms and hedge funds would not be in business without IBKR
  • Achieved new account growth at 17% y/y over the last 8 years; nevertheless, despite being a good business and exhibiting strong growth, IBKR has historically been a smaller position for us
    • Company has a notoriously steep learning curve and room for improvement, and we disagree with management on issues such as customer service and marketing strategies
    • There’s a lot of potential for the company if some of these issues can be fixed, and recently there have been some developments which indicate management’s viewpoint is changing
    • It’s the earlier innings of an inflection here, and therefore increased the position
  • IBKR finally wound down the bulk of the market maker business. In the last decade, with electronic trading and increased competition, market makers everywhere have had a tougher time (including IBKR)
    • Many investors viewed the division as a distraction, comprising only 6% of operating income and ROC has been declining for years
  • Core electronic brokerage division has been growing new accounts steadily at 17% y/y. More impressive is that this has been accelerating in recent months to 24% y/y in October
    • New accounts are also earning higher incremental ROC with each new customer increasing IBKR’s competitive moat
  • In terms of unit economics, estimate ~46% of IBKR’s costs are fixed; each new customer allows these expenses to be spread across a wider base, and shared among more clients. Additionally, more accounts means more trading volume, which leads to better execution costs with the exchanges
    • IBKR has historically passed on these savings to its customers, which further attracts new customers
  • Hedge funds clients were growing 3x faster than other client types
  • On the retail investor side, IBKR launched a debit / credit card hybrid. Similar to a debit card, it allows account holders to use the cash in their brokerage accounts directly when making purchases. Cardholders can also borrow money, like a credit card, but at much lower rates (1.41% – 2.66%)
    • Spending is collateralized by your investments

Image Source: Rathbones

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