Assets that don't earn.

Investing is an exercise in evaluating how a company’s “intercept” — the current state of internal affairs, collection of assets, and known information about the competitive environment — will influence its future “slope”.

In the early stage market, this becomes especially challenging as there is necessarily limited, incomplete, and outright unknowable information about a company's intercept upon which to base the evaluation of what shape and grade that slope will take over time.

In more mature companies (think Coca Cola or Salesforce) there, somewhat obviously, tends to be a tighter band around how the slope will trend. With more information available about the company — long term contracts, benchmarks against competitors, established leadership teams — more of the slope is locked in (and priced in) over the next year and beyond.

The earlier in its lifecycle a company is, again somewhat obviously, the less locked in the pitch of the slope is for any period of time into the future. This same framing tends to apply to building products and companies in new markets with few predecessors upon which to accurately contextualize progress.

A company's journey from new to mature is a journey from hypothetical value to real value. Mature companies are valued on their ability to turn assets into cashflow while emerging companies are valued on what might be called "assets that don't earn".

Put differently, mature companies are valued on their accumulated advantage while startups are valued on their accumulating advantage. Another term for the latter is business model leverage.

Accumulating advantage is core to the investment philosophy of many top early stage investors— including Keith Rabois who discusses the concept on this great podcast with David Perell of North Star Media — but it remains a challenging concept to fully internalize and identify in real time when evaluating an investment opportunity or thinking through how to create a “rich get richer” virtuous cycle in building a company.

One helpful example to illustrate the idea of accumulating advantage is Netflix and the (painful) journey that public market investor Bill Nygren took to finally understand how to assess the company's strategy and, by extension, the pitch of its future slope and its valuation.

Fast forward to just a few months ago: One of our young analysts comes into a large room and there are about 20 of us on the investment team that sit around the table. He has written a report on why we should buy Netflix and I'd gone through it...and of course, it's hard to get out of your mind that you missed buying at it like 5% or 10% of the current price. And the report didn't really jump out at me.

We go into the room and he starts by saying, "people subscribe to HBO NOW, and they pay $15 a month. They subscribe to Spotify, they pay $15 a month, Sirius XM, $20 a month. Those same people, when they rate the services, they subscribe to say Netflix is more valuable to them. If Netflix, instead of charging $10 a month, charged $15 it would be selling at 13 times earnings." And it was like the bell went off. That's that's a way of thinking about the business value there that I had never thought of — that the willingness of Netflix to sacrifice current income by not charging as much as they could for their product to instead grow their subscriber base 25% a year to a point where the moat has become almost so large that it's impossible to think of somebody displacing them.

$8 billion a year on programming. That's almost now two to three times what HBO spends on programming. And because the sub base is growing so rapidly, the cost per subscriber is going to be substantially less for any programming that Netflix considers buying compared to HBO. Now, clearly, that's a stock most value managers won't touch. It sells it almost 200 times earnings while the market is at 18 times earnings. It's just a name they don't even think about.

I think as value investing has evolved. Most of the interesting opportunities today are coming from these businesses where the P/E ratio does a really poor job of assigning value, the companies that have these unique non-earning assets.

In addition to analogies like this, I've also found it helpful to develop a few supporting questions (incomplete and constantly in development) that I ask when trying to understand if a company has a valuable accumulating advantage.

  • Is this company making tradeoffs that its competitors are unwilling or unable to make?

  • Why is the business “easier” now than it was 6 months ago and what will make it easier 6 months from now?

  • What unique bundles is this company built on? (Note: An example here might be a team competing for similar customers with a similarly featured product but gaining an advantage because of a proprietary distribution channel enabled by founder domain expertise and experience. Put differently, what "secrets" is the company founded on?)

A company's accumulating advantage and its “assets that don't earn” (yet!) represent the tip of the sphere behind which all the power of all of its resources should be aligned. For any capital allocator — an investor evaluating a company or an executive making decisions from the inside — cutting to the core of what drives a company's accumulating advantage is crucial to sustaining success.