Episode Transcript
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(00:00):
Welcome back.
For episode one fifty, I wanna do somethingcompletely different and record my first solo
episode.
But just like with my New Year's resolutions, Idon't really believe in waiting for an
arbitrary date to do something.
So, alas, I'm releasing this as episode oneforty three.
If you enjoy it, please let me know by sharingthis episode with a friend, which lets us know
that you value the content.
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Let's dive right in.
Across the first hundred forty two episodes,the one consistent component I found across all
top investors is the role of compounding intheir business.
Today, I'm gonna cover how the world's topinvestors compound their advantages in a hyper
competitive capital markets.
Lesson number one, when it comes tocompounding, is that everything compounds when
(00:43):
it comes to investing.
Whether you're investing someone else's moneyor your own, even areas that appear not to
compound.
Most investors assume that going from oneinvestment opportunity to another is a linear
exercise.
But in reality, it is a compounding exercise.
Your reputation compounds, your experiencecompounds, your ability diligence compounds.
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All these skills compound and stack on top ofeach other from one deal to the next.
That being said, while some things compoundexponentially, others only incrementally.
What compounds exponentially?
Above all else, relationships compoundexponentially.
This is both for obvious as well as non obviousreasons.
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Relationships compound because, of course,doing the second deal or the third deal with
somebody is much easier than the first deal.
On the first deal, your counterpart needs todiligence both the deal at hand as well as you,
the individual.
When you get to the third deal, the diligenceat that point is almost entirely based on the
deal presented, not on you as a counterparty.
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The implicit difference here is trust, which iswhy trust compounds within relationships.
When you present a second deal, you're muchmore trustworthy than when you had presented
the very first deal.
By the time you present the third deal, there'salmost an automatic trust in the relationship
and embedded trust in the diligence process.
Of course, capital allocators will rarely admitthis and may not even be aware of this, but
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indeed a bias of trust is present.
This trust bias is a heuristic or a mentalshortcut that serves to save investors time.
Before you go about criticizing this behavior,keep in mind that when psychologists studied
people's behaviors over many decades, there wasconsistency as it relates to ethics.
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Just take a moment to think about someone thatyou've known for twenty years.
Have their ethics changed dramatically?
I would venture to guess that although theirskills and maybe even their lifestyle has
changed dramatically, their ethics haveremained consistent throughout the twenty years
that you knew them.
There's another reason why relationshipscompound exponentially, and that is because of
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the familiarity between parties.
What does that mean?
Once you've done enough deals with acounterparty, you have an implicit
understanding of how the other side looks at anopportunity, how it fits into their overall
portfolio, and the kind of deal terms they careabout.
You essentially start with half of the dealcake already baked.
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The next factor that compounds exponentially isreputation.
Reputation compounds when it comes toinvesting.
Teddy Roosevelt once said, reputation is whatpeople say behind your back.
Reputation can be a key advantage when it comesto investing.
This is the number one reason why WarrenBuffett is able to negotiate superior terms on
his investments, both because of his reputationas an ethical counterparty and as his
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reputation as a great investor.
This is so much the case that every deal thathe's worked on has been kept extremely
confidential, lest it increase the price of thestock before the deal is ever announced.
The opposite, of course, is also true.
Negative reputations compound exponentially.
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Institutional investors oftentimes do a minimumof 10 reference checks on a potential manager
prior to investing, making it nearly impossibleto raise institutional capital if you have a
bad reputation in the market.
This is why, sadly, many investors will neverraise a single dime of institutional capital.
The next factor that compounds exponentially isproprietary information.
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This compounding factor is less obvious versusthe other ones.
There's a significant compounding effect whenit comes to proprietary information.
This is because proprietary information leadsto higher returns, which leads to improved deal
flow and turn leads to additional proprietaryinformation.
This is a virtuous cycle.
This is why some families are able to preservetheir wealth for many generations, especially
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in poor countries where information is moreconcentrated and limited to a small group of
powerful individuals.
This can even be the case when the nextgeneration is not as hardworking or even as
intelligent because proprietary information canbeat that much of a competitive advantage.
It becomes exponentially easier to make gooddecisions when you have access to proprietary
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information.
One does not need to be a genius to buy land inan area where there's a recently discovered oil
field that few people know about.
The same goes for buying secondary in a privatecompany that you know is doing well.
The next factor that compounds exponentially ispeople.
People compound exponentially.
Every CEO says, our most important advantage isour people.
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But if you don't have policies in place thatlead to attracting and retaining the very best
people, this statement is simply windowdressing.
How do you go about attracting and retainingthe very best people, the a players?
Firstly, a players want the ability to developskills and develop their own value in the
marketplace.
This could be a difficult pill to swallow forinsecure managers.
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Insecure manager may think, what happens if Idevelop my a player and he or she leaves my
organization?
The answer is that if you don't develop your aplayer, they are guaranteed to leave and likely
sooner than later as they have many options.
To the upside, having a fully developed aplayer for three years is more valuable than
having even an equivalent a minus player forten years.
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So many ways developing a players is the pricefor having a great organizations.
A players will recruit other a players at yourorganization.
A players are the most underrated recruiters onthe planet.
That is because a players wanna work with othera players.
Conversely, a players serve as a very effectivequality control for the business.
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A players have zero tolerance for even a singleb or c player on their team as they realize
that one bad apple can significantly hurt theentire team and organization.
This is why as investor, even with a smallinvestment team, you could argue that your
number one job is to make sure that you attractand retain a players.
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A players are the ones that will create theorganization that leads to sustained alpha and
performance.
The arbitrage when it comes to a players is topay them 10 to 25% over their market rate.
This is a competitive advantage in bothattracting and, perhaps most importantly,
retaining a players.
The reason you can afford to do this is becausea players will produce an order of magnitude
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more and higher quality output than even aminus players, leading to overall savings.
This arbitrage will only continue to grow asproductivity increases with the advent of AI
and AI tools.
And that's the lessons I've learned through thepodcast and also in my career on what compounds
exponentially.
(07:42):
Einstein famously said that compounding is theeighth wonder of the world.
What do you think?
Do you agree?
Thanks for listening to my episode oncompounding.
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