(Ep.38) The Acquirers Podcast: Marcelo Lima – Growth Underwriter, Software-As-A-Service (SAAS), And Intrinsic Value

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Summary

In this episode of The Acquirer’s Podcast Tobias chats with Marcelo Lima. He is the managing member of Heller House, who follow the time-tested strategies of Graham, Dodd and Buffett; invest with a considerable margin of safety in easily understandable, sustainable businesses. During the interview Marcelo provided some great insights into:

  • Has The Internet Changed Value-Investing Forever?
  • Warren Buffett Declined Jeff Raikes Advice To Invest In Microsoft When It Was Less Than $20
  • Why Have SaaS Companies Become So Much More Successful Post Internet?
  • The Bull Case For Netflix
  • The Problem With Grahamite Investing, And Graham’s Big Bet That Paid Off
  • The Three Components Of Disruptive Innovation
  • What Would Happen If Every Company In The S&P500 Became A Saas?
  • How To Successfully Execute A SaaS ‘Land And Expand Strategy’
  • Cloud Computing – The Next Big Adoption Curve
  • How Do You Value SaaS Companies?

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Full Transcript

Tobias Carlisle: I’m Tobias Carlisle. This is The Acquirers podcast. My special guest today is Marcelo Lima of Heller House. We’re going to talk about his journey from Benjamin Graham style liquidation investor, to more of a buffet franchise investor right after this.

Speaker 2: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.

Tobias Carlisle: Hi Marcelo. How are you?

Marcelo Lima: Hey Tobias. How are you doing?

Tobias Carlisle: Very well, thank you. Just before we get started, tell me a little bit about Heller House.

Marcelo Lima: Yes, so we started in 2010. I was working previously in… I left college and started out as a software developer for several years. And then I worked in real estate finance, I worked at a hedge fund and started the fund in 2010 really because I wanted to pursue some very specific ideas that I had. And back then it was the aftermath of the great crisis, right?

Marcelo Lima: There were a lot of these Ben Graham type situations that were very attractive, and a lot of them traded in foreign markets, specifically for us, we found a lot of things in London. And the reason for this is London has a lot of these closed-end funds, and so what happened on the lead up to the crisis is a lot of promoters, hedge funds, investors, et cetera, were raising these closed-end funds to go and buy European real estate or go buy some other type of hard assets. There was even a fund that we invested in that had carbon credits for pollution offset. And so, some of these were pretty complicated, some of these were a lot simpler.

Marcelo Lima: The overall theme though is that after the crisis, after 2008 and 2009, the asset values dramatically collapsed, right? A lot of these things had leveraged in the case of real estate. And so you had this double whammy effect. Imagine that you have a closed-end fund trading close to nav, but then all of a sudden the nav gets destroyed, there’s leverage on it, and then the spread widens, so it’s trading close to nav but now it’s trading at a 30% discount to a much discounted nav. And then you lose liquidity. The stock doesn’t trade as frequently. There’s no sell side coverage because now the sell side can’t really make a lot of money promoting these things.

Marcelo Lima: And so that created a lot of opportunities in London. We exploited that for several years and it works out. When it works out, it works out fantastically, right? And so there’s a very strong intellectual appeal to this Ben Graham type of investing. It’s very intellectually stimulating because when you can mathematically prove that something is below liquidation value, “Oh, maybe this building isn’t worth what they’re saying it’s worth, maybe it’s worth 50% less,” but even then it’s impossible for me to lose money.

Marcelo Lima: And I know what the rents are and I know what the market is like, et cetera. And then on top of that, there were a lot of these situations where these little closed-end funds had… the board of directors had been taken over by a hedge fund and they had put in place a process to liquidate the investments and return cash to investors. It was in fact liquidating and there was a hard catalyst in place.

Marcelo Lima: That worked out really well but as the years went by, the drawbacks of this strategy started appearing. And so these things are obviously pretty illiquid once you get in, but then as they liquidate and they become smaller and smaller, and they become even more illiquid. It’s counterintuitive, but as the thesis plays out and becomes sometimes more de-risked, it becomes harder to participate in the opportunity.

Tobias Carlisle: Just before you get too much further, how did you… so if your background was software and then real estate financing, did you say?

Marcelo Lima: Yes.

Tobias Carlisle: How do you make the leap to value investment from there?

Marcelo Lima: Yeah, great question. When I was in the real estate finance job, so I… long story, I was trying to raise money for a consumer products company that I had started on the side with a friend, and I was trying to raise money for it. And I came across this real estate investor who was doing tremendously well and he said, “Hey, come work with us. It’s a great opportunity.” And that’s when I jumped into real estate finance. While on the first month on the job, I read Warren Buffett’s biography. And-

Tobias Carlisle: [crosstalk 00:05:14] one.

Marcelo Lima: Exactly. And completely fell in love with this idea that you could invest in different businesses. You didn’t have to be tied to software or consumer products, or real estate, and that you could analyze things and pull the trigger when it made the most sense to do so. I just became a huge Buffett fanatic and learned everything I could about first Ben Graham and then Buffett read all of his letters and started going to Omaha and attending the value investing congress, et cetera.

Marcelo Lima: In a way, that was a very positive experience obviously because you learn a lot. In another way if you look at it, if you invert it, it also, I think, crystallizes in your brain a way of thinking that sometimes is hard to break, right? So I’ll give you an example. I saw, and this is something we’ll get into later perhaps, but I saw more than one short pitch for… on salesforce.com, at the Value Investing Congress. Famous investor goes on stage, says, “This company’s dramatically overvalued. Look, they’re losing money. This makes no sense. It’s a short.” And of course now we know that was incredibly wrong.

Marcelo Lima: But all of us were nodding and saying, “Wow, yes, of course, this thesis, this guy is so smart, this thesis is airtight, makes a lot of sense.” But we were fundamentally misunderstanding the change that came about with the rise of the internet and the delivery of software as a service. So that is all to say that being in this crowd of value investors and going to Omaha and listening to Buffett is a great education, but it can also perhaps prevent you from having a more open mind and embracing something that’s new.

Tobias Carlisle: Buffett’s own style though has always been more towards finding something that compounds and finding something that’s at a very high return on invested capital sustainably. And then you look at the growth of that over an extended period of time and try and buy that at a meaningful discount that you get a margin of safety. What has software as a service changed to what Buffett had traditionally done?

Marcelo Lima: Well, I wouldn’t say that it’s software as a service. I would say it’s the internet. The internet has created a world where all of a sudden you have something that never existed pre-internet, which is zero marginal costs. So I can create a product and let’s say in the pre-internet world, let’s say I am Procter & Gamble and I create a do type of detergent. I control distribution, so because I’m Procter & Gamble, I have my distributors, I have the slots in the supermarkets and I can… I own some shelf space. I own perhaps the end caps and I can place that new detergent.

Marcelo Lima: I can advertise it on television, and just for the purposes of this discussion, let’s be very extreme to make a point. And let’s go back to the 1950s. There’s three T.V. channels, call it, right? And so I can advertise, I have primetime advertising spots. I control all of them because they’re all… there’s only three channels. And I also advertise on radio, I advertise in print and the customer will go the shop, go to the supermarket, buy the product, have that brand recognition and go home, and rinse and repeat. And so the cycle continues.

Marcelo Lima: Now imagine all of a sudden the internet happens, right? And we have an explosion in the number of channels available. In fact, the whole concept of channels disappears when you have YouTube, and Facebook, and Instagram, and Twitter, et cetera. The barriers to advertising are no longer there. Again, the concept of primetime advertising to a large extent disappears. A lot of it is programmatic on Facebook and Instagram, et cetera. And the game becomes one.

Marcelo Lima: And now you have of course, this theme of software consuming more and more of what we… of the goods and services that we consume, right? So software is eating the world as Marc Andreessen says, and software can be delivered at zero marginal cost. Now, a company that has… let’s pick on Proctor & Gamble again and Procter & Gamble is a great business. I’m just contrasting it with this new world. The skills that Procter & Gamble has to, in terms of controlling distribution in the slots at the supermarket are less and less relevant or valuable perhaps in this new world.

Marcelo Lima: Again, if you e-commerce, right? You have infinite shelf space or practically infinite shelf space, and so the winner isn’t necessarily the incumbent. Business dramatically changed with the advent of the internet and it’s created a lot of dislocation and disruption is a very overused term, but it created a lot of disruption of incumbent businesses. And so I think that that’s what really changed. And it’s not something that Buffett was really onto until very recently.

Tobias Carlisle: How would you characterize something like Microsoft which existed pre-internet and sold an operating system that locked you in, and they sold that on floppy disks that were virtually costless to them. They had some distribution and they had some minimal costs of producing them. But as any business school student will tell you that the first disk that comes out costs, whatever, $1 million, and then every disc that comes out after that costs 30 cents or something like that. And they were selling them for hundreds of dollars.

Marcelo Lima: Yes, that’s a great point, right? And so that was software as a service pre-internet, if you will.

Tobias Carlisle: Software.

Marcelo Lima: And it’s funny that you bring this up in the context of our conversation about Buffett because there’s this famous email that I’m a big fan of. I think it’s just fascinating. Jeff Raikes, an executive at Microsoft, he also read the Lowenstein biography. This is back in the late ‘90s. And he wrote Buffett an email and said, “Hey, Mr Buffett, I just read your biography and this is how Microsoft is similar to See’s Candies. This is how we’re similar to Nebraska furniture.”

Marcelo Lima: Marty’s making all of the analogies that Buffett would understand and he says, “I know you like Coke and Coca-Cola, but we’re this money printing machine. We have all these PCs that have a Microsoft license just coming out of the factory.” And he says, “Look, I’ll concede that as far as the long term moat, it’s a little bit cloudier, right? It’s hard to tell whether Microsoft will have such a strong moat 10, 20 years from now as Coke will.”

Marcelo Lima: And Buffett replies to the email and says, “Look, you guessed, that’s exactly how I feel as well as far as the moat. I can predict Coke a lot better than I can predict Microsoft.” And what I find very interesting is that right around that time, this is late ‘90s, the volumes for carbonated soft drinks were really starting to fall in the United States and around the world. Consumer tastes were changing dramatically. Coca-Cola-

Tobias Carlisle: What were they shifting to?

Marcelo Lima: I think there was this explosion of drink-

Tobias Carlisle: Bottled water.

Marcelo Lima: Yes, not only that, it’s funny, I think it was… I forgot his name. It’s escaping me now, but the founder of Boston Beer. He was talking recently on a call and he said, “Look, when I was a kid, you had water and Coke, and that was it. Now you have Kombucha and ice tea, and Starbucks,” so there’s huge variety of drinks that you could go out and purchase. And so the only thing that we knew is that carbonated soft drinks volumes were going down and customers were really seeking alternatives, whether it was water or LaCroix, or coffee, or who knows what else.

Marcelo Lima: And so that traditional advantage that Coca-Cola had was becoming less and less relevant. And it was fascinating because Coca-Cola, the company was, in 2000, was trading at something like 40 times earnings and which is a very high multiple given the subsequent very low growth that it had experienced. Microsoft was also trading at a very high multiple. And that stock underperformed for a very long period of time after 2000. But it turns out now with the benefit of hindsight 20 years later that Microsoft was indeed a much more prosperous business than either Jeff Raikes from Microsoft or Buffett believed.

Marcelo Lima: Because perhaps there weren’t very high margin software. They were able to take cash flows and invest in adjacent businesses like gaming and Search, and they’re not huge in Search, but they do have I think 7 billion in revenue from Bing, which is kind of unbelievable. Gaming is a big business for them all their entire office suite. Microsoft Azure of course, is growing dramatically now their cloud offering. And so it turned out to be a much better bet than Buffett believed. And I find that fascinating.

Marcelo Lima: Yes, to answer your question, the internet accelerated that process of delivering software at very low marginal costs, whereas the marginal cost was a floppy disk back then, all of a sudden it was just the cost of transmitting the bits over the internet.

Tobias Carlisle: One of the companies that we were discussing before we came on air is Zoom. Would you like to just tell us a little bit about Zoom and then I just want to use that as a way that we can discuss software as a service.

Marcelo Lima: Yes, so, what’s fascinating is, and this ties into a broader discussion of disruption and what it is, but a company like Zoom, I think it helps if we talk a little bit about disruption, but the traditional theory of disruption envisioned by Clay Christensen is a theory that involves a new start-up company attacking an incumbent at the very low-end. It’s typically a low-end offering the company, it’s a lower margin offering. It’s attacking the customers that the incumbent doesn’t necessarily care about, because they are so low margin.

Tobias Carlisle: What would be an example of that?

Marcelo Lima: Right, so the classical example that Clay Christensen uses in his book, well, back then it was… he talks about hard disc drive makers and backload excavators, et cetera. A more recent example I think is Netflix, that everyone in the audience will be familiar with. Netflix, when it started out mailing DVDs, it was in many ways an inferior experience, because you didn’t have that instant gratification of going to the blockbuster store and getting the tape that you wanted. In some ways it was superior because you could have this long tail of the catalog available to you, but in-

Tobias Carlisle: [crosstalk 00:17:26] And you also didn’t have to go to the store.

Marcelo Lima: You also didn’t have to go to the store. You did have to wait though, right? You have to wait at the mail for the thing to arrive in the mail, et cetera. And then remember… I don’t know if you remember this, I remember clearly when Netflix started offering streaming, it was horrible, right? It was low resolution. It was choppy because bandwidth wasn’t really there. And so, it is clearly an inferior experience.

Marcelo Lima: Again, for a certain cohort of customers, it was good enough. And Netflix moved up market, so to speak, and started improving their offering, and then eventually started creating their own original shows and bypassing completely the existing value chain of the movie industry, which means not showing movies in movie theaters, going direct to consumer, et cetera. And of course, by virtue of being an internet… effectively a software as a service offering not in the traditional enterprise sense, but software delivered over the internet, they could then expand globally at a very rapid clip.

Marcelo Lima: That’s an interesting example of that. Now, there are other examples, for example, that do not fit the Clay Christensen definition like Uber. And so Clay Christensen came out and said, “Look, Uber’s not disruptive and the reason it’s not disruptive is they are not targeting… they’re not a low-end offering that came in and offered an inferior service at a cheaper price and then moved up market.”

Marcelo Lima: In fact, Uber started at the high-end. It was a replacement for Black Cars in San Francisco, the very expensive high-end. What’s interesting [crosstalk 00:000:19:12]

Tobias Carlisle: That was the original pitch for Uber that it would be a way to call a limousine, right? There’s that very famous dick that floats around. Most people probably became aware of Uber when it was in fact… that’s probably not a bad description of it though, wasn’t it? It was a low-end. You got into somebody else’s car, you didn’t get into a taxi and it costs less, and that was the idea run.

Marcelo Lima: Exactly. Even though Clay Christensen claims that Uber is not disruptive because of the way it began, the aftermath looks very much like disruption because to your point, they use the same technology that they developed for the high-end, meaning the app, the routing technology, this idea of matching riders and drivers, and they were able to segment that across the low-end as well. And now they have a number of offerings, they have low-end and all things between low-end and high-end. And that’s the difference now, when you have the internet, you’re actually able to serve everyone because your marginal cost is essentially zero.

Marcelo Lima: And so bringing the discussion back to Zoom if I am… let’s think of a pre-internet business. If I’m delivering some conferencing service without the internet, hard to imagine what that looks like, but… and I’m offering it to enterprise customers, so they’re paying me a lot of money to offer these services. I’m leaving the low-end open for a worse offering at a lower price. I’m leaving myself open to disruption there by a low-end provider. What Zoom can do though is they can just make it free for customers who don’t want to pay.

Marcelo Lima: And so as we were discussing prior to this call, anybody can go on zoom.com, sign up and start using their conferencing services for free. There’s a time limit and there’s obviously a lot of features that you don’t get, but its good enough. And so that prevents them in theory, right? Prevents them from being disrupted by a low-end attacker. And then what they can do is they can build all the features necessary requested by their most demanding customers as well, so they can serve everyone. And in fact, that’s what they’re doing. And of course, Zoom is just a toy model that we’re using here. This applies to a lot of these enterprise SaaS companies.

Marcelo Lima: Tobias Carlisle There are existing conference lines though, for example, we’re using Skype, which is a competitor to Zoom. And if you search free conference calling on the internet, you can find any number of free alternatives. Why would somebody shift from Skype or from a free alternative to Zoom?

Marcelo Lima: Yes, that’s a great question. And it’s funny because a lot of these companies have a lot of competition, right? It’s also the case for Salesforce. It’s just the space for customer relationship management software is incredibly crowded and yet the company continues to do very well. What I think is the case is, the companies that are very well managed, they have this tremendous focus on customer pain points.

Marcelo Lima: What is it that our customers are looking to do? What is it that’s difficult for them to do in these other offering, and how can we make it easier for them? How can we remove friction and just make the experience better and better all the time, and also build additional features that promote lock-in? Zoom has the network effect, which of course Skype does as well. But if I am a large enterprise and I have now developed all these Zoom rooms, so with all the hardware there and I have my transcription that’s built in, and I’ve got Zoom… if I have multiple people on the call, Zoom automatically focus on whoever’s speaking.

Marcelo Lima: If you’re constantly focused on building these features, it becomes harder and harder for somebody to switch out. And conversely, if you’re let’s say a Skype customer, you’re not going to have all that functionality. As you become a larger enterprise, you might have HIPAA compliance or whatever type of capability that you need as an enterprise customer that you might not be suited any longer to stay with the Skype offering.

Tobias Carlisle: Zoom does have that potential to get those network effects, and I think that that’s probably been Skype’s saving grace, even though the product probably hasn’t advanced much, and it is reasonably difficult to use. Still almost everybody has a Skype number and you can contact almost everybody on Skype. But what about something like Netflix? Where do you see Netflix’s a competitive advantage?

Marcelo Lima: Well, boy, that’s a long conversation, but Netflix has this incredible focus, right? I think part of the competitive advantage of these companies is the fact that they are founder-led and they have just the… they have earned the right to make these very tough decisions and steer the company in certain directions. And we see that very clearly today with Facebook, for example.

Marcelo Lima: By the way, for the folks who are listening to this, who are familiar with Tom Russo, Tom Russo likes to talk about… Tom Russo’s a famous value investor. He’s been running this very successful value portfolio for the front of the 30 years, and he likes to talk about the capacity to suffer, and how family-owned businesses have this ability to burden the income statement today in order to reap the rewards tomorrow.

Marcelo Lima: It’s funny because when you look at SaaS or something like Netflix, it very much looks like that, right? Netflix is famously losing money. However, the way you cut it from a cashflow perspective or an earnings perspective, but they’re playing a different game. They’re playing this game of conquering the world and garnering those customers all around the world, and having the largest audience because once they have the largest audience, they can then spend more money in content.

Marcelo Lima: Because if I spend 15 billion, which I think is what they’re spending this year in content, I can spread it across many, many more 140 million subscribers. Whereas my competitors, who are starting now, a lot of them are starting from zero, how can you stomach that type of content spend if you have effectively now zero customers to spread that content over?

Marcelo Lima: So Reed Hastings saw this very early on and he played out the chest in his mind and said, “Look, if that’s the end game, then I just have to be as aggressive as possible in acquiring customers.” Right? That was the game that they were able to… this is all very much in a nutshell, right? But their competitive advantage I think is really their strategy and their ability to pursue that strategy, which a lot of competitors don’t have.

Tobias Carlisle: How would you contrast them to something like a Disney offering?

Marcelo Lima: Yes, so now it’s a question on a lot of people’s minds is, what’s going to happen to Netflix when Disney Plus starts I think next month in November. And I tend to believe that this is going to be complementary and not really a substitution. I think there might be some substitution. Let’s say a family is subscribing to Netflix and might churn out and just subscribe to Disney Plus, but I feel that in the overwhelming case, it will be complimentary. In other words, people will add Disney Plus to their Netflix subscription and not really substituted because Netflix still has an extremely large catalog.

Marcelo Lima: It’s got completely different types of offerings in terms of the titles that they are willing to fund. Disney is going to be more likely much more family-oriented offering. I think it’s brilliant for Disney. It’s about time that they did something like this. I’ve already signed up. I got the deal where you can pay a huge discount for three years. So I’m very excited for that, but personally, I won’t be canceling my Netflix subscription because I feel that it’s something that I’ll need to have as well

Tobias Carlisle: In order to compete in this new world, it sounds like you need to be a content producer and it’s not quite like being a cable company which had to punch into your house and had the connection there, and it was… if you’re in various parts of the States, you have one cable company in your area and they basically charge you whatever they want and there’s nothing you can do about it. Whereas for Netflix, it’s just a tile on your Apple T.V., and if you look through the tiles that are available, there are a lot there.

Tobias Carlisle: And basically, I think that what people tend to do is they have a show that they like. Game of Thrones for example, means that you need an HBO subscription. Once game of Thrones goes away, HBO’s offering looks a lot weaker, and I’m sure that there are a lot of people thinking about churning off. Netflix needs to have that killer show, doesn’t it? Or is it always going to be the bargain bin of, you’re just going to scroll for 45 minutes. Maybe you find something you like, maybe you don’t. What do you think?

Marcelo Lima: Yes, look, and I want to be clear. We do own Netflix. It’s a quite small position for us, so it’s not something that I am pounding the table on et cetera. I’m a big believer in the company long term and I… if you do the math, I believe that the company can be extremely profitable in the future. Having said that, there are challenges which you just outlined. What I think is the case is that Netflix has to have two things.

Marcelo Lima: One, it has to have filler content, which is the content that you described as just flipping through the catalog and being on a couch and vegging out and watching Friends or Seinfeld or whatever the case may be. But then there also needs to have that attraction, right? So Stranger Things or Game of Thrones in the case of HBO, something that will keep people that must watch content. Which is the strategy, let’s say, that HBO or Showtime have been very successful with. So we’ll see how that plays out.

Marcelo Lima: I think that Netflix is doing a very good job with its local content. So things in India and in Brazil, and Germany in other countries has been extremely successful. And a lot of that content travels very well. So they’ve been pointing out how a Brazilian show was popular around the world. There’s a Spanish show, Money Heist, which was very popular around the world, et cetera. So that that shows that this strategy of amortizing content costs across the huge base of subscribers works. We’ll see if they can continue with their magic touch.

Tobias Carlisle: It becomes a slightly more difficult proposition now, doesn’t it? Because it becomes you need to have that killer content. You need to have that thing that people will go and see, and it makes you a little bit more like a movie studio, which if you miss in any given year, then that could hurt you pretty significantly.

Marcelo Lima: Right. But let me take the other side of that argument, right? If I have the largest content budget and the largest audience, then I’m going to attract the best producers, the best actors, the best talent, right? And so it becomes a lot easier “to actually produce winning content”. If I’m Netflix and I have a roster of phenomenal writers, producers, actors, et cetera, I’m going to have my share of hits and my share’s going to be bigger than the next guy’s share because the next guy is spending a fraction of what I am in content, has a fraction of my audience.

Marcelo Lima: So you could, I think very persuasively, make this argument of increasing returns, where the bigger gets bigger by virtue of already being bigger than everybody else and having that ability to attract all that talent.

Tobias Carlisle: Just changing gears a little bit, we leaped ahead. You sent me this wonderful document, a white writing on a black background. And there was some very interesting points in that early on that I want to make sure that we address. You talked about some of the problems with granite investing. So let’s go back to that. And then I think it was largely driven by a study that Irving Khan did on Geico. So would you please take us through that?

Marcelo Lima: Yeah, sure. And by the way, you noticed I like to use dark mode in Word-

Tobias Carlisle: In everything.

Marcelo Lima: In everything. So we were talking about the drawbacks of this liquidation type of investing and how it becomes a small part of your portfolios that goes along. And then you also have to pay taxes when the thing finally liquidates two, three years from now. Again, going back to Tom Russo, he talks about having all these unrealized gains in something like Heineken, that he’s owned for 30 years. And that’s pretty attractive, never having to pay taxes on it if you don’t sell it.

Marcelo Lima: In our case, we were also in foreign markets, so we had to hedge the currency, which is fine, but catching the currency has a drag on your portfolio because it costs money to hedge. And then I think the biggest one is opportunity costs. So what I realized is that while I was grinding this out and going on these one-off situations, and putting all this work into figuring out what these liquidations were going to look like, there were these phenomenal businesses that were just compounding and I wasn’t even looking at them.

Marcelo Lima: So when I opened my eyes to this, I went back. And it’s funny because accidental almost, I rediscovered this part of Ben Graham, which I had read many years prior. So this epiphany was, Ben Graham in the appendix to Intelligent Investor, he writes almost, matter of factly, he says, “Oh, it’s ironic that we put 20% of our fund in this one company.” He doesn’t even name the company. We know it’s Geico, but he doesn’t even name it. “We put 20% of our fund in this company in 1948.” And the thing was a 145 bagger, actually between the time he bought it in the peak, it was a 600 bagger. But the way he describes it in the appendix that makes it sound like it’s a 145 bagger over 24 years.

Marcelo Lima: And he says, “That one stock made more money.” He says, “Ironically enough, the aggregate of profits accruing from the single investment decision far exceeded the sum of all the others. Realize the 20 years of wide-ranging operations in the partner, specialized fields, involving much investigation, endless pondering and countless individual decisions,” right? So everybody knows the famous stories of Northern Pipeline and the Guggenheim liquidation, and all that. Those things were a lot of work, right? He had to solicit proxies and wait for the next annual meeting, and build his case and all that. These things were liquid.

Marcelo Lima: So even back then, it was a ton of work and the profits were capped and then you have to move on to something else. And that one investment made more profits than all that. So I thought, “Hey, could you have put on a 21st century analyst’s hat and analyzed Geico with all the things that we know today in terms of disruption theory and the way businesses evolve, and the total addressable market and all that.” And so, I went back and I said, “Look what is Geico?” Right? So Geico was this company that that Graham invested in 1948. It was founded in 1936. So what could we have figured out right before Graham invested? So let’s go through the list here.

Marcelo Lima: So in 1948, if you looked at car registrations, this is public government information, car registrations had compounded at 20% a year over the previous 47 years, right? So a lot of people are buying cars. If you look at cars per capita, there was only one car or truck per capita in the U.S., okay. So maybe population is growing a lot. There’s going to be baby boomers now. Maybe that wasn’t a known fact, but maybe there’s room for more cars. I found this article in the New York Times from February, 1947, so a year before Graham invested and the article quoted a car dealership saying, “Look, if you try to buy a car, you’re going to find a wait list that’s going to take you months and it might even take you into the next year. We just don’t have enough cars to supply to people.”

Marcelo Lima: And part of that was because there were steel shortages after the Second World War, but clearly, there was pent up demand. In fact, I found this funny thing, which is crazy to imagine today, people were vacationing in Europe and they were taking their cars in the ships to go to vacation in Europe, because it’s like you land in Europe and go to Hertz and rent a car. It didn’t exist. Right?

Tobias Carlisle: That’s amazing.

Marcelo Lima: Yeah. And then finally, the Interstate Highway System had been talked about since 1938. And there was a series of documents that had been published with a proposal for the Interstate Highway System. So, okay, so here you’re Ben Graham, and you’re like, “Okay, well, this thing, there’s going to be an explosion of miles driven.” And if you think of this, Brian Arthur’s or the ever increasing returns, when you have a new technology like the car, you’re going to have a lot of things that are enabled by the car. So you’re going to have gas stations and you’re going to have probably a lot of hotels and destinations that people can actually take their cars to go see and things to do.

Marcelo Lima: So that will create this flywheel effect where the more things there are to go and do, the more cars get sold and vice versa. Right? So and in fact, a couple of decades later, Walmart was founded in the ‘60s as a business uniquely enabled by the car, right? And then finally, Geico was a disruptive business because it was direct to consumer. It didn’t have the sales agent and the additional layer of costs associated with that. And they have something like half the cost structure of a traditional insurer. This is also in the urban con study. I think it was a 14% cost ratio compared to 28% cost ratio for a traditional insurer. Oh, and finally, a better risk targeting model, right?

Marcelo Lima: So this is before Big data, before FICO Scores, how do you figure out the low risk cohort to target? Well, the government employees’ insurance company writes the name of the company and then they slowly started spreading and going to veterans and teachers, and people with bachelor’s degrees, which they were all lower risk customers. So ticks all the boxes, right? You have this huge target addressable market, you have a disruptive innovator and you have this huge secular tailwind. Now, could you apply that type of thinking to investing today? And if so, could you just build a portfolio of Geicos and just get rid of all those cigar butts? Right?

Tobias Carlisle: And so that’s what you sought to do with Heller House. You’re trying to identify these companies. Yes, so you’ve talked about this is the three components of disruptive innovation, just to… I think I’m just summarizing what you’ve just said. The enabling technology, the Innovative Business Model and a coherent value network, and that’s the… I missed the gentleman’s name, but that’s the guideline that you’re looking for when you’re seeking these businesses.

Marcelo Lima: Right. So this is textbook, Clayton Christensen, right? And you could argue whether these things have evolved, but I think the core of the theory is completely spot on. And the enabling technology is something like internet distribution. The Innovative Business Model is something like Netflix mailing DVDs, and then streaming or software as a service, a new way to deliver the product or service. And that the coherent value network is really about having, like in the case of the automobile, the value network was the creation then of gas stations and roads, and everything that enabled that business to develop.

Marcelo Lima: The example that Clay Christensen gives in the book which is super interesting, is steamships versus sailing ships. At the turn of the… from the 19th to the 20th century, steam ships were about to take over. But before that, they were worse in just about every way. They were slower than sailing ships. They were more expensive than sailing ships. And so, they were very suited to inland waterways where you didn’t have wind or perhaps you had to travel against the wind. And performance was measured in a very different way.

Marcelo Lima: And the customers of the sailing ships who needed to go across the Atlantic or cross the ocean, had really no use for an inferior technology. But that inferior technology kept getting better and better, and better, and over time, took over the business of the sailing ships. And by then the manufacturers of the sailing ships had no expertise in building high technology steam ships and all of them failed at transitioning to this new technology, so.

Tobias Carlisle: One of the very interesting points that you raise, you pose this question, what if every company in the S&P 500 became a software as a service? What impact does that have?

Marcelo Lima: Yeah, so Mark Andreessen has this thesis that software is eating the world and we can clearly see that happening. But then he goes a step further and he says, “Look, if that’s the case, then that means that every company has to become a software company.” And again, we’re already seeing that. Like, I go to a lot of these conferences and you see old school companies saying, “We’re hiring a bunch of developers. We’re becoming a software company. We’re hip, come work for us.” And it’s true to a big extent. And they have to do it because otherwise, they’ll be left behind.

Marcelo Lima: But then Mark Andreessen says, “Well, let’s take it a step further. If this is all true, then it turns out that the largest businesses in the world, the most successful businesses in the world will eventually be software businesses.” And again, we can already see that happening in many cases with things like Facebook and Alphabet, Google, right? These are some of the most valuable companies in the world and they’re almost purely software based. So it’s an interesting thought experiment because software as a service has this very interesting characteristics.

Marcelo Lima: Like, let’s go back to Walmart, for example, Walmart for many, many years after its inception in the ‘60s, it was not generating free cashflow. It was a “money losing business” because they were building a lot of stores, they were opening a lot of distribution centers and they were expanding across the country. But the unit economics were very attractive, right? So they would build a store and they had a very high ROI on those stores. The same thing is true for the most successful software as a service companies.

Marcelo Lima: So they are spending a lot of money on research and development today to build the product and maintain it. They’re also spending a lot of money in sales and marketing because, back to our previous point, it makes a lot of sense to expand and try to capture as many customers as possible because then you can deliver services to them at a zero marginal costs. So that makes the income statement look awful. It makes it look like a money, which it is, a money losing business. Right? But again, if the unit economics are there, and the way we measure unit economics in the SaaS world, is this a lifetime value of the customer, how long are you going to be my customer? How much are you going to pay me?

Marcelo Lima: And so that’s the value of you as a customer, divided by the customer acquisition costs, which is how much am I spending to acquire customers in the first place? If that’s a very high ratio, then it’s a good return on investment, and therefore, I should be pouring money into this opportunity. In fact, the canonical example is that if you’re a successful SaaS company, the faster you grow, the more money you lose. And now obviously, everything that’s good gets taken to an extreme. And so you also have bad SaaS companies that are growing like this, and it’s you have to distinguish between the good ones and the bad ones.

Marcelo Lima: Now, by virtue of this, these companies trade at very high PE multiples or sometimes inexistent PE multiples if they’re losing money. So just as a thought experiment, it would be funny if the most meaningful S&P 500 companies or the large… let’s say the entire index is going to compose of these companies because software’s eating the world, that would just be bonkers, right? It would throw off a lot of people’s models of the world because people are relying on, “Oh, the S&P is trading at a seven times PE multiple, the 30-year or the 10-year treasury is at 2.5%, sort of make sense.

Marcelo Lima: But all of a sudden, if your PEs are a 100X, let’s say that they’re fully justified, right? Because these companies are growing and they’re… let’s say a 100X is the correct number, it would be this crazy world. And I just think it’s interesting to think that way just to, as a forcing function, to adapt as an investor on how you analyze things.

Tobias Carlisle: So you say that may manifest as a bubble or it might appear as a bubble, but it wouldn’t in fact be a bubble because they would be. They may be undervalued at that level.

Marcelo Lima: Right. So I think that if we could snap our fingers and that world existed all of a sudden, I think a lot of people would be saying we’re in a bubble, right? The same way a lot of people are saying that SaaS companies are in a bubble right now. And I think some of them are, but I think some of them are not. So you really have to distinguish.

Tobias Carlisle: Do you view that state as a transition state or as an end state?

Marcelo Lima: Well, I’m not really saying that this is going to happen. I just think it’s an interesting thought experiment. I think the most likely scenario is that we’re going to have a lot of very valuable software based companies, but by the time they become big enough to be a big part of the index, they will be already very profitable and therefore, trading at a much more normal multiple. So Facebook as an example trades today at a very low multiple relative to the quality of the business. And it’s not really an enterprise, obviously, not an enterprise SaaS company, but it’s a “software as a service company” in the sense that it delivers software over the internet at next to zero marginal costs. So very different.

Marcelo Lima: And I know I don’t want people to get angry at me not making this distinction because they don’t have monthly subscribers and churn numbers, and all that. But effectively, it’s a software company.

Tobias Carlisle: So you say that the strategy in this marketplace is to land and expand. So can you just describe what that is?

Marcelo Lima: Yeah. So I heard this phrase recently and I don’t remember who said it, but you cannot till, you cannot harvest off land that you haven’t conquered yet, right? So first, you have to conquer the land and then you have to plant the seed and harvest the land. So let’s play this out, right? Because there’s a zero marginal cost to conducting business over the internet, if I am not the aggressive guy who’s going to build, let’s say whatever product that is, let’s say whether it’s Zoom or Slack, or Netflix, or whatever it is, if I’m not going to be the aggressive guy who’s going to build this product and conquer the world first and then monetize my user base, somebody else will, right?

Marcelo Lima: If I, let’s say, I launch zoom and I’m charging 50 bucks a month, somebody will undercut me and offer a freemium version where it’s free to use and then you can upgrade as you need it. And I will be disrupted if I’m charging 50 bucks a month to everyone. That’ll prevent me from landing the most customers. Therefore, the better strategy is to offer that freemium version and get the most customers possible, right? Invest heavily in sales and marketing to then try to upsell those customers into a paid tier.

Marcelo Lima: And so, you can see this clearly with the company like Slack, right? So Slack offers you this free tier where a number of users can use the product and then they’ll say, “Listen, oh, you’re trying to search, guess what? If you want to search past 10,000 messages, you have to pay us because we’re not going to store your messages if you don’t pay us.” And so that becomes then a choice whether you want to upgrade or not, but to get those increased better features, you have to. So, but they already have you as a customer, you’re already used to using them. You have all your channels set up and you’re like, “You know what? Seven bucks a month, fine.” Right? And so then you become a customer.

Marcelo Lima: So I think it’s a very interesting strategy. And if you play the game theory on this, you can see how it’s a strategy that makes a lot of sense.

Tobias Carlisle: You say that the incumbents have two problems when they’re confronted with challenges like this.

Marcelo Lima: Right. So the first problem is, and this is something that Clay Christensen describes a lot and very clearly, is this idea that if you’re going to… like because disruptors start out at the low-end and because they start out with these relatively unprofitable customers, and a lot of times, they start in markets that are inexistent or very small because these are not markets served by the incumbents, by definition. That becomes a very, very poor proposition. If I am a large incumbent and I have 5 billion in sales, why on earth am I going to spend my time chasing an opportunity that may or may not pan out in a market that may or may not exist?

Marcelo Lima: At a lower margin that I have right now, I’m never going to do that. I’m going to dedicate all of my resources to serving my most profitable customers, and trying to sell them more things. So that’s a huge problem. And then the second problem is they have this skill in controlling distribution in pre-internet world, controlling distribution, again, back to the Procter & Gamble example, I have the slots in the supermarket and the end caps, and the trucks to the supermarket. And I also have this skill in segmenting my customers. So I’m going to sell, I have the premium detergent and the medium, and the low-end detergent.

Marcelo Lima: I do not have the skill, however, in going direct to consumer, I do not have the skill in internet advertising. I do not have the skill in aggregating customers at scale, this land and expand motion. So it’s very difficult for these companies to do these two things, obviously to disrupt themselves and to have this sort of internet mentality. By the way, it’s fascinating because if you if you look at the history of Amazon, Jeff Bezos read this book; Innovator’s Dilemma, and he makes all of his top executives read the book.

Marcelo Lima: And it’s fascinating to me because as you read the book, you’re like, “Wow, Amazon has engineered itself to be the antidote to this, to sort of…” can you see a problem in the book and you’re like, “Wow, Amazon, that’s clearly why Amazon does X or Y.” And I’ll give you an example, small markets or inexistent markets only really matter if you’re a small team, right? If you’re a huge company, you’re not going to look at it.

Marcelo Lima: So what does Amazon have? Amazon has these two pizza teams, right? Because a two pizza team, a market that’s $10 million in sales or $100 million in sales is going to be a meaningful market. And so that takes care of that problem, right? So it’s very interesting and there’s endless examples of this in the book where you’re reading it and you’re like, “Wow, Amazon operates this way to counteract this problem.”

Tobias Carlisle: So I love the description that you’ve given. How does it show up in your portfolio? What do you hold? A further question, how do you manage those positions? How many do you hold? How many do you trim when they grow? How do you look after the portfolio?

Marcelo Lima: Yeah, that’s a great question. So I really want to get to the trimming question because I think it’s a very interesting point. As you study these companies, you start seeing all these secular trends and secular trends are displayed in these technology adoption curves. So if you go back and look at the history of technology since the industrial revolution, every technology has had this adoption curve where everything from electricity to indoor plumbing, the automobile, dishwashers, the radio, T.V., internet, social media, et cetera. And it starts out obviously with zero penetration and then it goes how many households have the access to this product or service?

Marcelo Lima: And then you can see okay, well, what are the businesses that are taking advantage of this adoption curve and what are the businesses that have the wide moats or the growing moats that are riding this wave? And Apple is this canonical example, that we don’t own Apple by the way, but it’s a canonical example of a company that created the iPhone and it was a very successful new category, this computer in your pocket with the touch screen, et cetera. And it became this enormous adoption curve of more and more people around the world adopting this product. And so they rode that to become one of the world’s most valuable businesses. Right?

Marcelo Lima: Facebook, again, was social media, the adoption of social media around the world. So Google with Search and then Android. So where are we on these adoption curves today? What are the adoption curves of the future and how can we position ourselves to take advantage of that? That’s how I think about the portfolio. So one big adoption curve that I’m very excited about is cloud computing. So the analogy there very briefly is back in the day in during the industrial revolution, every factory people were electrifying. Electricity became a thing in the late 1800s. And people were electrifying their factories and replacing, let’s say water wheels or steam power with electricity.

Marcelo Lima: And it was very burdensome. You had to build your own power plant and you had your own engineers, and all that. And this entrepreneur, [Salmon Soul 00:56:10], came and said, “Look, I’ll build a centralized power station and I’ll run a wire to your factory. Now you can get rid of all this machinery and all your engineers, and all that.” Well, that’s exactly what’s happening with cloud computing, right? It’s like get rid of all your servers and your database administrators, and all your… a lot of your IT folks dedicated to just maintaining this hardware. We’ll keep it all for you in the cloud in a central secure data center. And we’ll run a fiber optic cable to your office and we’ll give you incredible functionality through all these pieces of software, these APIs and all these things that we’re developing and constantly updating and patching.”

Marcelo Lima: And so that’s exploding. And every company around the world is in the process of moving to the cloud or is already on the cloud. And the largest one is Amazon Web Services. So those companies, Amazon Web Services, number one, Microsoft Azure, number two, and Google Cloud Platform, number three. I’m ignoring the Chinese clouds because, Alibaba and Tencent, because I have a hard time believing that they will be successful in the West. Like which chief technology officer is going to want to put data in a Chinese cloud? Unless you’re serving Chinese customers and you’re required to, I don’t think it’s going to be that big of a business.

Marcelo Lima: But so those companies are growing very fast. You can see the numbers. AWS discloses its sales and operating income, and then you have estimates of what the size of the market is. And so where are we on that adoption curve? So that’s very exciting. But then this is an enabling technology, right? The cloud enables new business models to be built on top of it. And of course, that’s software as a service. And so, what are the platforms being built on top of AWS and Azure, and Google Cloud? And that’s another layer that we’re looking at, obviously, to see these adoption curves taking place. So that’s a very big theme in the portfolio.

Tobias Carlisle: How do you value something like that? You’re looking at you’re estimating the size of the market, the total addressable market. You’re trying to work out what that’s worth at close to a steady state, and then you’re discounting that back. I mean, I understand the working out the lifetime value of a customer, working out the cost to acquire that customer, but how do you ultimately value something like that?

Marcelo Lima: Yeah, great question. So, oh yeah, and I want to get to your question about trimming, which I think is a very interesting question, but the value of anything is just the present value of its future free cash flows. I do believe there is strategic value. Like we have all these customers, we haven’t monetized them yet and we have… but I don’t value things based on strategic value. It’s really old school free cash flow. So the way I think about it is these companies, they all have a certain margin and the margin structure today probably looks very different from the margin structure at maturity, and by maturity I just define it as the company is large enough now to have a more rational cost structure in terms of sales and marketing expenses to its revenues and R&D to revenues, et cetera.

Marcelo Lima: And we can look at comparables and look at what these companies should have in terms of margin, like Salesforce when it was just starting out versus Salesforce today, and et cetera, and there’s plenty of examples. So a company like Slack is a good one to pick on because Slack has 85% gross margins, and that’s a very good starting point, right? If you’re selling a product that has 85% gross margins, then you have a lot of play there as far as your operating expenses. So it’s quite likely that Slack is going to have very healthy free cashflow margins down the road. And you can look at Atlassian as a potential comparable, although Atlassian is the gold standard of very low sales and marketing expenses.

Marcelo Lima: But it’s possible that Slack is going to have a 25% to 30% free cashflow margins. Which is in fact what the company has guided to. So what you do is, what we do in our case is we always build a model for these companies and we figure out, “Well, how many customers can they have realistically and how much can their top line grow, and how will the margins evolve? Is there going to be any free cashflow along the way that gets piled up on the balance sheet or is used for M&A, mergers and acquisitions.” And we try to come up with a realistic value for the business several years from now. And then we figure out what the internal rate of return is between today’s price and the future price of the business.

Marcelo Lima: By the way, I always tell everyone I know that my models are wrong. I just don’t know the magnitude and the direction because these things are art, as you know, a lot of art and a little bit of science. But it’s better to have a rough idea of what the market is imputing. So I’ll tell you, back in the day when I was investing in things at 10 times earnings, for example, right? The way that I would do this, I remember buying eBay, for example, eBay in 2008 was trading at something like six times free cash flow at the bottom, or maybe it was at the bottom in 2009.

Marcelo Lima: And I remember buying this thing and making a case that, look, anything below 10 times earnings, if I’m using a 10% discount rate, if you plug it into the perpetuity formula, it’s implying perpetual decline saying this company’s never going to grow again. And I just think that’s absurd. I think eBay will grow. So that is a very interesting way to bracket your margin of safety. And you can do the same thing with high growth companies. You can say, “Well, how low of a rate of growth do I have to put into my model such that I get the current enterprise value between now and the judgment day?”

Marcelo Lima: And sometimes it’s just this incredibly low rate of growth and you’re like, “Well, I clearly do not believe that this is going to be the state of the world. So I think that there’s a very low risk that I’m going to lose money on this, but I have huge optionality to the upside if the company grows the way I think it’ll grow.” And back to our discussion on Microsoft versus Coca-Cola, obviously, not all of these companies are going to become big like Microsoft. But they have a lot of flexibility as far as building products and discovering customer pain points because they are software based companies, because they all have visibility.

Marcelo Lima: These companies know what you’re clicking on in their application, what features you’re using, what features are frustrating their users, and they can then build things to improve that customer experience. So it’s this very tight flywheel that has really never existed in the history of business. So it’s very interesting.

Tobias Carlisle: Marcelo, it’s absolutely fascinating and I could keep on speaking to you for another hour, but that is the full hour. I’m very grateful for you coming on and educating me and everybody who listens. If folks want to get in touch with you, if they want to learn more about you, how do they go about doing that?

Marcelo Lima: Well, thank you Tobias. And I’m on Twitter, @MarceloPLima, M-A-R-C-E-L-O-P-L-I-M-A, and the website is hellerhs.com.

Tobias Carlisle: And I’ll make sure that those links are in the in the show notes. Marcelo, thank you very much.

Marcelo Lima: My pleasure, Tobias.

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