The Right Tail – How Errors Of Omission Hurt Your Returns

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In this week’s episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed The Right Tail – How Errors Of Omission Hurt Your Returns. Here’s an excerpt from the episode:

Jake Taylor: Me too. So Bill, what’s your topic today?

Bill Brewster: Piggybacking on the Akre article thought, right? I had sent out into the airwaves of the Twittersphere that I thought that it was potentially not a mistake. My question was why is a lack of errors of commission so revered in this game when the right tail can do so much of the work?

Tobias Carlisle: I thought that was a very interesting point. I’m glad you brought that up. Let’s talk about that.

Bill Brewster: Good. I sort of in the conversation diverted a little bit of the conversation to GameStop because I had said, “If there’s not much of a right tail then I think an error of commission is almost certainly and error. But if there is the possibility of a right tail, then I don’t think that you necessarily made an error. That might just be probabilities manifesting in a negative way.”

Tobias Carlisle: Let’s just define right tail. What does that mean?

Bill Brewster: Well yeah. So that’s part of it, right. I mean it’s all a risk/reward skew. So if you think GameStop is a 10 cent dollar and it could 10X or 5X or something like that, it’s got plenty of right tail. I didn’t mean it just as, “Buy compounders and let them go forever.” That wasn’t really my thought process. What I was really getting at is I feel like Buffet particularly is so revered for not making errors, and I have massive respect for his track record. But the other side of it is what if he had bought Google when he said he should’ve? And how do you balance that-

Tobias Carlisle: Stick a billion in.

Bill Brewster: Yeah, that’s right. I mean, whatever. So I don’t know, it’s just the thought that I was coming upon. And I think historically I have avoided things because I haven’t wanted to make an error of commission. In retrospect, I don’t know if that’s the right thing. Certainly, looking back today, I probably should’ve pulled more triggers. But you could say that about a lot of different things today, so I don’t think today is the right framework. And are you right for the right reasons is a whole nother discussion. But that’s what was on my mind.

Tobias Carlisle: I thought it was very interesting. And it helped me. I’ve been thinking about it too in this kind of context, right? So we’re in this market right now which seems to be rewarding very high-growth companies, and I have trouble getting comfortable with those companies. But maybe the way through it is to say… So Y Combinator, you guys familiar with the Y Combinator model?

Bill Brewster: Yeah.

Jake Taylor: Mm-hmm (affirmative).

Tobias Carlisle: Where they every year they take in, I don’t know the exact number but it’s something like this, say 100 small entrepreneurs who have startup ideas. And I think they seed them with $100,000 each, which I think means that they’re committing $10 millions in capital in any given year.

Jake Taylor: The math checks out.

Tobias Carlisle: Yeah. I just made that up on the spot, but it’s something like that. It’s roughly that kind of scale, like many, many small bets, with the idea that if you have lots and lots of these little, small bets, one of them or several of them… The traditional model for a VC fund is to have 10 positions, and you know that a handful are going to be massive winners, basically a handful will break even, and the rest are losers. And the idea is that the massive winners make so much money that the whole fund does really well. So their approach is you got to get lucky to get one or two out of 10, you got to get less lucky to get 20 or 30 out of 100. So you just seed a lot of these little positions.

Tobias Carlisle: What I interpreted what you were saying, Bill, was that you’re going to have a lot of these losers, and it’s very hard to distinguish between the monster winners, the Shopifys and the Netflixes and so on. So what you should do is you should have lots and lots of these small bets, knowing that many, many of these are going to be errors of commission. Because in this instance, making an error of omission is the worst error. So you want to have a tiny little part of all of these businesses that are going to go up 10, 20, 30, 60 times. And that’s how your portfolio works. So you take a kind of angel VC model and you put it into the public market.

Bill Brewster: Yeah, that was a bit of what I was thinking. I mean certainly you don’t want to make it with a concentrated bet. But Shopify was something I was looking at. I couldn’t quite get there. I don’t know, would it have been smarter, rather than having a hurdle that says, “I have to be able to put 5% of my portfolio into this,” is it enough to say, “Boy, I think this thing has a very legit product, a super long runway, and could work from here, so maybe a 1% position makes sense today.” And if it sells off big time, you can still come over the top of 1%. That’s not going to kill you. But right now it’d probably be 4%. That’s good.

Tobias Carlisle: And if you love the position. Or if you love the underlying business and it’s the valuation that you can’t get comfortable with, if you put in a point and it backs off 50%, now you got price, stick in a point, you’ve still got a fairly small exposure to this thing. But now you’ve got your price, you got 1.5% in it. Maybe you take it up a little more even then. I think that’s a smart approach. I think there’s something really interesting in it.

Bill Brewster: It’s part of what I’m thinking about, yeah. There’s some of these that I can’t get there on valuation. But for the really good ones that I think are really awesome, does it make sense to have a little bit of exposure? And then, to your point, if it sells off, as long as my assessment of the business hasn’t changed, buy a little bit more.

Jake Taylor: I would push back to challenge that at least my understanding is that VC funds have not returned very good results as a category. So maybe that’s not something you’re looking to emulate.

Tobias Carlisle: I think that they say if you divide the VC universe into four, the very vast bulk of the gains are in the top quarter of VC funds. And the reason for that is, unlike public market investing where any… can open up a brokerage account and take a little bit of Shopify, you need access to get the good investments in VC. And part of being a successful startup is I got Benchmark to invest in me.

Jake Taylor: Right.

Tobias Carlisle: That’s the signal. It’s not just money, they want the brand. They want the imprimatur of somebody else to say this is a worthwhile investment.

Jake Taylor: I always wondered how that word was pronounced.

Tobias Carlisle: I don’t know if that’s the correct pronunciation. But I think that’s what they used to call… That’s how they stamped the coins.

Jake Taylor: Yeah. Well, my understanding is that you almost, in a VC fund, you can’t afford that sin of omission. Because that one, if you miss it, if you don’t have the one Google in that population of startups, then you miss all of the returns basically. So you have to bet on everything to make sure that capture the one crazy unicorn.

Tobias Carlisle: Which makes it hard, right? It means you just got to…

Jake Taylor: Very hard.

Tobias Carlisle: Every guy who walks in the door, you got to stick some money in his company.

Jake Taylor: Here’s a check.

Bill Brewster: Yeah, well you’re certainly judging humans, right? And saying, “If I like this guy, I can’t let him walk out the door, especially if I like his product.”

Tobias Carlisle: Travis Kalanick.

Bill Brewster: Yeah.

Tobias Carlisle: He walks in the door, you cut him a big check.

Bill Brewster: There’s clearly a tension with this. I mean you can’t erode your criteria so much that you’re just spraying at everything. But I do think that there is some gray area here that can be applied. And I mean it’s almost like a Chris Meyers coffee-can portfolio type, 100 beggars. That would be where I would be looking to apply this sort of thought process, where it’s like, “I don’t know. This thing could really be huge and it’s got some traction.” Does it make sense to just sort of coffee can that with a small percentage? I don’t know.

Jake Taylor: Ignorant of valuation?

Bill Brewster: Not ignorant of but I mean, yeah, you’d probably stretch on some of these.

Tobias Carlisle: But it’s also true that all of the, and we’ve discussed this before but it’s worth reiterating that all of the monster winners overtime, Walmart, Microsoft, take your pick, have always come out of the most expensive… Everybody knows that they are the companies where they want to invest. The thing is that, even knowing that, everybody underestimates how good the end up being. But, then again, there’s part of me that thinks this is real bull market talk. This is real…

Jake Taylor: So late-cycle topic.

Tobias Carlisle: This is real Tesla tripling into the last six months.

Bill Brewster: When we’ve got the author of Deep Value talking potential VC strategies in the public markets, you know it’s late cycle.

Jake Taylor: Check. Check please.

Bill Brewster: I mean, look, it’s not how I run my money. My money is not at all in that way. But I just think that, personally, I do not belong in the same sentence as Chuck Akre, right? Or Tom Russo or Buffet or any of these guys. So to look at what they’ve done and not at least think a little bit about how could I improve my process, I think is just silly. So that was one of the thoughts that I had.

Tobias Carlisle: So I saw this funny comment on Twitter. Buffet or Buffet’s lieutenants, I don’t know who did it, but whoever’s taken the big position in Apple, and then it’s had this monster run. And then someone said, “Does he sell?” A question I got on Twitter. I think, as we discussed before, it’s so hard to get into those positions. There’s so much money that he’s put into it and rolling around. He can’t get out. He’s stuck in Apple now, even if he thinks it’s overvalued, he just has to say, “Well, we’ve front-end loaded our returns, but we’re still going to be in.”

Jake Taylor: Yeah, nevermind the tax consequences as well on that.

Tobias Carlisle: Yeah, right. You get liquidity in tax issues. There’s no way he’s selling out of that.

Bill Brewster: It’s not like with that kind of size you can go into the option market either, right?

Tobias Carlisle: Yeah, you can’t. That’s right.

Jake Taylor: Hedge out, yeah.

Bill Brewster: There’s no way that they could absorb it.

Jake Taylor: There’s no hedging out.

Bill Brewster: Yeah, I think the same thing. I mean I bet he’s just mad. I bet he’s stewing a little bit because he’s thinking about that the buybacks don’t go as far and he’s like, “Ah!”

Jake Taylor: Clogged my buyback thesis.

Bill Brewster: That’s right. I’m sure it feels good though also.

Tobias Carlisle: I bet he doesn’t think about it much.

Bill Brewster: We might be in the middle of the melt up. I mean it’s very possible. There has been a lot of stuff going on that’s…

Tobias Carlisle: The market has melted up. It has been bananas. Tesla and Apple have just gone vertical.

Bill Brewster: Yeah,…

Jake Taylor: I think it’s all these…

Bill Brewster: … I was talking to my buddy. The other day I said, “If you were buying momentum and trading technical, at this stage you’re just drawing a line straight up.” It barely even moves horizontally.

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