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Circle of Competence Issue #35

Quote of the week: "Learning never exhausts the mind." - Leonardo da Vinci



This week I listened to a great podcast by The Real Estate Guys

on networking and attracting like-minded people. I stumbled upon Robert and Russell's work this week and look forward to listening to future episodes. Given the topic of networking, I started thinking more broadly about the purpose of Circle of Competence. A few thoughts:

My first goal is simply to expand my own circle of competence as broadly as possible - I am shooting for Munger level broadness of fields and Buffett level depth of financial expertise - and share what I am learning and reading with other like-minded individuals.

My second goal is to expand my network of investors and business men and woman who are on their own journey of expanding their own circles of competence, to connect with my readers on individual levels, and learn from their experiences. The key point of the podcast above was that connections and relationships are best made when both parties have something of value to offer the other. While I may not have access to gobs of capital at my disposal, I think my added value is purely intellectual and would anticipate that most of my readers' would be as well. Just last week, I connected to a young investor working with a search fund and found our conversation highly stimulating - and we'd never met in person before! So if you are a subscriber and have a question, a need, a thought, a recommendation, or just want to chat - please reach out. I love meeting new people and have met several through this blog in the half year I've been writing. These people have made the effort so much more rewarding.

Finally, I write to organize my thoughts. There really is no better way to solidify your thinking than writing it down and refining it. I have heard and read this many times from great writers such as Buffett, Howard Marks, Seth Klarman and others... but until I began doing it myself, I had no idea how clarifying the writing process would be for my own thoughts.

The Outsiders

I just finished a copy of Will Thorndike's 'The Outsiders: Eight Unconventional CEO's & Their Radically Rational Blueprint for Success' and boy was it a page turner (H/T Neil O'Donnell)! I could write pages of lessons learned from the book, but I wouldn't want to spoil the fun for potential readers. I can't recommend this book highly enough because it gives real world examples of capital allocators that achieved stunning returns using tactics that seemed unorthodox by Wall Street standards at the time. The main themes of the book include:

- sound capital allocation as the CEO's highest priority

- when to issue equity as a form of currency (and when not to issue equity)

- when to use debt opportunistically

- stress cash flow creation rather than accounting earnings which can be manipulated

- be willing to stick to your convictions when you know they are the most rational course of action

It is no surprise that the book ends with Buffett as the master allocator, but interestingly enough, he spotted some of these other CEO's early on and invested alongside them. Not only was he a master at investing, but he was able to spot those around him who were as rational as he was at allocating every marginal dollar in their business. This takes a LOT of skill to identify managers who think, act, and perform the way you do, often from reading only their investor letters and public filings. Overall a wonderful read and I recommend it for those looking to learn more about how these CEO's allocated their time, resources, and human capital to achieve some of the most insane track records in the history of American business.

Cannabis sector - bubble or opportunity?

I've been following an interesting mini bubble in cannabis stocks recently (take for example Jamie Catherwood's piece on Tilray's meteoric rise and fall since its IPO in July 2018), and I believe it is an interesting psychological phenomenon of markets that tends to occur towards the end of economic cycles. Take for example this short piece from John Hempton of Bronte Capital on a 'Crypto Pot Stock' pitch he was emailed earlier this year - essentially combining two of the bubbliest asset classes into one! After coming across Aswath Damodaran's piece on cannabis valuations, I decided to share some thoughts around the industry. Mini bubbles can occur in sectors that exhibit hype far beyond economic reality and the legalized cannabis industry is no different this time.

Capital is always looking for the next best use, the next best investment opportunity, and pent up demand for a piece of the nascent cannabis industry has caused stocks such as Tilray to become valued at an astonishing market cap that is 392 times book value and an enterprise value that is 494 times current sales. Given the current industry dynamics that include robust tax and regulatory hurdles that many companies will face, the mere 10-15% growth of the industry, and the commodity like product being sold, the initial conditions are not ripe for any sort of competitive advantage to emerge until someone achieves massive scale. Another route that Damodaran suggests that the industry could take is that of the pharmaceutical industry - the medical use case for marijuana - in which case the margins may be higher for patented products that can be sold at premium prices. In this case, there may be one or two companies that hit the jackpot and take an abnormal share of the profits in the medical marijuana industry. These two potential outcomes beg the question of "how does one know which company will 1) scale into large profits in the first scenario or 2) will have the high quality product that is used by the majority of the medical marijuana users in the second scenario?"

So why the crazy valuations? In short, I believe 1) we are near the end of the current economic cycle with a lot of capital searching for the highest returns (and doing anything to achieve these return - we've seen how this ends!) and 2) investors see the nascent marijuana industry as the new tobacco industry that could scale into the same type of profits Big Tobacco did decades ago. As for me, however, I think I'll pass on both the product and the stock being sold.


No links this week unfortunately, because I'll be in Disney World on a family vacation!


- Jesse Felder & Fred Hickey on trusting your research (Superinvestors)

- Preston Pysh & Stig Brodersen with David McAlvany on precious metals investing (The Investors Podcast)

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