Return on Brain Damage

Hidden Figures is a great movie.  It’s a great story about women, but also a story about math.  The continual discussion about the endless calculations (note: these calculations are basically done by hand) that go into sending people to the moon is amazing, truly spectacular.  The Imitation Game is another great movie where genius is revealed to us mere mortals.  I love the occasional opportunity to see geniuses solve great mysteries and perform extraordinary feats of accomplishment.

The Big Short, however, is a poor movie about investing.  Don’t get me wrong, it’s a great story, but it teaches a poor lesson about investing.  The investment decisions made by the people in the story are fairly complicated and, more importantly, difficult to execute.  Great investing, over the long run, is best executed when you keep things as simple as possible.

Bill Ackman made famous the phrase, “return on brain damage.”  By this, he means the following:  Some investments are so simple and provide adequate returns that the return is very high in relation to the level of brain damage.  However, some investments require a lot of brain damage that almost any sort of return does not adequately compensate you for the level of brain damage required.

Buffett has phrased this idea in a different way, but with a similar lesson: “If you are in the investment business and have an IQ of 150, sell 30 points to someone else.”

John and I both invested in Verisign (VRSN) between August and September of 2016.  We have posted about this in the past, so you can read the thesis here.  VRSN is a great example of one of the best return on brain damage investments ever.  Let me unpack that statement.

VRSN’s business is basically a monopoly on the registration and renewal of .com and .net websites.  This is a contractual relationship VRSN has with the agency, ICANN, in charge of “governing” the internet.  In late 2016, Ted Cruz was upset that ICANN was transitioning this governing role from a US-centric position to a more international body (I am simplifying here).  However, this process had been over 10 years in the making and it was highly unlikely that Ted Cruz’s frustrations were going to affect this contractual monopoly going forward.

With 60% operating margins and effectively no competition, VRSN’s business is like nothing I have ever come across.  The investment in 2016 boiled down to one simple question:  Was this contractual monopoly likely to continue over the objections of Ted Cruz?  John and I both thought the answer to this question was fairly easy to answer in the affirmative.

In other words, the investment decision could be boiled down to one question and that one question could be easily answered.  This idea is discussed by Buffett in 2004.  He describes a real world lesson with zinc production as follows:

Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel. Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.

But Matt, if this is true, why are investment idea presentations full of data that take up 50 to 100 slides?

Great question!

I am not entirely sure why complexity is so popular in the investment world, but here are my top 3 guesses.

  1. People like solving puzzles and expect investment decisions to be hard and are therefore attracted to the investment ideas that are complex and require a lot of intellectual capacity to understand.
  2. Investment Managers present complex ideas as a means to show off their intellectual horsepower.  Investment Managers are always partially in the asset raising profession and what better way to show potential investors your intelligence than discuss an overly complex idea.
  3. Additionally, Investment Managers are paid to do something.  If Investment Managers stood up daily and preached how easy their investment decisions were, you might get a few investors thinking, “Why I am paying this guy to invest in these “simple ideas.”

This reasoning is obviously counter-intuitive and I would get a lot of pushback from other investment managers on these points.  Even if I am completely off-base about why complexity exists in the investment world (a perfectly acceptable outcome), I still firmly believe investors and investment mangers would do better by significantly reducing the complexity in their investment decisions.

How about a few examples for my present portfolio.  VRSN is one of the simplest and best ideas in this “return on brain damage” category, but I will try to be as succinct as possible with these three examples (If you haven’t read a VRSN conference call transcript, you should.  If you work on a high floor in a tall office building, you might be able to finish the entire transcript by the time you reach your floor).

Apple: Is Apple a consumer brand so strong that its customers (and potential new customers) will continue to buy its product for the foreseeable future as long as its products are on par with the competition?

Although this question is fairly simple, it requires some continual monitoring on two points, 1) that Apple’s products are staying on par with its competitors and not falling drastically behind. And 2) that the consumer brand aspect of Apple is strong enough that few customers are leaving its ecosystem for comparable or even marginally better/worse product offerings from competitors.

For me, this is a good example of boiling down the investment decision to a simple question with an answer that you can figure out for the present time and monitor going forward.

Google: This is a three-part question, but the answers are fairly straightforward.  Will digital advertising grow in the future?  Will Google continue to have a large share of digital advertising in the future?  And, will Google use its profits wisely to maintain its current and future share of the digital advertising world?

The first two are easy and I have been slowly convinced that the third is most likely a “yes.”  All of these questions are easy to understand, easy to figure out and easy to monitor. John does such an excellent job of laying out the simplistic case for an investment in Google here.

Facebook: Will the majority of users remain on Facebook owned properties 10 years from now.  And, if yes, will Facebook’s advertising continue to be as effective to advertisers going forward?

These questions are fairly timely and would take some unpacking why I think both are likely, however, the questions themselves are not overly complex.

Simplicity is great, especially in investing.  Anything not simple should be questioned, unless you are going to the Moon, which I assume will remain fairly complex for the foreseeable future.

Matt Brice is the portfolio manager at The Sova Group and can be reached at Disclosure: Matt Brice and The Sova Group clients own shares of Apple and Facebook.

Verisign: The Golden Yardstick

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