Patrick O’Shaughnessy — Jerry Neumann Conversation

Conor Witt
Jul 16, 2017 · 9 min read

Typically I don’t take formal notes when I listen to podcasts. I will jot down ideas, quotes, or specific segments to revisit when I feel like I can’t let myself forget them, but beyond that I just tend to listen. I looked forward to this episode of Invest Like the Best with Jerry Neumann as I do each week when a new one is released. In this particular podcast, however, I found myself taking notes the entire time. I was at a YMCA in Lincoln, NE and had an hour before they closed. I wanted to get a quick workout in after a long day. That didn’t end up happening. Instead, I spent the entire time on my phone listening to this interview and frantically taking notes. I felt I couldn’t not get this stuff on paper. I also found so many parallels to other people/ideas/quotes. Below are some of the notes I took and subsequent parallels I found.

Disclaimer: the use of “I,” “me,” or any possessive pronoun has absolutely nothing to do with me. It’s straight from the podcast.

The Deployment Age

First stage — new system of innovation — high risk, lack of understanding around its applications, adoption, impact, etc

  • Capitalists start pouring money with no specific idea of how the return will be generated → just a risk worth taking with high potential outcomes for return
  • Obvious uses where you can make a lot of money
  • Bubble → Crash

Second Stage (Deployment Phase) — Market is then driven by production capitalists (not financial capitalists)

  • Post-crash, things start to calm down…it’s driven by production capital who doesn’t like to take risks…b/c they don’t like to take huge risks, innovation starts to slow (sustaining innovation > radical innovation)
  • Less risk-driven; just want to invest where they can make money → much more predictable market (this part is the Deployment Age) — “were not doing anything crazy” — want to grow our companies; regulation put in place; S-Curve starts to flatten out again
  • Once S-Curve gets flat enough, capitalists start looking for somewhere else to put their money so the next cycle starts

Technological System → Technological Revolution → Constellation of Innovations → Money Pours In → Bubble → Bust → Production Capital takes over → Regulation comes in → Innovations become more integrated into society → S-Curve flattens out → Financial Capitalists look for new opportunities

Moving the Needle

Logical Question: So why not just go find the next thing as productive capital takes over for financial capital in the current system?

  • Carlota Perez’s answer: if they could, they would, but that’s not what happens…Making the move forward towards the next thing → need a lot of weight

You have this whole constellation of technologies in a system…no one technology can move ahead too far from the pack b/c they are all more or less dependent on each other

  • Reverse Salient” → you need to push the whole system forward; to do that you need a lot of money
  • Ex.) Internet → seems pretty cheap, but consider all of the fiber optic cables and all of the software/hardware that enables this. Need a lot of money…need societal alignment in order to push this one technology along (which means they’re not pushing along other technologies)
  • So when VC’s (tiny sector on a relative basis) say they’re going to move things along, they’re just wrong…they don’t have that kind of leverage…they have the leverage to introduce really cool new ideas which might later inspire others…You can’t do it by yourself…you need society behind you

“In this era when beta has become so cheap in the public sense, alpha has become more dear even though its harder and harder to find.”

Replicating Tactics vs. Mindset

When you look at the really successful VCs, people don’t replicate their strategies

  • People look at VC like “picking” … nobody goes behind the scenes and asks why the best make so much more money than the average VC…the reason is because the strategy they’re employing is terrifying to most people (again, unknown = frontier, where opportunities lie)
  • Ties into Patrick’s comments in his interview with Scott Norton (~minutes 41–45): “I think a good rule of thumb is that you want to look for things where there’s no manual. Where there’s no playbook. Where someone hasn’t figured out outline — here’s the process for how to do it. Usually that means there’s too much competition. It’s colonized and not a frontier.”

Unconventional success is not emulating the approaches/tactics of the best (whether it’s Swensen @ Yale, Marks/Karsh @ Oaktree, Feld @ Foundry, Sequoia, Benchmark, USV, etc)…it’s a mindset and a willingness to tolerate uncertainty…an understanding of probabilistic distributions (Marks, Wenger, etc). Ties into Adam Robinson’s idea of investing in things that don’t make sense (great Ben Carlson post on this here.)

They’re investing things where there’s “Knightian uncertainty” — look at Foundry’s group portfolio and you just laugh and ask “what are these people doing?”

  • Return and Ridicule — Fred Wilson has found that there is a high correlation between ridicule in the short term and outsized returns in the long run…the things that appear stupid, crazy, and outlandish are often things that go on to do well down the road
  • Uncertainty=uninsurable b/c you don’t know what the probability distribution looks like; Risk=predictable, insurable, quantifiable
  • Frank Knight — this is at the core of entrepreneurs making money…they’re going after uncertain prospects b/c if they weren’t uncertain, then some incumbent would have come in and snapped it up

Uncertain prospects are where the alpha is…so if you embrace uncertainty then you can find the alpha…but people hate uncertainty (Ellsberg Paradox = ambiguity aversion)

On doing things that look insane because that’s the way to move into the frontier. They’re insane based on our historical understandings. But the cyclicality of history pushes forward in the investment process/timeline that Neumann describes (high risk and little capital = big rewards; bigger players enter the market investing more and building out infrastructure to facilitate and scale the tech — less money to be made; then the dumb money follows later and returns are unimpressive/average; ironically; that’s when people are looking for alpha (which is limited) even though beta is so cheap

Neumann’s Process

Divide ideas into two categories: (a) the ones that are definitely bad and (b) the ones where you don’t know. Relates to Munger’s idea of getting rid of bad ideas and trying to not be stupid > trying to be smart. You can’t predict the future.

People have a bad sense of what other people are going to use/like/do. Nobody has good instincts on things you can’t predict. But you have the discipline to be willing to invest in things you can’t predict. I don’t know what’s going to happen here:

  • Good job — make a decent distinction and sort out ideas that are definitely bad. Sort out ones you don’t know and say these might work, but I’m not sure
  • Great job — if you can embrace the fact that you don’t know, you’re doing a great job
  • Bad job — the people who actually think they know. Example of investing in ICO’s cause they’re absolutely certain cryptocurrency is going to be the biggest thing ever (he’s not suggesting that it isn’t, just saying he doesn’t know). Those are the people who are going to lose all their money.

Who benefits from innovation?

TV/Radio example: Commercial viability comes from low cost that allows it to be in everyone’s home (same way TV’s and radio were scaled)

Then, next question: is the money made from the hardware itself? Neumann’s answer: No, it was made based on the content that was subsequently created and enjoyed on that hardware

  • Ralph Wanger: “since the industrial revolution, going downstream, investing in businesses that will benefit from new technology rather than investing in the technology companies (or technology) themselves, has often been the smarter strategy”
  • Radio example — Value was created inside the content industry, so the radio stations, the ones that created the content for the radios, were the ones that made the money. So these are complementary assets (radio + complementary companies)…but radios (RCA, etc) didn’t make that much money

VR case study — whether or not there is a bigger scale market outside of his 14 year old kid playing Call of Duty with VR, who is going to make the money with it?

  • VR has similarities to the TV/radio example above. VR must have some standard format that allows content to be distributed across lots of people/viewers. VR devices will be relatively cheap and standardized. The money will be made in the VR content.
  • The problem is, VR content will (according to Neumann) be created by incumbents b/c that in itself is not that innovative. Sustaining innovation, but not radical innovation. Doesn’t really allow an opening for startups. Disney is going demolish any startup in that play b/c there’s very little risk on Disney’s side

A/R — Neumann thinks this is different. Not actually being entertained, you’re overlaying something over the world. Real uses are much more ad hoc. Machinist working on factory floor. A/R glasses on…says “turn this bolt” — no more manual telling you how to fix things…you’re just told as you need it via A/R. Manual is in the software. Development of A/R glasses for fixing some kind of machinery is more niche. So you can profit in the hardware/software portion vs. in the content. These glasses don’t have to be standardized. the person who buys glasses in example above (machinist) is not the same person who buys the glasses to look at data on a trading floor. Niche. High value.

Solving Puzzles

  • There’s no process by which people solve puzzles or problems. No recipe. People do whatever they do. People just use their brains and try to work to come up with a creative way to find a solution.
  • This is why capitalism is a safe bet. There is no roadmap or formula. Those that say there is are lying. There may be comparable takeaways that can be applied to different/new things. Frameworks are useful. But they are models. (“All models are wrong. Some are useful.” — George Box) There is no right way to solve these problems, and there will always be new problems to solve. (New frontiers). If there was a recipe for building successful billion dollar companies, then you would have just factories churning out billion dollar companies. It’s logically impossible to do this. So if anyone says here’s my framework. Here’s my thesis. These are going to be the billion dollar companies. This is what they look like. They act like this. This is how I find them…they’re selling you something.
  • I don’t believe in thesis. I don’t believe in recipes. I don’t believe that there is some archetype for founders or companies. Opportunities are ad hoc. Somebody comes to you and sells you something. And you make a value judgment. Is this true? (which you can’t know). Is this a possible state of the world in the future — if this happens, how does the world bite back?
  • If this happens, how does the world bite back? How does everybody else in society respond? how do other companies respond? How does the government respond? What are all of the obstacles to this actually happening? Can this company wind its way through these systems/obstacles to get to this goal? The answer is never “yes.” It’s “maybe” or “no.”

Investment in Bank Simple case study— customer centricity > asset centricity. (banks now — you’re not the customer, you’re the supplier of money. So they treat you like Wal-Mart treats their suppliers.) Simple’s approach: we’re going to flip it around…we’re going to make the customer be the people that deposit the money.

  • Systems analysis approach: is this possible? Is there a possible scenario in the future where this is a very large company? And the answer to me was “it’s unlikely, but its possible. There’s a 1% chance of this being 1000x. Still a positive expectation bet. That was my thinking.”
  • The way to get “good” at solving puzzles is just to solve a lot. Each one is going to be different. There’s not one way to do it. So the answer to what makes you special isn’t some holy grail formula that you apply and nobody else knows about. Its just that you do the job. You keep doing it and learn from experience. And apply subconscious heuristics

On why Neumann has made successful investments

  • Trying to make unconscious heuristics conscious.
  • Uncertainty — trying to find uncertainty. But everyone’s trying to find uncertainty, so I’m going to consciously look for markets that don’t yet exist b/c there’s that uncertainty.
  • Try to be rational. Most people “satisfice.” I’m an engineer. I’m going to be rational. When I can’t be rational b/c there’s not enough data to be rational, I’m going to admit to myself that I’m not able to be rational here
  • Make a checklist of the risks; which of these risks can I mitigate through due diligence, which can’t I mitigate ever b/c there’s this deep-seated uncertainty (i.e. is the market going to be this big, or that big, or is there going to be a market at all?), And which one of these uncertainties can I mitigate over time as we learn?
  • If I mitigate these three uncertainties, then I can get the next round done…next year is spent experimenting, exploring, trying to figure out if these hypotheses they made are true or not. And then once we’ve gotten those checked off, we’ll still have some uncertainties but we can go to the next round and say this is a great company and you should invest

If there’s anything special about me, it’s that. That I am trying to be conscious about what I’m doing.

  • Analytical and opportunistic —I decide if something makes me nervous enough that it could be a good bet
  • Humility is his process

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