Timing is hard: February 25, 2018 Snippets

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Social Capital

9 min readFeb 26, 2018

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This week’s themes: Warren Buffett is right again whereas I eat crow; and some recognition for companies in the Social Capital family around the world.

Quick note: the flu hit us hard this week, so we’ll take a slight departure from our planned progression in Snippets — we’ll be back to conclude our health care and cost disease series as soon as we can. Thanks for your understanding!

Berkshire Hathaway’s annual letter to shareholders for 2017 came out on Saturday, and although it wasn’t one of the all-time greats, it was still a delight to read. In addition to a frank discussion about Berkshire’s businesses, including their insurance losses in the face of natural disasters like this past year’s Gulf hurricanes, we got a final update and closure to “The Bet”: Warren Buffett’s 10-year wager on the relative performance of actively managed funds versus the S&P 500. As it turns out, the most interesting outcome of the bet wasn’t who won (Warren did, obviously) but rather something that happened about halfway through.

As many of you may remember, during the throws of the financial crisis in 2008, Buffett offered up a wager to anyone who would take it that over the next ten years, a low-fee indexed investment into the S&P 500 would outperform handpicked, “creme de la creme” investment products by the world’s smartest hedge fund managers — with the proceeds of the bet going to a good cause. The advisory firm Protegé Partners took the other side of the bet, which at the time was a popular position: with the economy in turmoil and the market in free fall, of course intelligent and qualified advisors could give you an edge over an index fund; how could they not? So the bet was made: in corner 1, we had five handpicked fund-of-funds, each allocated into a basket of accomplished, well-regarded fund managers (who, it should be pointed out, could be rotated in and out on a yearly basis!); on the other side, we had the plain old S&P 500: nothing you or I couldn’t purchase in five minutes for a six dollar fee. And the stopwatch began.

The mechanics of the bet, which turn out to be important, were as follows: each party (Buffett and Protegé) would each purchase a batch of zero-coupon U.S. Treasury bonds that would mature in ten years, whereupon they would pay out $500,000 each. Although the bonds did not pay interest, they delivered a 4.56% annual return if held from the start date until maturity — or, in other words, they cost just under 64 cents on the dollar at the start of the bet. At maturity, both participants would donate their payout to the cause of the winner’s choice.

Now here’s where the story took an unexpected turn. Five years into the bet, the price of those bonds had gone up — way up. With five years to go, the bonds were selling for 95.7 cents on the dollar — which means that at price, their annual return until maturity would be far less than 4.56% — in fact, it would be less than one per cent. So Buffett and Protegé faced an interesting choice. They could simply stick with their original bet and leave the money in those treasury bonds. Or, they could sell them with five years remaining for 95 cents on the dollar, and then invest that money in literally anything else — so long as they could get a one percent return or better annually over five years, they’d come out ahead. So that’s exactly what they did: they both sold the bonds, and reinvested the money into Berkshire Hathaway stock. Warren ended up winning the bet, but for the purposes of this story, it didn’t matter who won: they ended up nearly doubling their charitable donation in the following five years as the stock market rose, leaving that measly 1% annual return behind: to all of us, it’s obvious in hindsight; to people like Warren, it’s obvious in foresight too.

When you look at it from that perspective, it was rightfully an easy decision: You have a 5-year lockup period; you want to generate as much return as possible (for a good cause, too). You think you can beat .88% annual return? I’ll bet you can! You can beat that, on average, by investing in just about anything; including a basket of diversified industrial companies like Berkshire, or any other bundle of productive assets for that matter. If five years is a fixed constraint, you have the opportunity to make a prediction where the wind is at your back. Barring some highly unusual timing — in this case, Berkshire’s five year return being less than 5% total, which we might expect to happen very occasionally but certainly not with much likelihood — you’ll come out ahead. Those are the kind of predictions you want to make: ones where the burden is not on you to get the timing right.

Now let’s contrast these types of smart predictions, which Warren is in the habit of making regularly, with one that I made a few years ago that a) turned out to most definitely not come true and b) is somewhat topical this week. Here’s the deal: Dropbox filed for their S-1 this week, finally going public after many years of product development and company growth. Two and a half years ago, I had written a blog post about Dropbox where I expressed my pessimism about the business — not because the product was bad (I used it frequently, then and now, without complaints) but because I believed that pressure from cloud platforms like AWS from below, and changing workflow patterns based more around communication and less around the file system (I had leaned on Slack as an example a lot here) would mean that files and the file system would be a far less defensible foundation for a profitable business in the near future. And, naturally, that meant Dropbox would be toast: their defensible position would be overwhelmed by new kinds of market power from above and from below.

Of course, my prediction turned out to be absolutely wrong. Dropbox continued to build a great business, and soon they’ll be doing so as a publicly traded company with years of durable growth and profit ahead of them. And yet I don’t think my individual arguments back then were all that bad — I still think that cloud providers like AWS are going to threaten everybody from below (that has definitely become clearer over the past 2 years!), and I still think that the nature of files and documents are being reshaped around the new ways we’re communicating (and Slack is doing great). What did I get wrong? What I got horribly wrong, above all else, was timing. It turns out that the time it took Dropbox to establish and expand a durable business was a lot shorter than the time it would take for our broader infrastructure and workflows to rearrange; the latter is still only beginning to happen, and it will take a long time. In other words, I had made a prediction that could only come true if the timing of future events followed a quite unlikely pattern: an unprecedented acceleration in both communication and infrastructure deployment, as well as a meaningful slowdown on Dropbox’s part. Neither happened, and now I’m eating crow.

If there’s any take home message here, aside from “be like Warren”, maybe it’s this: you’re a lot better off making bets where time is on your side, and the burden of proof is not on you to astutely predict the the timing of anything in particular. That’s the basis behind Berkshire’s investment philosophy, after all: in the long run, if you buy businesses at sensible valuations, be patient, and let compounding do its magic, you’ll generally come out ahead without having to be lucky on the timing of anything. If A pays off steadily whereas B requires astute timing, you’re almost always better off picking A. And on the flip side: a contrarian bet that needs B to happen faster than A in order to come true, even if it’s logically sound, is probably not the wisest bet to make if A is proceeding full steam ahead and B will only happen at some unknown future time. It’s a lesson I’m still learning, and I know others are too. Fortunately, mistakes are the best kinds of learning opportunities.

(Not so) smart cities:

Stop saying ‘Smart Cities’ | Bruce Sterling, The Atlantic

After early fanfare, Sidewalk Labs’ big Waterfront Toronto partnership may be in trouble | Jeff Gray, The Globe and Mail

What happens when an app company runs a city bus? Part 1: the good | CityMapper

What happens when an app company runs a city bus? Part 2: the bad | CityMapper

Podcast episodes for your listening enjoyment:

The Gruen Effect | 99% Invisible

Google and Antitrust | Exponent.fm, with Ben Thompson & James Allworth

The history of online video with JibJab’s Gregg Spiridellis | The Internet History Podcast

Around America:

Fire-torn California town becomes a ‘living lab’ for electricity microgrids | Emma Foehringer Merchant, GTM

The future of American manufacturing, and the choices we’ll need to make | Meredith Haggerty, Racked