How the Best invest

Hello everyone. Thank you so much for joining me. I'm joined today by Hamilton Helmer who is the author of this book, 7 Powers; the foundations of business strategy. I think this book popped into my inbox about a year ago - I think from the MOI global newsletter, and it looks so fascinating I immediately ordered it on Amazon and once it arrived I just read it in one sitting because I thought this is answering quite a lot of my questions, and giving me a real framework for looking at at companies. Now my origins, my first jobs were in Silicon Valley and then there was a go, go, go culture, and now I sit in value investing which is a very slow mindset. This is the first book for me, that reconciled both of them, and so I'm really pleased to have Hamilton join us today. Can you tell us what got you started in investing and what led you to writing the book?

Sure. So I'll give you kind of a roundabout story. So my career has been exclusively around the topic of strategy. So, as soon as I finished  my PhD, I went to work for Bain Company, and then started my own strategy consulting firm, which I ran for a couple of decades. Then I taught strategy at Stanford and continued to sort of research it and wrote the book out of that. Strategy is really motivated by one question, which is what is it that makes companies successful? And it's not a very far leap to go from that question, if you believe that creating a value - in other words making a company valuable, is is probably the best measure of success, then strategy is really about that. So from that, you then kind of realized that strategy and value, really, if you get kind of technical about it or mathematical duals, that are the same problem framed a different way. So, over decades of studying companies from the inside as a business advisor and teaching about them, then having my students research them I persisted in trying to understand that question.

A couple of things came out that in retrospect are sort of simple, but weren't, they weren't so clear to me at the beginning. One is that that successful companies, meaning ones that generate attractive returns that, that is serially correlated. So if Apple is doing well this year, and you're wondering how they're going to do next quarter, that's not a random draw.

It's highly correlated with how they did in the last quarter, and that goes on for years in companies. And there's, there's good research on that basically of that. So there's persistence, and then if you look at the understanding value from a technical point of view, if you do sort of cashflow analysis and net present values and that kind of thing, what you see is that almost all values in the future.

So if you take a company that's growing, I don't know, 10% a year, and then you say how much of its value is after year three. So, the first three years take those out of the equation, and it's almost all of it. You know, I can't remember the numbers, but probably 85% for a company like that, and so persistence is really critical because persistence is what makes a company attractive in the far, far further future and that's what really drives value. So then the question for value is the identical question for strategy, which is “what is it that creates persistent attractive returns?” After framing it a little more specifically, it's what economic structures create that.

So my life work has really been around trying to understand that question and what I've taught us about that, and what motivated writing my book was over the years of thinking about this and struggling with it mightily I might say, I came to be able to generalize a bit about that.

If you had to ask this question about economic structures that create persistent attractive returns, what is their character, what's their nature? And then what are they? The term I use power is for one of those structures - that’s what a structure of a system is, power. And as far as I can tell, there are only seven of them, although I'd love to find an eighth or ninth - I'm always looking for it, cause it'd be a great investment opportunity, it’d be so obscure. But being able to generalize at that level to say that they're only seven. So that's seven encompasses - I probably did 200 strategy cases in my consulting firm, I probably had my students probably pull out another 200 cases. So out of those, seven covers everyone and I haven't seen any exceptions, but I'm always looking. That ability to generalize about that is quite powerful and useful and and that's what motivated me to write the book and stock. 

The stock part came in. I I've been an equity investor longer than I've been a strategy expert. So I started in my early twenties, and my mother actually was a great stock picker. I remember early on in my life she had a broker she used simply because she knew when he recommended to to buy something that it was the top of the market. She did extremely well, and so it was sort of a role model for me I'd say. I got into it you know, not knowing much to begin with and learn, but then eventually these things intersected, because I realized that that understanding of these economic structures gave me some insights into long-term performance that might not be fully realized yet in market prices.

Those intersected and then over time they informed each other. So the investing have formed, you know, my understanding of strategy and my understanding, the strategy informed investing. 

And in the book, obviously talking about the seven powers, you defined power as the set of conditions, creating the potential for persistent differential returns. Can you explain what that means? 

Sure. It's just what I've been talking about. It just means the company's really strong for a long time. It's as simple as that! I mean more technically it means that returns that are materially above the cost of capital over a period, so there's both a magnitude and a duration associated with that specifically. I'd, I'd say the duration, you know, that's simply a choice of how you think about it, but I'd say five years or more probably. And then you can pick what you think is materially different than the cost of capital, but I know, 10% or something.

But, that's all it is - it’s just simply saying that this company is doing really well. And it has a structure in place that gives you some assurance that that will continue. So it's just it's so power is just a super set of Warren Buffett's moats. When Buffett talks about moats, that’s what he's talking about. He's talking about structures of persistence and he doesn’t - of course he's a huge hero of mine and you know, a better investor than I’ll ever be I’m sure. But, his moats are not all the ones that are uncovered in that book.

So if there's very interesting dialogue, if you ever want to read it when the Microsoft - any trust stuff was going off and going on, they published correspondence between bill Gates and Warren buffet, and in it, Warren buffet said why he couldn't invest in Microsoft. I actually was an investor in Microsoft way back then and, you know, Buffet is very disciplined and he understands what he understands and what he doesn't understand - and that had some characteristics that he didn't understand, but that's really what, what we're really talking about is moats. 

So what I loved about your book is that a value investors can use it. Venture capitalists can use it and corporate leaders can use it. Who did you have in mind when you wrote that book?

So, the audience that I really had in mind were company founders, and the reason for that is is something that I observed and in my work as a strategist, which is that there are sort of crux moments in the formation of a company strategy. So you think of the formation of a strategy as putting those structures that I just talked about in place, right, and that happens - there’s this one of the great strategy scholars, a gentleman by the name of Henry Mintzberg, you know, he talked about how strategy wasn't designed, but crafted, which means that it's over time you see how customers are going and you get this feedback and you think about this and bit by bit, you kind of put it together.

So a strategy at that level is an invention, it’s not something where a guy like me sits in a room and thinks it up for a company. It's a founder; an entrepreneur, invents this over time, and it's not something that he can do immediately, it’s over, as Mintzberg says, it's over a period of crafting it.

So, the thing about that is that then the question is “okay, I've, I've come to this understanding of these structures of attractive performance. Is that useful to somebody in that process? How can that be useful?” It can't be useful me coming in and trying to design one of those structures because I don't have the founder's information and it'd have to take place over time as too much uncertainty and so on.

So the question was, what can I do to help these guys do what is really important. And it turns out that that the way strategy typically happens is there sort of an open window period, or you have lots of degrees of freedom and you can kind of set up one of these structures. But then the window closes because the business matures, all the competitors know what everybody else is doing.

Remember, strategy is you're when trying to get a larger piece of the pie really, and everybody else is fighting you for that and it's a standoff and you don't don't get anywhere. So there's this open window where that's not the case and you can actually invent something that gives you more value.

So the question is in that brief open window period, which I believe is in the early stages when a company's in very high flux, not in a more mature stage - what could I do to help? And I realized that how I could help would be cognitively if, I could provide a framework that was not simplistic, meaning that covered most of the bases but also was simple, meaning that it was easily memorable. Then that framework could help entrepreneurs as they go through time in thinking about “Oh yeah. If I go a little bit to the left, rather than the right then that seems like there's a better chance of power there”. And so you have to dial back your aspirations, have a more modest goal, but it's a very important goal. 

And so 7 Powers - writing the book was an effort to create that simple, but not simplistic framework, that would act as a cognitive guide for founders and that's really that's really its purpose. 

Okay. Interesting. If you were forced to pick one of your seven powers as being the most important for the post Corona economy, which one would you pick? 

You know, that's a hard question. I'd say that the, the pandemic is more or less orthogonal to the concepts. They apply every company, every period, every geography, and I don't think the pandemic really changed that much - they’re far more pervasive in general in that. I think that one thing you can say is that the pandemic accelerated -  if you think about where technology's going, sort of more in the cloud, probably more remote this kind of stuff - the pandemic accelerated some trends, but those trends weren’t so much about power. But I can say that in general you know, the more common, you know - I think tech companies have benefited from the pandemic or not all of them, but many of them because it's sort of accelerated moments. I think those companies, typically the types of power are network economy, scale economies, counter positioning, and switching costs. You know, I think branding in corner of resource and process power are rarer. So I'd say those, but I think the whole point of generalizing this is that it is not specific to a place in time or a particular type of company, but actually as far as I can tell is general across all situations.

Great. Has there been any surprising reaction to your book that you didn't anticipate that someone invites you to speak? Or was there something that came out of it that surprised you? 

Yeah, I've had lots of surprises. Oh, actually one of the surprises for me was that it's been embraced by the investment community. That was unanticipated by me, even though I am an investor and you use the concepts. So the two big audiences for the book have been value investors and tech founders I'd say and it starting to work its way a little bit into classrooms, and I think into larger corporate America because if you have a large mature corporation these concepts absolutely apply, but typically your power structure is already in place. So it's more so it's more looking at you know what's coming down the pike that I have to worry about, or how do I best capitalize on this particular type of power that I have? So it's not quite as dramatically existential as it is for a founder, but still very important. So surprises - I've been so pleased by the reception that that itself has been unexpected, that there's been take off for the book - it’s been so great. 

I've had a lot of really interesting developments from it that were unexpected. The book was motivated by hoping technology and one, I don't know exactly a surprise, but I've had many of them reach out to me for a strategy dialogues and that's such a treat for me, you know. They’re full of energy, highly inventive, super sharp, deeply involved in our businesses. I think that entrepreneurial activity is as the lifeblood of an economy, so that’s a treat. There are things that people using that stuff have come back to me that I guess you'd not categorize as surprise, but certainly have taught me things.

So one of the big lessons has been that the genome types of durable performance are simple. So there are only seven of them and you can state that simply, but the phenotypes are not. So when you get into a specific company and say, “does this particular situation that I'm facing - this set of customers, this set of competitors, this technology - is there power there?” That’s highly idiosyncratic and complex and in a changing fast dynamic technology area, often quite hard to figure out.

So it's not like you read something powers and all of a sudden you turn lemons into lemonade. It's actually that you can over time kind of move things in a positive direction, but you have to be very thoughtful and deep about it and highly particular. So that’s been sort of a fun reaction - I loved it.I was trying to decide whether the book would have any math and, you know, as an economist, you find that math is a useful shorthand for logic, and so it's simpler than reality, of course, but it forces you to a specificity in your logic that normally you wouldn't have with just language.

So I decided “yeah, I'll do it but I'll put it in dependencies so people don't have to read it if they don't want to”, which I did, and then the funny thing that's come out of it is that the response to that is utterly bi-modal. So some people say “dumbest thing ever, totally skipped that, I don't know why he did it. He's just trying to show off that he’s an egg head”. Another group said “best part of the book, just absolutely brought home the concepts”. I had one woman who is just a brilliant, brilliant technologist entrepreneur say to me that the math on the counter positioning chapter was the best thing in the entire book. And so you know, that's been a surprise. 

That sounds really so, so interesting. We touched on this before in value investing we have this concept of a moat, which I think I understand, and the wider it is, the better. You talk about barriers and I love this term you use the “unassailable perch” companies that companies are going towards. Are they the same moat and barrier? Are they the same, or do you see a difference? 

Well, when you're thinking about value you know, the companies put a lot in, you know; time and money and everything else, and you want to get something out. So value is how much you get out, or how much you put in. A formal part of that is a net present value time discount - it’s a net present value cash flow, right, so you’re looking at cashflow. So, increasing cashflow requires two things. So you have to do something that's worth something so people will either pay more or it costs you less. So you can imagine something that just increases your PNL or more specifically your cashflow statement, so that's the magnitude fees, and then you need a duration piece because you want that magnitude over a period of time, and that's the barrier. I just tell my clients business is hard and they say, am I really paying you for that? And the reason it's hard is that, you know, people are smart and and trying hard, and there's a lot of information out there, and if your profits can be arbitraged away by somebody else then your best assumption is that they will be. Maybe you'll get lucky, but I wouldn't base your career on that. So you need the barrier. The barrier is something that makes competitors either not want to try to take that away from you or not being able to take that away.

So you need those two things. I think concept of a moat you know, the wording of it's a little fuzzy because that sort of sounds like a barrier; a moat, you think of a moat around a castle, that's the barrier. But that needs to be combined with a castle, which is attractive, to get cashflow. So the moat gives you the time and the castle gives you the magnitude. Those are highly synonymous. But it's very simple. It's just that you want to be able to earn a better than average returns over a long period of time, so you need something that creates good returns. That comes down to an invention; you know, business model a brand, something. Then you have to have something that prevents others from taking away from you. 

One more question for you Hamilton. Before we let you go back into this California sunshine, I'm very jealous.

So it's cloudy today actually. 

It's better than London. 

That’s a pretty low bar. 

I'm pretty stupid to have moved here. We are now in a place where intangible assets comprise quite a lot of company valuations. How do you approach valuation of a seven powers company? 

So it's, so it's really simple. Buffett's kind of laid it out. I mean, if you have a moat and you have a castle that is surrounded and it's attractive, you figure out how much that castle produces and then you have that over a long period of time. And all 7 Powers is, it's just a formalization of that. So if you're doing cashflow modeling, you know, the fact that you'd have power would have a profound impact on your return on capital, right? That's what it's all about. You look at that over a long period of time, and if you had a moat, you'd be more confident that it would be your probability assessment of it 10 years from now will be much more positive than if you didn't know. So you end up with a much higher expected value. So there's nothing complicated about it that way. The only thing is that in certain situations, understanding whether there is power is complicated because that thing I mentioned before, the phenotypes are complex, even though the phenotypes.

Thank you so much Hamilton for your time, and I'm sure this will be listened to quite a lot and I myself have learned so much more, so thank you. 

My pleasure, my pleasure, and good luck with our outlook event. It should be great.