The unspoken secret about new company formation is that you need to get lucky. Roll the dice, get a business outcome. Here's why capital allocation allows you to build a large business using more skill, not luck.
This is a companion discussion topic for the original entry at https://commoncog.com/capital-allocation-antidote-to-business-luck
This is such an excellent article! This is personally quite motivating. It shows that spending time saving money, and bootstrapping a business patiently can still lead to big success. I could spend 5 years trying to build a side business while working and saving, and even in the case of failure I am left with a nest egg to buy into an existing business. If that one also blows up for some reason, I can just start again, but this time with all the skills and experience from all of these.
Not sure if you are familiar with Alex Hormozi, but this essay makes his current business strategy obvious. He takes ownership in other companies that have product market fit (buying other people’s dice rolls) and uses his skills and knowledge to grow them. He talks about how thinking on longer time horizons almost guarantees you will succeed, which perfectly matches the case of Buffett, and the other cases you mention.
It is also funny that this closely aligns with the FIRE movement, as that is just personal, small-scale capital allocation skill. I.e. if you don’t spend all your money and save in ways that compound with time, anyone can reach “financial freedom.” All one needs to do is to take this view and expand the scope of options to capital allocation techniques other than low-risk index funds.
Ahh, I wasn’t familiar with Alex Hormozi, but I see the reference now.
It’s funny that I hadn’t made the connection between FIRE and capital allocation before, but the analogy is so obvious now that you’ve pointed it out.
I also don’t want to make it seem like this is easy — there are many lessons to be learnt from studying capital allocators who have travelled this path before. Depending on the exact structure of the game you want to play, you have to nail incentive design, org design, operating rigour, business analysis, people judgment, deal structure and so on. But at least this is a skill issue, not a luck issue. Which is the whole point of Commoncog’s ‘expertise of business’ approach!
Once I read the article it finally clicked into place. I now understand the importance of capital allocation. I was reminded of several examples of successful empires built from a single business. EF Education is a private Swedish company which is 100% family owned by the Hult family. Started by the father in 1965, they followed the “internal business” playbook to build a huge empire.
There was almost no luck involved. They harvested cash flows to grow several brands under the umbrella of educational travel and English schools abroad (especially China) The sons are now running the business 100% though they did have professional CEOs at some point. EF Education First - Wikipedia
Another example is the financial services company I work for now Alvarez and Marsal. Started in 1984 as a way to help businesses with restructuring and turnaround services, they’ve now build a very successful global empire offering just about anything related to financial services. Their claim to fame was handling the restructuring of Lehman Brothers in 2008. Alvarez and Marsal - Wikipedia
It’s funny — in a way the entire Capital Expertise series was really a way for me to sneak this insight right in the middle, and just for members.
And it’s not really an insight — it’s so obvious once you understand it that you should be able to see it everywhere.
Buffett or Munger (I can’t remember which of the two) once said that there was never any doubt in their heads that they would get rich. They’ve also said that they were always willing to wait for it. Given the context of this essay, perhaps it’s easier to see why.
The interesting counter to this is companies that buy other companies to grow but don’t make it. For example TripAdvisor has only grown via M&A and many startups grow via M&A but it doesn’t always work. What do you attribute that to? Incorrect allocation decisions?
I’ll leave this for others to answer. At this stage of the series, it should be easy — everyone should have all the pieces!
I’m glad somebody else brought up the example of companies that don’t do this well. I was reflecting on the Google leaders who do not seem to have the skill of capital allocation. They struck absolute gold with search ads, and somehow took one of the most profitable businesses of all time and did not manage to build a single other successful business out of it. You can say they bought YouTube and Gmail and are building Google Cloud, but their track record is quite poor at assessing other businesses. Can you imagine what Buffett or Munger could have done with the profits from search ads?
I’ve also been reflecting on how this applies to personal finances, the skill of saving and reinvesting in other possibilities that will generate cash. I haven’t figured that one out.
This got going in my mind too, especially after seeing Buffett’s test of “has a CEO created at least a dollar of value for every dollar of retained earnings over the course of her tenure?” that @cedric mentioned in part 6 of this series. I suppose the equivalent would be creating a dollar of value for every dollar saved, with the caveat that “cheating” by spending all your money on your vice of choice isn’t a good way to achieve this test.
These implications come to my mind when trying to apply the notion of capital allocation to personal finance:
- Your ability to choose which asset classes you invest your savings into, and your returns from your investments, is critical to your long term success.
- The focus on avoiding fees that Ramit Sethi rails about is much clearer when you frame those fees as money you have to earn back from your investments to have a chance to achieve Buffett’s test for personal finance.
- If we expand the considerations a bit to the overall triad, one of the reasons for the recommendation to purchase index funds or other passive investments is to achieve the best balance of operational excellence for the amount of time you can invest in this work (while limiting the expense mentioned above).
- This frames up one of the challenges that many people I know are dealing with, which is how to handle stock they own in the company they work for. There is a tension between the risk of having your life wrecked if your job and your main asset class both go in the tank at the same time (e.g. folks that worked at Enron and didn’t sell their stocks before everything collapsed) and minimizing loss from taxes and potential lower returns if you diversify. I don’t have a great answer for this, and would appreciate thoughts and pointers to other deeper thinking on this topic.
Assessing a business I believe is the key to successful capital allocation for expansion (aka empire building). This requires almost no luck! It’s pure skill. You have an existing business that is already making money and all you have to do is figure out if you can absorb it and grow. Didn’t Cisco master this playbook? They’re quite famous for growing via mergers and acquisitions.
I think it’s interesting that, when it comes down to it, it doesn’t actually matter where the wealth comes from. @cedric talked about this through the lens of Berkshire and of Amazon - but it’s equally available to anyone who has a solid cashflow through a stable income or a actuarially equivalent pool of wealth. This probably also ties into Piketty’s “r > g” idea (that return on capital tends to outpace the rate of economic growth). And on the other side of the balance - it also doesn’t actually matter what the wealth gets invested into, just that one has the ability to effectively discern good investments from poor ones. This may also explain why so many folks like Marc Andreessen who were clearly successful as entrepreneurs have transitioned into acting as VCs.
This all hinges on having a decent die roll in the first place, no? If you come up empty and shut a project/business down, there’s no capital to reallocate!
VC backed startups have a small chance of a big payout, and a huge chance of 0; in that way they are non-ergodic. Smaller bootstrapped startups can serve more niche markets that the VC companies can’t go after, so there are more opportunities for a moderate die roll (but come with their own challenges, as many seem to not get any traction at all).
So perhaps the takeaway is to combine the effectual affordable loss principle on a smaller swing with a higher chance of some kind of payout that you can then leverage into other capital investments?
There’s also the fact that whatever business you end up with on the first dice roll should, ideally, be able to generate enough free cash flow that you can use as a seed for future acquisitions/bets.
I used Berkshire as an example because it is so stark, but in truth what Buffett did with the dying company is truly remarkable — it’s not easy to rebuild around a dying source of cash flow, even as you are pulling cash out as rapidly as you can. I’m not 100% sure of the details, but I believed it helped that a) Buffett was already, at that point, a remarkable investor, and immediately knew where to sock that money, and b) he had a few other entities that were semi-Berkshires (Blue Chip Stamps and Diversified Retail) that he eventually folded into Berkshire.
Yeah, I wasn’t even considering doing anything backed by VC. In my view that feels like leverage, which increases the risk of being left with nothing. It seems better to focus on consistent growth and cash flow. This limits the kinds of businesses that you are likely to succeed at.
The other side of the optimism at the prospect of having to start over after failure with no capital is the fact that I would have that experience. The right combo of skills and experience is probably better than capital.
At the risk of being too academic, it feels like we can strip this down to this basic sequence building on @paul’s takeway above:
- Find or establish an opportunity where more value is being generated, or has the potential to be generated, than what it costs to create
- Obtain the ability to capture enough of that generated value to create a stream of capital
- Direct the stream of capital towards finding or establishing additional opportunities for value generation that can be captured as additional capital streams
What I like about this formulation is that it is straightforward to see how each element of the business triad is useful in doing this well:
- Capital: minimizing the barriers to acting on value opportunities
- Market: creating the power required to capture value from those opportunities
- Operations: maximizing the conversion of value into a capital stream
For instance, @joesweeney’s point about not requiring leverage can also be framed as reducing the risk that enough value can be generated to be worth the investment. @paul’s point about ergodicity is also highly relevant here - you can take a lot more risk if you are making parallel bets than you can making serial bets, but you need a lot more resources to do so and hence need bigger returns.
Such a thought-provoking topic!