“One of the key things to investing, and I think this is a life truism, is to be aware when you hear a voice in your head that says, and you usually squint your eyes or you’ll hear someone say the following words: ‘That doesn’t make sense.’ And that’s always a sign of something really powerful.” –Adam Robinson (in an interview on “The Tim Ferriss Show”)

To many people more confident about how the future will unfold than we are, 2016 may go down as a year that didn’t make much sense. The majority of so-called “experts” were wrong on things such as Brexit and the U.S. election, and wrong on how Mr. Market would respond to the results that occurred. For our part, we try not to rely too much on prediction, and instead focus our efforts on individual stock selection among businesses that can survive whatever the future has in store, at prices that give us some margin for error in case we are wrong. But the powerful lesson from studying the phrase “that doesn’t make sense” rests in the fact that it often means one of two things: 1) One’s current view of how a certain part of the world works is wrong, and it will make sense once that view is corrected (and in hindsight); or 2) There is something much bigger going on, which one does not yet understand.

The example that Robinson used to illustrate the second point had to do with real estate investor Sam Zell noticing where Starbucks locations were opening up, and using that data point as the spark that led Zell to see the bigger force of China’s construction boom when it was still in its early stages. While we weren’t able to locate enough information to tell that story in more detail, there is another story, still in progress, that also illustrates the point: the rise of the internet, and its effect on non-internet businesses.

During the internet bubble of the late 1990s, many investors, especially in the value crowd, found themselves looking at valuations that didn’t make sense. And they were correct about the value of many of those businesses. But the bubble went on for a long time, and for many, when it seemed like valuations were as far detached from reality as they possibly could become, they just continued becoming further detached. As investors and students of how the world works, we want to see things as they are, and learn the proper lessons from the things we study. And often that means asking ourselves a second, related question—especially when we catch ourselves thinking that something doesn’t make sense. Nobel Prize-winning psychologist Danny Kahneman often asks himself this question. As described by Michael Lewis in his latest book, The Undoing Project, “…when Danny heard an illogical argument, he asked, What might that be true of?

And to an investor focused on value investing in the late 1990s, there were plenty of illogical arguments to be found, whether it was a focus on eyeballs (webpage views) over profits, or any other metric that left one reminded of the story about a business losing money on every sale, but making it up on volume. In the internet bubble, there was more than one answer to the Kahneman question above, which aims at getting at the underlying truth of the topic at hand. One answer was psychological. Berkshire Hathaway Vice Chairman Charlie Munger has said that on several occasions, Warren Buffett has made the point that “It’s not greed that drives the world, but envy.” And envy played a big part, as people hated seeing their neighbors getting rich, and the urge to participate grew too unbearable to ignore for a large swath of people. (Munger also makes the point that envy and jealousy made two out of the Ten Commandments. That’s probably a good sign that their power shouldn’t be underestimated.)

But the internet and the way it would change business models in the future was an incredibly powerful force that people were either right to get excited about, or right to be worried about if their profits depended on a business model that could be disrupted. During the bubble, investors and the prices they were willing to pay for that future became detached from reality. But the forces pushing change continued unabated, as Moore’s Law continued to drive down the cost of computing, thus driving the cost of internet distribution closer and closer to zero.

Bill Gates, in his 1995 book The Road Ahead, wrote, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” And that overestimation of the short-term and underestimation of the long-term is what happened, and continues to happen, with the internet. When married with a good product, some of the businesses that ended up gathering the most eyeballs were able to reap the rewards of network effects and the winner-take-all nature of the internet to become some of the most valuable businesses in the world today. Google, which in its early days in 1998 offered to sell itself for $1 million; and Facebook, which wasn’t even launched until 2004, have completely upended the advertising industry, and are two of the most valuable (and plenty profitable) businesses in the world today.

And there’s Amazon.com, which was front and center during the bubble. It was trying to upend an industry much larger than that of advertising. Ironically, an investor would have actually earned a reasonable return even buying it at its peaks during the height of the bubble from 1999 to early 2000, although the hype and price then would have been hard for a value investor to justify. But while those were still the beginning days of retail on the internet, the numerous department and mall store closings announced during the last few months are prime examples of the power that the internet can wield, and as the accompanying chart from visualcapitalist.com shows, the shift in customer attention has also shifted market values during the last decade.

We bring all of this up to stress the importance of the internet and technology to almost all businesses. While the changes during the last 20 years have been massive, there is still much to come and much to think about, both from an opportunity perspective as well as a risk-management perspective. As technologist Kevin Kelly wrote in his most recent book, The Inevitable, “In terms of the internet, nothing has happened yet! The internet is still at the beginning of its beginning.” While we don’t expect to be considering the purchase of any of the major technology companies mentioned above—absent another 2008-like market decline—there are profitable businesses that will benefit from the tailwind technology will provide. Indeed, some of them are run by management teams we admire that have carved out smaller, growing niches; we’d love to own them at a fair price. We were able to make investments in two of them during the early 2016 market decline: one in decent size (BrainJuicer) and one (Tucows) in which, when it was raining gold, we unfortunately brought our thimble.

““Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.”
–Warren Buffett, 2009 Letter to Shareholders

[us_separator]
This post has been excerpted from the Boyles Asset Management Q4 2016 Letter to Partners. Read another excerpt.

[moi-video-boyles]
[generic-disclaimer]