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Kyle Grieve (23:01)

All right, back to the show now. After reflecting on these two investments, I realized something quite profound. Unmanaged emotions never disappear, they just evolve. Emotions get smarter, more articulate, and even better at concealing themselves. After reading more and more on Spinoza, I came to a clear realization regarding emotions. Humans, myself included, are completely bound by emotions, and we do not clearly understand our own emotions enough to prevent them from distorting decision making. Or put simply, we're just wired wrong. So the lesson here is on risk. In academia, risk is measured by such factors as volatility, price and beta. But in reality Risk is how our emotions play tricks on us, distorting our perception. The second lesson is on the power of loving or liking bias. This bias binds you to a more painful reality. It masks flaws that would have given you pause. And the more attached you become to a hypothesis, the less likely that new valid data will change your mind. And third, the market will punish psychological weakness at alarmingly fast rates. Bad analysis might mean your investment goes nowhere for several years if you buy it with a large enough margin of safety. But bad psychology can cost you instantly, just like it did on my crypto adventure. Now, the biggest tool for combating your emotions is to acknowledge that they're there and to see which decisions that you're making now come from rational or emotional thinking. Only then can you triumph over the adverse effects of emotions. Now, while emotions will have the biggest impact on our investing, we still need to make sure that we are putting the right businesses inside of our portfolio to at least, you know, set us up with the best chance to succeed. And to do that, we need to embrace another concept that I learned from Anthony Bolton. Now, I'd love to share a story here about when I was overwhelmed by another investor's expertise. So a few years ago, I invested in Micron, a business that manufactures silicon chips. I remember reading Analysis deep into the night from this one guy on Seeking Alpha. And I was constantly, you know, just in awe at this guy's ability to understand Micron and its industry. He knew how Micron was doing versus competitors, how far Micron was ahead in terms of microchip size compared to Chinese competitors, the direction of pricing, which customers had excess inventory, and other just mind boggling factoids that I hadn't even thought were material to my thesis. I felt a little out of my league. I thought to myself that I needed to get to this level if I ever wanted to feel like I had an edge. But the more I researched, the more I realized that that goal was entirely out of reach. Not only did I not have the time or really inclination to learn as much as this guy, but I also had 10 other positions to understand deeply as well. Plus a full time job and a family. Now, as I began thinking more and more about it, I realized that it was impossible to make that a goal to strive for. Because unless I could spend, you know, 40 plus hours per week researching semiconductors, chances are that I would never become as knowledgeable as this guy. Now let's imagine for a second two different investors. We'll call them Deep Diver Dave and Sufficient Generalist Steve. So Deep Diver Dave absolutely loves detail. He invests in maybe just one thing a year, and he knows everything there is to know about the industry. Someone like Shelby Davis comes to mind here, an investor who only really invested in insurance and knew all the key players and developments inside of that one industry. Now, Deep Diver Dave reads everything about the industry. Every news article, every 10k analyst reports industry reports and journals, and feels the need to know more than literally anybody on the planet about the industry that he's digging into. But something dangerous has happened in Deep Diver Dave, taking this exact approach. Where he once had several winners, he's now experiencing many large losers that have erased a ton of the returns that he's had over the past five years. And this is because he's become a little too overconfident in his information and because he feels he spent so much time and effort understanding this one industry, he's paralyzed to move somewhere else, keeping his capital in some pretty mediocre investments. Now, we look at sufficient generalist Steve. He's obviously a generalist. And while he doesn't know nearly as much about one industry as Deep Diver Dave, he's perfectly fine with that because he focuses on information that he needs to know to make investments that will bear adequate returns. So you could say he focuses specifically on material variables and skips the immaterial ones. Steve knows that there's only so much time in a day, and he's very, very picky about where he spends his time as he realizes that there's an opportunity cost to everything that he does. So this means that Steve has to live with incomplete information at times. But he's okay with that as long as the incomplete information is unlikely to harm his investments. He still does a ton of the research that someone like Deep Diver Dave would do, but he takes a more direct approach, focusing only on the information that he needs to make an investment or take a pass. So sometimes he'll even speak with experts on an industry or a business just to get, you know, key insights that he wants from that person who probably has a lot more knowledge than he'll ever have. Anthony Bolton himself is an excellent example of this investor archetype. Now, Bolton's insight crystallizes the difference between Dave and Steve. The question that Bolton would pose to US Investors is, what kind of edge do we get from spending, say, 40 hours on a company versus only 20? And if we know more than 99% of the average investor after spending 20 hours, what does 40 hours get us? 99.5%. Does that actually make a difference in our investing process. If I knew Micron was good, cheap and had good growth potential, did it really matter what small adjustments competitors were making? That probably wouldn't really affect Micron's business. The more I thought about it, the more I came to the conclusion that, you know, depth is not the same as clarity. Depth is a great way to spend time and unfortunately, even waste it. When you are thinking about clarity and time in general, you must focus on where your time is best spent and not on wasting time trying to get a negligible edge versus other investors. So now we get back to that Micron example. Once I realized that all the time spent researching all this extra stuff was unnecessary, it led to a potent insight. I began to see that information isn't always better. What matters is knowing what actually matters and acting on it at the right time. So even today I still wrestle with this problem. It's so easy to spend another five to 10 hours on a business I might already own to just learn a little bit more about it or learn about a specific aspect of it. But I have to ask myself, you know, will this make a difference to me in the long term? I generally have an excellent idea of what KPIs that I'm looking for in all of my businesses. And as long as I'm staying on top of the developments inside of that company that directly affect those KPIs, I'm in pretty good shape. But if I spend too much time needlessly deepening my knowledge, I'm simply taking time away from putting that into better things. So what I learned from Bolton was that the edge regarding information isn't from knowing everything, it's from understanding and focusing only on what matters the most and to gently remind yourself to stop once you know enough. So now when I'm looking at a business's quarterly, I'm not scrambling to spend five, 10 or 20 hours needlessly trying to understand some low impact nuance that may subtly affect the company. I focus on my KPIs, their current state, what's moving them, and what's likely to happen over the near medium and long term. It's my simple way of telling myself that I know enough already. Now I remember waking up on April 2nd of 2025 opening up my Yahoo Finance app, rubbing my eyes and seeing just a sea of red. And this wasn't just a small drop. I remember some sizable, you know, minus 5% or greater drops that day, not too long after the market had opened. But you know, I was pretty Calm. I've been through situations like this before. After doing some reading, I saw what all the fuss was about. The US Tariff News. I had text messages and direct messages from other investor friends who were checking in and talking about all the carnage that was going on in the market that day. Many investors were panic selling, predicting that other investors would sell. They reasoned that they would just do it first so they would lose less. For me, it was just another wild day in the market. Now, reflecting on this day got me thinking. What if the hardest part of investing isn't in the analysis, but in the waiting part? So let me explain a little more. I recently did an episode about something called intentional inactivity. Now, in that episode, I discussed a really, really good story. So it was about this gentleman named Fabius, who was a Roman emperor and general. And so the story goes, he basically did nothing as his enemy attacked him. Basically, he knew that his enemy was trying to lure him out to have a conventional battle. Now, instead of fighting a fight that he knew that he would probably lose, he simply did not move his troops out onto the battlefield. Now, to the lay Roman, this might have looked like he was frozen and afraid. But to Fabius, he was just coiling. You see, intentional inactivity can easily look like incompetence until it starts to work. And Fabius was simply biding time, allowing his army's numbers to swell as more and more soldiers were called to the front. Now, once he knew he had the edge, he met his enemy on the open battlefield and he defeated him. Now, back to April 2. While the average investor may have looked at my inactivity as incompetence, I too was practicing intentional inactivity. I sold zero stocks in the month of April because many of my businesses were just simply well positioned, I thought, to deal with tariffs. And I felt that many countries would begin bargaining to reduce tariffs. Sure, there might be a hit to the margins of some of my businesses, but it was nothing that would really break my thesis. And besides, why sell companies that I didn't think lost that much intrinsic value when their share prices were being beaten to a pulp? But I also realized, like all humans, that I'm wired to want to do something under stress. I just noticed that I don't really get stressed about my investing during the exact same times as probably the normal investor. I get more stressed out when a business that I own shows weakness in its fundamentals. So my wiring for doing something in these situations is an area that I know I need to work on. Like Fabius, I needed to focus on controlled disengagement and patience during these times to avoid coming to the wrong conclusion. So intentional inactivity isn't just about emotional discipline. It's also about structural advantage. When I did my episode about systems and mental models, I began to create some very interesting connections with Fabius. When I thought more and more about feedback loops, I realized that compounding is like a contained machine. When you open the door, you let heat escape, and it takes a lot of time to heat back up. Now, these minor interruptions have very high costs. So any small adjustment that I could make to my portfolio, such as, you know, trimming or what other people do, like sectional rotations or panic selling, obviously create a drag on compounding. So in this sense, inactivity isn't laziness or incompetence at all. It's really a form of engineering. So I realized that my portfolio was most likely to compound when I touched it the least. So if you got a chance to look at Buffett's best investing decisions, it wasn't some sort of, you know, brilliant trade or financial engineering. With the use of heavy amounts of leverage, they were simply able to find great businesses and hold them. Investors tend to admire Buffett because he's very smart, and I also believe this to be true. But his true superpower is his ability to just sit still. Charlie Munger said, never interrupt compounding unnecessarily, and Buffett was a master at it. The irony in Buffett and Munger's success stories was that they resulted from doing as little as possible for the longest possible time. So one regret that I had from the tariff tantrum was that I didn't deploy enough capital when the market was showing weakness. While it's easy to blame that on maybe a lack of courage on my part to deploy, you know, cash that I had during a downturn, when I actually look back at my portfolio, that problem wasn't really a problem because I just didn't have cash to deploy then. So if I wanted to add to a position, the only strategy that I could have used was to just sell a current position that was probably going to be trading at a loss. So when I look back at that event today, I feel a deep sense of regret that I just couldn't buy more of the businesses that I thought deserved a larger weighting in my portfolio. So one possible strategy that I've been kind of formulating and tinkering with is to just add cash from my job each month based on my savings, but then to put a Restriction on, you know, how often I'm actually buying new stocks or adding to current positions. I still haven't figured out exactly how this would look like, but I'd really like to start taking advantage of situations like the tariff tantrum in April or, you know, the AI scare that we just had in October and November, all in 2025. So my temptation to act takes the form of deploying money from my brokerage account immediately into the best possible situation in my portfolio or into a new idea. But that's probably not the way to take advantage of intentional inactivity. Fabius and Buffett would disapprove. My compounding machine might be letting the hot air out using this strategy rather than, you know, maybe being more selective about where I pick and choose my spots to get the compounding engine even hotter. So the two big lessons here are that I initially felt that action on a monthly basis, such as keeping my cash allocation as close to zero, made me feel productive. You know, it allowed me to continue building positions, but at a cost. And that cost is that, you know, waiting is what produces the most remarkable results. So instead of deploying capital throughout the year, maybe I should have deployed the lion's share of it when the market decided it temporarily did not like stocks. Had I done that, there's no doubt in my mind that my returns this year would have been much, much better. So that was my lesson from April. I underestimated the strength of patients as a part of my compounding engine. But inside the companies that I invest in, the compounding engine looks much, much different. It's not just patients, you know, it's people. And this year, I saw something in the Netflix story, the Amazon story. Then again, in the nine case study that I outline in the book the Compounders. And it was so consistent and predictive that it was really hard to ignore. So let me take you into that story because it's added another lens through which I analyze businesses today. Now, when I think about what makes businesses such as Netflix, Amazon, Bergman and Bevin, Constellation Software, or Heiko so great, I also think about how these companies can survive highly competitive industries. After all, they all certainly have very, very big advantages. But they just can't rest in their laurels because a competitor is probably waiting right around the corner to eat their lunch. And the magic fairy dust that connects all these businesses is culture. Culture is often visible long before a stock price appreciates for decades. So let's discuss exactly why that is so. In 2001, Netflix had a significant issue. The tech bubble just popped. And funding for tech focused businesses was drying up faster than the Mojave Desert. They just fired 33% of their workforce and their founder, Reed Hastings felt sick to his stomach about it. But oddly enough, a few weeks after firing these poorer performers, he observed something very, very strange and unexpected. Productivity rapidly increased. Hasting realized that these poor performers were dragging down the excellence of the outperformers that were already inside of Netflix. And this became the bedrock of his principle talent density. The other two bedrocks candor be open, blunt and have quick feedback loops to avoid complacency. And the final one was a reduction in control. When you remove rules, you empower your employees to make great decisions without wasting time seeking approvals. These three principles gave me my first clue that a culture helps predict behavior, and behavior helps predict compounding. Before founding Amazon, Jeff bezos worked at D.E. shaw, an elite quantitative hedge fund. But De Shaw was fascinating because he wasn't just recruiting these traditional finance types. They were actually recruiting people like mathematicians, computer scientists, physicists and generalists who had these kinds of unusual problem solving capabilities. Their interview process was famously very quirky and probing. It was built around some open ended analytical puzzles rather than focusing solely on the applicant's resume. You know, they'd ask questions that seemed quite odd, such as how many fax machines are there in the United States now? As a result of these experiences with Shaw, Bezos cloned many of Shaw's hiring practices when he started at Amazon. And embedded into Amazon's culture was his unique hiring operating system. They had a concept called the bar raiser program, and this was a single person in the hiring process who had the power to veto any hire. This prevented the culture from being diluted by mediocrity and it ensured that Amazon kept raising the bar on new hires. They also focused on two themes that were heavily emphasized in the compounders, which were decentralization and long termism. Amazon fostered this mental model that Bezos called the two pizza teams. Any team working on a project should be small enough that it can be fed with two pizzas. That meant that teams stayed small and efficient. If you could get the same output from a two pizza team, why bother with a ten pizza team? Bezos was also fond of his Day One philosophy, which showed that he thought Amazon still had a very, very long way to go in its maturation. This allowed him to take some long term bets that maybe were a drag on the business in the short term, but had potentially very, very large effects years down the road. Amazon was my second Confirmation on the power of culture. And it showed that high talent autonomous cultures behave very differently under stress. They remain resilient and even can improve their abilities while the average corporation just simply fails. Amazon showed me that high quality, scalable decision making was a key to the compounding process. Then we move on to the compounders. So these were boring businesses like Heiko, which manufactures third party plane parts, yet has quietly destroyed the market's return for decades. Across all nine of these case studies, the DNA was very similar to Netflix and Amazon. The businesses used small teams and empowered them to make the decisions. They optimized the incentive system to keep employees accountable and to make them feel like owners of the business. They also had employees who just loved what they did and helped carry the culture forward for these winners for the next generation. The companies outlined the compounders had a kind of cultural feedback loop. Good culture attracts high caliber talent. Good talent makes high quality decisions. Better decisions compound at higher rates and with lower risk. And compounding reinforces culture. And culture continues to attract top talent. It's a reinforcing feedback loop, the kind of feedback loops that I'm always searching for inside of a business. Now let's complete the circle and connect these three stories. Netflix showed this, you know, high level of cultural innovation by emphasizing things like talent, candor and responsibility. Amazon showed how important it was to improve the quality of its talent and give them more decision making autonomy. The compounder showed that creating compounding feedback loops based on culture improved and extended a business's Runway, which helped allow it to compound for decades. The key here is that culture is the upstream indicator to search for in businesses that can compound for decades. The financial results are the downstream outcome of that strong culture. And once you see this, it really becomes impossible to unsee it. So how did these insights affect how I analyze companies? By emphasizing company culture when I speak to management, I'll also see where businesses are using things such as centralization versus decentralization and you know, which direction that they're moving towards. I also pay special attention to the candor that management exhibits to ensure that they are highlighting both wins and losses. I also try to ask questions that cover longer timeframes. Maybe I'll ask something such as if all things go well, where do you see yourself in three years? And see if they have a quick answer or if they just haven't really given it much thought. All these learnings weren't just a nice idea to just ponder, you know, they have become a genuine filter and checklist item that I can add to my toolbox to help separate good from bad investments, as well as sharpen or dull my conviction in current positions. Now that I understand the compounding engine inside of a business, I'll continue to find ways to identify cultural aspects as quickly and accurately as possible to just keep my own compounding engine going. Now, while businesses like Netflix and Amazon were founder led, I've actually challenged the whole founders effect this year. So doing my company DNA episodes actually showed me one of the greatest strength of founders. Now, do founders matter? Of course they do. But I think not necessarily for the reason that most investors assume. Great companies don't just survive purely because they have a founder at the helm. They survive because founders left behind a codified DNA that outlives them. So when you look at businesses like Netflix, Amazon, McDonald's and Home Depot, these were four businesses that I researched quite in depth this year. And even though they're no longer founder led, these businesses continue to generate significant cash flow and remain very, very relevant today. Now why is that so? When Bernie Marcus first came up with the idea of Home Depot, it wasn't just to replicate what he'd already done at his former job. He wanted to recreate the do it yourself experience for his customers to make it the best possible experience. Bernie Markus and Arthur Blank were just obsessed with service and empowerment. Let's take a quick break and hear from today's sponsors.

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Kyle Grieve (46:41)

All right, back to the show. Home Depot associates were taught to run towards customers and to go out of their way to serve them as best as possible, rather than what some of their competitors were doing, which was, you know, running away from customers and trying to keep distance. Bernie and Arthur eventually left the management of the company to their predecessors. And yet when you looked at the culture that they created, it hasn't really changed that much. Since they started the business in Atlanta, Home Depot's orange blooded DNA has replicated itself from just four locations at inception all the way up to about 2,347 locations today. McDonald's offers a very unique way of looking at culture. Ray Kroc wasn't even the founder of McDonald's, but he really defined its DNA. The business was founded by the McDonald's brothers. But where Kroc's principal value came was in really scaling the systems, products and services that McDonald's is so well known for today. Kroc employed the right people to help set up these systems and make it a core part of McDonald's operations. So what were some of these systems first was a standardization of operations, making sure that a burger in California tasted the same as a burger in Illinois. And Kroc knew that customers wanted food quickly, not in, you know, 20 minutes. So he created the systems inside of each McDonald's so that McDonald's could pump out its product at a very quick pace while maintaining quality. He also made sure that locations were clean and were desirable places to, you know, go quickly eat a meal. And he made sure that all of these procedures were replicable not only in the US but all over the entire world. And the ironic part, the man who wasn't the founder created one of the most durable founder DNA of any business today. Next was Coca Cola. So in terms of DNA, Coke has outlived literally dozens of CEOs as the business was founded all the way back in 1886. So Coke has survived numerous leadership transitions, wars and even globalization. Now, where Roberto Goizzetta came into play wasn't so much in creating Koch's DNA, but in strengthening the DNA that it already had. Instead of diversifying Koch's folks into non Coke related areas such as media, shrimp and wine, Goizuera ensured Coke stayed focused on what it's known best for Coca Cola. And even he actually made a massive mistake with New Coke. But he was able to overcome it. Due to the strength of Coca Cola's brand, Goizueta was hyper focused on brand dominance, expanding distribution and bringing Coca Cola to every corner of the earth. He designed Coca Cola to focus on generating cash, running efficient operations by incentivizing things like profits and relentlessly pursuing consistency. Coca Cola is strong proof that a business with exceptional DNA can compound across multiple eras and compound at even higher rates once it has the right person under management focusing on the right things. And it also shows that a business even as great as Coca Cola can be misled by wrong management for a time. Now Bezos, who I've already discussed today regarding the bar raiser program, the Day one mentality and the two pizza teams brought his own unique flair and experience with him when he created Amazon. But it wasn't just those things that drove him to engineer Amazon's DNA. I would say that similar to Ray Kroc and Bernie Marcus Bezos was just obsessed with his customers and with delighting them at every possible opportunity. And another vital aspect of Amazon's DNA that was passed on from Bezos was this high velocity decision making. So in his 2015 letter to shareholders he wrote, speed matters in business. Many decisions are reversible and do not need extensive study. So he split decision making into two types. So there are type one decisions which had these kind of one way doors, and there are type two decisions which had two way doors. A type one decision was high stakes, hard to reverse and required a slow and deliberate thinking process. Type 2 decisions were low stakes, reversible and should be made pretty quickly. Bezos felt the biggest mistake that companies make is to treat type 2 decisions like type 1 decisions. This wasted time and energy that could have been better spent elsewhere. This is why Amazon tested out many choices that just didn't end up working, such as their attempt at a mobile via the Amazon Fire phone. Now, similar to many compounders, which Amazon clearly has been, Bezos also focused on decentralization. Bezos designed the company to be this kind of loosely coupled but tightly aligned company. Amazon can be thought of as kind of a conglomerate of thousands of small startups glued together by a shared culture. And Amazon has flourished even after Bezos has stepped down as CEO, showing that a well developed system can outlive even the most legendary founder. Now, there are four lasting DNA traits I think were repeated among all four of these exceptional businesses. The first, customer obsession. Home Depot displayed customer obsession by making sure that its customers left the store with exactly what they wanted and at unbeatable prices. Amazon focused its efforts on delighting customers rather than just focusing on the competition. And McDonald's focused on consistency as it already had an exceptional brand. Number two is service ethos. McDonald's relied on its speed and predictability. Home Depot made sure all of its employees, even if they weren't consumer facing, knew how the business worked at the floor level. Number three is operational discipline. Coke focused on its global distribution network to ensure that customers could easily access its product. No matter where they traveled in the world. McDonald's had their hamburger University where they educated their staff in detail on the inner workings of McDonald's functions. And fourth here is align incentives. Coke under Goy Sueta focused on profits over growth. Bernie Marcus and Arthur Blank made sure every Home Depot employee felt like a business owner, which is why they went out of their way to end up helping customers. And McDonald's made sure that they served their franchisees as best as possible to help set them up for success. That's the founder DNA framework. A good founder makes themselves just non essential to the running of a business. That's the mark of a truly legendary founder, because once the business is able to copy their DNA, the company is just set up to survive, no matter what obstacles come its way. So you could say the best founders don't build companies, they create cultures that can survive them. Now, we've discussed a lot here about culture and company DNA, which helps businesses survive across multiple eras. But at my heart, you know, I'm an investor and I also want to focus on things like survival. If I hope to achieve financial freedom, I need to make sure that I actually reach the finish line. So let's say I want to make it to the finish line with as few war wounds as possible. Well, in that scenario, I've come to realize that I need to place probably less emphasis on the upside and even more emphasis on downside protection in order to maintain durability. So the interesting thing about compounding is that, yes, it's very, very powerful, but it's shockingly fragile as well. One single bad decision, excess leverage, poor portfolio management, or emotional overconfidence can easily erase years of great decision making. Whereas I used to think of downside protection as being overly defensive, I now see that as a vital part of keeping the compounding engine running. In an uncertain and unknown world, it's no surprise that I've underestimated the fragility of compounding. Humans have always underestimated fragility. In against the Gods, I discuss risk in a lot of detail. And through history, new people have picked up the flag to try to better understand risk and how to quantify it. As time has passed from gambling with sheep bones to gambling on sports, we have learned that risk has some sort of structure, but it's definitely not intuitive. Humans want to believe that the world is stable, but in reality, it's probabilistic. And progress comes from taming randomness. We can never entirely avoid it, simply because randomness will never stop breaking things. And investing is no different. Outlier events will dominate our results, both to the upside and to the downside. So what exactly do we need to do in order to make sure that we're not blowing up our portfolio? We focus on the key lessons of Seth Klarman, the margin of safety. So Klarman understood that in investing there are two types of investors. The speculator who relies on stories, momentum and short term narratives to justify their investments. And then you have the investors Those who focus on things like durability, cash flow, and buying assets for more than they're worth. While it's easy to think of the margin of safety as being a purely analytical tool, it's really a psychological tool first and an analytical tool second. The margin of safety is protection from our own misjudgment, which happens a lot more often than even I'd like to admit. It's humility, which helps determine the proper position sizing. It's in refusing to pay for a business that's priced for perfection. And lastly, it's in designing a process that assumes that you will be wrong but can still survive when you swing and miss. So when I invested in crypto, I had no margin of safety. I used leverage, which I thought was a multiplier of returns, but in reality, it just multiplied my own fragility. I also had too much emotional reasoning that I allowed myself to masquerade as in depth analysis. So the margin of safety essentially serves to reduce fragility, a concept that I've taken embarrassingly long time to understand. Now, one investor who helped me understand this better was John Neff, because he emphasized specifically earnings power under adverse conditions. He was intentionally looking at how businesses would grow when everything was just going to crap. And this meant that in the case of things going decently or well, that was just pure upside. Now this matters more than ever. In current times, interest rates have climbed and they're unstable. Inflation has been rampant. Geopolitical arrests are evident around the world, and, you know, even in our backyards, supply chains have been disrupted by onshoring. The number of unknown unknowns is following kind of this exponential arc. Now, I've been pretty good at finding investments that haven't gone to zero. Only one business I've ever owned is no longer in the market, and that's because it was bought out at a premium. Every other business still has ongoing operations. But I must admit that I bought some companies that I thought could perform well in adverse conditions, but then when those conditions arose, they just didn't perform as well as I'd hoped for. Alibaba was a great example where I thought the business would perform well, but they had several headwinds that I didn't weigh heavily enough, and therefore I was heavily disappointed. As a shareholder this year, I saw how businesses would react to many of the issues that I listed previously. Businesses like Lumine and Topicus, which specialize in vertical market software companies, continue just kind of chugging along because they have very little inventory and they're therefore unaffected by tariffs. They also don't need to worry about moving their manufacturing or switching suppliers to avoid tariffs or really geopolitical tensions. These are businesses that have very low levels of fragility. While businesses like Lumine or Topicus aren't exactly the sexy kind of AI plays that seem to be dominating the markets today, they are the types of businesses that are much less likely to be killed. Those are the businesses that I love the most. So these stories tell me three things. 1 risk is much older than markets, 2 fragility is an underappreciated attribute of the margin of safety, and 3 durability under stress separates the winners from the losers. When I combined these three things, I was able to develop a much more robust downside protection system. So how have I integrated this into my investing this year? There are a few ways. If I'm looking at the more analytical angle, it's simply by increasing the probabilities of my bear thesis. Instead of using low numbers like 10%, which is unrealistic, I might now default to 33% in my inflection point businesses, I use an even higher number, maybe closer to 40%. Doing this helps me take into account just how a company will perform under adverse conditions, and it builds right into my evaluation and analysis. Another way to think about this is in the multiples that I use at terminal value. When I look at the price of businesses today, it's very obvious that investors are projecting the present into the future. The S&P 500 trades at around a 28 times multiple. This means that many investors are pricing in future growth and enthusiasm, and that's only under solid conditions. What happens in a downturn? Do all these businesses continue growing at historic rates? Are investors likely to hold them once they see a cut in profits? This is why I focused on multiples that are better aligned with a business's average rather than those that the market is focused on. Just maybe. Over the past year, after spending time thinking about fragility and downside protection, I realized that much of it doesn't come from macro shocks or competitive threats. It comes from people making key decisions within a business. And more specifically, it results directly from the incentives that guide people's behavior within a company. If culture shapes how a company operates, incentives help determine why they operate in very specific ways. Munger once said, I think I've been in the top 5% of my age cohort all my adult life in understanding the power of incentives, and yet I've always underestimated that power and never a year passes but I get some surprise that pushes my limit a little further. I felt like I've been studying incentives for years, but in 2025 I really made it a much higher priority. And like Munger, I feel like I always underestimate its power. The problematic part about incentives is that they don't shout from the rooftops about how important they really are. They're subtle, but they create predictable patterns. Researching them this year has reinforced the idea that if you want long term alignment between shareholders and management, you really need incentive structures that support it. Incentives help shape the conditions under which key management and capital allocators make very, very key decisions. In my opinion, the best incentive structure that I've ever seen is Constellation Softwares, which is why I hold positions in both of its spinoffs. The incentive structure for the spinoffs was nearly identical to Constellations. Now the key here is the structure of these incentive systems. So managers at various levels receive cash as part of their incentives. But this cash is used very unusually. So instead of going straight to the employees bank accounts, a portion of the cash, usually around 75%, is used to buy shares in their own company on the open market. And to make things even better, the shares are then held in escrow for three to five years. So how exactly do they unlock this bonus? Well, it's tied to things like return on capital thresholds. There are no short term bonuses tied to things like revenue or stock prices. To try to make a quick headline grabbing deal to just deduce your bonus. The system incentivizes things like cost discipline, capital allocation efficiency and long term thinking. Now the outcomes of this system help shape the behavior of Constellations managers and capital allocators. Managers think like owners because they literally become owners under the incentive system. If a new deal comes onto their desk and the hurdle rates aren't correct, they simply know they can just walk away from that deal and let another sucker accept the terms. Since Constellation is a forever home for vertical market software businesses, it creates this positive reputation as well for many of its acquisition targets. People who are selling to them know that they can trust that Constellation will treat their business respectfully if they sell to them rather than to someone else. Now this exact system helped clarify just what strong alignment looks like to me. Patience, discipline and an owner operator focused mindset. The system is so good that it's also spread to other VMS businesses outside of the Constellation universe, such as Computer Modeling Group. Now today I've discussed one of Seth Carman's central teachings on the margin of safety. But he also had Some really, really excellent insights in his book on the power and abuse of incentives on Wall Street. And even though the book was published in 1991, there really isn't anything that he said that still is not relevant today regarding the narratives on Wall Street. So his point was that there's just too many participants along the investing value chain where people are incentivized to promote certain activities which they probably shouldn't be. And these are things such as promoting trading, selling narratives to earn commissions, and closing deals no matter what the terms are, just to earn a bonus based on that deal. Now, the system that these people are in are not designed to really protect investor capital whatsoever. They're really just designed to increase the profits for their employer and themselves. Now, it's not even necessarily malicious. They're just following the behavior that is guided by their incentive system. Now, while I have no real ties to Wall street in terms of my money as I manage it all myself, the situation is still very fascinating. It has helped me to see just how powerful incentives are and how they affect the people around me. For instance, my mom has a registered retirement income fund which is basically just an annuity up in Canada. She wanted me to take a look at it once, and I saw what she was getting out of it and the fees that were being charged to her. We were both pretty outraged at how much the fees the manager of the annuity was taking for themselves. And my mom hadn't even actually realized it until I pointed it out to her. They were making a fee that nearly matched my mom's monthly payments. Just crazy. So what her annuity manager was doing is to collect a bunch of cash from my mom and invest into something that just generates income. Then when she reached a certain age, which she's already reached, they would pay her with the principal and interest that was accrued. They're making money on the principal that they invested and on the annuity that they pay her. Today, the managers are most likely part of some sort of large bank or institution. So they're interested in maximizing their own profits for the bank and themselves and not in the best interest of my mom. Now, I couldn't leave this part on incentives without mentioning the impact that Charlie Munger has had on my thinking of it. Incentives are deeply intertwined with how we behave. But what Munger taught investors from his talk on psychological misjudgments is that incentives also change perception. Yes, incentives obviously cause people to do weird things, but they also cause people to rationalize very specific behavior that they might otherwise Be appalled at when your behavior determines how much money you make, you will twist reality to justify what you are doing. I can't tell you how many shows or movies I've watched over the years where you see some drug dealer who's justifying what they do because they say if I don't do it, someone else will. This is them just justifying what they are doing, even though it's very apparent that it's not a good thing. Now obviously this is an extreme case, but I think you get the gist. Now, the terrifying part about incentive cause bias is that it's stronger and much more pervasive than people admit. It can even cause honest and intelligent people to do very weird things. So let's look at an otherwise normal business like Wells Fargo, the US bank. So in 2016 they had a scandal that went public, but the misbehavior that had been happening was from many years prior. So what was happening was that Wells Fargo set these uber aggressive sales targets for their employees. They needed to hit eight products per customer. So employees were paid and promoted based on the number of accounts that they opened. And managers were evaluated based on sales team growth. So you had a system in which both parties worked together and unfortunately their system was broken. Thousands of employees, many of whom were hardworking, honest and normal people, began opening millions of fake accounts for customers, 3.5 million accounts to be exact. These people weren't unethical by nature, but they justified their actions based on the incentive structure that they followed. That is Incentive caused bias. So when it comes to incentives, there are three areas which these stories really teach us to focus on. The first is that aligned incentives create owner like behavior, which is what we want to see from the businesses that we invest in. Second, misaligned incentives predict short termism and unnecessary activity. And third, incentives shape our perceptions, decision making and culture. After meditating on this over the years, I've examined how it's impacted how I analyze businesses and invest. When I'm speaking to management teams, I always try to emphasize the incentives of managers, lower level management and salespeople. This helps me see if employees are incentivized to create shareholder value or just to pad their own pockets. When I'm speaking with management, I'm also actively listening to just how they discuss them. Are they talking about how well they're going to do next quarter or in the next five to 10 years? How focused are they on cost discipline? I pay very close attention to compensation structures as well. And these can easily be found in a company's filings. I pay special attention to whether they have long term or short term incentive KPIs and whether they help align or misalign management and shareholders. I've also spent time thinking about my own incentives regarding my own stock portfolio. So my goal is to double my capital every five years and that means I am technically incentivized to take risks to achieve that lofty goal. So I think that's why risk has become so significant to me. I have to play this delicate game of finding great opportunities with the right upside, but also, you know, can't go to zero or hopefully not even go close to zero. Hopefully they can't go down 50%. I want my pie and to eat it too. So when I used to analyze companies I didn't place enough emphasis on the proxy or circular. Now it's one of the first things I do as I want to make sure a business has shareholders best interest in mind or else there's just no real reason to continue researching it. So while incentives can be boring, like many long term compounders, they have outsize effects when done right. When your investments are being managed by people whose behavior is set up specifically to benefit all the parties involved, you just tip the odds in your favor of that investment being a good one. And that is something that we can all strive for. Thanks for spending time with me today. If you'd like to continue the conversation, please follow me on Twitter Rational mrkts or connect with me on LinkedIn. Just search for Kyle Grieve. I'm always open to feedback, so please feel free to share how I can make this podcast even better for you. Thanks for listening and see you next time.

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