Lessons From Sam Presti

In June, the Oklahoma City Thunder won the NBA Championship. In my mind, it was one of the most well-deserved success stories in recent memory. Their General Manager, Sam Presti, has built two (actually almost three) title contending teams in his 18 years as GM.

Imagine for a moment what it must be like to run a professional basketball team in Oklahoma City. They are technically the third smallest market in the league, ahead of only New Orleans and Memphis, but they are arguably less “famous” than those two. In other words, if you were a budding super star, a young belle of the ball coveted by all the teams in the league, where would you prefer to live, New York, L.A., Miami, Chicago? Or… Oklahoma City?

Thus the built-in handicap of being in a location much better known for petroleum exploration: star players generally want to play under brighter lights. Unlike the L.A. Lakers, who can attract the services of LeBron James, The OKC Thunder must rely on draft picks, player development, opportunistic trades, and a culture/ethos that can keep the homegrown stars home.

Building a high functioning organization in any business, any industry, share many common denominators. Sam Presti has done it, with one metaphorical hand tied behind his back no less. I have watched many hours of his marathon pre- and post-season press conferences over the years, mesmerized by how similar his philosophies are with value investing[1]. To wit:

·       Instead of splashing out for flashy free agents or make blockbuster trades, he opts to collect draft picks, then nurture the young talent that come from those picks. Instead of chasing hot stocks or trying to get allocations to hot IPOs, we value-oriented folk prefer to find hidden gems that are initially ignored by the collective, then patiently wait for them to flourish.

·       Instead of chasing players that are coveted for their statistical output in the hot strategy du jour (e.g. 3-point shooting), he focuses on players that can stack quality possessions (e.g. tenacious defenders that can force turnovers). Instead of recycling the same valuation metrics to determine if a company is mispriced (e.g. P/E ratios), I try to gleam if there are hidden or buried intangibles that have a high probability of becoming cash in the future.

Perhaps most poignantly is his mantra that to be exceptional, one must be willing to be the exception. And its inverse: to be an exception, one must be exceptional. To beat the S&P 500, to be exceptional, we must aspire to be an exception and compose our investments in a way that is substantially different from that powerful benchmark. Success is never guaranteed. Luck and uncertainty remain untamable wildcards. Best any of us can do is to play the odds the rational way through relentless self-improvement and humility and wait for the breaks of the game to favor us on occasion. The OKC Thunder’s 2025 NBA championship trophy is proof that it works, and it is why I was so enthralled by their incredible season.

His pre- and post-season pressers are Must See TV for me

I’ll share one last lesson from Sam Presti that has stuck with me, actually a lyric formally attributed to the band A Tribe Called Quest – but I hadn’t heard of it until he quoted them:

“Scared money don’t make none.”

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[1] On the flip-side, ex-Philadelphia 76ers GM Sam Hinkie, upon his resignation in 2016 after losing a power struggle, leaked a self-serving letter that name-dropped investing luminaries like Buffett, Munger, Seth Klarman, and Howard Marks. Hinkie is a perfect example of an empty intellectual, a belly full of read knowledge but unable to translate any of it into actual results; and when held accountable, lashes out with highfalutin words. He has not held another management position in the NBA since.

2024 Annual Letter to Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

Look Who’s Back. Back Again.

As I’ve written several times before, presidents and partisan politics have no correlation to economic prosperity generated by corporate profits over the long run. Dimensional Fund Advisors periodically updates their helpful chart showing just how irrelevant who is sitting in the White House is to the S&P 500 Index:

Source: https://www.dimensional.com/us-en/insights/how-much-impact-does-the-president-have-on-stocks

And with three presidential elections in Incandescent Capital’s nascent history, maybe a chart of how your money has grown with me through three different administrations is closer to home:

Incandescent Capital returns since inception

As you can see, basically: politics don’t matter. Because corporations are not in the “business” of politics – they are in the business of adjusting to whatever the public policies are. At least, successful corporations worth investing in are. However the winds may blow, they set their sails profit-wards. This goes for us portfolio managers as well.

Most importantly, election day came and went, thankfully, once again, without any widespread unrest. The Trump administration redux will have less surprises for the world this time around. We can probably expect two things with high probability: less regulation, and more chaos. Keynesian animal spirits have been on full display in the days after November 6th, with the stock market expecting more unchecked growth and lower taxes. But on the flip side, the bond market has sold off, with yields rising on expectations of more inflation and higher deficits.

Look. It’s all mostly uncertainty and noise. Bottom line is, I urge you to not make economic decisions based solely on politics. I’ll remind you with the same anecdote I shared in my letter four years ago to-date:

“In 1951, I proposed to my wife. And my father-in-law was the most conservative guy in Nebraska except maybe for my dad. My father-in-law said, ‘I want to have a talk with you.’ So I went over to his house to have a talk. And he sat there and he said, ‘Warren,’ he says, ‘I just want to absolve you from any worries. You’re going to fail. And the reason you’re going to fail – my daughter may starve to death and you’re going to fail, but I’m not going to blame you – it’s because the Democrats are in and they’re all Communists.’ I listened to this thing for three hours. I have seen people make economic decisions based on their political feelings and it is not the way to do it.”

-Warren E. Buffett, February 2017 ¹

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¹ https://www.cnbc.com/2017/02/27/billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box.html

2023 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

2022 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

A Little More on the Present Value of Future Cash Flows

In an earlier post I laid out why it mathematically makes sense all securities, equities and bonds alike, decline when interest rates rise. Essentially, the cumulative value of future cash flows become less valuable in the present because the risk-free alternative has become more attractive. Instead of earning 0% in completely safe bank accounts, you can now earn over 3%. That makes folks less interested in taking a particular risk for 5-6% returns, and would perhaps demand 9-10% returns for equivalent risk.  

At first blush, a 5% difference seems modest. But consider how it affects security prices. If we invest $100 in a security that will earn us $5, that’s a 5% return. But if we want to sell that security right now, when investors demand a 10% return, we’d only be able to sell it for $50. Obviously I’m simplifying a lot¹, but at the core, that’s how interest rates can nosedive the value of a security from $100 to $50.   

Nevertheless, it is largely irrelevant to us, the patient investor.  

Because if we ignore the price movements and don’t sell, and the security delivers its cash flows year in and year out, the value still accretes. The cash piles up irrespective of day-to-day interest rate movements and we continue to earn our return! If we put our $100 investment in a lockbox and don’t bother stressing about its present value on a regular basis, the only thing we care about is the cash it’s generating for us: the $5 annual return. And whether it can potentially grow to $6, $8, $12, and beyond in the years ahead.  

We cannot control interest rates, nor can we control the perception of market participants. What we can control is the accuracy of our analysis and the decision to buy or sell based on what the market is offering².

Our holy grail is an environment where interest rates are at or near a peak (thereby weighing on prices but without the prospect of further declines) and other investors are indiscriminately fearful (thereby demanding a higher rate of return, which further weighs on prices). When we invest in this environment, we get to own not just the intrinsic value of capable corporations growing their per-share values over time, but also the possibility of a lower interest rate future and improving investor sentiment that could pull forward even greater returns.

This idea, in essence, is why we value investors shouldn’t sweat the macro. Interest rates and elections and geopolitics and the animal spirits of markets will always be unpredictable. Good businesses purchased at reasonable prices will endure. Accordingly, I increasingly think of us as collectors: We collect enduring assets that benefit from time.

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¹ Don’t @ me, bond people.

² Simple, but not easy. I’m by no means saying this business is a walk in the park and everyone else is stupid.

One Equation To Rule Them All

For about, let’s say, 13 years now, since the economy emerged from the Great Financial Crisis, U.S. equities have been in a relentless bull market. 2020 provided a shocking reprieve, but the velocity with which it roared back essentially made it feel like a brief nightmare on a hot summer afternoon that you wake up from and realize, oh wait, I just fell asleep on my hammock in a tropical paradise. The bull was gored, but trillion dollar government handouts provided a turbocharged shot of morphine.

Well, now the drug has run its course, and there is no more on the horizon. Interest rates, particularly housing mortgage interest rates, have spiked seemingly overnight to levels not seen in 13 years as the central bank tries to contain inflation. This has been the missing ingredient in killing the bull market. Interest rates are intrinsically and inextricably tied to all security valuations. Like a see-saw, when rates goes up, prices must come down.

Slowing growth has also spooked erstwhile euphoric market participants, particularly those who piled into high-multiple tech names. For the first time in many, many years, Facebook, Apple, Amazon, and Netflix in particular are decelerating rapidly. This is primarily a function of their size, as they are now either so big they’ve run out of markets to grow into and/or they’ve accumulated too many enemies and/or they no longer attract the finest talent because they’re perceived to be soulless Goliaths more driven more by corporate interests than by the change-the-world ethos they were conceived from. And because of their sheer size, they have an outsized influence on the S&P 500 index.

Let’s quantify this double-whammy. A central tenant in fundamental equity valuation is the calculation of its so-called terminal value, whereby a stream of cash flow is divided by a percentage figure derived from subtracting its growth rate from its cost of capital (which is directly tied to interest rates). So now we have cost of capital rising and growth rate slowing, inflating the denominator of this formula which deflates the resulting terminal value. In other words, this all makes sense. The market is acting perfectly rationally by declining.

Terminal Value = Free Cash Flow / (Cost of Capital - Growth Rate)

I continue to believe the most comparable period to today’s market condition is the Nifty Fifty in the ‘60s rather than the 2000 dot-com boom and bust, although there are admixtures of both present. The tech giants of today mirror the Nifty Fifty: absolutely dominant companies who grew at such consistent paces that investors eventually (mistakenly) believed there is no bid too high. Similar to today, inflation then took hold, followed by rapidly rising interest rates, which pulled down security valuation across the board. The companies remained dominant, but their stock prices retreated and took years to recover. The dot-com era was in contrast riddled with mostly profitless companies with no path towards said profitability. This, though, describes large swaths of the crypto/Web 3.0 ventures. It does appear to me the vast majority of those will eventually fail as most do not actually generate any intrinsic value to society.

A fair sidebar question would be, if I am so steely convinced about this, why not go net short? And the answer is because the market is a forward discounting mechanism, i.e. every day, everyone is trying to figure out where rates will stabilize and by extension, where security prices should settle. As certain as I am that as rates go up, prices will go down, I’m just as uncertain how this is reflected day-to-day in the market. Predicting this movement is the purview of the short-term speculator, the trader who attempts to game the voting machine .

Also, I could be wrong! Macroeconomic stuff like interest rates are notoriously difficult to predict. Is it possible inflation quickly subsides later this year, leading to less rate hikes? It's certainly not impossible. There are always contra-indicators that inject just enough prognostic doubt in the short-to-medium term. And there's always the human element, prone to bouts of irrationality. The prospect of churning our portfolio and incurring capital gains taxes and trading fees in light of this much uncertainty seems like folly.

Contrary to many market participants, I’m feeling mostly sanguine (and edging towards enthusiasm) about this correction. It’s unhealthy for markets to become untethered to fundamental realities and pose as the world’s biggest casino. It distorts capital allocation which distorts incentives which distorts true, real growth in productivity and innovation. Companies that don’t produce sufficiently differentiated or necessary products or services to generate sustainable profits don’t deserve capital. Certainly, some speculation is necessary in cutting edge projects, e.g. biotech, but not in perpetuity. A return to a mostly rational market is good for humankind in the long run.