Complexity Investing & Semiconductors (with NZS Capital)

In this episode of "Acquired," hosts Ben Gilbert and David Rosenthal engage with public equities investors Brenton Johns and John Bathgate from NZS Capital. They delve into the intricacies of semiconductor technology and the investment principles that guide NZS Capital, emphasizing the importance of resilience and adaptability in both company operations and investment strategies. The conversation covers the dynamics of the semiconductor industry, highlighting TSMC's pivotal role and the geopolitical risks it faces. They also discuss the concept of "complexity investing," where understanding the ecosystem and the interplay of various players like ASML, Intel, and Samsung is crucial. The episode further explores the idea that long-term, steady growth often trumps short-term hypergrowth, with the discussion touching on the significance of creating more value than capturing it, and how this ethos underpins the investment philosophy at NZS Capital.

• Ben Gilbert and David Rosenthal host the special episode of Acquired, a podcast about technology companies and their backgrounds.
• Ben Gilbert is a co-founder and managing director of Pioneer Square Labs and PSL Ventures.
• David Rosenthal is an angel investor based in San Francisco.

"Welcome to this special episode of acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert, and I'm the co founder and managing director of Seattle based Pioneer Square Labs and our venture fund, PSL Ventures."

This quote introduces the hosts and the theme of the podcast, which delves into the stories of technology companies.

• Brenton Johns and John Bathgate are public equities investors at NZS Capital.
• NZS Capital's investment principles are based on complexity theory.
• The hosts found the content from Brenton and John so insightful that they watched it multiple times and discussed it at Capitol Camp.

"Brenton and John are public equities investors at a hedge fund called NZS Capital, and they spend a lot of their time researching semis."

The quote introduces Brenton and John as experts in public equities investment, particularly in the semiconductor sector, and highlights their association with NZS Capital.

• Complexity theory is the foundation of NZS Capital's philosophy.
• Brenton and John learned about complexity theory from books like "The Origin of Wealth" and "Complexity."
• Complexity theory involves understanding complex adaptive systems and emergent behavior.
• The Santa Fe Institute played a key role in developing the concept of complexity theory.
• The theory is applied to investing by focusing on adaptability and resilience rather than prediction.

"Complex adaptive systems are all around us, right? That's what governs the world. That's how the world works."

This quote explains the prevalence of complex adaptive systems in the world and their significance in understanding how the world operates, which is central to NZS Capital's investment philosophy.

• Resilience, rather than productivity, is a key focus for long-term success.
• The concept of resilience was inspired by the study of ants, which showed that not all ants are constantly productive, but the colony thrives due to its adaptability.
• Companies that optimize for resilience, often led by founders or long-term CEOs, are more interesting for investment.

"They're optimized around resilience, around living as long as possible. Let's say it that way."

This quote emphasizes the importance of optimizing for resilience in organizations for longevity and success, which is a guiding principle for NZS Capital's investment strategy.

• Pilot is a startup-focused accounting firm that provides financial services to companies.
• The firm is backed by notable investors, including Sequoia, Index, Stripe, and Jeff Bezos.
• Pilot's services include finance, accounting, tax, and CFO services.

"Pilot both sets up and operates your company's entire financial stack."

The quote highlights the comprehensive financial services provided by Pilot, which is a partner of the Acquired podcast.

• The podcast hosts remind listeners that the show is not investment advice.
• The hosts may hold stocks discussed in the episode, so listeners should do their own research.

"Now, as always, this is not investment advice. We almost certainly hold stocks that we talk about on this episode."

The quote serves as a disclaimer that the podcast content is not investment advice and encourages listeners to conduct their own research before making investment decisions.

• NZS Capital's philosophy is based on the concepts of resilience and optionality.
• The firm looks for companies that can grow durably and compound value over long periods.
• They avoid companies that focus on extracting maximum economics from their customers and prefer those that create shared value.

"We're really looking for this durable, resilient growth."

This quote summarizes NZS Capital's focus on finding companies that exhibit durable and resilient growth for long-term investment.

• Resilience refers to companies that are expected to grow steadily and sustainably over time.
• Optionality refers to companies with the potential for high growth in specific scenarios, similar to venture capital investments.
• NZS Capital combines these two approaches in their portfolio, with a concentration on resilience and distribution of optionality.

"We concentrate resilience. That's about 15 names and just over half the portfolio. And then we distribute optionality."

This quote explains how NZS Capital structures their portfolio by concentrating on resilient companies and distributing investments in companies with high optionality.

• Root Mo stocks are companies that have a resilient base and also possess significant optionality.
• These companies are given a higher percentage in NZS Capital's portfolio.
• Examples include Amazon in 1997 and eBay with its PayPal division.

"We love resilience with out of the money optionality."

The quote captures NZS Capital's enthusiasm for companies that combine resilience with potential for high growth, termed "Root Mo" stocks.

• NZS Capital applies the concept of power law distributions to later-stage companies.
• The firm seeks to avoid companies that are likely to go to zero and focuses on those with the potential for significant returns.
• The investment approach is similar to venture capital but applied to more established companies.

"We fully expect a third of the portfolio to go to zero, a third to return capital, and really only like one or two companies at the sort of head of the curve are going to be this hopefully ten, 5000 x."

This quote describes the power law distribution approach to portfolio construction, which NZS Capital adapts for their investment in more mature companies.

• Complex adaptive systems are a fundamental aspect of life and markets, leading to emergent behavior and unpredictability.
• These systems do not adhere to normal distribution but are governed by power laws.
• The insight that risk models based on normal distributions are flawed parallels the analogy of malfunctioning airbags.

"Well, once you accept the fact that all of life is governed by complex adaptive systems and the markets are also governed by complex adaptive systems, which means emergent behavior, you can't predict the future. You focus on adaptability. Then of course those complex adaptive systems tend to be governed by power laws."

This quote explains the relevance of complex adaptive systems to understanding market behavior and the inadequacy of traditional risk models.

• Economic models in education often do not match the realities of business and investing.
• Venture capital investors frequently observe that a few big power law winners drive the market, challenging the traditional models.

"This has always been my beef when I was in business school with economics as applied to business and investing in the real world is you studied this stuff and you're like, wait a minute, I actually work in the industry, and this is not how it works."

Ben Gilbert expresses his past frustration with the disconnect between academic economic models and the practical experiences in the industry.

• In a coin flipping contest analogy, the expected positive return is misleading as it leads to many bankruptcies and a few massive winners.
• This phenomenon is known as a non-ergodic system, where time averages do not equal ensemble averages.

"But that's not really true. What you get is a lot of people going bankrupt and a few massive winners... So the average is not average."

Brenton Johns describes how individual outcomes in a power law system can differ significantly from the average, resulting in a skewed distribution of winners and losers.

• High conviction in investments is often synonymous with overconfidence and bias due to sunk costs.
• The goal is to maximize the probability of getting lucky, not to predict the future with certainty.

"Conviction for us means, hey, I've done a ton of work, so I've got a lot of sunk cost, which means I've got bias. And I think that my view of the future is better than yours."

Brenton Johns critiques the concept of conviction in investing, highlighting its association with bias and overconfidence.

• Investing is seen as a team sport, where the team's role is to identify and call out biases in each other's decisions.
• Admitting when one is wrong and moving on is a key part of the culture.
• Detailed documentation of investment rationales is essential for reviewing decisions and maintaining accountability.

"The way we view team is our role is calling out bias in each other... But we all know that bias is really easy to identify in other people and really difficult to identify in yourself."

John Bathgate emphasizes the importance of teamwork and the mutual responsibility to challenge biases within the investment team.

• The portfolio is divided into an optionality tail and a resilient portion, with the expectation of higher turnover and acceptance of failure in the optionality segment.
• The process involves documenting reasons for optionality bets and evaluating whether to maintain, adjust, or exit these positions based on evolving evidence.

"It's okay to be wrong and move on and fail quickly, versus string ourselves along on a three year journey on a tough position."

John Bathgate discusses the team's approach to managing the optionality portion of the portfolio, emphasizing the importance of acknowledging failures and adapting quickly.

• Semiconductors are viewed as crucial building blocks of the information age and are a significant part of the resilient portfolio.
• The distinction is made between semiconductor companies that focus on the leading edge and those with a broad catalog of parts.
• Valuations and the predicted range of outcomes are key considerations when assessing semiconductor investments.

"We look at some of these companies, we think the valuations are actually quite reasonable, and we choose to sort of bring the portfolio more towards resilience."

Brenton Johns explains the rationale behind including semiconductor companies in the portfolio, emphasizing their role in the information age and the reasonable valuations they present.

• Silicon carbide is an alternative technology to silicon with applications in electric vehicles and high voltage uses.
• Companies like Cree are at the forefront of this technology, representing classic optionality with uncertain but potentially significant outcomes.

"So potentially, then, that's like classic optionality, right? We honestly don't know, but has a chance where either this stuff isn't that hard to do, and they have a two year lead on their competitors, or it's incredibly hard to do, and they do become one of these companies where they're doing something that no one else in the world can do."

John Bathgate discusses the potential of silicon carbide technology and Cree's position in the market, illustrating the concept of optionality in the semiconductor space.

• Statsig is used for rolling out and testing AI product features.
• Notion uses Statsig to manage its rapidly evolving generative AI features.
• Statsig can ingest data from data warehouses, integrating with a company's existing data.
• It works regardless of how feature flagging is currently set up and does not require migration from current solutions.

"So for anyone who's used notion's awesome generative AI features and watched how fast that product has evolved, all of that was managed with Statsig."

The quote explains that Notion's development and deployment of AI features have been efficiently managed using Statsig, highlighting the tool's efficacy in managing fast-evolving product features.

• Cadence is owned by NZS as a resilient position in the portfolio.
• Cadence and Synopsis form a duopoly in the EDA space.
• The decision to invest in Cadence over Synopsis was influenced by the management team, market share gains, and company culture.
• Direct engagement with company CEOs and management teams is a part of NZS's investment process.

"I think what steered us towards Cadence one is the management team. So Lip-Bu Tan at the time was the CEO... He was just so focused on the culture of the company... in terms of turning around the culture and really taking a company that was in a very difficult position in the financial crisis and really re architecting the product positioning of the company, and he's so customer centric."

The quote discusses the reasons for NZS's investment in Cadence, emphasizing the impact of the CEO's focus on company culture and customer-centric approach.

• Engaging with company management can provide valuable insights beyond public information.
• Investor conferences and industry trade shows are underutilized resources for gaining insights into companies.
• Management presentations at industry conferences can offer unique perspectives compared to investor-focused presentations.

"It's mostly free, too, and from industry trade organizations. And it's a huge resource."

The quote suggests that industry trade organizations offer valuable and often free resources that can provide deep insights into companies, which are beneficial for investors.

• Samsung is a leader in DRAM and NAND memory with significant market share.
• Samsung's foundry business is smaller compared to its memory business.
• TSMC specializes in logic chips and is crucial to the technology ecosystem.
• The semiconductor industry is described as a "superorganism" with interconnected companies like TSMC, ASML, and others.

"Samsung is very good at making memory... They have over half of the market share in DRAM, which is incredible."

This quote highlights Samsung's dominance in the memory sector of the semiconductor industry, particularly in DRAM.

• TSMC is considered one of the most important technology platforms globally.
• The geopolitical risks associated with Taiwan and China are acknowledged and factored into NZS's investment considerations.
• The interconnectedness of the semiconductor ecosystem amplifies the potential impact of geopolitical conflicts on the global economy.

"I think TSMC is more important than Apple. If Apple disappeared off the face of the earth... it really would not be as big of a deal versus if for some reason China moved to seize Taiwan or however it went into play and all of a sudden TSMC sabs were shut down..."

The quote underscores TSMC's critical role in the global technology landscape and the potential consequences of geopolitical disruptions to its operations.

• The spirit of Moore's Law is expected to continue for the next 10-15 years.
• EUV systems from ASML are enabling the continued shrinking of transistors.
• The semiconductor industry is focused on "more than more," which involves finding ways to increase performance beyond traditional scaling.

"ASML is kind of on record saying they think that EV will last about 15 years in terms of... It will be an effective way to drive performance and like drive shrink, basically, is the way the industry kind of frames it is you'll be shrinking the transistor to pack more performance into a chip."

The quote explains that ASML's EUV technology is anticipated to sustain the progress of Moore's Law by enabling further miniaturization and performance enhancement of semiconductor chips.

• Moore's Law has progressed beyond just transistor density to encompass innovations in packaging and chip architecture.
• Chiplets and multi-chip packages are becoming a significant part of semiconductor strategies to improve performance.
• Transitioning from FinFET to gate-all-around architecture at the transistor level, with 2nm or 3nm technologies, is a key development.
• System-level performance is increasingly important, with companies focusing on creating clusters of processors with proprietary interconnects.
• The semiconductor industry is shifting from a chip-centric to a computing-centric approach.

"Moore's law is going now is it's not just about the transistor, it's really about the package." "You can actually split up chips into multiple chips called chiplets, which AMD is doing." "We are moving to a new transistor architecture, either a two nanometer or three nanometer, depending on which company you're talking about, to a gate all around architecture."

These quotes highlight the advancements in semiconductor technology that go beyond traditional transistor scaling, emphasizing the importance of packaging and new transistor architectures in maintaining the pace of Moore's law.

• Apple has become an aggregator in the semiconductor space, integrating most of the important chips on a single logic board.
• TSMC plays a key role in manufacturing and packaging these chips, allowing for efficient communication between components without the need for low-bandwidth buses.
• The value chain is shifting towards integration and aggregation, with companies like Apple capturing additional margin by putting components together.

"Apple basically says, well, we've designed this logic board and we've designed most of the important chips, and we've situated them together." "TSMC manufactures it. They do all the packaging."

These quotes explain Apple's approach to integrating multiple chips into a system on a chip, highlighting the role of TSMC in the manufacturing process and the trend towards greater integration in the semiconductor industry.

• The semiconductor ecosystem is healthy, with multiple companies capturing high margins.
• Texas Instruments (TI) and Microsoft are compared in terms of operating margins, with TI having surprisingly high margins despite focusing on commodity chips.
• TI's end markets, such as industrial and auto, contribute to its profitability, blending technology with industrial characteristics.
• Fabless business models, like Nvidia's, have high gross and operating margins with low cyclicality, benefiting from TSMC's manufacturing capabilities.

"Who has higher operating margins, Texas Instruments or Microsoft?" "TI's end markets, two thirds of which are industrial and auto." "Nvidia's got close to 70% gross margins and low 40s operating margins, really, with very little cyclicality."

These quotes discuss the profitability of different players in the semiconductor industry, comparing companies like Texas Instruments and Microsoft and highlighting the success of fabless models like Nvidia's.

• TSMC's open innovation platform is crucial for industry collaboration and advancement.
• The platform allows for sharing of semiconductor IP and is akin to GitHub for the semiconductor industry.
• TSMC's open ecosystem approach has outperformed Intel's closed system, driving the industry forward.

"That's exactly what I was going to say. I think it's really true." "TSMC said, oh wait, let's form an alliance with everyone because this is really going to take everyone to keep driving this forward."

These quotes emphasize TSMC's strategic move to create an open innovation platform that fosters collaboration and has become instrumental in advancing semiconductor technology.

• The semiconductor manufacturing process involves multiple layers of complexity, with companies like ASML, Trumpf, and Zeiss contributing specialized equipment and expertise.
• The interdependence of these companies and their innovations make it unlikely for one company to integrate vertically and perform all functions.
• The semiconductor industry's success relies on an ecosystem approach, where no single entity can master all the required technologies.

"ASML's partnership with Zeiss, the Lens company, is also really special." "No one can do all of this. It's just way too hard. It really does take a village."

These quotes illustrate the complexity of semiconductor manufacturing and the necessity of collaboration among specialized companies to drive technological progress.

• Crusoe is a provider of clean compute cloud services, particularly for AI workloads, partnering with Nvidia.
• Crusoe's data centers utilize stranded or clean energy sources, offering cost and environmental benefits.
• The company's approach to locating data centers at energy sites contrasts with traditional cloud providers who build near internet hubs.

"Crusoe's data centers are nothing but racks and racks of a." "Because Crusoe's cloud is purpose built for AI and run on wasted, stranded, or clean energy, they can provide significantly better performance per dollar than traditional cloud providers."

These quotes describe Crusoe's business model, focusing on the use of clean energy to power AI data centers, which sets it apart from conventional cloud service providers.

• ASML is critical to the future of Moore's Law, with its EUV lithography technology being a key enabler.
• The collaboration of industry giants like Intel, TSMC, and Samsung to invest in ASML underscores its significance.
• ASML's long-term development and iterative improvements in EUV technology are a result of industry-wide support and feedback.

"ASML, which at the time was like kind of a sleepy dutch company that had like a $20 billion market cap." "They partnered and actually bought 25% of ASML to inject capital into ASML to develop uv systems."

These quotes recount the strategic moves by major semiconductor companies to support ASML's development of EUV lithography, highlighting the collective effort to sustain Moore's Law.

• TSMC has created significant value for its customers, with major clients like Nvidia and Apple contributing to its success.
• The Taiwanese government's ownership stake in TSMC reinforces its status as a national champion, making it difficult for other entities to acquire the company.
• The discussion includes speculation on the current percentage of government ownership in TSMC.

"I couldn't find in our research, how much of TSMC does the taiwanese government currently own?" "Some things don't have a price at which they are for sale."

These quotes touch on the challenges of determining the exact government ownership in TSMC and the implications of such ownership for the company's strategic autonomy and market position.

• The investment philosophy discussed emphasizes the importance of creating more value than captured and the concept of asset duration.
• Companies like TSMC exemplify the benefits of leaving money on the table for customers and partners, which can lead to sustained long-term growth.
• The idea of "flat growth" is introduced, where consistent growth over a long period is preferred to short-term hypergrowth.

"If you grow 20% a year for, like 50 years, like TSMC, you will destroy every group on out there." "So what you need for that is a negative feedback loop, right. So the negative feedback loop for TSMC is, I'm going to come in, I'm going to take what used to be the special sauce of your business, and you're going to trust me to do that."

These quotes delve into the investment strategy that prioritizes consistent growth and the creation of long-term value, using TSMC as an example of a company that has successfully implemented this approach.