Investor Interview: Sleepwell

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Feb 01, 2022

Today we have the third edition of the Investor Interviews segment where we take a look at investing from another unique perspective.

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This next guest is well-known on twitter as @sleepwellCap. He is also well known contributor here on Substack where he authors a fantastic blog titled ‘The Sleepwell Strategy’ which includes one of my all-time favourite pieces of financial/technology writing - ‘Music Streaming Royalties 101’.

So without further adieu, lets get into the interview with Sleepwell, where we dig deep into his background, investing style and get his expert opinion on all things Spotify, audio and Web3.

Background
Investing Style
Spotify & Audio
Quickfire

Firstly, a bit of housekeeping - some of you may have noticed I haven’t posted any deep-dives on here for a while. Well, the past several months I’ve been working hard on something slightly different than usual…

At some point within the next next week, the plan is to release the first part of a two-part deep-dive into Ethereum - analysing the asset, the technology and what I believe it’s potential is for the future.

Keep an eye out.

Background

Welcome, Sleepwell. Let’s get straight into it.

How did you get interested in investing? What are your main areas of focus? Also, maybe you could talk a little about what you do for fun.

I was born and raised in South America and moved to the US for college where I studied engineering. In my sophomore year I started playing around with the stock market, having no idea what I was doing. I’ve always enjoyed learning about companies I find interesting, so this seemed like a fun way to (try to) make some money. Almost instantly I knew I wanted to work in finance. I did a few internships and landed a full-time job in one of the big investment banks. I worked in wealth management, rates and credit research and more recently in equity research covering industrials. Currently I’m taking some time off before I move on to the next adventure on the buy-side.

I consider myself a generalist. My areas of focus are music, technology, financials and industrials. I don’t limit myself to these, I’m always interested in learning about new companies that I find fascinating. Investing is a lot about pattern recognition, so there’s tremendous value in learning about different industries, even if you don’t end up investing in them.

In terms of fun, I like having a balance between my creative side and being phisically active. I think both are important to lead a healthy and fulfilling life. On the creative side I’m a musician (I play guitar, sing and write songs) and just recorded my first album. My favorite sport is skiing, and I also enjoy running and hiking. It’s certainly not a coincidence that you’ll find some of these activities reflected in my portfolio ($SPOT $UMG $MTN).

What inspired you to start posting on twitter, and where did the name Sleepwell come from?

I have used Twitter on the personal side for a long time and stumbled across FinTwit a few years ago, but didn’t interact too much. I noticed there was an interesting investing community, so I decided the best way to get more involved was to create an account solely focused on that. I took the anonymous route for work-related reasons, but then realized there were benefits to it: you’re actually building a brand and it’s very meritocratic based – people are judging solely based on the quality of content you post, not by how you look, how old you are, where you went to school or where you’re from. I thought that was very powerful.

The Sleepwell name is something that has been in the back of my mind for a while. It originally came from a Buffett quote from the 80’s when he said something like “I sleep well at night knowing that billions of men will grow a beard tonight and have to shave tomorrow morning”, talking specifically about his investment on Gillette. Over time it’s grown on me and now has its own bigger meaning. It’s as much about owning things that help me sleep well and doing things on a day to day that help me lead a better, happier and healthier life.

Part of what makes investing enjoyable for me is the ability to mix my passions with making money. For example I have a deep interest in the future of AR/VR, so learning about the industry ends up being enjoyable. As you mention, you are a musician.

I'd like to ask a bit about what you play/do music-wise? Also does the combination of your hobby with investing had any impact on your choice to focus your energy towards the audio sector?

I’ve played the guitar for almost 20 years and started singing more recently because I didn’t have a choice (nobody wanted to sing the songs I was playing!). I also recently recorded my first album, to be released this year, so I’m very excited for that. It was a great experience to learn about the industry from the artist perspective.

I’m a strong believer in investing in things that genuinely interest you, it’s such a big life hack. There’s no point in spending time studying an industry or company that bores you and you don’t enjoy researching, especially with all the hours that you have to commit to acquire the required knowledge, truly grasp what matters and develop your own view. This is not to say I won’t pay attention to what’s happening in other industries and learn lessons from them, but I wouldn’t see myself going deeply into an O&G exploration company or a biotech startup. Naval says we should strive to find something that feels like play to us and work to everybody else, and that way you come out way ahead in life. I think that’s a very powerful idea that I try to apply to many aspects of my life.

This is why music (and more recently audio) was a very natural place for me to look at deeply. I enjoy spending time learning about it, researching it, really trying to understand where it’s going. I think my portfolio, over time, will be a reflection of the best businesses in sectors that I find fascinating and want to be constantly reading about and getting smarter on. I’d say that’s probably the only screening tool I use: “Will I have fun learning about this company?”

Couldn’t agree more.

Now, lets move onto your investing ‘style’.

Style

One thing I find particularly interesting is the differing styles between investors.

How would you describe your investing style? And how would you say your investing style has evolved over time?

I would describe my investing style as constantly trying to find what best fits my personality. I like to know what I own as best as I can, feel comfortable with the risks and to enjoy the research process. This can take me anywhere, and you’ll realize if you look at my portfolio that I own value, growth, compounders, serial acquirers, even special situations. I never think about them that way though, this is just the outcome of my process for finding companies that I find attractive and I’m not limiting myself to any bucket or style. Like many, I started in the traditional value investing school but have slowly migrated away from it, not to say I don’t seek a margin of safety, I just don’t think any of the traditional metrics like low P/B or P/E works as well as it used to, it’s a lot more complex and competitive today.

Recently I’ve been focused on extending the duration of my portfolio, by trying to find companies that I’m comfortable holding for a decade or more, but these ideas don’t come very often. This is especially true in today’s age of disruption where the average company lifespan has shortened significantly. In fact I’d say that I’ve probably found 4 so far that fit this criteria. If you’re successful in finding long duration quality assets at the right price, you’re likely to outperform. It’s been proven time and time again that time horizons are one of the few edges left in the market, you’re playing an entirely different game when you’re thinking about a company 10 years down the line when most of the market is focused on the next quarter or maybe the next year.

Do you have any main influences in terms of investing style?

I’ve gone through many stages in my investing life and try to read as much as I can about the most successful investors, regardless of their style. I think any fundamental investor can learn a lot about Druckenmiller or Soros, it’s kind of crazy to ignore what they’ve achieved. I also think it’s useful to study the great capital allocators like John Malone, Tom Murphy, Mark Leonard, just to name a few. At the end of the day, most of their company’s achievements have been driven by how they invested the excess cash flows their business generated, not as much by their operating expertise.

Recently I’ve really enjoyed reading the Nick Sleep (Nomad Partnership) letters – who went through a transformation in his own style. Twitter has also been an incredible place to find and connect with other investors. Alex Morris, Francisco Olivera, Andrew Walker, Josh Tarasoff, Eric Boroian, Mostly Borrowed Ideas, John Huber and Rishi Gosalia are some that come to mind who I’ve had the chance of connecting with, learning from and we’ve become friends through the platform. I’m truly grateful for that.

Do you have any common characteristics you look for in a company you end up investing in?

I can’t say all of them share one specific characteristic, but generally I try to look for good or great businesses where I can form a view and conclude with reasonable confidence that they’re being misunderstood by the market through a mispricing. It usually involves a company going through some kind of material change that perhaps doesn’t get captured in a DCF or a multiple lens. It could be in their strategy, a new business initiative, new competition, an acquisition program or a long term trend that the market hasn’t fully grasped.

If you look at any sell-side model, for example, you’ll find that they don’t model any M&A, which for a company like Constellation Software is outright ridiculous, the founder and CEO literally tells investors acquiring other software companies is their core business. Other examples include companies that don’t have a good comparison or any precedent because they’re playing in a completely new industry (sometimes even building it themselves). You have to be able to see patterns, use second order thinking and borrow ideas from different mental models to figure out what the end-state may look like. It creates opportunity because the market tends to be more of a “show-me” state, and these things don’t show up in a financial statement.

I think when you can correctly identify opportunities like these before the market fully appreciates them you can make real handsome returns. I focus on ROIC, its defensibility over time, but more importantly, the reinvestment potential and any upward inflections in ROIC (i.e. ROIIC). It’s been proven that the market is not particularly good at forecasting this and there is a high correlation between ROIC direction and stock performance.

A good example is Ally Financial, the largest online bank and auto lender in the US, which I’ve owned since 2015. This was a restructuring story initially, which then became a successful turnaround and more recently has turned to a story of growth, optimization and new initiatives. Return on Equity a few years ago was in the mid-single digits (7-8%) and so logically, it traded below book value (~0.7X) because it was earning below its cost of capital. What the market was missing was that the legacy problems were behind them (subprime mortgage book, GM/Chrysler exposure) and they had built a great deposit and banking franchise that was low-cost, sticky and high growth (also replacing high interest debt), while on the asset side they had a nice moat around their auto lending business and new consumer banking products, like lending and investing. They also started buying back significant amounts of stock below book value. What this translated to was a visible path to high-teens/low-20% earnings growth and ROEs increasing to 15%. More recently management has guided to 16-18% over the medium term. The stock has performed well (up almost 200% in 5 years), but still trades at 1.1X book and 6-7x earnings, while still buying back a boatload of stock (12% of market cap). I think there’s still room to go as the market hasn’t yet fully appreciated the underlying growth and quality story given the valuation.

What is your typical allocation strategy? And what is your attitude towards risk?

I run a pretty concentrated portfolio, but it’s mostly my own money. My top 5 positions usually make up ~70% of my portfolio and the largest one around 20%. I realize this is unconventional, but I’m quite comfortable operating like this given the type of investments I own and the time I’ve spent doing work on the companies that make up the majority of my portfolio. There’s been a lot of studies that prove that beyond 7-10 stocks or so, there’s very limited benefits to diversification. I also focus a lot on the potential downside scenarios and risks, which comes natural given my fixed income background. Needless to say, I don’t mind the volatility and don’t have any investors (besides some family) to answer to or feel pressure from.

One way I like to think about my allocation, is that I’m essentially giving capital to the CEOs of my portfolio companies, just like if they were investors managing my money. I think it’s a helpful mental exercise. I’m quite comfortable outsourcing my capital to managers like Mark Leonard (Constellation), Daniel Ek (Spotify), Joe Shoen (U-Haul) and Reed Hastings (Netflix). Buffett has a great quote that says “If a CEO retains in earnings the equivalent of 10% of the company’s net worth every year and reinvests it in the business, he will have been responsible for 60% of the invested capital of the business in 10 years”. I think investors don’t spend enough time thinking about the capital allocation skills of management, which is a very big driver of investment outcomes over the long run.

Spotify and audio

Spotify was one of my very first deep-dives. It’s a company that has always interested me as an early adopter and investor. So I feel it would be a massive missed opportunity if I weren’t to ask you a few questions on the topic of spotify/audio, as it’s something you are so vocal about on Twitter.

In my opinion it's almost an illusion that the audio market is ‘mature’. It definitely has some incumbent players like the big record labels, however streaming as we know it today really only stemmed from the piracy age. As you can see from the graph below from Matthew Ball, it looks like the audio industry is just getting started. Especially with the recent introduction in things like social audio.

I guess my first question is…

…What do you see the audio opportunity to be? And why do you think Spotify is the best positioned company to benefit over other players like Apple Music?

Audio as a media format is very unique and probably a decade or two behind others like TV, social media and video games in terms of internet-level penetration and monetization. The reason for this is that piracy almost destroyed the industry and basically set it back in time. This meant they had to rebuild the business model from the ground up and successfully compete with a free product, so the consumer proposition of streaming had to be incredibly valuable in order to convince consumers to try and eventually pay for it. An incredible achievement if you ask me.

I think we’ve only started to see the tip of the iceberg of where the industry is going. Personally I think it will surpass the previous peak and most likely be multiples of what it used to be. Why? In the CD-era most of the market was made up of just four countries (US, Japan, UK, Germany) and people were spending on average $80 per year while getting just a handful of songs. That number today is probably half, and you have literally every song in the world in the palm of your hands, can listen to it at any time and get a personalized experience via recommendations. It’s also a lot more global. I think eventually people will end up spending more, because it’s a much higher value proposition vs. the old days and there’s a lot of big markets that will be monetized that previously weren’t.

Spotify is the only scaled global audio platform that’s solely focused on going after audio – both music and non-music content. It competes with the Big Tech companies, but importantly it has for a while, and has been beating them consistently, proven in terms of total of users, growth, retention and engagement metrics.

There’s a couple of factors that play to Spotify’s advantage. The first one is focus, which should not be understated. Since day 1, Spotify has been solely working on music streaming, and knowing what they were going up against (piracy, labels, lots of competitors) they well knew innovation and execution were key to their survival, so it’s become very much ingrained in their DNA to move fast, iterate and improve the product consistently. We also saw this three years ago when they shifted their strategy more broadly to audio, putting a lot of their energy into podcasting, and quickly becoming the biggest podcast player in the world.

The second advantage they have is scale. As the biggest music and audio streaming platform in the world, Spotify has more data (which feeds their recommendation engine), spends more on R&D and specific to podcasting, can spend more on content which it can amortize over more users. They also have an advantage in aggregating the whole podcast market and introducing a better advertising model that connects brands with podcasters and listeners. I can’t really think of any other company that has a real shot at unlocking this, and Spotify is basically building this business in front of us, which strengthens the ecosystem and the overall value of the platform. Finally, given the low gross margin profile of the core subscription music streaming business, you either need to be scaled or have other businesses subsidize the product (like Big Tech does), this means it’s going to be unlikely that small subscale players survive as standalone in the long run and deters new competitors from entering the market.

The third advantage, which ties into scale, is personalization. Users spend over ⅓ of listening time in Spotify’s own playlist (algorithmic and editorial). If you add to that user generated playlists your own content library (liked songs, saved albums) probably another ⅓. This means that almost 70% of the time users are listening to a curated personalized library, so even though music may be a commodity on its most stripped down version (a song or an album), presenting it in a highly unique and personalized way has a lot of value for consumers. Because Spotify has the most users, it is most likely to serve all users better recommendations through a combination of Machine Learning algorithms that leverages the existing data of hundreds of millions of users. Think about it this way: there’s a higher chance there’s somebody else with a very similar taste to yours versus other platforms. It’s very hard to catch up to that and it’s one of the reasons why Spotify user’s spend 2-3X on the platform compared to competitors.

Let me expand a bit more on the competitive landscape, because it’s an important part of the thesis. One way to think about this is asking yourself “If competition is so ruthless, with pockets as deep as they come, and the product is a commodity, why is Spotify still winning?” I think it’s instructive to think hard about this question. The Big Tech companies have unlimited resources (human capital, billions of cash lying around) and cross-selling advantages (Apple bundle, Amazon Prime, YouTube videos) and they still have not been able to catch up to Spotify, which maintains over a 2X advantage in paying users, even more so with ad-supported. Engagement is also higher and they’ve started raising prices in some markets. It’s quite clear that whatever Spotify is doing is working well and consumers are making a deliberate choice to stick with and join the platform. It’s important to keep a close eye on this and new developments, but so far these are the facts.

Geographically it also varies a lot. Apple is strong in the US, YouTube is big in Southeast Asia and India and there’s also a lot of local players in other regions (Anghami in the Middle East, Audiomack in Africa, JioSavvn in India). Tencent Music dominates China, but Spotify does not compete with them directly, they swapped an equity stake pre-IPO and now own ~8% stake in each other. Spotify is available in 180+ markets and has a global and local perspective, in some of these they will dominate and others not so much, but they have a very realistic shot of surpassing 1 billion users in the next 10 years. At 1 billion users, there’s a lot of strings they can pull to monetize more. As the former CFO used to say, “everything changes at scale”.

What do you see as the biggest challenge for this industry? Intermediaries like the big record labels seem to be a big headache for Spotify and their profitability - at least in the short term. Maybe you could talk a little bit about this dynamic.

I think the biggest challenge going forward will be finding incremental ways to monetize to increase consumption spend per capita, which is still extremely low. This includes convincing ad-supported users to pay for a subscription in Emerging Markets. The way I see it, streaming as a consumer proposition has been proven to work, so it’s just a matter of time for it to become more fully penetrated over the next decade or two, which gives the industry great runway growth.

I expect there will be a core streaming revenue (with pricing power) and higher-value add-ons that will sit on top of it, benefiting everyone in the ecosystem (consumer, artist, Spotify, label etc.). Think for example about the super-fan, who pays the exact same amount as a casual listener to listen to their favorite artist. There’s a lot of things that could be done here to monetize that super-fan in more effective ways, and we know this person wants to support and pay up for their favorite artists. Ideas here range from NFTs to paying for extra-special content, such as a pre-release window or special edition merch. Ek has suggested there’s a lot more they can do in terms of monetization models.

In terms of the labels and Spotify, I’ve been quite vocal about the misunderstandings of their relationship on Twitter. This is a symbiotic relationship today, because they need each other and they must cooperate together to keep the industry healthy and growing. Spotify needs the labels, which account for 2/3 of music listening share, but the opposite is true as well: the labels need Spotify, which accounts for ~20% of their revenues (and growing, as opposed to labels shrinking in Spotify) and also represent their highest growth and margin revenue opportunity. These are public companies with financial metrics to meet and investors to please, who have been sold on the idea that streaming is the future. It’s pretty much out of the question that they consider pulling out the catalog, lose all that high margin revenue, be left dealing with the 3 Biggest Tech companies (where music is a low priority) and have to deal with a PR nightmare and onslaught of artists, songwriters and managers that stop getting paid, likely sue them. Listeners would clearly be upset as well. This also begs the question of what they get out of that, they can’t create another platform, they’re not a tech company and it takes years and billions, and they certainly don’t want to be left dealing with less competitors. The labels like to see Spotify growing as it directly benefits them and it’s more likely they will cooperate together going forward to keep growing the industry revenue pie.

What role do you think podcasting and live audio will have in Spotify’s future? Clubhouse seemed to be very popular then die. We’re beginning to see other audio-first apps pop up here and there.

Maybe at the same time, what’s your opinion on Spotify Greenroom? It seems like a potentially interesting experiment, but also hasn’t really taken off.

I think podcasting is a bigger opportunity than people realize. We’re talking about the equivalent of linear TV to streaming video on-demand, but in this case from radio to internet streaming audio (call it podcasting or live audio etc.). Radio is still almost a $40B industry (bigger than recorded music) which is crazy, and most of those dollars should migrate over to the internet once the ad-infrastructure is in place given a better experience and ad-targeting. Spotify is aggregating the podcast market but more importantly is creating an advertising network (advertisers, listeners and creators) that will unlock a lot of inventory and standardize this process in one central location, much like Google did for the web.

I agree that Greenroom is mostly an experiment and hasn’t taken off, but I think for that small price they really had no other option but to test it out and learn a few things. Rumors are that they will integrate it into the core Spotify app which I think would make sense, and Spotify acknowledges that the Live audio opportunity will unlock a lot of new opportunities for creators and fans like Q&As, listening sessions, live concerts etc., so they definitely need to pay attention to that. It’s such an nascent market that it’s hard to predict exactly what it’s going to look like 10 years down the line. Live Audio is very much to be determined still if it’s really going to be a big thing - Clubhouse has been a flop by most accounts and Twitter Spaces has been Ok, but I wouldn’t call it a home-run either.

Slight tangent, but one particular hot topic over the past year has been crypto.

I’m wondering if you have any opinions on the state of the crypto market? If not, is it something you would be willing to learn more about?

The reason I ask is because I see a potential link with Spotify and NFT’s (e.g. Spotify issuing an NFT if you buy tickets to a gig through the platform, or buy merch, or support the artist directly).

I’ve started doing some work in this space, specifically around blockchain and web3. I felt I was being irresponsible for not understanding a lot of these concepts and the underlying trends. I don’t have any strong opinions on the state of that market at the moment. It certainly feels very speculative in certain pockets but I don’t think there’s necessarily anything wrong with that, we saw the same in the TMT bubble in the early 2000s and it would have been foolish to ignore it.

For Spotify and Music specifically, it’s definitely something I think about a lot, from both a risk and opportunity perspective. I know Daniel Ek has his eyes on this and they’re trying to find ways to see how they can get involved and help creators monetize better, and this seems to fit well here. NFTs are an interesting angle because it seems to be working very well to effectively monetize your most hardcore fans, but it’s tough to tell how much of it is actually people paying for the art or exclusivity vs. people speculating on these assets. It doesn’t seem to be for fundamental reasons.

In terms of the potential of a blockchain-powered music platform I have a hard time picturing what that would look like because it’s virtually impossible to build one without having the entire world’s catalog on it. We’ve seen examples of this many times (i.e. Tidal testing exclusives). Platforms like Audius are more like a Soundcloud for Web3, I don’t see how they could convince the labels to get on-board since they are the intermediaries they’re trying to disrupt. The other obstacle is creating a product that users love, because at the end of the day, the users are the ones who pick the winner. Building the perfect UX and acquiring users takes a lot of time and dollars. It’s no coincidence that the biggest music streaming companies were built by tech companies that have a lot of capital and Spotify which has spent billions in R&D and marketing.

Thanks Sleepwell.

Finally, lets move on to a couple of quickfire questions.

Quickfire

What would be your advice to a new investor looking to get into stocks and investing?

Look for companies you genuinely interest you and you want to learn more about. This will make the entire process much more enjoyable and you’re more likely to put in the required work. Curiosity is also incredibly important, your interests will expand over time and will compound on itself.

Finally, I’d recommend every new investor to spend time writing down their investment thesis on a company, it will feel odd at first but you’ll surely get better at it. Writing is a great way to crystallize your thoughts and will make you a better thinker and investor; all the best investors I know of are also excellent writers.

What is your biggest investing mistake and what did you learn?

I’ve had two complete wipe-outs, but I actually wouldn’t consider them my biggest mistakes and they were also smaller positions. Mistakes of omission have been a lot more common and costly. These are investments that I did not invest in but probably should have as I knew the story well enough. Netflix comes to mind, I’ve understood their business model well enough to invest in the company since probably 2017, but I think back then I was too strict on price of entry, and I think it got to 10% above my target price…which was incredibly dumb! If you’re looking at owning a stock for the long term, a 10% difference on the entry point is literally a rounding error. Thankfully I learned my lesson and as a result became more flexible with this rule going forward… Something similar happened with Google where I thought below $1000 would be a great entry point, so once it got close enough I started buying it. Thankfully, because the stock never got below that price again and I would have missed it had I been very strict on that.

Do you have any books or podcasts you would recommend around investing?

I’ve probably learned more about investing from non-investment related books. I lay them out in this thread. Three I’d particularly recommend from here are Influence, by Robert Cialdini; Superforecasting, by Phil Tetlock; and Da Vinci by Walter Isaacson.

I’ve also incorporated podcasts into my research process. I likely listen to the same podcasts most people do on investing, my favorite ones are The Business Brew and Business Breakdowns. I also like searching for the ticker, company or executive on Spotify. You’d be surprised how many interviews you usually find for a decent sized company.

If you had $100K which you were forced to invest now between 3 stocks (weighted equally) over the next 10 years, which 3 stocks would you choose, and why?

Spotify, Constellation Software and Amazon.

I have a pretty good visibility of their prospects of growth and the competitive environment for the next 10 years at current valuations, within reasonable confidence. I’m also quite comfortable with their risks and downside scenarios and I think they are different enough that they provide good enough diversification even though it’s only 3 stocks.

That concludes my interview with Sleepwell.

I would like to say a massive thank-you to Sleepwell for the thoughtfulness of the answers here, and to once again strongly recommend you check out his work on both Twitter and Substack.

Cheers,

Innovestor

A guest post by

Sleepwell

Trying to find Investments that help me sleep well. Fixed income background. Engineer & Sleep enthusiast.

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