Danoff, Davis, Lynch: Stock-Picking Ahead of the Crowd

Janet Yang: Hi there. Good evening. Thank you everyone for joining us today. I am so excited and proud to present to you this next panel. The three managers here are really some of the best stock-pickers in the industry. All three have won Morningstar's Manager of the Year Award, so suffice it to say, they've made a lot of money for a lot of people over a long period of time.

To my left is Chris Davis from Davis Advisors. Chris has a few portfolios and funds under his belt, and one of them is Selected American Shares. He's run that fund for, going on 20 years now, and over that time its outperformed well over 90% of its large blend peers.

Next to him is Will Danoff. Will is probably best known for his work on Fidelity Contrafund, over his 24 years there. That fund has outpaced the large-growth peer by more than 400 basis points a year.

Finally last, but not least is Dennis Lynch from Morgan Stanley. Dennis and his team have amassed a pretty nice record, as well, and a particularly strong 2013 allowed them to become one of the most recent Manager of the Year Award winners. And he received that award just this past January.

So, the three managers here to some extent have gotten that success, I think, by focusing on companies that have strong competitive advantages. We're here today to talk about those companies, talk about those competitive advantages, which companies have them, which don't, how that competitive edge gets sharpened over time or maybe dulls, and who are the winners and losers.

We'll make sure to save the last 15 minutes or so for audience questions. But for now, let's start with the kind of big picture.

The three of you look for, I think, companies with strong competitive advantages, but you do approach it in different ways. Let's start with you, Will, first. You keep a pretty arduous schedule, I think, where you are meeting with four or five companies and their management teams every day; that goes to about 20 a week or more. Can you tell us what are you trying to suss out during those meetings about a company's competitive edge that you might not be able to find from filings or from an investor presentation?

Will Danoff: Janet, that's a really good question. I will say that I once talked to Warren Buffett. The first time I met Warren Buffett, and I said, "You must have a good gig. You get to talk to lots of companies. Your CEOs tell you what's going on." And he says, "Don't listen to any CEOs because a good CEO is going to tell you what they think you want to hear." And he said it's all in the numbers.

I guess, if you play to your strengths, Fidelity, as you said, Janet, sees a lot of management teams. They come around and give us updates because if we are not the largest shareholder, we could be the larger shareholder, and I just try to make sure I understand what management is trying to accomplish.

I'm sure Dennis and Chris feel the same way. What are you doing? What are your highest priorities? What do you think of China? How is the Internet going to affect you? Issues that we all read about every day, how are these going to affect your businesses? But mostly, what is your strategy? What is your competitive differentiation? What is a real value proposition to your customers? And you know, you want to try to assess the management team.

We have all sat across the table from managements. Are they engaged? Are they excited about their business? Do they know their business really well? Do they think long term? Do they think about their customer? And you'd be surprised. Over the course of a month, if you are seeing 80 companies, there are one or two that do stand out.

Chris Davis: And sometimes they just jump of a page. We were talking backstage about Bobby Kotick and Activision, a company that we own together, and every once in a while, you meet somebody and they really do just jump off the page in terms of their numeracy, their energy, their engagement, their value discipline, and you're exactly right. You see 20 and one jumps out of you, and you think about the outsider CEO. That sort of culture, when you see it, boy, you know it.

Danoff: Yes. And then I mean also part of it is, you get to monitor what these executives are saying, and we've all been doing this for a long time, so, over 10 or 15 or 20 years, you start to realize this management team, Chris goes way back with the Sandlers. They do what they say they are going to do. They've got a very profitable model. They reinvest their capital wisely. They don't overspend at the top. They tend to acquire and get stronger at the bottom. Part of it is just watching what these companies do, part of it is just looking at the long-term record, and saying, "Wow." I was with a company today which has been around for about 20 years, and they've done a really nice job. And you can just sort of say, "I better pay more attention." I kind of missed the first 20, but I don't want to miss the next 20 years.

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Yang: So you see those companies for 10 or 15 years. I guess you could see them evolve over time. Chris, in your most recent shareholder letter, you talked about adaptability being something that you look for. Can you talk about that in terms of how you are looking at a company's competitive edge?

Davis: I would bet that's a characteristic that we all look for in management's is that ability to adapt. Look what it means in our business, right. So my grandfather started investing in 1948. We started taking clients in the New York Venture fund in 1968. The requirement that you adapt, that's not an option, what worked in the '70s, didn't work in the '80s. What, worked in the '80s, didn't work in the '90s. The nature of capitalism and competitive advantage is that capitalism high returns attract competition, and competitive advantage is a temporal thing. It can be whittled down or it can be expanded, but what really matters is management's ability to adapt and I think about that, as an investment firm. You think about, all of the business models that were carved in stone, 20 years ago, 10 years ago, 30 years ago. World Book Encyclopedia, carved in stone. What about the pharma industry? Absolutely safe. Blue chip. Buy it and forget it. What about retail? What about media?

All of the companies that you list at one time as stalwarts, absolutely unassailable franchises, it is amazing how capitalism works to bring them under attack. And the number one symptom to look for in a management in terms of vulnerability to that is complacency. You saw it in the Big Pharma companies. You saw it in some of the big media companies. You have to be very aware of how models can change, things like consumer products, things like newspapers, the world changes.

I think that lack of a willingness to adapt at a corporate level, but as investment managers, what worked for us when we started didn't work. My grandfather said, "We have to hold to unchanging principles, but adapt to changing times." The markets, the economies change. The disciplines that we use, valuation discipline, character assessment, the assessment of competitive advantages, all of these things--those don't change. Those are unchanging principles. But the way the economy and the business models change is constant, and boy, in this business, if you're not learning, you're falling behind. You've got to come to work every day, looking at what's new, what's changing.

Dennis Lynch: I think that's why, too, it's important to meet with the companies and the managements as you guys pointed out. It's important to meet with the company managements consistently, but I think in general with the rate of change accelerating, it's also good to try to have some kind of analysis on your team. It's not just doing the blocking and tackling, talking to the companies because they're not always going to be the ones to tell you that things are changing, especially when it's adverse change.

One thing we did actually was created a role on our team, somebody who does topic research, so he's not an analyst in the sense that most of our traditional teams are built around. But instead of being an expert on semiconductors or retail, he focuses on a big sort of micro theme, something changing. In fact, the first project we had him do was 10 years ago was Internet media, to try to understand--this was post the dot-com bubble--how powerful is this new form of advertising and what does it mean to not just the companies that are providing it, but the ones that might be competing with them.

As a result of that type of analysis, it helped us sort of stay away from some of the more conventional media companies that I think have been sort of pushed to the side based on some of the success in the Internet world. So I think managements are so important, talking the companies making sure what they say is consistent, but also trying to create inputs in research that might be differentiated looking at the world a little differently. When you have a role like that it is different. It reminds me back 10 years ago, we owned a lot of radio-station companies, and the radio station analysts weren't going to be the ones to tell you that guess what the game's over; the companies are highly levered and with this new alternative of Internet media they're going to have a big problem. The managements weren't going to tell you that either, and many of them I really enjoyed meeting with at the time. So I think it is important as you think about competitive advantage if you are going to own stocks for long periods of times like we all do, to certainly do the blocking and tackling, but also try to incorporate maybe a broader view about what's happening and from a standpoint of creative destruction.

Davis: Yes, and when you think about what Dennis says, one of the critical points there, is that if you get a portfolio manager that wears blinders or an analyst that says "Oh, I'm the newspaper guy," "I'm the media guy," "I'm the U.S. domestic guy," it is a crazy way to view the world. We don't own any businesses that look at their competitive set and say, "I only compete against domestic mid-cap" or "I only complete against emerging markets," it wouldn't make any sense. So, you think about how often a portfolio manager gets compartmentalized into a box, and they miss what's coming.

I was joking today about when I started at a trust bank. They had a domestic beverage analyst, they had a European beverage analyst, and they had the emerging-markets team. I look at that today, and I think, look at our beer industry. Anheuser-Busch and Miller are not just owned by foreign companies, they are owned by emerging-markets companies, right. The Brazilians own Anheuser-Busch and the South Africans own Miller SAB, and then you look at Heineken, and you say, "Well that's the European company, except they make a lot of money in the U.S." Except the most profitable market for Heineken in the world is Nigeria.

When you get people that wear blinders, and I think one of the characteristics of portfolio managers when they have this sort of long-term view, this generational view of investing, is that you constantly resist being put into a box, and I think that's an important characteristic.

Lynch: We have very expert-based world and system. The sell-side is set up around that expertise; the buy side tends to be so. Making sure you don't fall too much into that one camp of thinking is so important. And on our team specifically, we try to make sure people follow multiple industries, just so they're not thinking about one thing only and applying one set of metrics. And by the way, experts are useful if the world is not changing in a dynamic fashion, so I don't mean to say that expertise in and of itself is not a good thing. But when the world is changing, and there is dynamic change coming, the experts are probably the ones that are going to recognize it last on the margin.

Danoff: Dennis makes a really good point about managements' often don't tell you, and sometimes they don't even see it. So, the importance of casting a wide net, engaging with small and mid-cap companies to help you understand what's happening in an industry and how it can affect the big companies--Chris and I have done very well with EOG. Why didn't Exxon or why didn't Chevron figure out the shales? There it is. These U.S. companies, they've been in the U.S. forever, and it takes a little independent to be innovative. I think actually Continental bought the acreage in the Bakken from Exxon or one of big boys.

And that's what so much fun about the business. These entrepreneurs come, they have a better idea, they have a different perspective, and only in the United States or often in the United States they can make it happen and make a lot of money for themselves and for the shareholders.

Yang: Let's talk about a few more, I guess, concrete examples of companies and their kind of competitive edges. When I took a look at all three of your portfolios, there are seven holdings that all three of you hold. Visa is one of the bigger ones, and American Express and MasterCard also show up in a few of your portfolios.

Will, I'm going to start with you, again, because you own all three actually, you're the only one that owns all three. From a competitive standpoint, what makes those credit card companies and payment processors so attractive to you?

Danoff: As I thinkone of the biggest stock funds in the world, I own a lot of stocks. I own more than these guys. What I've learned from Dennis and Chris is the importance of concentration, the importance of lowering your turnover, and the advantages of concentration and lowering your turnover is you think before you dive. I was lucky on the MasterCard IPO to say this is a duopoly, this is a capital-light industry, and this is a high-margin business. Then back when they went public, maybe eight or 10 years ago already, there was just a big tidal wave, a tailwind of cash and check going to plastic, and you saw this 10-year trend, 20-year trend, it was continuing. And then with the emergence of Internet commerce, clearly, there is no cash and check on the Internet. So the credit card companies were going to benefit. And in the case of MasterCard, and I think in Visa, as well, going public was going to give them an opportunity to really cut costs and have professional management as opposed to be a confederation of bank executives running the show.

It was one of those long-tail, "we think we can grow 15%, 20%, generate a ton of free cash flow" margin opportunity, and that was why I ended up buying. I think MasterCard became public first and then Visa followed, and they've both been better than I think most investors would have thought. It's been really unbelievable. We'll see what the Internet--if someone smart out of Silicon Valley can replicate or disrupt what they're doing, but at this point, they haven't been able to.

Davis: And think about what Will says because what's so interesting there in terms of insight into how a portfolio manager thinks is, you think about the sort of the tailwinds that affect the business that they are in. People spend more every year, the amount of spending that happens on plastic, as a percentage of that spending grows, so those two growth rates compound on each other. You look at the fact that it's a duopoly or triopoly with American Express. You look at the things that will keep in a global expansion, and then you look at the bottom up. You say these companies were owned in sort of as consortiums. They were sort of mutual structures. There was no leadership, so there's probably a margin opportunity. You think about the fact that what they do is they process transactions; they get paid basis points.

The cost of processing that transaction is computer time. That falls. The cost of that falls with Moore's law. So, on a bottom-up basis, you start looking at what are the incentives for the people involved? What are the cost structures of the industry? And you put that together, and there you sit with these three companies, and I think there's a lot to looking at that industry, like payments.

And then the last thing he said is the fact that you have to look out of technology. What will disrupt them, right? There are a lot of merchants that hate paying 1.5% or 2.0% as a tax on every transaction, which they have to pay through the Visa, MasterCard, American Express systems, broadly. They would like to figure out a way around it, and there are a lot of people in Silicon Valley working on it. We have to watch that. We have to be open to that and visit with tiny companies like we've done over the years, too. So there's a lot in that answer that I just thought was terrific of recognizing that--it's what you said, Dennis--there are these themes that we want to understand and then there's the company-specific data.

Danoff: And the other point is and Dennis and Chris and I have an advantage that these companies are coming public. There was a new discovery factor. I vaguely remember when MasterCard went public, there was a lawsuit, and then maybe Wal-Mart was shaking the tree. So there was a little controversy. [Many investors had lukewarm thoughts about] MasterCard and Visa, and often if you can engage, there's an opportunity in the first couple of years of what I call discovery.

I'll never forget I was the retail analyst at Fidelity in the late '80s and going to the first Costco that opened on the East Coast, sitting next to some guy in a bus trip and saying, what do you think of Costco? He said it was the first time he saw the store and the stock had already tripled or quadrupled, and I was like, thinking of myself, "Where have you been?" And he said his firm didn't look at companies below $2 billion in market cap. And the stock had gone from $400 million to $2 billion. There's a certain institutional thinking of "[The stock is] not in my index, or it's not in my little market cap range." So, new companies in and of themselves can create opportunities.

Davis: It'll be too much work.

Danoff: Yeah, yeah that's true, too.

Lynch: All of them, of course, also have this very strong network effect and that can be a very powerful, long-life competitive advantage. So I think that's probably something we've all incorporated with the thesis there.

I actually made a pretty big mistake with MasterCard. From a decision-making standpoint, I think it's kind of worth noting, when you look at the business and what it could be over time, based on everything you just described, I think it was obviously a great idea from the IPO, and it took us about a year or so to buy post the IPO. And it was partly because, like with most people--you'd mentioned the lawsuit--the lawsuit looked like such a high percentage of what the proposed market cap was going to be or a meaningful percentage. And I think the right way to think about in retrospect was to not worry about if there's a lawsuit; take that out of the equation. Just take a look at what the business can be and how big it can be an endgame five or 10 years from now, with a more profitable management, independent quality. And then say how meaningful is this lawsuit in relation to that number? And unfortunately, at least for the first period of time, we anchored a little bit too much on that risk, which looked bigger in the context of where the sort of market cap was.

Davis: We did, too. That prospectus had some really scary language in it and, I agree. But the fact that you went back to it, that's a tough thing for portfolio managers. You know, we hate passing on something at $20 per share and then looking at it again at $40. I passed on Google at the IPO and we have that stock certificate hanging on our wall of shame. We have a mistake wall, where we frame the stock certificates of our biggest mistakes every year, and we put a plaque on the bottom, "What was the transferrable lesson learned?"

Now, thank God, we revisited it at $300. Well, you feel like an idiot buying a company at $300 that you passed on at $60. But stocks don't know where they've been, and sometimes value investors have a bias that if the stock was $60 and now it's $20, we automatically think it must be cheap. Sometimes growth investors have a bias, where they think if it's gone from $20 to $60 it must be good. Neither one is true. The stocks don't know where they've been; where they've been says nothing about what the value is. And sometimes buying a stock that has doubled or tripled is the greatest value of your career, and sometimes passing on a company that's down 80% is the best decision of your career. So it's anchoring on those prices, and it's hard to overcome that bias, like to revisit that MasterCard IPO. You were right.

Danoff: I totally agree that one of the lessons that anybody who has been in the business, we've all been in the business for a long time, is if the stock has doubled or tripled, you have not missed it. If the earnings are going to go up another fivefold, you've got to just swallow hard, and say it's more of a buy or as attractive as it was. Stocks follow earnings. I think about some of the great wealth creators in this country, Michael Dell didn't sell after the first double [in value]; Bill Gates didn't sell after the first double. So as investors if the story is unfolding, if there is a multiyear tailwind, if this is a big idea that can go global, and a company can grow on a capital-efficient way, hang on and stay with it.

The only other point I would make on the MasterCard and Visa, Janet, is that when we were able to talk to the banks and Chris knows this better than anybody else, credit cards have high returns on equity and high returns on assets. Visa and MasterCard are supplying to a better portion of the bank business. The bank customers love it. The consumers, of course, it's tremendously convenient to whip out a card as opposed to fiddle with some cash or whatever, or write a check. And that was sort of a perfect idea.

Davis: And you had a little Lollapalooza effect. The Economist a couple of months ago had an article that correlated crime rates in neighborhoods where there was more plastic than cash. For example neighborhoods were things like welfare checks are put on debit cards rather than mailed, in places where there is not a lot of check cashing, it actually lowers crime. Well of course it makes sense, it's like the National Cash Register Company reducing employee embezzlement. It's something I never thought of when we invested in credit card companies, but it does actually affect the global rollout of them. The tax authorities love it, but also this idea that cash itself has a lot of danger associated with it.

Yang: We hear a lot of agreement on stage right now over the credit cards. I want to try to stir the pot a little bit. And Facebook, I think, is a good candidate for that. There is some question, I think over, its competitive edge, and, maybe generally, you know when investors are looking at it. Part of it might be just because it's Internet-related, but there have been predecessors, Myspace, Friendster, where we know the predecessors flamed out pretty spectacularly. Dennis, I'll let you make the case for it. Why is Facebook different?

Lynch: Well, you know we talked about MasterCard and Visa having a strong network effect, and I certainly think with Facebook, that that is definitely the case with over 1 billion interacting on one platform. It's very hard to just move them to another platform suddenly. I think the core of the Facebook thesis is thinking that there is definitely a franchise to that collection of people that's growing. It doesn't mean that it's unassailable; nothing is unassailable. We talked about Visa and MasterCard positively, but there are new technologies that are coming out that we've all got to watch out for. At the heart of their business is sort of a technology solution, and something could come along that's a lot cheaper, frankly, and we're all poised to look out for that.

In the case of Facebook, most of what they're providing people is free. So I think there's a pretty high hurdle for why people would want to switch to, let's say, let's call it another social network. It doesn't mean, though, that they can't be displaced possibly by alternative uses of time. I think that's probably more likely a concern over time as I think about our holding as opposed to suddenly there is going to be a new Facebook; I don't think that's the issue. It's just that will Facebook's economics be affected by something new that comes along that captures people's attention and time?

Because at the core, if you look at how much time people spend on Facebook and the engagement, despite the fact they've slowly ramped up their advertising, the statistics are very powerful as to how useful people consider the service. I think at this point, given the scale and the network effects, it's unlikely you're going to see a Myspace kind of crash.

The real question would be more I think is if something else emerges, I don't know, virtual-reality, something that captures people's time and attention more powerfully, that is certainly something we'll be on the lookout for. But at the heart of our thesis behind owning the company, we've owned it for a number of years now through thick and thin, it is that network effect that I think is hard to displace. And of course the economic opportunity seems very large if you look at the amount of advertising spending that they're getting per user, some of the examples of companies in Asia, or even Google, how much they're getting per user. I think there is a pretty long runway for that sort of Lollapalooza-type effect that Chris alluded to, that this could continue to be a very big idea. Certainly some of that's already played out. It's not without risk like any of our holdings.

Danoff: The other point that Dennis didn't mention is management. When Mark Zuckerberg speaks, you have that once in a light bulb kind of "Wow!" This is a gentleman that before he was 30, had 1 billion users and has been able to build a global phenomenon and also built a very profitable business and built a very strong team.

For me, the fact that they were able to pivot around the IPO, most of the business was done on the desktop. Mark and his team saw the smartphone emerging very quickly and like any great CEO, he said, "Guess what, all engineering is now going to focus on the smartphone." I think he made a mistake. As Chris says, we all make mistakes. We've got to learn from our mistakes and the three of us have made a lot of mistakes. And we just have to try to keep learning. But Zuckerberg bet on HTML; it turned out it was Android and iOS that he should have written the app on. And there are other still some issues that it is an app. But they've executed exceptionally well.

The margins are going through the roof. The revenues I think were up 72% last quarter. The revenues are going through the roof. The engagement stays strong and their growth is still continuing. So, one again has a sense that they can continue to grow relatively rapidly for the next several years.

Davis: Will talked about mistakes. I'm about to make one because here I'm going to challenge Dennis Lynch and Will Danoff on Facebook. So this may be a mistake because actually I admire everything that you say about the company, in terms of the users, the management, the ethos, the culture. I think what kept us out of it; it's very unusual in our place. We write very detailed investment summaries when we look at businesses. We like having that record because one of the things we focus on a lot is how you fool yourself; the subsequent effects make you misremember. So we love having this record and this discipline of looking at it.

Facebook was one of the only companies we ever wrote an investment summary saying why we were choosing not to invest. And it was very controversial at that time because it looked like free money. It was going to be such a hot IPO and all of that, and so we're going to have to say to clients why we didn't put in for this monster IPO. Didn't we read the papers and so on? And of course, we owned a lot of Google. And so, it wasn't like this was a business we weren't comfortable studying. And as you say, there was a lot to admire. I think for us the one difficulty was around how we thought about monetization.

And this is what I mean. When you go on Google, you are seeking information. So the idea that they are serving up ads may well be a convenience to you. It may aid in your assistance, in your looking for information. To me, in the beginning, my sort of macro thinking about Facebook was people are on Facebook to communicate with one another, and it may feel a little spooky to them if they are talking to a friend about going to the Bahamas if all of a sudden an ad is served up. And I said it would be as if the head of [a phone company], said I've got a great business idea. We are going to listen in on everybody's conversations. And whenever they say the word Bahamas, we are going to interrupt their conversation and putting an ad up for the Bahamas. I said it would make people little uncomfortable.

And so I wasn't sure how well it would monetize, and I think what they have done in terms of moving toward that, way exceeded our expectations. So I think we felt quite virtuous based on how badly performed. We're worried about the mobile switch. But I think just what you say, just like Bill Gates missing the Internet and then rebooting Microsoft around the browser, I think it was amazing to see how that company pivoted. And with Sheryl Sandberg driving monetization, Facebook has done a very good job.

But we preferred Google because what we love to do is focus on the value created to the advertiser, rather than on the user experience. And so there it was harder for us to see, but in all of our checks with firms that are advertising, what we've seen is more and more they're pleased with the results they're getting about Facebook, and that's gone some way to changing our view.

Danoff: Chris makes a really good point. Well, two things. You were wise to pass on the IPO, because the stock went from $38 to $20 or $15 even, but I do remember in a follow-up, asking because, when you have 1 billion users, you can do a lot of A/B testing, and 50 million users with ads, 50 million users without ads, 50 million users with video ads, 50 million users with text ads. And I remember asking David Fischer and Mark, "What's the experience? When you put the ads in, do people like it or not?" And they like it, and they may even like it more because the ads can be relevant. If you are actually interested in the Bahamas and you see an ad to save money to go to the Bahamas, that's going to make you feel better about it.

Lynch: Or if it comes also with an endorsement of someone as your friend.

Danoff: Right. I mean that would be the Holy Grail.

Lynch: You're on Facebook to interact with your friends and see what they're up to. And occasionally they're liking things, and so there's that endorsement factor from the advertising standpoint.

Davis: I remember, it was actually an executive at Facebook that once said, "Our goal is to monetize the trust that you have in your friends." And I remember they said never say that again, and they haven't said it again.

But how about this, just to stir the pot once more. The other thing that has worried me in terms of Facebook has been about capital allocation, and of course, in companies like Facebook, that are fundamentally capital-light--you have data centers and there's real capital intensity there, but not relative to the amount of money that they can generate.

So, you really start thinking about what is the reinvestment risk. And for some of these companies, it's mergers and acquisitions. And so I'd be curious how--obviously, Google bought Android, which ended up working out pretty well. They bought YouTube, which worked out great. They bought this little satellite company [Skybox]. They bought Motorola. Now, Motorola looked lousy, but it seems clear that a lot of it was about intellectual property and patent portfolios and being to defend themselves.

Danoff: And good for them they sold it to Lenovo.

Davis: And they sold it. But how do you think about that with Facebook. And so that's the other thing I thought a lot about. I admire, as I say, I think it's a great management, I think it's a great board, and I think they're monetizing well. But that's the other thing I've been curious about.

Danoff: Right. Honestly, Chris, I think you have to give the great founder a little bit more leeway. He's built this tremendous company; he's built value. He sees a vision that instant messaging may indeed be another platform. And as I heard it, they had almost 500 million users; he sees line of sight to 1 billion users in two years. I'm not going to maybe bet against that, if that's what he says. And because he has 1 billion users and, whatever, $130 billion market cap, paying $20 million for 500 million users [in the WhatsApp acquisition] may be a bargain. But you're right. By the way, they don't have any revenue, and I don't know if they have any plans to monetize yet, and I think there were 50 employees, Dennis. So that seemed like a high price to pay. We'll see.

Lynch: Yeah, I think it's a legitimate question, but I do think Mark's a very smart guy, and I think the whole team is very talented, so I'm willing to give him a little bit of leeway.

Davis: And YouTube was expensive

Danoff: Right.

Lynch: Capital allocation certainly matters big time, especially long term. I think when I look at companies that are earlier in the life cycles, I'm a little less focused on it because I think the opportunity is so big fundamentally in their core business, whereas the more mature a company gets, certainly capital allocation really becomes the most important thing. But in the life cycle of a company, long term we'll see, but I think it's a little less important given I think the economic opportunity I have right now ahead of themselves.

Davis: Whenever we write an investment thesis, too, we talk about what can go wrong? We call it a premortem, and we begin it by saying, it's five years later this investment was a disaster, this is what happened, this is what made the investment go wrong.

And in the case of this inversion, writing an investment summary about why we didn't buy Facebook or weren't going to at that time, we had to put where we could be wrong and it could end up with Facebook being great, and, of course, monetization was a big part of that.

But another part of it was we looked at the revenue per user compared with other types of media. Like we sort of said, you know if you own ABC, what revenue do you generate per viewer? Then we though if you own The New York Times, what revenue do you generate per reader? And we went through a whole series like that. And when you looked at it that way, Facebook was so low versus what seemed reasonable based on how much people value that service. And so, and I think that is the learning part.

Lynch: That's a big part of why we liked it, is exactly that. And the trend at least, they've done a good job not creating a huge cost for the users by having too many ads too quickly and all that. As they become more relevant, maybe they can push that a little bit. But I think that's exactly right, or just even a though experiment of like, when you have 1 billion users, and if they all paid $10 a year, that's like a $100 billion company in and of itself. Now again, that creates other issues maybe about your competitive moat, where now suddenly you aren't a free service, and someone might [disrupt you]. I'm not suggesting [Facebook should begin charging users], but at least when you think about the scale, it's massive, and the ability to get a little bit out of a lot of people in that context is what we thought created exciting upside.

Danoff: I guess they could have asked their users, "Do you want ads? If you don't want ads, pay us $0.01 a day or whatever."

Lynch: It is a weird world though, where companies are exploding and becoming important more quickly than I think they have in the past, maybe it's because of Amazon Web Services and things like that.

There was a guy, Benedict Evans from Andreessen Horowitz recently wrote, like 10 years ago somebody would raise $10 million, have 100 a employees and 1 million customers pretty quickly. Now, you have 10 employees, you raise $1 million and you have 100 million customers. So, the idea, it's hard for us--Will made that statement--it's hard to get your head around the idea that something could be meaningful when there is only like 10 employees. But I'm not sure. And the interesting thing to watch going forward based on how change is happening more quickly and things are scaled so much faster today, it's hard to get your head around that. It's a valid point, but you also want to think how much does it matter in a world where you can outsource a lot of these things initially to get to a massive scale of 100 million users.

Once you have that there is--as Chris pointed out related to the media spend per user--you got to get that small thing right, and it leads to pretty quick economic value. Because I'm technically, I guess, a growth investor, that is a big challenge seeing what could something be five to 10 years out based on what it is today.

And once you have some of these first-mover advantages that lead to these big businesses without a lot of capital intensity, it's really interesting to try to figure out how big a company can be and what you might be willing to pay for that today. But it is a little different like, you know, you hate when people say, "Things are different this time." I get it. You don't want to ever make the argument that financial theories or financial valuation and things like that are changing, and I don't mean to suggest that.

But look at Facebook. In 2007, Microsoft invested in Facebook and the implied valuation was $15 billion, and everyone thought that was insane. Seven years later, it looks like a bargain, even if you think Facebook is 50% overvalued. But at that point in time, it was trading at 50 times revenue.

So, I'm not saying you should run out and buy companies with those characteristics every time. In fact, you definitely should not. But there is this interesting dynamic of watching companies get bigger more quickly and become important more quickly that has to do with the Internet and Amazon Web Services, and the ability to scale very quickly a user base that we haven't quite seen before, and it's something that's I think on all of our minds.

Yang: I do want to make sure that we save time for audience questions. If you have a question, just find a person in a red shirt and they'll bring you a microphone.

Davis: While you're doing that, I just wanted to pick up on one thing Dennis said which is, the old song on Wall Street is the four most expensive words are "this time it's different." But I think Dennis is exactly right. It's also true that every time is different, and some things do change. Exxon and what John D. Rockefeller did changed the world. What Bill Gates did changed the world. What is happening in Internet scale changes the world. [Saying "this time it's different"] was a way for people to hide, not adapt.

Yang: We have a question right up here.

Unidentified Speaker: Do you see premortem for Baidu?

Davis: Well, somebody want to take a whack at Baidu?

Danoff: Baidu.

Lynch: Baidu.

Danoff: China is a little harder to navigate. When I visit with Chinese companies, one of the important questions is, "Talk to me about government relations." What's been fascinating with Baidu is just like with Google in their core search business, how strong is that as the world goes to mobile? Baidu has shown that they can monetize the smartphone perhaps better than with a desktop, but that's been an issue as Tencent has grown so quickly. Is Tencent going to hurt them?

Lynch: I think we all have probably speculative-sized position in Qihoo which is a challenger leveraging their security software on browser to get up to now I think about 20% market share in China on the desktop search. And I think the difference between Baidu--well, I'm not supposed to talk about Baidu because of our compliance--but anyway, the bottom line is if you look at Google as a proxy in the U.S., they own Android, and the shift to mobile was much more natural for them to be able to defend their situation. They've also had a consistent market share, with no clear number two that has had any kind of growth of any sort.

Qihoo, on the flip side in China, has had very significant market share. They've gained about a 20% of the share of the market. That's of search, not yet dollars. And then you also have a shift to mobile which can be a problem for these kinds of companies. So I think that there's some risk there when you think about the entire Chinese search market.

Davis: And I'd say, it's funny, because people say, "What would you guys be doing studying China or studying Chinese Internet companies or whatever it is?" First, I think anybody who is investing today who is not studying China as just part of their overall framework is kind of nuts. I'll give you a statistic I read on plane here. Bill Gates was reviewing a new book, and it was a terrific review. It's a book called Making the Modern World: Materials and Dematerialization. One of the comments in there was about the cement industry. If you take all of the cement used in the United States of America, in the entire 20th century, China has used more than that amount in the last three years.

Now, how can you not be studying what that means to the world? As we've looked at China, one of the difficulties is just what you say, is that any company that is already there has sort of ties into government and local officials. So, if you want to be in the beer industry you've got to compete with the local regional brewery that employs people and the guys on the take somewhere. It's very difficult in state-run enterprises to change culture, and it's difficult in businesses that had been there a long time to disrupt them. The internet has created a wonderful way to create a new industry that doesn't have that entrenched bureaucratic competition. It has often the blessing of the government because they want to keep out the U.S. So, it's like the Galapagos, right? You've got these species that exist there that don't have to compete with Google.

Danoff: Having their government kick Google out.

Davis: To me the biggest risk in looking at those, and when I think about a premortem on this it's a about what will happen to the cash that they generate? Will they be allowed to give it to shareholders? There, I don't know. Look at Alibaba. Amazon has $100 billion of gross merchandise volume roughly going through their system. What is Alibaba? Something like $230 billion of commerce happening on that website. How can you not study those things and try to understand them.

Here's the worst market, the worst market for the last five years on earth probably is China. Wouldn't you expect investors to sort of, just the way you'd run your Geiger counter over the debris of the Internet meltdown in 2002 and 2003. John Templeton said don't ask what looks good in the world, ask what looks terrible. And China studied some of that.

Anyway, if there are two words I never thought I'd say in my life, especially in a forum like this, they would be: Chinese Internet. But I would tell you, just as somebody that is an investor and curious about the world, I think you'd be crazy not to study them. And we have made some small investments there. They're tiny as a percentage of our portfolio, but you know what our investments in cable were tiny as a percentage of our portfolio when that was a new industry, or wireless, or Intelin 1990. That's part of adopting.

Yang: Let's make sure to get one more question in and let's go to the side here.

Davis: That's her nice way of saying don't talk so much.

Unidentified Speaker: Thanks, gentlemen. Can you comment on 3-D printing in the future for investors there?

Yang: Dennis, is that one you've studied.

Lynch: I would say generally, it's an interesting area. It's one of our thematic research topics. There are a few public companies, but in general I think that there is a lot of possibility or potential for huge innovation and affecting existing industries that comes with that. But it's not clear like in maybe some other areas who the actual winners might be, and it might be one of these cases where technology improves and our quality of life improves, but there's not one sort of obvious winner as a result. But I do think it's something to watch in terms of distributed manufacturing or distributed production of some goods.

Actually, I bought a 3-D printer just to kind of learn about it. You can make a comb, and you can make these things that you don't have to go to the store for. And of course, it's still early. It sort of sits there, and we don't use a whole lot yet. But you probably would have said the same thing if you brought a computer in late 1970s, right. So, you can see there is potential there for something new and different. But it's certainly very early-stage, and we're not using that as a part of our analysis for some of the manufacturing industries and worried about it quite yet.

Davis: I'll tell you one thing you better be doing though when you study it, is sometime you study technology not to invest, but to see where you own something that's a dead man walking. You know study Hewlett-Packard to understand what it could do to Xerox. You better study Nokia and then Apple to understand what they are going to do to the photography industry or to Kodak. And you better study 3-D printing, if not for the investment opportunity, to understand what it could do to spare-parts distribution or things like that. Lots of very mature businesses could be disrupted, and one of the real reasons to study these businesses is sometimes for defense rather than offense.

Yang: Let's give the audience some food for thought, some closing thoughts, I think, as we close out here. Maybe if each one of you could give maybe the most interesting disruptive change that you see on the horizon and how that would affect companies' competitive edges, and which companies will be the winners and losers. I'm going start with Dennis down there first.

Lynch: I think the idea that software is eating the world, which is a Marc Andreessen sort of thought, is very valid, so we're constantly looking for areas where software can sort of replace people or how it affects how businesses can be more efficient through the use of software. So I think software and understanding its uses and implications are really important. But there are so many things that we're tracking. 3-D printing we're tracking and electric cars. There is a lot out there I think that could lead to some very big changes in the world.

And as I mentioned earlier, things are changing more quickly than they used to. It's the accelerating rate of change, and we see that with our handheld devices, the way we spend so much time on them today versus five years ago, and what they actually provide to us in terms of a service and the capability. I think one of the big challenges we all face because we care about this thing called an competitive advantage is understanding how all these sorts of technological advances lead to rapid company formation, the growing importance of some of those companies, and how that reflects back on some of the companies in industries we always thought were bulletproof, but maybe they're not quite so bulletproof.

Even in area like consumer staples. Or think about Tesla; it's a top five branded car manufacturer in the U.S., like how would that even be possible 10 or 15 years ago? It just wouldn't happen that fast. But because of things like social networks and the rate of change in the technology and the access we all have, I think we have to acknowledge that. When we think about say consumer staples, health. Everyone is suddenly so much more focused on health and lifestyle, and for so many of these awesome Warren Buffett-type businesses, it's not like they are as bulletproof as they used to be either.

I think things are changing quickly. I mentioned a few areas that we're certainly focused on, but I think that the hard thing sitting here is trying to figure out how that affects competitive advantage for all of our holdings.

Danoff: I think, I want to end on an optimistic note. On one hand, you could say big data. There is going to be three computers up here [on the panel] in the future, and we're going to be out of a job, Janet. But I think in the end, entrepreneurs, as Dennis said, it's Telsa. Elon Musk was South African. He came to this country for an education. He built his business in Silicon Valley, and you know he's got his space company [SpaceX] down in Southern California. Great entrepreneurs, great technologists want to come to this country, and Chris, Dennis, and I and you all have an opportunity to partner with great visionaries who can embrace the future, can build a big business, and with technology, the returns can be very high.

The growth can be very quick, and I see it over and over. I'm sure my colleagues do as well. These companies are coming. They are excited. They're not worried about a lot of issues that we worry about in this country, and that's what so great about the stock market. Chris, I'm sure your grandfather wouldn't imagine the kinds of companies that you're looking at; 50% margins is unthinkable and cash generation.

So, over and over, I see this. I remember speaking with John Browne, who ran British Petroleum, and he was a Member of the House of Parliament, he may still be a Lord. I sort [asked him for his] observation because I wanted him to talk about the Iran-Iraq war I think back 10 years ago. He said, "I don't want to talk politics, but I will tell you, British Petroleum does business in 85 countries in the world, and there's nothing like doing business in the United States of America."

So, buy U.S. equities, and I think over time, you're going to be really happy.

Davis: AndI love this as a wrap-up question because, we all invest knowing terrible, disruptive, awful things are going to happen in the next 10 years, just like what happened in the last 10, and the 10 before that, and the 10 before that. There is a lot to worry about in the world, and we have to invest knowing there are going to be those disruptions. But it's the other side. Black swans are not just bad things. It's not just a bomb in Times Square or a failed Treasury auction or war in Ukraine or whatever will be the awful things that are certain to happen during our investment horizon during the next decade or two.

But at the same time, there's this other side, there are these large, unexpected, enormously positive events that moved the world forward, and shale gas is one. What we talked about in terms of the Internet and technology is one. Globalization has been one. And so I think invest sort of knowing both sides of that, holding the both in your head that awful things are going to happen, and yet at the same time, spectacular things are going to happen, too. And how do you balance that growth with that risk? And how you do you put that together, and that the whole secret in the sense the whole goal of investing is to try to balance those two.

Yang: Gentlemen. Thank you for joining us today.

Davis: Thanks so much.

Danoff: Thank you.

Lynch: Thank you.