Identifying Durable Compounders Through AI, Experienced Founders, and Market Discipline - Episode Hero Image

Identifying Durable Compounders Through AI, Experienced Founders, and Market Discipline

Invest Like the Best with Patrick O'Shaughnessy · · Listen to Original Episode →
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TL;DR

  • Companies leveraging AI can achieve significant cost reductions and revenue growth, enabling them to gain substantial market share and create persistent competitive advantages that competitors struggle to replicate.
  • "Act II" entrepreneurs, those who have successfully built and exited previous ventures, possess invaluable lessons in navigating complex business challenges and technological shifts, increasing their probability of future success.
  • The public markets, despite short-term volatility, offer a proven framework for building generational companies by providing daily valuation signals and investor discipline that can align internal teams and external capital.
  • Investing in companies with strong human capital and operational excellence, even without traditional hard assets or network effects, can yield durable long-term compounding if leadership focuses on talent, culture, and capital allocation.
  • The shift from a zero-interest-rate environment to positive real rates necessitates a return to valuing companies based on free cash flow and organic growth, penalizing those that cannot demonstrate a path to profitability.
  • Companies that can adapt to discontinuous change by leveraging new technologies like AI to enhance existing advantages, rather than being disrupted by them, are best positioned for sustained long-term success.
  • Building an investment firm that is better after its founders depart requires a culture of intellectual honesty, continuous learning, and a commitment to developing colleagues, ensuring long-term institutional strength.

Deep Dive

Henry Ellenbogen's investment philosophy centers on identifying and backing the rare "1%" of companies that achieve sustained, long-term compounding growth, often starting as small-cap businesses. His firm, Durable Capital Partners, is built to maximize the probability of investing in these exceptional companies by deeply understanding people and change. This approach requires a long-term perspective, a focus on adaptable leaders, and a willingness to navigate market volatility by doubling down on conviction when prices fall, rather than being swayed by short-term market noise or algorithmic trading.

Ellenbogen's core insight is that true wealth creation comes from a select group of companies, roughly 40 out of thousands, that can consistently deliver 20% annual returns over a decade. This realization, informed by studying market history and the performance of funds like T. Rowe Price's New Horizons, shifted his focus from broad market participation to identifying these "valedictorian" companies. He observed that a significant majority of these compounders begin as small-cap entities, underscoring the importance of early-stage investing. This philosophy extends to his firm's structure and operations, which are purpose-built to support this long-term, high-conviction approach.

A critical element of Ellenbogen's strategy is identifying "Act II" entrepreneurs -- founders who have prior success and apply those hard-won lessons to new ventures. These individuals possess a deeper understanding of business fundamentals, exception management, and organizational scaling, giving them a distinct advantage. He views his own firm, Durable, as an Act II endeavor, applying lessons learned from previous investment experiences. This focus on experienced, resilient leaders who can navigate technological shifts and market downturns is paramount, especially in an era of rapid change driven by AI.

The disruptive potential of AI is a central theme, viewed as at least as impactful as the internet, cloud, and mobile revolutions. Ellenbogen believes AI will not only transform technology companies but also existing diversified businesses across various sectors by lowering costs, driving revenue growth, and enabling new competitive advantages. He contrasts this with the "China cost" advantage of the previous decade, which focused on product manufacturing, asserting that AI's impact is on intellectual property and operational processes. Companies that leverage AI effectively can gain significant market share and create persistent advantages, akin to Amazon's early mastery of logistics.

Ellenbogen advocates for a "dollar cost averaging up" strategy, meaning he is only willing to invest if he is excited to invest more at higher prices as the company proves itself. This approach requires a tolerance for short-term volatility and a conviction that the company's long-term trajectory is sound. He contrasts this with the prevailing market structure, where short-term performance pressures and algorithmic trading often lead to excessive volatility, creating opportunities for patient investors who can assess true business fundamentals. He believes the public markets, despite their short-term fluctuations, offer valuable discipline and transparency that can ultimately benefit strong companies and their investors, particularly in navigating significant transitions.

Ultimately, Durable's success hinges on its people and its culture, which prioritize intellectual curiosity, teamwork, humility, and a long-term perspective. The firm actively cultivates an environment where individuals are encouraged to learn from each other and grow their capabilities, fostering a collective pursuit of investment excellence. This human-centric approach, combined with a deep understanding of technological change and a commitment to rigorous analysis, underpins their strategy of identifying and backing the exceptional companies that drive long-term economic growth.

Action Items

  • Audit investment memos: For 3-5 recent investments, review memos to identify patterns in successful predictions and areas of misjudgment.
  • Develop "Act II" founder assessment framework: Create criteria to evaluate founders' prior experience, resilience, and ability to apply lessons to new ventures.
  • Track AI adoption impact: For 5-10 portfolio companies, measure the effect of AI on cost reduction, revenue growth, and headcount efficiency.
  • Analyze competitive advantage evolution: For 3-5 companies, assess how AI or other technological shifts may alter existing competitive moats.
  • Refine team development process: Implement structured feedback mechanisms (e.g., 360 reviews) to ensure colleagues actively contribute to each other's growth.

Related Episodes

Key Quotes

"The key ingredients of the recipe that's become how you attack and think about markets where did it come from where did it start there's probably a couple of places it's come from one was frankly my own personal background so i came into investment not directly out of school it's not like i went a finance path i went to politics i wasn't an economics major i was actually organic chemistry and a history of technology major and i worked in politics for many years as i started to try to figure out what i wanted to do professionally and eventually i started to think more about investing and i got involved in it i started to think about investing based on a lot of the same principles that i learned in science in particular biology that in order to have organisms that sustain over a long period of time and persist much like human beings they have to be in balance with their ecosystem"

Henry Ellenbogen explains that his investment philosophy is rooted in principles observed in science, particularly biology, emphasizing the importance of balance within an ecosystem for long-term sustainability. This perspective extends to how companies should interact with their customers, employees, shareholders, and communities. Ellenbogen's background in organic chemistry and history of technology, coupled with his early work in politics, provided a unique foundation for his analytical approach to investing.

"The philosophy we have today is predicated that over a rolling 10 year period you have about 40 stocks that compound wealth at 20 a year or go up a little bit over six x so about 1 of the stock market are the valedictorians and that's what we want to go do like a lot of things in life you get through looking at lateral examples biology and then you look at anecdotes and then if you like to double click or you're maybe a geek on data you start to really study it and then obviously since then we've tried to create an investment philosophy that maximizes the probability of investing in those 40 companies and the other thing that we have basically found out is that was interesting is about 80 of those companies actually start their compounding journey as small cap companies"

Henry Ellenbogen highlights a core tenet of his investment strategy: identifying the rare "valedictorian" stocks that drive significant long-term wealth creation. He quantifies this by stating that approximately 40 stocks, or about 1% of the market, compound wealth at 20% annually over a decade. Ellenbogen also notes a crucial pattern: a significant majority (80%) of these high-performing companies begin their journey as small-cap entities, which informs his focus on this segment of the market.

"The first is if you've been one before you have a higher probability of being one again which just sounds so simple but is actually really interesting we look at who has actually done it and if we don't really know the company and we haven't studied it before we'll go double click and go essentially study it see if there's an opportunity but if not go do a case study on it so we want to go learn it one of my partners annukdate basically teaches a class she's amazing at columbia business school the value analysis program and partially this is our way of going back to school as an organization and partially is our way of giving back to our community but the class is based on this and the students literally do about six case studies a year so i would say you just start by basically studying the ones who've done it and then obviously trying to study the patterns of those who've done it that's number one in how we do it"

Henry Ellenbogen emphasizes a key indicator for identifying potential top-performing companies: prior success. He believes that companies and founders who have previously achieved significant compounding growth have a higher probability of repeating that success. Ellenbogen's firm actively studies these past successes, even incorporating this into an academic setting through a class taught by one of his partners, to build a comprehensive understanding of the patterns associated with enduring wealth creation.

"The other thing that's hard about it is when i went and looked at these firms i do think there's a level of growth you have to pursue durables a performance driven organization we break every tie in pursuit of investment excellence we haven't really you know market ourselves or tried to get new investments since 2022 and why is that well i think we're performing really really well but i just believe markets are pretty full and we're a long only firm we're not going to short it we're not going to really try to time markets but if you're going to be our investor over time and we're going to do well by you we should probably take more of your capital when i'm balanced the entry point is lower than higher we're going to break everything we're going to really understand if we're going to do less what it means to be able to on the public side to be able to own meaningful positions and companies to really be able to trade if there's quarterly volatility such that we can buy more when things are attractive everything that if we're only going to do maybe five i think since 2023 we've done 14 new private investments so we're back to doing five a year if we're only going to go do five and we're going to start relatively small a lot of times we start by investing 10 or 20 million dollars it's going to make an impact for our investors right we got to be a performance driven organization and for our entrepreneurs we got to be able to do exactly what we've done for louise we have to be able to do for dylan i think we're doing for dylan we have to be able to support canva and bending spoons and the next generation of those so we got to go do that"

Henry Ellenbogen explains Durable Capital's disciplined approach to growth and investment selection, emphasizing their focus on investment excellence over aggressive marketing. He notes that the firm has not actively sought new investments since 2022, attributing this to strong performance and a belief that markets are currently full. Ellenbogen highlights their strategy of taking more capital from existing investors when entry points are favorable and their commitment to making a significant impact with a limited number of new investments, particularly in private companies.

"I think we want to have fun and we actually root for everyone the reason i say this is i'm a huge sports fan i love studying sports to me there's two types of competitive greatness and they both work there's michael jordan who was such a fierce competitor that essentially if you didn't rise to his level he drove you out of there and it works and those bulls showed up with a chip on their shoulder every game and it was amazing and they were great and then there are the people who play basketball and they say this game is great we want to have fun and we want to elevate the game and we want to win and that people who compete with us we think they're great and we're rooting for them now of course if we're going to play against them we're going to be competitive on that day and we're going to win

Resources

External Resources

Books

  • "The Intelligent Investor" by Benjamin Graham - Mentioned as a foundational text for understanding value investing principles.

Articles & Papers

  • Colossus profile on Henry Ellenbogen (Colossus) - Traces Henry's story and his rise as an influential investor.
  • Study from Chicago on the 4 things (University of Chicago) - Referenced for its insights into market performance.

People

  • Henry Ellenbogen - Founder and Managing Partner of Durable Capital Partners, guest on the podcast.
  • Jack LaPorte - Henry Ellenbogen's mentor at T. Rowe Price.
  • Sam Walton - Founder of Walmart, mentioned in relation to the New Horizons Fund's history.
  • Jeff Bezos - Founder of Amazon, learned from by Henry Ellenbogen.
  • John Malone - Mentioned as an individual Henry Ellenbogen learned from.
  • Dom Cooke - Managing Editor at Colossus, wrote a profile on Henry Ellenbogen.
  • Anuk Date - Partner at Durable Capital Partners, teaches a value analysis program at Columbia Business School.
  • Luis von Ahn - CEO of Duolingo, discussed for his leadership and technological expertise.
  • Toby - Founder of Shopify, compared to Luis von Ahn for technological strength.
  • Aneel Bhusri - Co-founder of Workday, pioneered HR systems of record.
  • Dave Duffield - Co-founder of Workday, pioneered HR systems of record.
  • Max Levchin - Co-founder of PayPal, founder of Affirm, discussed as an Act II entrepreneur.
  • Brian Strang - Technical Operations Lead at Congress Asset Management, shared his experience with Ridgeline.
  • Mitch Rales - Co-founder of Danaher, brought Kaizen to the US.
  • Steve - Mentioned in relation to learning from Lone Pine.
  • Peter Drucker - Mentor to Jay Henick, influential in his understanding of incentives.
  • Jay Henick - CEO of Colliers, founder of First Service, discussed for his capital allocation and incentive alignment.
  • Reed Hastings - Founder of Netflix, discussed for navigating the transition to streaming.
  • Steve Kerr - Coach of the Golden State Warriors, discussed for his leadership style.
  • John Wooden - Legendary basketball coach, discussed for his coaching philosophy.
  • Magic Johnson - Basketball player, associated with the Lakers' fun and elevating style of play.
  • Draymond Green - Basketball player, associated with the Warriors' energy and transformation of the game.
  • Klay Thompson - Basketball player, associated with the Warriors' energy and transformation of the game.
  • Kareem Abdul-Jabbar - Basketball player, discussed as one of the greatest college basketball players.
  • Bill Walton - Basketball player, discussed as one of the greatest college basketball players.

Organizations & Institutions

  • Durable Capital Partners - Henry Ellenbogen's investment firm.
  • T. Rowe Price - Investment firm where Henry Ellenbogen built his reputation.
  • New Horizons Fund (T. Rowe Price) - Small-cap growth portfolio led by Henry Ellenbogen.
  • Walmart - Mentioned in relation to its IPO and historical significance.
  • Columbia Business School - Where Anuk Date teaches a value analysis program.
  • Workday - Company co-founded by Aneel Bhusri and Dave Duffield, discussed for its cloud-based HR systems.
  • Peoplesoft - Company pioneered by Aneel Bhusri and Dave Duffield.
  • Oracle - Acquired Peoplesoft.
  • Duolingo - Language learning platform, a significant holding of Durable Capital Partners.
  • Shopify - E-commerce platform, mentioned in relation to its founder Toby.
  • Affirm - Fintech company founded by Max Levchin, discussed for its use of AI.
  • PayPal - Co-founded by Max Levchin.
  • Slide - Company founded by Max Levchin.
  • Congress Asset Management - Client of Ridgeline.
  • Danaher - Company co-founded by Mitch Rales and Steve Rales, known for implementing Kaizen.
  • GE - Company turned around by a former Danaher executive.
  • Amazon - E-commerce giant, discussed for its cost curve advantage and use of technology.
  • Costco - Retail company, mentioned alongside Walmart and Amazon for leveraging advantages.
  • Domino's Pizza - Discussed for its successful use of technology to improve convenience and customer relationships.
  • Carvana - Online used car retailer, mentioned for its reconditioning centers.
  • Colliers - Real estate services company, discussed for its asset management and consulting platform.
  • First Service - Company founded by Jay Henick.
  • Harrison Street - Real estate asset management firm, part of Colliers.
  • Two Sigma - Quantitative hedge fund, discussed in relation to man versus machine investing.
  • Millennium Management - Hedge fund, discussed in relation to market structure and short-term capital.
  • Citadel - Hedge fund, discussed in relation to market structure and short-term capital.
  • Valeo - Hedge fund, discussed in relation to market structure and short-term capital.
  • Point72 - Hedge fund, discussed in relation to market structure and short-term capital.
  • Netflix - Streaming service, discussed for its transition to streaming and original content.
  • Disney - Media conglomerate, mentioned in relation to content and distribution.
  • Viacom - Media conglomerate, mentioned in relation to content and distribution.
  • Comcast - Media conglomerate, mentioned in relation to content and distribution.
  • Time Warner - Media conglomerate, mentioned in relation to content and distribution.
  • OpenAI - Artificial intelligence research laboratory, discussed for its AI advancements.
  • Apple - Technology company, mentioned for its AirPods and translation capabilities.
  • UCLA - University basketball program, associated with John Wooden.
  • Golden State Warriors - Professional basketball team, discussed for their style of play and innovation.
  • Lakers - Professional basketball team, associated with Magic Johnson.

Tools & Software

  • Ramp - Financial management platform for companies.
  • Ridgeline - Operating system for investment managers.
  • AlphaSense - Market intelligence platform for investors.
  • Tegus - Platform for research and insights.

Websites & Online Resources

  • ramp.com/invest - Website for Ramp.
  • ridgelineapps.com - Website for Ridgeline.
  • Alpha-Sense.com/Invest - Website for AlphaSense.
  • thepodcastconsultant.com - Website for The Podcast Consultant.
  • joincolossus.com - Website for Colossus.
  • psum.vc - Website for Positive Sum.

Other Resources

  • Act II teams - Founders applying lessons from a first company to a new frontier.
  • Dollar Cost Averaging Up - Investment strategy of buying more as a stock price increases.
  • Kaizen - Japanese philosophy of continuous improvement, applied to business processes.
  • Physical Kaizen - Application of Kaizen to physical labor and manufacturing.
  • Digital Kaizen - Application of Kaizen to digital processes and white-collar work.
  • Robotics - Technology discussed for its potential to lower costs and drive efficiency.
  • AI (Artificial Intelligence) - Discussed as a transformative technology impacting various industries.
  • Internet - Previous technological shift discussed for its impact.
  • Mobile - Previous technological shift discussed for its impact.
  • Cloud - Previous technological shift discussed for its impact.
  • Small Cap Companies - Companies that often start their compounding journey as small caps.
  • Compounders - Companies that consistently compound wealth over time.
  • Good to Great Thesis - Internal concept at Durable focusing on companies that can improve significantly.
  • Human Capital - Emphasized as a key source of competitive advantage.
  • Scale - A competitive advantage discussed in relation to companies.
  • Network Effects - A competitive advantage discussed in relation to companies.
  • Investment Memo - Document used by Durable to articulate investment theses.
  • Kaisan - Japanese philosophy of continuous improvement.
  • Positive Sum - Company associated with Patrick O'Shaughnessy.
  • Colossus Review - Quarterly publication by Colossus.
  • Man Versus Machine - Concept discussed in relation to investing.
  • Agency Principle - Discussed in relation to short-term market views.
  • IP Based - Refers to businesses leveraging intellectual property, contrasted with product-based businesses.
  • Fulfillment Centers - Physical infrastructure used by companies like Amazon.
  • Cost Curve - The trajectory of cost reduction over time.
  • Intellectual Honesty - A principle valued at Durable Capital Partners.
  • Resilience - A key trait sought in people and companies.
  • Humility - A principle valued at Durable Capital Partners.
  • Fiduciary Duty - The obligation to act in the best interests of investors.
  • Growth - Measured by market share.
  • Profitability - Drives efficiency and discipline.
  • Innovation - Essential for long-term success.

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