This episode reveals how a mere 1% of public stocks drive market wealth, and why AI is now the ultimate catalyst for identifying these rare compounders across every sector.
The 1% Rule: Unearthing Generational Companies
- Ellenbogen discovered that over a rolling 10-year period, approximately 40 stocks (1% of the market) compound wealth at 20% annually, achieving over 6x returns.
- 80% of these wealth-compounding companies begin their journey as small-cap entities.
- A critical lesson emerged from Walmart's early sale: one "bad" decision (or daily market pressure) can mathematically erase numerous good ones.
- Ellenbogen states, "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 6x. So about 1% of the stock market is the are the validictorians."
Identifying Compounders: "Good to Great" and Act 2 Teams
- Ellenbogen emphasizes studying companies that have previously compounded wealth, building a "library" of case studies to identify recurring patterns.
- The "Good to Great" thesis applies to diversified companies outside traditional tech, like Domino's Pizza, which leveraged technology (its app) to enhance convenience and gain market share.
- "Act 2" teams—experienced founders solving new problems with modern technology—demonstrate a higher probability of success. Aneel Bhusri and Dave Duffield (Workday) and Max Levchin (Affirm) exemplify this.
- Ellenbogen notes, "If you've been one before, you have a higher probability of being one again."
Durable's Purpose-Built Philosophy and Market Volatility
- Durable allocates 10-15% of its capital to private markets, viewing early-stage growth companies as future compounders, not just short-term plays.
- Investment memos are structured to articulate a thesis for buying more shares at higher prices if the company executes, rather than focusing on an exit strategy.
- Ellenbogen argues that 80-90% of institutional flow is driven by firms with short-term (1-3 month) horizons or quants, leading to increased earnings volatility.
- This short-term focus creates opportunities for long-term investors to "dollar-cost average down" into fundamentally strong companies during market sell-offs, as seen with Colliers and Duolingo.
- Ellenbogen asserts, "If you work at a firm that deeply measures your risk every day... it probably means you can't have a time horizon longer than your career horizon."
AI: Kaizen for Human Work and Uncatchable Advantages
- AI enables "Kaizen for human work," allowing companies like Affirm to significantly reduce legal and compliance costs without adding headcount.
- This shift mirrors the "China cost" phenomenon of the 2010s, where product-based businesses had to leverage global supply chains for cost advantage; AI now applies this to IP-driven processes.
- Ellenbogen draws an analogy to Amazon's early strategy: leveraging a 3-5% cost advantage to reinvest in physical infrastructure (fulfillment centers), creating an uncatchable, persistent competitive moat.
- Robotics, powered by general-purpose Large Language Models (LLMs), is poised to deflate physical labor costs at 15-20% annually, creating "power law businesses" for early adopters.
- Ellenbogen states, "AI represents a sort of kickoff of Kaizen to human work world and that that is going to have lots of stories like the Amazon story you just said where someone gets on one of these curves early and they can't be caught."
Public Markets: Discipline, Alignment, and Enduring Moats
- Public markets provide "daily marks" and a depth of investors that force companies to balance growth, profitability, and innovation, preventing complacency.
- The Netflix transition from DVD mail to streaming exemplifies this: public market pressure (stock dropping from $280 to $70) forced Reed Hastings to realign strategy and raise capital, ultimately leading to massive success.
- Ellenbogen favors "physical real estate" as a competitive advantage (e.g., Amazon's fulfillment centers, Carvana's reconditioning centers) due to its difficulty to replicate.
- He also values "soft" competitive advantages: exceptional human capital, operating excellence, strong culture, and disciplined capital allocation, as seen in companies like Danaher and Colliers.
- Ellenbogen argues, "The path to building a compounder or even a what some people would say a generational company through the public markets is, you know, proven and if you understand how to do it actually very clear what you do."
Building a Durable Firm: Culture of Learning and Excellence
- Durable aims to build an investment firm that improves beyond its founders' tenure, fostering internal talent from diverse backgrounds.
- The firm prioritizes intellectual curiosity, team-based competition, and resilience, recognizing that even great companies experience volatility.
- Internal processes, like detailed investment memos, quarterly operating reviews, and three-year look-backs, ensure accountability and continuous learning without punitive blame.
- Ellenbogen advocates for an "and business" approach: driving growth, innovation, and profitability, using the CFO function to set standards that force sharp, agile decision-making.
- Ellenbogen emphasizes, "We want people who compete but want to compete as a team sport."
Investor & Researcher Alpha
- Capital Reallocation: Investors should scrutinize non-tech companies for their AI adoption strategies. The "Kaizen for human work" thesis suggests significant cost advantages and market share gains are imminent in IP-heavy traditional businesses, not just pure-play AI firms.
- New Bottlenecks: The ability to integrate AI into existing physical and technological infrastructure will become a critical differentiator. Companies with established distribution networks or complex physical assets (like reconditioning centers) that can leverage AI/robotics will create unassailable moats.
- Research Direction: Focus research on "Act 2" entrepreneurs and management teams with proven resilience and a track record of navigating technological shifts. Their ability to apply past learnings to new AI-driven challenges offers a higher probability of success than entirely new ventures.
Strategic Conclusion
The future of wealth creation lies in identifying the rare 1% of companies that master the "and business" of growth, innovation, and profitability. AI accelerates this by extending Kaizen to human work, creating uncatchable competitive advantages for disciplined leaders who embrace public market accountability. The next step for investors is to actively seek these "good to great" transformations across the entire economy.
