Narrow Focus
This week we discuss the most recent report on Evolution, confirmation bias, and why AI won't kill Google's business
Dear Clients and Friends of Farrer Wealth Advisors, we are pleased to bring you the Farrer Wealth newsletter, which includes our latest blog posts, fun facts, and general articles we find interesting. Happy reading and happy investing!
Disclaimer - This newsletter is for informational purposes only. None of the below should be considered investment advice nor solicitation for investment. Please see full disclosures at the end of this newsletter.
Latest Blog Post
Narrow Focus
It happened again folks, like clockwork – the once-a-year-without-fail short report on Evolution came out this week. Longtime readers would know that Farrer has been invested in Evolution for quite a while. The company is controversial because it operates in a space (online gambling) that undoubtedly has dark edges. Further, it is stated clearly by the company that most of its revenues comes from “unregulated” markets. Thus, it is an easy target for those who want to overemphasize those risks for either clout, money, or a genuine desire to highlight risks to investors.
Since 2021, the most serious of reports was lodged with the New Jersey Division of Gaming Enforcement (NJDGE) accusing Evolution of all sorts of malpractice. In the end, the NJDE dropped the case against Evolution after almost three years of investigation finding no evidence behind the allegations. However, the report has had a lasting effect and following its release, almost every year we get a short-report, lawsuit, or some sort of news (intended or not) that drives Evolution’s stock price down.
This week, InPractise (IP), a primary research firm, dropped a report on Evolution titled “Evolution Gaming’s Asia and Crypto Risk” which highlighted potential issues related to the revenues Evolution derives from Asia. Now, the IP team went out of its way to highlight that this is not a short report, and that they hold no position in the company. However, the report is written in an overwhelmingly negative fashion. Which makes me think - if it walks like a duck, talks like a duck…
When the 2021 report was lodged with the NJDGE, I wrote a piece discussing the various points of the report (can read it here). However, I’m not going to do that again. For one, I think constantly defending a position makes it hard for you to sell later, but also, I don’t know if the IP report produced much new information (though the murkiness of what is ‘grey market’ vs a ‘black market’ and how this could be decided by the whims and fancies of a regulator was a good point).
Now let me be clear. I am not going to assign nefarious reasoning behind the release of the IP report. I have met one of the co-founders before, been invited to speak on their panels (coincidently about Evolution) and found nothing untoward about them. So, when they say that they released the report simply to highlight risks to investors, I’m going to take that purpose at face value.
However, I do think the report is a good study in confirmation bias and how this leads to process errors in investing. I’ll also go through examples of my own errors, so it doesn’t seem like I’m just ‘picking’ on someone who released a negative report about one of our holdings.
To establish that confirmation bias exists, you first must establish a bias. In my interactions with IP and based on the snippets of the various interviews they release, it's hard to say they don’t have a negative bias toward Evolution. Let me highlight some of the interview titles/snippets they’ve released over the past ~2 years:
Evolution Gaming: B2B Aggregators and Regulatory Outlook
Evolution Gaming: Aggregator / Operator Relationship
Evolution Gaming: Asian B2B Landscape
Evolution Gaming: Europe vs Asian Live Casino Distribution
Evolution Gaming: Asia iGaming Value Chain & Crypto Casinos
Evolution Gaming: Workings of A Crypto Casino
Evolution: Crypto Player Behaviour & Payments Flow
Ever since the 2021 report was released it does seem like IP is biased toward finding out more about Evolutions operations in a few areas 1) Unregulated markets (in particular Asia) 2) its Aggregator distribution model and 3) Crypto casinos. Power to them here, the company, for example, doesn’t go into detail about its Asia operations, so investors are left to find out for themselves. Further, there are undeniable ‘dark’ parts of the online gambling industry in Asia. Do aggregators (Evolution’s clients) bend rules? It certainly seems so. Do they use agents who at times will circumvent the law? Yep. Do online casinos use/accept crypto? Absolutely! (although I don’t see how this is a problem, if cafés and bars accept crypto now, why shouldn’t casinos?)
The point is not that these are not worth investigating, but what the report tries to do is point to all these “issues” and then link them back to potential problems for Evolution, and this is where I think the confirmation bias lies. If you believe X then you will find all sorts of things to prove X and ignore what proves Y. IP thinks negatively of Evolution, and thus will try to link risks back to them. Let me use a few examples –
The IP report implies that Asian revenues/profits are at particular risk due to the higher concentration of crypto casinos in the region. “Our research suggests Asia could generate ~50% of (Evolution’s) EBITDA, of which crypto is crucial to a significant majority.”
It then quotes a “Former CEO of a Crypto Operator” who states “When crypto is in a bear market, the volume of deposits always decreases. Conversely, when it's in a bull run, it increases”
These two quotes imply that Evolution is earning much of its EBITDA from Asia (which could be true, as Asia accounts for 38% of total revenues), but more importantly that much of this EBITDA is derived from crypto, and thus will be highly sensitive to the price of crypto. But the evidence doesn’t allow this assumption to hold water. In 2022 when bitcoin fell 65%, Evolution’s Asia revenues increased 67% and overall EBITDA margins increased ~50bps (we don’t know EBITDA at a regional level).
There was another instance where the IP report tries to link increasing crypto exposure to the reason why 2022 accounts receivables days increased. The implication is that as crypto prices fall then operators/aggregators suffer and thus take longer/default on payments to Evolution (who bills in fiat currency). However, account receivable days also increased in 2023, a year when bitcoin zoomed ~150%. Further since the IP report was released Evolution has clarified crypto only makes up a single digit percentage of Gross Gaming Revenue, which makes IP’s claims of correlation even more tenuous. There were other allegations about aggregators/agents, but even IP has to admit Evolution is just a supplier, there is only so much they can control their clients, and any oversight should be done on moral reasons.
My point here is not that IP did something dirty, but simply that they made mistakes that all investors do repeatedly. They had a point of view and tried to support it when the facts pointed the other way. I made my own version of this mistake years ago (in fact I feel mine was even more blatant). Still hazy from 2020 I was convinced that online marketplaces are amazing businesses (I have since tempered this belief). In 2021, I started to investigate a company called Redbubble. It was an Australian marketplace for ‘unique’ merchandise. I was impressed by its growth, its unique model (it produces goods for the artists) and its long tail of designs. Perhaps because I was looking to continue my 2020 run or that I had seen other investors make good money in this stock, I really wanted the investment to work. This desire warped into blinders, and I remember totally ignoring two pieces of strong evidence about the weakness behind the company.
Purchases per active user was something like 1.2x – which implied that there was little stickiness with the user base. In fact, a lot of the ‘growth’ that attracted me was driven by mask sales and I’m sure you can can guess what happened to that growth when covid ended.
We found a senior ex-employee to speak to via LinkedIn and he brought up a point that still sticks with me today. He mentioned that unaided brand awareness was poor. So poor in fact, that users would buy items off Redbubble but also claim to have never heard of the brand. Essentially, they would Google for a “unicorn face mask,” find it on the site, buy it, but never connect the purchase to the brand. This implied that the company would remain captured by the Google ‘tax’. To make this worse, I had personally bought something of Redbubble and not realized it!
These two points alone should have made me drop the idea, but I wanted to do the investment, and thus ignored these two glaring points. The investment was a dog, and we sold out around A$3.50 for a ~35% loss when other parts of the thesis broke (the stock now trades around A$0.60 – so silver lining?). The failed investment was a painful reminder of how crippling confirmation bias can be. When you strongly believe that a certain company is a good or bad investment your focus narrows, your blinders come on, and you fall prey to confirmation bias.
Confirmation bias isn’t limited to investing of course. It's pervasive in all forms of thinking. The clearest example is in politics. Rarely do you find measured opinions in this hellhole of a topic. For example, depending on your point of view, Trump is either all good or all bad. He could save puppies from a burning building and if your bias is that “Trump is bad,” you will discount that action and think it was a media grab. If he were to rob a bank in front of you and your bias is that “Trump is good,” you would think that bank had it coming.
It’s a hard bias to fight. We are pre-programmed to think in the binary. When our ancestors saw the tall grass move in the savannah, they either ran or prepared to fight. Anyone who dilly-dallied probably got eaten. Coming back to the investing world, there are ways to fight this bias of course. Pre-mortems, idea-killing exercises, inversion etc. all help. Its also important to go into a research process without any set assumptions (good investigative journalists do this well). However, when it comes to fighting confirmation bias, it’s a constant battle against what’s built within us, so I wish us all the best of luck dealing with it.
Thanks for reading and happy investing.
Chart of the Week
100-Baggers: This was a great list of the companies whose stock’s have 100x over the past 15 years (source). I hope the companies in your portfolio make this list one day.
Links of the Week
This was a well researched article about why AI search engines can’t kill Google.
We talked about process errors above, this blog post gives you a ‘negative’ checklist that helps to reduce errors in investing.
Mildly preachy - but this was a good list highlighting 17 Thoughts about Money.
Is private equity actually worth it? The FT finds out.
Not investing related but I found this list of five simple tests to see how long you will live fascinating. Thanks Ahmed for the share.
A kind request - if you enjoyed this newsletter, I would be most grateful if you could give it a ‘like’ or share it. Thank you!