Bad Blood

(Image: Zen Buddha Silence by Marilyn Barbone)

July 21, 2019

Bad Blood: Secrets and Lies in a Silicon Valley Startup, by John Carreyrou, is hands-down one of the best business books I’ve ever read.  (It’s up there with Business Adventures, by John Brooks, and Shoe Dog, by Phil Knight.)  The book tells the story of the rise and fall of Theranos. 

In brief, here’s why it’s such a great book: Carreyrou was the investigative reporter who broke the Theranos story in 2015.  Carreyrou interviewed 150 people and withstood enormous pressure from the company’s charismatic CEO and her attorneys—led by one of the best and most feared lawyers in the country.  Other key whistle-blowers also withstood great pressure.  Many of the facts of the story are unbelievable.  And finally, Carreyrou does an outstanding job telling the story.

Theranos was a company founded by Stanford dropout Elizabeth Holmes when she was just 19 years old.  She claimed that she had invented a semi-portable device that could do every kind of blood test using only a tiny drop of blood obtained by a pin prick to the end of a finger.  Holmes declared that you could get the results in a few hours and at a much lower price than what other labs charged.

Had Theranos’s technology worked, it would have been revolutionary.  The only problem: it never came close to working.  There are different kinds of blood tests that require different laboratory instruments.  If you do one kind of blood test on a tiny sample, there isn’t enough blood left to do the other kinds of blood tests.

But Holmes believed in her vision so much, and she was such a charismatic and brilliant saleswoman, that she raised close to $1 billion dollars from investors.  This included $700 million in late 2013.  How?  See this CNN Business interview (Sept. 20, 2018): https://www.youtube.com/watch?v=BXfw-S62ISE

As Carreyrou explains to Julia Chatterley in the CNN Business interview: Holmes launched the purportedly innovative technology in Walgreens stores in California and Arizona.  In addition, when seeking investors, she focused on the family offices of billionaires while avoiding investors with any sophistication related to next-gen diagnostics.  When the less sophisticated investors learned that Theranos was giving blood tests in Walgreens stores, they assumed that its technology must be real.

Theranos offered 250 blood tests.  Unbeknownst to investors and to Theranos’s business partners—Walgreens and Safeway—240 of these tests were actually done on Siemens machines.  Theranos would collect tiny blood samples from finger pricks and then dilute them so that the Siemens machine could analyze them.  (This also required modifications to the Siemens machines that Theranos engineers had figured out.)

Only 10 of the 250 blood tests offered by Theranos were done on the company’s machine, the Edison.  Moreover, the Edison was shockingly unreliable.  Ultimately, a million blood tests done by Edison machines were voided.

Here is the outline for this blog post.  (The outline does not include the Prologue and the Epilogue, which I also touch on.)

  1. A Purposeful Life
  2. The Gluebot
  3. Apply Envy
  4. Goodbye East Paly
  5. The Childhood Neighbor
  6. Sunny
  7. Dr. J
  8. The miniLab
  9. The Wellness Play
  10. “Who is LTC Shoemaker?”
  11. Lighting a Fuisz
  12. Ian Gibbons
  13. Chiat/Day
  14. Going Live
  15. Unicorn
  16. The Grandson
  17. Fame
  18. The Hippocratic Oath
  19. The Tip
  20. The Ambush
  21. Trade Secrets
  22. La Mattanza
  23. Damage Control
  24. The Empress Has No Clothes

 

PROLOGUE

November 17, 2006.  Henry Mosley, Theranos’s chief financial officer.  Good news from Tim Kemp: Elizabeth Holmes, the twenty-two year old founder, had shown off the company’s system to executives at Novartis, a European drug giant. She had told Kemp, “It was perfect!”

Carreyrou writes:

This was a pivotal moment for Theranos.  The three-year-old startup had progressed from an ambitious idea Holmes had dreamed up in her Stanford dorm room to an actual product a huge multinational corporation was interested in using.

Mosley was a veteran of Silicon Valley.  Carreyrou again:

What had drawn Mosley to Theranos was the talent and experience gathered around Elizabeth.  She might be young, but she was surrounded by an all-star cast.  The chairman of her board was Donald L. Lucas, the venture capitalist who had groomed billionaire software entrepreneur Larry Ellison and helped him take Oracle Corporation public in the mid-1980s. Lucas and Ellison had both put some of their own money into Theranos.

Another board member with a sterling reputation was Channing Robertson, the associate dean of Stanford’s School of Engineering. Robertson was one of the stars of the Stanford faculty… Based on the few interactions Mosley had had with him, it was clear Robertson thought the world of Elizabeth.

Carreyrou says that Theranos also had a strong management team, which impressed Mosley.  Furthermore, Mosley understood that the market Theranos was targeting was huge.  Pharmaceutical companies spent tens of billions of dollars on clinical trials to test new drugs each year.  If Theranos could make itself indispensable to them and capture a fraction of that spending, it could make a killing.

Carreyrou notes that Elizabeth had asked Mosley for some financial projections, which he provided. Elizabeth asked him to revise the projections upward.  Mosley was a bit uncomfortable, but he knew it was a part of the game new tech startups played to attract VC money.

Something wasn’t right, though.  Although Elizabeth was enthusiastic about the presentation to Novartis, some of her colleagues seemed downcast.  With some digging, Mosley found out the problem from Shaunak, a fellow employee. Theranos’s blood-testing system was unreliable. This was the first Mosley heard about the issue.

Well, there was a reason it always seemed to work, Shaunak said.  The image on the computer screen showing the blood and settling into he little wells was real.  But you never knew whether you were going to get a result or not.  So they’d recorded a result from one of the times it worked. It was that recorded result that was displayed at the end of each demo.

Mosley was stunned.  He thought the result were extracted in real time from the blood inside the cartridge.  That was certainly what the investors he brought by were led to believe.  What Shaunak had just described sounded like a sham. It was OK to be optimistic and aspirational when you pitched investors, but there was a line not to cross.  And this, in Mosley’s view, crossed.

Later, Mosley politely raised the issue with Elizabeth.  Mosley said they couldn’t keep fooling investors.  Elizabeth’s expression immediately became hostile.  She told Mosley he wasn’t a team player and said he should leave immediately.  Elizabeth had fired him.

 

A PURPOSEFUL LIFE

Elizabeth wanted to be an entrepreneur at a young age.  Carreyrou:

When she was seven, she set out to design a time machine and filled up a notebook with detailed engineering drawings.

When she was nine or ten, one of her relatives asked her at a family gathering the question every boy and girl is asked sooner or later: “What do you want to do when you grow up?”

Without skipping a beat, Elizabeth replied, “I want to be a billionaire.”

These weren’t the idle words of a child.  Elizabeth uttered them with he utmost seriousness and determination, according to a family member who witnessed the scene.

Carreyrou explains that Elizabeth’s parents encouraged her ambition based on a distinguished family history.  She descended from Charles Louis Fleischmann on her father’s side.  Fleischmann was a Hungarian immigrant who created the Fleischmann Yeast Company, which was remarkably successful.  The Fleischmanns were one of the wealthiest families in America at the beginning of the twentieth century. 

Bettie Fleischmann, Charles’s daughter, married her father’s Danish physician, Dr. Christian Holmes.  He was Elizabeth’s great-great-grandfather.

Aided by the political and business connections of his wife’s wealthy family, Dr. Holmes established Cincinnati General Hospital and the University of Cincinnati’s medical school.  So the case could be made—and it would in fact be made to the venture capitalists clustered on Sand Hill Road near the Stanford University campus—that Elizabeth didn’t just inherit entrepreneurial genes, but medical ones too.

Elizabeth’s mother, Noel, also had notable family background.  Noel’s father was a West Point graduate who became a high-ranking Pentagon official who oversaw the shift from draft-based military to an all-volunteer force in the early 1970s.  The Daoust line could be traced back to one of Napoleon’s top field generals.

Chris Holmes also made sure to teach his daughter about the failings of his father and grandfather.  They had cycled through marriages and struggled with alcoholism while they squandered the family fortune.  Elizabeth later explained that she learned about greatness, but also about what happens if you don’t have a high purpose—your character and qualify of life suffered.

When Elizabeth was a kid, she liked to play monopoly with her cousins and brother.  She was intensely competitive.  She got furious when she lost and at least a few times ran right through a screen on the front door of the condo owned by her aunt and uncle.

Elizabeth became a straight-A student in high school by working hard and sacrificing sleep.  Stanford was the natural choice for someone interested in computers and science who wanted to be an entrepreneur.  She was accepted to Stanford as a President’s Scholar in the spring of 2002.

Carreyrou explains how Elizabeth got interested in biotechnology:

Her father had drilled into her the notion that she should live a purposeful life.  During his career in public service, Chris Holmes had overseen humanitarian efforts like the 1980 Mariel boatlift, in which more than one hundred thousand Cubans and Haitians migrated to the United States.  There were pictures around the house of him provided disaster relief in war-torn countries.  The message Elizabeth took away from them is that if she wanted to truly leave her mark on the world, she would need to accomplish something that furthered the greater good, not just become rich.  Biotechnology offered the prospect of achieving both.  She chose to study chemical engineering, a field that provided a natural gateway to the industry.

Elizabeth took Introduction to Chemical Engineering from star faculty member Channing Robertson.  She also convinced him to let her work in his lab.  She had a boyfriend for a time, but broke up telling him that she was starting a company and wouldn’t have any time to date.

After her freshman year, Elizabeth had a summer internship at the Genome Institute of Singapore.  Earlier that year (2003), severe acute respiratory syndrome (SARS) had hit Asia.  Elizabeth’s job was testing patient specimens gathered using low-tech methods like syringes.  She thought there was a better way.  Carreyrou:

When she got back home to Houston, she sat down at her computer for five straight days, sleeping one or two hours a night and eating from trays of food her mother brought her.  Drawing from new technologies she had learned about during her internship and in Robertson’s classes, she wrote a patent application for an arm patch that would simultaneously diagnose medical conditions and treat them.

Robertson was impressed, saying:

“She had somehow been able to take and synthesis these pieces of science and engineering and technology that I had never thought of.”

Robertson urged Elizabeth to follow her dream.  So she did: she launched a startup, tapping family connections to raise money.  By the end of 2006, she had raised almost $6 million. Her first employee was Shaunak Roy, who had a Ph.D. in chemical engineering.  Elizabeth had worked with Shaunak in Robertson’s lab.

Elizabeth and Shaunak dropped the patch idea and came up with a cartridge-and-reader system:

The patient would prick her finger to draw a small sample of blood and place it in a cartridge that looked like a thick credit card.  The cartridge would slot into a bigger machine called a reader.  Pumps inside the reader would push the blood through tiny channels in the cartridge and into little wells coated with proteins known as antibodies.  On its way to the wells, a filter would separate the blood’s solid elements, its red and white blood cells, from the plasma and let only the plasma through.  When the plasma came into contact with the antibodies, a chemical reaction would produce a signal that would be “read” by the reader and translated into a result.

Elizabeth envisioned placing the cartridges and readers in patient’s homes so that they could test their blood regularly.  A cellular antenna on the reader would send the test results to the computer of a patient’s doctor by way of a central server. This would allow the doctor to make adjustments to the patient’s medication quickly, rather than waiting for the patient to go get his blood tested at a blood-draw center or during his next office visit.

By late 2005, eighteen months after he’d come on board, Shaunak was beginning to feel like they were making progress.  The company had a prototype, dubbed the Theranos 1.0, and had grown to two dozen employees.  It also had a business model it hoped would quickly generate revenues: it planned to license its blood-testing technology to pharmaceutical companies to help them catch adverse drug reactions during clinical trials.

 

THE GLUEBOT

Edmund Ku was a talented engineer with a reputation for fixing tough problems.  When Ku interviewed with Elizabeth Holmes in early 2006, he felt inspired by her vision.

Elizabeth cited the fact that an estimated one hundred thousand Americans died each year from adverse drug reactions.  Theranos would eliminate all those deaths, she said.  It would quite literally save lives.

Ed’s job would be to turn the Theranos 1.0 prototype into a product that could be commercialized.  It soon became clear to Ed that this would be the most difficult engineering challenge he had faced.  The main challenge was that Elizabeth required that they use only a drop of blood pricked from the end of a finger.

Her obsession with miniaturization extended to the cartridge.  She wanted it to fit in the palm of a hand, further complicating Ed’s task.  He and his team spent months reengineering it, but they never reached a point where they could reliably reproduce the same test results from the same blood samples.

The quantity of blood they were allowed to work with was so small that it had to bediluted with a saline solution to create more volume.  That made what would otherwise have been relatively routine chemistry work a lot more challenging.

Adding another level of complexity, blood and saline weren’t the only fluids that had to flow through the cartridge.  The reactions that occurred when the blood reached the little wells required chemicals known as reagents.  Those were stored in separate chambers. 

All these fluids needed to flow through the cartridge in a meticulously choreographed sequence, so the cartridge contained little valves that opened and shut at precise intervals.  Ed and his engineers tinkered with the design and the timing of the valves and the speed at which the various fluids were pumped through the cartridge.

Another problem was preventing all those fluids from leaking and contaminating one another.

Meanwhile, having burned through its first $6 million, Theranos raised another $9 million.  A separate group of biochemists worked on the chemistry work.  But Elizabeth kept the two groups from communicating with one another.  She preferred to be the only one who could see the whole system.  This was far from ideal.  Ed couldn’t tell if problems they were trying to solve were caused by microfluidics, which was their focus, or chemistry, which the other group was responsible for.

One evening, Elizabeth told Ed that progress wasn’t fast enough.  She wanted the engineering department to run twenty-four hours a day.  Ed disagreed.

Ed noticed a quote cut out from an article sitting on Elizabeth’s desk.  It was from Channing Robertson:

“You start to realize you are looking in the eyes of another Bill Gates, or Steve Jobs.”

Carreyrou:

That was a high bar to set for herself, Ed thought.  Then again, if there was anyone who could clear it, it might just be this young woman.  Ed had never encountered anyone as driven and relentless.  She slept four hours a night and popped chocolate-coated coffee beans throughout the day to inject herself with caffeine.  He tried to tell her to get more sleep and to live a healthier lifestyle, but she brushed him off.

Around that time, Elizabeth was meeting regularly with the venture capitalist Don Lucas and also (less regularly) with Larry Ellison.  Lucas and Ellison had both invested in the recent Series B round that raised $9 million.  Carreyrou comments:

Ellison might be one of the richest people in the world, with a net worth of some $25 billion, but he wasn’t necessarily the ideal role model.  In Oracle’s early years, he had famously exaggerated his database software’s capabilities and shipped versions of it crawling with bugs.  That’s not something you could do with a medical device.

Since Ed had refused to make his engineering group work 24/7, Elizabeth had cooled towards him.  Soon she had hired a rival engineering group.  Ed’s group was put in competition with this new group.

Elizabeth had persuaded Pfizer to try the Theranos system in a pilot project in Tennessee.  The Theranos 1.0 devices would be put in people’s homes and they would test their blood every day.  Results would be sent wirelessly to the Theranos’s office in California, where they would be analyzed and then sent to Pfizer.  The bugs would have to be fixed before then.  Ed accompanied Elizabeth to Tennessee to start training doctors and patients on how to use the system.

When they got to Tennessee, the cartridges and the readers they’d brought weren’t functioning properly, so Ed had to spend the night disassembling and reassembling them on his bed in his hotel room.  He managed to get them working well enough by morning that they were able to draw blood samples from two patients and a half dozen doctors and nurses at a local oncology clinic.

The patients looked very sick.  Ed learned that they were dying of cancer.  They were taking drugs designed to slow the growth of their tumors, which might buy them a few more months to live.

Elizabeth declared the trip a success, but Ed thought it was too soon to use Theranos 1.0 in a patient study—especially on terminal cancer patients.

***

In August 2007, Elizabeth had everyone in the company gather.  Standing next to Elizabeth was Michael Esquivel, a lawyer.  Equivel announced that the company was suing three former employees—Michael O’Connell, Chris Todd, and John Howard—for stealing intellectual property.  Current employees were not to have any contact with these individuals.  And all documents and emails had to be preserved.  Moreover, the FBI had been called for assistance.

O’Connell held a postdoctorate in nanotechnology from Stanford.  He thought he had solved the microfluidic problems of the Theranos system.  O’Connell convinced Todd to form a company with him—Avidnostics.  O’Connell also spoke with Howard, who helped but decided not to join the company.

Elizabeth had always been very concerned about proprietary information getting out.  She required employees—as well as any who entered the Theranos office or did business with it—to sign nondisclosure agreements.

Meanwhile, the engineering teams vied to be first to solve the problems with Theranos 1.0.  Tony Nugent, an Irishman, was the head of the team competing with Ed’s team.

Tony decided that part of the Theranos value proposition should be to automate all the steps that bench chemists followed when they tested blood in a laboratory.  In order to automate, Tony needed a robot.  But he didn’t want to waste time building one from scratch, so he ordered a three-thousand-dollar glue-dispensing robot from a company in New Jersey called Fisnar.  It became the heart of the new Theranos system.

Soon Tony and team had built a smaller version of the robot that fit inside an aluminum box slightly smaller than a desktop computer tower.  Eventually they got the robot to follow the same steps a human chemist would.

First, it grabbed one of the two pipette tips and used it to aspirate the blood and mix it with diluents contained in the cartridge’s other tubes.  Then it grabbed the other pipette tip and aspirated the diluted blood with it.  This second tip was coated with antibodies, which attached themselves to the molecule of interest, creating a microscopic sandwich.

Therobot’s last step was to aspirate reagents from yet another tube in the cartridge.  When the reagents came into contact with the microscopic sandwiches, a chemical reaction occurred that emitted a light signal.  An instrument inside the reader called a photomultiplier tube then translated the light signal into an electric current.

The molecule’s concentration in the blood—what the test sought to measure—could be inferred from the power of the electrical current, which was proportional to the intensity of the light.

This blood-testing technique was known as chemiluminescent immunoassay.  (In laboratory speak, the word “assay” is synonymous with “blood test.”)  The technique was not new: it had been pioneered in the early 1980s by a professor at Cardiff University.  But Tony had automated it inside a machine that, though bigger than the toaster-size Theranos 1.0, was still small enough to make Elizabeth’s vision of placing it in patients’ homes possible.  And it only required about 50 microliters of blood.  That was more than 10 microliters Elizabeth initially insisted upon, but it still amounted to just a drop.

Once they had a functioning prototype—it worked much better than the system Ed was working on—Elizabeth suggested they call it the Edison (since everything else had failed).  Elizabeth decided to use the Edison instead of the microfluidic system.  Carreyrou points out the irony of this decision, given that the company had just filed a lawsuit to protect the intellectual property associated with the microfluidic system.  Soon thereafter, Ed and his team were let go.

Carreyrou continues:

Shaunak followed Ed out the door two weeks later, albeit on friendlier terms.  The Edison was at its core a converted glue robot and that was a pretty big step down from the lofty vision Elizebeth had originally sold him on.  He was also unsettled by the constant staff turnover and the lawsuit hysteria.

Although Elizabeth was excited about the Edison, it was a long way from a finished product.

 

APPLY ENVY

Elizabeth worshipped Steve Jobs and Apple.  In the summer of 2007, she started recruiting employees of Apple.  Ana Arriola, a product designer who worked on the iPhone, was one such recruit.

…Elizabeth told Ana she envisioned building a disease map of each person through Theranos’s blood tests.  The company would then be able to reverse engineer illnesses like cancer with mathematical models that would crunch the blood data and predict the evolution of tumors.

Ana and (later) her wife Corrine were impressed enough that Ana decided to leave behind fifteen thousand Apple shares.  She was hired as Theranos’s chief design officer.  Elizabeth wanted a software touchscreen like the iPhone’s for the Edison.  And she wanted a sleek outer case.

Since fans like Channing Robertson and Don Lucas were starting to compare Elizabeth to Steve Jobs, Ana thought she should look the part.  Soon Elizabeth was wearing a black turtleneck and black slacks most of the time.

Elizebeth’s idealism seemed like a good thing.  But there continued to be other aspects of working at Theranos that seemed stifling (to say the least).  Different groups were prevented from sharing information and working together.  Moreover, employees knew they were being spied on—including what they did on their computer and what they did on Facebook. 

Also, one of Elizabeth’s assistants kept track of how many hours each employee worked.  Elizabeth had dinner catered—it arrived at 8 or 8:30 each night—in order to encourage people to put in more hours.

Finally, people were constantly getting fired from Theranos.

One person Elizabeth recruited to Theranos was Avie Tevanian.  Avie was one of Steve Job’s closest friends.  Avie had worked with Jobs and NeXT, and then went with Jobs to Apple in 1997.  Avie was the head of software engineering.  After an arduous decade, Avie retired.  Elizabeth convinced Avie to join the Theranos board.  Avie invested $1.5 million into the company in the 2006 offering.

The first couple of board meetings Avie attended had been relatively uneventful, but, by the third one, he’d begun to notice a pattern.  Elizabeth would present increasingly rosy projections based on the deals she said Theranos was negotiating with pharmaceutical companies, but the revenues wouldn’t materialize.  It didn’t help that Henry Mosley, the chief financial officer, had been fired soon after Avie became a director.  At the last board meeting he’d attended, Avie had asked more pointed questions about the pharmaceutical deals and been told they were held up in legal review.  When he’d asked to see the contracts, Elizabeth had said she didn’t have any copies readily available.

There were also repeated delays with the product’s rollout and the explanation for what needed to be fixed kept changing.  Avie didn’t pretend to understand the science of blood-testing; his expertise was software.  But if the Theranos system was in the final stages of fine-tuning as he’d been told, how could a completely different technical issue be the new holdup every quarter?  That didn’t sound to him like a product that was on the cusp of commercialization.

Avie started asking more questions at the board meetings.  Soon thereafter, Don Lucas contacted Avie and informed him that Elizabeth was upset with his behavior and wanted him to leave the board.  Avie was surprised because he was just doing his duty as a board member.  Avie decided to look at all the material he’d been given over the previous year, including investment material. 

As he read them over, he realized that everything about the company had changed in the space of a year, including Elizabeth’s entire executive team.  Don needed to see these, he thought.

Ana Arriola was also growing concerned.  One morning, Ana brought up a question to Elizabeth.  Given that the technology wasn’t working, why not pause the Tennessee study in order to fix the bugs first?  They could always restart the study later once the product was functional.  Elizabeth replied that Pfizer and every other big pharma company wanted her blood-testing system and Theranos was going to be a great company.  Then Elizabeth suggested to Ana that she might be happier elsewhere. 

Ana knew it wasn’t right to use an unreliable blood-test system in the Tennessee study.  Later that same day, she resigned.

When Avie showed the material he’d gathered to Don, Don suggested to Avie that he resign.  Avie was surprised that Don didn’t seem interested in the material.  But Avie realized that he’d retired from Apple for good reason (to spend more time with his family).  He didn’t need extra aggravation.  So he told Don he would resign.

Don then brought up one more thing to Avie.  Shaunak Roy was leaving and was selling his shares to Elizabeth.  She needed the board to waive the company’s rights to repurchase Shaunak’s stock.  Avie didn’t think that was a good idea.  Don then said he wanted Avie to waive his own right as a board member to purchase the stock.

Avie was starting to get upset.  He told Don to have Theranos’s general, Michael Esquivel, to send him the information.  After reading it, Avie thought it was clear that he could buy some of Shaunak’s stock.  Avie decided to do so and informed Esquivel.  That prompted an argument.

At 11:17 p.m. on Christmas Eve, Esquivel sent Avie an email accusing him of acting in “bad faith” and warned him that Theranos was giving serious consideration to suing him for breach of his fiduciary duties as a board member and for public disparagement of the company.

Avie was astonished.  Not only had he done no such things, in all his years in Silicon Valley he had never come close to being threatened with a lawsuit.  All over the Valley, he was known as a nice guy.  A teddy bear.  He didn’t have any enemies.  What was going on here? 

Avie spoke with a friend who was a lawyer, who asked Avie if, given what he now knew, he really wanted to buy more shares in the company.  No, thought Avie.  But he did write a parting letter to Don summarizing his concerns.  The letter concluded:

“I do hope you will fully inform the rest of the Board as to what happened here.  They deserve to know that by not going along 100% ‘with the program’ they risk retribution from the Company/Elizabeth.”

 

GOODBYE EAST PALY

In early 2008, Theranos moved to a new location on Hillview Avenue in Palo Alto.  It was a drastic improvement over their previous location in East Palo Alto.  That area—east of Highway 101 (Bayshore Freeway)—was much poorer and had once been the country’s murder capital.

Matt Bissel, head of IT, was in charge of the move.  At 4 o’clock in the afternoon the day before the movers were scheduled to come, Matt was pulled into a conference room.  Elizabeth was on the line from Switzerland.  She told Matt she’d just learned that Theranos would be charged an extra month’s rent if they waited until tomorrow.  She told Matt to call the moving company immediately to see if they could do it.  No way.  But Elizabeth kept pushing.  Someone pointed out that the blood samples wouldn’t be kept at the right temperature if they were moved immediately.  Elizabeth said they could put them in refrigerated trucks.

Finally, Matt got Elizabeth to slow down after pointing out that they would still have to do an inspection with state officials to prove that they had properly disposed of any hazardous materials.  That meant no new tenant could move in until then.

Matt greatly admired Elizabeth as one of the smartest people he’d ever met, and as an energizing leader.  But he was starting to grow worried about some aspects of the company.

One aspect of Matt’s job had become increasingly distasteful to him.  Elizabeth demanded absolute loyalty from her employees and if she sensed that she no longer had it from someone, she could turn on them in a flash.  In Matt’s two and a half years at Theranos, he had seen her fire some thirty people, not counting the twenty or so employees who lost their jobs at the same time as Ed Ku when the microfluidic platform was abandoned.

Every time Elizabeth fired someone, Matt had to assist with terminating the employee…In some instances, she asked him to build a dossier on the person that she could use for leverage.

Matt was bothered in particular about how John Howard was treated.

When Matt reviewed all the evidence assembled for the Michael O’Connell lawsuit, he didn’t see anything proving that Howard had done anything wrong.  He’d had contact with O’Connell but he’d declined to join his company.  Yet Elizabeth insisted on connecting the dots in a certain way and suing him too, even though Howard been one of the first people to help her when she dropped out of Stanford, letting her use the basement of his house in Saratoga for experiments in the company’s early days.

Matt decided it was a good time to launch his own IT company.  When he informed Elizabeth, she couldn’t believe it.  She offered him a raise and a promotion, but he turned her down.  Then she grew very cold.  She offered one of Matt’s colleagues, Ed Ruiz, Matt’s position if he would look through Matt’s filed and emails.  Ed was good friends with Matt and refused. (There was nothing to find anyway.)  A few months after Matt left, Ed decided to work for Matt’s new company.

Meanwhile, Aaron Moore and Mike Bauerly wanted to test two ofthe Edison prototypes built by Tony Nugent and Dave Nelson.  This was informal “human factors” research to see how people reacted.

Aaron took photos with his digital camera to document what they were doing.  The Eve Behar cases weren’t ready yet, so the devices had a primitive look.  Their temporary cases were made from gray aluminum plates bolted together.  The front plate tilted upward like a cat door to let the cartridge in.  A rudimentary software interface sat atop the cat door at an angle.  Inside, the robotic arm made loud, grinding sounds.  Sometimes, it would crash against the cartridge and the pipette tips would snap off.  The overall impression was that of an eighth-grade science project.

Aaron and Mike visited their friends’ offices to do the tests.

As the day progressed, it became apparent that one pinprick often wasn’t enough to get the job done.  Transferring the blood to the cartridge wasn’t the easiest of procedures.  The person had to swab his finger with alcohol, prick it with the lancet, apply the transfer pen to the blood that bubbled up from the finger to aspirate it, and then press on the transfer pen’s plunger to expel the blood into the cartridge.  Few people got it right on their first try.  Aaron and Mike kept having to ask their test subjects to prick themselves multiple times.  It got messy. There was blood everywhere.

This confirmed Aaron was worried about: A fifty-five-year-old patient in his or her home was going to have trouble.  Aaron passed on his concerns to Tony and Elizabeth, but they didn’t think it was important.  Aaron was getting disillusioned.

A bit later, Todd Surdey was hired to run sales and marketing.  One of Todd’s two subordinates was on the East Coast: Susan DiGiaimo.  Susan had accompanied Elizabeth on quite a few sales pitches to drug makers.  Susan had been uncomfortable about Elizabeth’s very lofty promises.

Todd asked Susan about Elizabeth’s revenue projections.  Susan replied that they were vastly overinflated.

Moreover, no significant revenues would materialize unless Theranos proved to each partner that its blood system worked.  To that effect, each deal provided for an initial tryout, a so-called validation phase…

The 2007 study in Tennessee was the validation phase of the Pfizer contract.  Its objective was to prove that Theranos could help Pfizer gauge cancer patients’ response to drugs by measuring the blood concentration of three proteins the body produces in excess when tumors grow.  If Theranos failed to establish any correlation between the patients’ protein levels and the drugs, Pfizer could end their partnership and any revenue forecast Elizabeth had extrapolated from the deal would turn out to be fiction.

Susan also shared with Todd that she had never seen any validation data.  And when she went on demonstrations with Elizabeth, the devices often malfunctioned.  A case in point was the one they’d just conducted at Novartis.  After the first Novartis demo in late 2006 during which Tim Kemp had beamed a fabricated result from California to Switzerland, Elizabeth had continued to court the drug maker and had arranged a second visit to its headquarters in January 2008.

The night before that second meeting, Susan and Elizabeth had pricked their fingers for two hours in a hotel in Zurich to try to establish some consistency in the test results they were getting, to no avail. When they showed up at Novartis’s Basel offices the next morning, it got worse: all three Edison readers produced error messages in front of a room full of Swiss executives.  Susan was mortified, but Elizabeth kept her composure and blamed a minor technical glitch.

Based on the intel he was getting from Susan and from other employees in Palo Alto, Todd became convinced that Theranos’s board was being misled about the company’s finances and the state of its technology.

Todd brought his concerns to Michael Esquivel, the company’s general counsel.  Michael had been harboring his own suspicions.  In March 2008, Todd and Michael approached Tom Brodeen, a Theranos board member.  Since he was relatively new, he said they should raise their concerns with Don Lucas, the board’s chairman.  So they did.

This time, Don Lucas had to take the matter seriously.

Lucas convened an emergency meeting of the board in his office on Sand Hill Road.  Elizabeth was asked to wait outside the door while the other directors—Lucas, Brodeen, Channing Robertson, and Peter Thomas, the founder of an early stage venture capital firm called ATAventures—conferred inside.

After some discussion, the four men reached a consensus: they would remove Elizabeth as CEO.  She had proven herself to young and inexperienced for the job.  Tom Brodeen would step in to lead the company for a temporary period until a more permanent replacement could be found.  They called in Elizabeth to confront her with what they had learned and inform her of their decision.

But then something extraordinary happened.

Over the course of the next two hours, Elizabeth convinced them to change their minds.  She told them she recognized there were issues with her management and promised to change.  She would be more transparent and responsive going forward.  It wouldn’t happen again.

A few weeks later, Elizabeth fired Todd and Michael.  Soon thereafter, Justin Maxwell, a friend of Aaron and Mike’s, decided to resign.  His resignation email included this:

believe in the people who disagree with you… Lying is a disgusting habit, and it flows through the conversations here like its our own currency.  The cultural disease here is what we should be curing… I mean no ill will towards you, since you believe in what I was doing and hoped I would succeed at Theranos.

A few months later, Aaron Moore and Mike Bauerly resigned.

 

THE CHILDHOOD NEIGHBOR 

Richard Fuisz was a medical inventor and entrepreneur.  He was following what Elizabeth was doing at Theranos.  The Fuisz and Holmes families had been friends for two decades.

Elizabeth’s mother, Noel, and Richard’s wife, Lorraine, had developed a close friendship.  But the husbands weren’t as close.  This may have been because Chris Holmes was on a government salary, while Richard Fuisz was a successful businessman who liked to flaunt it.

Money was indeed a sore point in the Holmes household.  Chris’s grandfather, Christian Holmes II, had depleted his share of the Fleischmann fortune by living a lavish and hedonistic lifestyle on an island in Hawaii, and Chris’s father, Christian III, had frittered away what was left during an unsuccessful career in the oil business.

Carreyrou later explains:

Richard Fuisz was a vain and prideful man.  The thought that the daughter of longtime friends and former neighbors would launch a company in his area of expertise and that they wouldn’t ask for his help or even consult him deeply offended him. 

Carreyrou again:

Fuisz had a history of taking slights personally and bearing grudges.  The lengths he was willing to go to get even with people he perceived to have crossed him is best illustrated by his long and protracted feud with Vernon Loucks, the CEO of hospital supplies maker Baxter International.

Fuisz traveled frequently to the Middle East in the 1970s and early 1980s because it was the biggest market for his medical film business, Medcom.  On one of these trips, he ran into Loucks.  Over dinner, Loucks offered to buy Medcom for $53 million.  Fuisz agreed. 

Fuisz was supposed to be head of the new Baxter subsidiary for three years, but Loucks dismissed him after the acquisition closed.  Fuisz sued Baxter for wrongful termination,asserting that Loucks fired him for refusing to pay a $2.2 million bribe to a Saudi firm to remove Baxter from an Arab blacklist of companies doing business with Israel.  Carreyrou:

The two sides reached a settlement in 1986, under which Baxter agreed to pay Fuisz $800,000.  That wasn’t the end of it, however.  When Fuisz flew to Baxter’s Deerfield, Illinois, headquarters to sign the settlement, Loucks refused to shake his hand, angering Fuisz and putting him back on the warpath.

In 1989, Baxter was taken off the Arab boycott list, giving Fuisz an opening to seek his revenge.  He was leading a double life as an undercover CIA agent by then, having volunteered his services to the agency a few years earlier after coming across one of its ads in the classified pages of the Washington Post.

Fuisz’s work for the CIA involved setting up dummy corporations throughout the Middle East that employed agency assets, giving them a non-embassy cover to operate outside the scrutiny of local intelligence services.  One of the companies supplied oil-rig operators to the national oil company of Syria,where he was particularly well-connected.

Fuisz suspected Baxter had gotten itself back in Arab countries’ good graces through chicanery and set out to prove it using his Syrian connections. He sent a female operative he’d recruited to obtain a memorandum kept on file in the offices of the Arab League committee in Damascus that was in charge of enforcing the boycott.  It showed that Baxter had provided the committee detailed documentation about its recent sale of an Israeli plant and promised it wouldn’t make new investments in Israel or sell the country new technologies.  This put Baxter in violation of a U.S. anti-boycott law, enacted in 1977, that forbade American companies from participating in any foreign boycott or supplying blacklist officials any information that demonstrated cooperation with the boycott.

Fuisz sent a copy of the memo to Baxter’s board of directors and another copy to the Wall Street Journal.  The Journal published a front-page story.  Fuisz then was able to get copies of letters Baxter’s general counsel had written to a general in the Syrian army.  These letters confirmed the memo.

The revelations led the Justice Department to open an investigation.  In March 1993, Baxter was forced to plead guilty to a felony charge of violating the anti-boycott law and to pay $6.6 million in civil and criminal fines.  The company was suspended from new federal contracts for four months and barred from doing business in Syria and Saudi Arabia for two years.  The reputational damage also cost it a $50 million contract with a big hospital group.

Fuisz was upset, however, that Loucks still remained CEO.  So he came up with another attack.  Loucks was a Yale alumnus and served as trustee of Yale Corporation, the university’s governing body.  He also chaired the university’s fund-raising campaign.  Commencement ceremonies were coming up that May.

Through his son Joe, who had graduated from Yale the year before, Fuisz got in touch with a student named Ben Gordon, who was the president of Yale Friends of Israel association.  Together, they organized a graduation day protest featuring “Loucks Is Bad for Yale” signs and leaflets.  The crowning flourish was a turboprop plane Fuisz hired to fly over the campus trailing a banner that read, “Resign Loucks.”

Three months later, Loucks stepped down as Yale trustee.

All of that said, Fuisz’s initial interest in Theranos’s technology came more from opportunism than any desire for revenge.  Fuisz had made quite a bit of money by patenting inventions he thought other companies would want at some point.  Carreyrou:

One of his most lucrative plays involved repurposing a cotton candy spinner to turn drugs into fast-dissolving capsules.  The idea came to him when he took his daughter to a country fair in Pennsylvania in the early 1990s.  He later sold the public corporation he formed to house the technology to a Canadian pharmaceutical company for $154 million and personally pocketed $30 million from the deal.

Fuisz listened to an interview Elizabeth did for NPR’s “Biotech Nation,” in May 2005.  In that interview, Elizabeth explained how her blood-test system could be used for at-home monitoring of adverse reactions to drugs.

…But as a trained physician, he also spotted a potential weakness he could exploit.  If patients were going to test their blood at home with the Theranos device to monitor how they were tolerating the drugs they were taking, there needed to be a built-in mechanism that would alert their doctors when the results came back abnormal.

He saw a chance to patent that missing element, figuring there was money to be made down the road, whether from Theranos or someone else.  His thirty-five years of experience patenting medical inventions told him such a patent might eventually command up to $4 million for an exclusive license.

Fuisz filed a fourteen-page patent application with he U.S. Patent and Trademark office on April 24, 2006. It didn’t claim to invent new technology, but to combine existing technologies—wireless data transmission, computer chips, and bar codes—into a physician alert mechanism that could be part of at-home blood-testing devices.  The application said clearly that it was  targeting the company Theranos.

Meanwhile, for other reasons, the Fuisz and Holmes families grew apart.  By the time Elizabeth became aware of Richard Fuisz’s patent, the two families were no longer on speaking terms.

 

SUNNY     

Chelsea Burkett and Elizabeth had been friends at Stanford.  Elizabeth recruited Chelsea to Theranos.  Chelsea found Elizabeth to be very persuasive:

She had this intense way of looking at you while she spoke that made you believe in her and want to follow her.

About the same time Chelsea joined Theranos, Ramesh “Sunny” Balwani came on board as a senior Theranos executive.  All that Chelsea knew was that Sunny was Elizabeth’s boyfriend and that they were living together in a Palo Alto apartment.  Sunny immediately asserted himself and seemed omnipresent.

Sunny was a force of nature, and not in a good way.  Though only about five foot five and portly, he made up for his diminutive stature with an aggressive, in-your-face management style.  His thick eyebrows and almost-shaped eyes, set above a mouth that drooped at the edges and a square chin, projected an air of menace.  He was haughty and demeaning towards employees, barking orders and dressing people down.

Chelsea took an immediate dislike to him even though he made an effort to be nicer to her in deference to her friendship with Elizabeth.  She didn’t understand what her friend saw in this man, who was nearly two decades older than she was and lacking in the most basic grace and manners.  All her instincts told her Sunny was bad news, but Elizabeth seemed to have the utmost confidence in him.

Elizabeth and Sunny had met in Beijing when Elizabeth was in her third year of a Stanford program that taught students Mandarin.  Apparently, Elizabeth had been bullied by some of the students and Sunny came to her defense.

Sunny was born and raised in Pakistan.  He pursued his undergraduate studies in the U.S.  Then he worked for a decade as a software engineer for Lotus and Microsoft.  In 1999, Sunny joined CommerceBid.com, which was developing software that would have suppliers bid against one another in an auction.  The goal was to achieve economies of scale and lower prices.

In November 1999, a few months after Sunny joined CommerceBid as president and chief technology officer, the company was acquired for $232 million in cash and stock.  Carreyrou:

It was a breathtaking price for a company that had just three clients testing its software and barely any revenues.  As the company’s second-highest-ranking executive, Sunny pocketed more than $40 million.  His timing was perfect.  Five months later, the dot-com bubble popped and the stock market came crashing down. Commerce One [the company that acquired CommerceBid] eventually filed for bankruptcy.

Yet Sunny didn’t see himself as lucky.  In his mind, he was a gifted businessman and the Commerce One windfall was a validation of his talent.  When Elizabeth met him a few years later, she had no reason to question that.  She was an impressionable eighteen-year-old girl who saw in Sunny what she wanted to become: a successful and wealthy entrepreneur.  He became her mentor, the person who would teach her about business in Silicon Valley.

In 2004, the IRS forced Sunny to pay millions in back taxes after he had tried to use a tax shelter. Sunny liked to flaunt his wealth.  He drove a black Lamborghini Gallardo and a black Porsche 911.  Carreyrou writes:

He wore white designer shirts with puffy sleaves, acid-washed jeans, and blue Gucci loafers.  His shirts’ top three buttons were always undone, causing his chest hair to spill out and revealing a thin gold chain around his neck.  A pungent scent of cologne emanated from him at all times.  Combined with the flashy cars, the overall impression was of someone heading out to a nightclub rather than to the office.

Sunny was supposed to be an expert in software.  He even bragged that he’d written a million lines of code.  Some employees thought that was an absurd claim.  (Microsoft software engineers had written the Windows operating system at a rate of one thousand lines of code per year, notes Carreyrou.)

Carreyrou adds:

There was also the murky question of what she told the board about their relationship.  When Elizabeth informed Tony that Sunny was joining the company, Tony asked her point-blank whether they were still a couple.  She responded that the relationship was over.  Going forward, it was strictly business, she said.  But that would prove not to be true.

Carreyrou continues:

When Elizabeth pitched pharmaceutical executives now, she told them that Theranos would forecast how patients would react to the drugs they were taking.  Patients’ test results would be input into a proprietary computer program the company had developed.  As more results got fed into the program, its ability to predict how markers in the blood were likely to change during treatment would become better and better, she said.

It sounded cutting-edge, but there was a catch: the blood-test results had to be reliable for the computer program’s predictions to have any value… Theranos was supposed to help Centocor [in Antwerp, Belgium] to assess how patients were responding to an asthma drug by measuring a biomarker in their blood called allergen-specific immunoglobulin E, or IgE, but the Theranos devices seemed very buggy to Chelsea.  There were frequent mechanical failures.  The cartridges either wouldn’t slot into the readers properly or something inside the readers would malfunction.  Even when the devices didn’t break down, it could be a challenge coaxing any kind of output from them.

Sunny always blamed the wireless connection.  That was true sometimes, but there were other things that could interfere.  Nearly all blood tests require some dilution, but too much dilution made it harder for Theranos to get accurate results.

The amount of dilution the Theranos system required was greater than usual because of the small size of the blood samples Elizabeth insisted on.

Furthermore, to function properly, the Edisons required the ambient temperature to be exactly 34 degrees Celsius.  Two 11-volt heaters built into the reader tried to maintain that temperature during a blood test.  But in colder settings, including some hospitals in Europe, the temperature couldn’t be maintained.

Meanwhile, Pfizer had ended its collaboration with Theranos because it was not impressed by the results of the Tennessee validation study.

The study had failed to show any clear link between drops in the patients’ protein levels and the administration of the antitumor drugs.  And the report had copped to some of the same snafus Chelsea was now witnessing in Belgium, such as mechanical failures and wireless transmission errors.

When Chelsea returned from her three-week trip to Europe, she found that Elizabeth and Sunny were now focused on Mexico, where a swine flu epidemic had been raging.  Seth Michelson, Theranos’ chief scientific officer, had suggested an idea to Elizabeth.

Seth had told Elizabeth about a math model called SEIR (Susceptible, Exposed, Infected, and Resolved) that he thought could be adapted to predict where the swine flu virus would spread next.  For it to work, Theranos would need to test recently infected patients and input their blood-test results into the model.  That meant getting the Edison readers and cartridges to Mexico. Elizabeth envisioned putting them in the beds of pickup trucks and driving them to the Mexican villages on the front lines of the outbreak.

Because Chelsea was fluent in Spanish, she and Sunny were sent.  Elizabeth used her family connections in order to get authorization to use the experimental medical device in Mexico.

Once again, things did not go smoothly.  Frequently, the readers flashed error messages, or the result that came back from Palo Alto was negative for the virus when it should have been positive.  Some of the readers didn’t work at all.  And Sunny continued to blame the wireless transmission.

Chelsea grew frustrated and miserable.  She questioned what she was even doing there.  Gary Frenzel and some of the other Theranos scientists had told her that the best way to diagnose H1N1, as the swine flu virus was called, was with a nasal swab and that testing for it in blood was a questionable utility.  She’d raised this point with Elizabeth before leaving, but Elizabeth had brushed it off. “Don’t listen to them,” she’d said of the scientists.  “They’re always complaining.”

At the time, Theranos was struggling financially:

The $15 million Theranos had raised in its first two funding rounds was long gone and the company had already burned through the $32 million Henry Mosley had been instrumental in bringing in during its Series C round in late 2006.  The company was being kept afloat by a loan Sunny had personally guaranteed.

Meanwhile, Sunny was also traveling to Thailand to set up another swine flu testing outpost.  The epidemic had spread to Asia, and the country was one of the region’s hardest hit with tens of thousands of cases and more than two hundred deaths.  But unlike in Mexico, it wasn’t clear that Theranos’s activities in Thailand were sanctioned by local authorities.  Rumors were circulating among employees that Sunny’s connections there were shady and that he was paying bribes to obtain blood samples from infected patients. When a colleague of Chelsea’s in the client solutions group named Stefan Hristu quit immediately upon returning from a trip to Thailand with Sunny in January 2010, many took it to mean the rumors were true.

On the whole, Sunny had created a culture of fear with his bullying behavior.  The high rate of firings continued, and Sunny had taken charge of it.  Remaining employees started to say, “Sunny disappeared him” whenever Sunny fired someone.

The scientists, especially, were afraid of Sunny. One of the only ones who stood up to him was Seth Michelson.  A few days before Christmas, Seth had gone out and purchased polo shirts for his group. Their color matched the green of the company logo and they had the words “Theranos Biomath” emblazoned on them. Seth thought it was a nice team-building gesture and paid for it out of his own pocket.

When Sunny saw the polos, he got angry.  He didn’t like that he hadn’t been consulted and he argued that Seth’s gift to his team made the other managers look bad.  Earlier in his career, Seth had worked at Roche, the big Swiss drug maker, where he’d been in charge of seventy people and an annual budget of $25 million.  He decided he wasn’t going to let Sunny lecture him about management.  He pushed back and they got into a yelling match.

Soon thereafter, Seth found another job at Genomic Health in Redwood City.  When he went to give his resignation letter to Elizabeth, Sunny was there.  He read the letter and threw it in Seth’s face, shouting, “I won’t accept this!”

Seth shouted back: “I have news for you, sir: in 1863, President Lincoln freed the slaves!”

Sunny’s response was to throw him out of the building. It was weeks before Seth was able to retrieve his math books, scientific journals, and the pictures of his wife on his desk.  He had to enlist the company’s new lawyer, Jodi Sutton, and a security guard to help him pack his things late on a weeknight when Sunny wasn’t around.

Sunny also got into a yelling match with Tony Nugent.  Chelsea attempted to get through to Elizabeth about Sunny, but she was unable to.

Chelsea wanted to quit, but still wasn’t sure.  Then one day the Stanford student with the family connections to Mexico stopped by with his father, who was dealing with a cancer scare of some sort.   Elizabeth and Sunny persuaded him to allow Theranos to test his blood for cancer biomarkers.

Chelsea was appalled.  The validation study in Belgium and the experiments in Mexico and Thailand were one thing.  Those were supposed to be for research purposes only and to have no bearing on the way patients were treated.  But by encouraging someone to rely on a Theranos blood test to make an important medical decision was something else altogether.  Chelsea found it reckless and irresponsible.

She became further alarmed when not long afterward Sunny and Elizabeth began circulating copies of the requisition forms doctors used to order blood tests from laboratories and speaking excitedly about the great opportunities that lay in consumer testing.

I’m done, Chelsea thought to herself.  This has crossed too many lines.

[…]

Chelsea also worried about Elizabeth.  In her relentless drive to be a successful startup founder, she had built a bubble around herself that was cutting her off from reality.  And the only person she was letting inside was a terrible influence.  How could her friend not see that?

 

DR. J

Dr. J was Jay Rosen’s nickname.  Rosen is a doctor who is a member of Walgreens’s innovation team, whose goal is to find ideas and technologies that could create growth.

In January 2010, Theranos approached Walgreens with an email stating that it had developed small devices capable of running any blood test from a few drops pricked from a finger in real time and for less than half the cost of traditional laboratories.  Two months later, Elizabeth and Sunny traveled to Walgreens’s headquarters in the Chicago suburb of Deerfield, Illinois, and gave a presentation to a group of Walgreens executives.  Dr. J, who flew up from Pennsylvania for the meeting, instantly recognized the potential for the Theranos technology.  Bringing the startup’s machines inside Walgreens stores could open up a big new revenue stream for the retailer and be the game changer it had been looking for, he believed.

…The picture Elizabeth presented at the meeting of making blood tests less painful and more widely available so they could become an early warning system against disease deeply resonated with him.

On August 24, 2010, a Walgreens delegation arrived at the Theranos office in Palo Alto for a two-day meeting.  Kevin Hunter was the leader of a small lab consulting firm Colaborate.  Walgreens had hired him to evaluate and launch a partnership it was setting up with the startup.  Hunter’s father, grandfather, and great-grandfather had all been pharmacists.

Walgreens and Theranos had signed a preliminary contract.  Walgreens would prepurchase up to $50 million worth of Theranos cartridges and loan the startup $25 million.  If the pilot went well, the companies would expand their partnership nationwide.

Hunter asked to see the lab, but Elizabeth said later if there was time.  Hunter asked again.  Elizabeth pulled Dr. J aside.  Then Dr. J informed Hunter that they wouldn’t see the lab yet.

Theranos had told Walgreens it had a commercially ready laboratory and had provided it with a list of 192 different blood tests it said its proprietary devices could handle.  In reality, although there was a lab downstairs, it was just an R&D lab where Gary Frenzel and his team of biochemists conducted their research. Moreover, half of the tests on the list couldn’t be performed as chemiluminescent immunoassays, the testing technique the Edison system relied on.  These required different testing methods beyond the Edison’s scope.

Carreyrou writes:

Hunter was beginning to grow suspicious.  With her black turtleneck, her deep voice, and the green kale shakes she sipped on all day, Elizabeth was going to great lengths to emulate Steve Jobs, but she didn’t seem to have a solid understanding of what distinguished different types of blood tests.  Theranos had also failed to deliver on his two basic requests: to let him see its lab and to demonstrate a live vitamin D test on its device. Hunter’s plan had been to have Theranos test his and Dr. J’s blood, then get retested at Stanford Hospital that evening and compare results.  He’d even arranged for a pathologist to be on standby at the hospital to write the order and draw their blood.  But Elizabeth claimed she’d been given too little notice even though he’d made the request two weeks ago.

Despite Hunter’s suspicions, Dr. J and the Walgreens CFO, Wade Miquelon, continued to be big fans of Elizabeth.

In September 2010, Elizabeth and Sunny met with Walgreens executives at the company’s headquarters in Deerfield.  Elizabeth and Sunny suggested they do blood tests on the executives.  Hunter wasn’t at the meeting, but he heard about the blood tests later.  He thought it was a good opportunity to see how the technology performed.

Hunter asked about the blood-test results a few days later on the weekly video conference call the companies were using as their primary mode of communication.  Elizabeth responded that Theranos could only release the results to a doctor.  Dr J…reminded everyone that he was a trained physician, so why didn’t Theranos go ahead and send him the results?  They agreed that Sunny would follow up separately with him.

A month passed and still no results.

There was another issue, too. Theranos had suddenly changed its regulatory strategy.  Initially Theranos said the blood tests would qualify as “waived” under the Clinical Laboratory Improvement Amendments, a 1988 federal law that covered laboratories.

CLIA-waved tests usually involved simple laboratory procedures that the Food and Drug Administration had cleared for home use.

Now, Theranos was changing its tune and saying the tests it would be offering in Walgreens stores were “laboratory-developed tests.”  It was a big difference: laboratory-developed tests lay in a gray zone between the FDA and another federal health regulator,the Centers for Medicare and Medicaid Services.  CMS, as the latter agency was known, exercised oversight of clinical laboratories under CLIA, while the FDA regulated the diagnostic equipment that laboratories bought and used for their testing. But no one closely regulated tests that labs fashioned with their own methods.  Elizabeth and Sunny had a testy exchange with Hunter over the significance of the change.  They maintained that all the big laboratory companies mostly used laboratory-developed tests, which Hunter knew not to be true.

Hunter argued that it was now even more important to make sure Theranos’s tests were accurate.  He suggested a fifty-patient study, which he could easily arrange.  Hunter noticed that Elizabeth became defense immediately.  She said they didn’t want to do it “at this time,” and she quickly changed the subject.

After they hung up, Hunter took aside Renaat Van den Hooff, who was in charge of the pilot on the Walgreens side, and told him something just wasn’t right.  The red flags were piling up.  First, Elizabeth had denied him access to their lab.  Then she’d rejected his proposal to embed someone with them in Palo Alto.  And now she was refusing to do a simple comparison study.  To top it all off, Theranos had drawn the blood of the president of Walgreen’s pharmacy business, one of the company’s most senior executives, and failed to give him a test result!

Van den Hooff told Hunter:

“We can’t not pursue this.  We can’t risk a scenario where CVS has a deal with them in six months and it ends up being real.”

Almost everything Walgreens did was done with its rival CVS in mind.

Theranos had cleverly played on this insecurity.  As a result, Walgreens suffered from a severe case of FoMO—the fear of missing out.

There were two more things Theranos claimed were proof that its technology works.  First, there was clinical trial work Theranos had done with pharmaceutical companies.  Hunter had called the pharmaceutical companies, but hadn’t been able to reach anyone who could verify Theranos’s claims.  Second, Dr. J had commissioned Johns Hopkins University’s medical school to do a review of Theranos’s technology.

Hunter asked to see the Johns Hopkins review.  It was a two-page document.

When Hunter was done reading it, he almost laughed. It was a letter dated April 27, 2010, summarizing a meeting Elizabeth and Sunny had had with Dr. J and five university representatives on the Hopkins campus in Baltimore.  It stated that they had shown the Hopkins team “proprietary data on test performance” and that Hopkins had deemed the technology “novel and sound.”  But it also made clear that the university had conducted no independent verification of its own.  In fact, the letter included a disclaimer at the bottom of the second page: “The materials provided in no way signify an endorsement by Johns Hopkins Medicine to any product or service.”

In addition to Walgreens, Theranos also tried to get Safeway as a partner.  Elizabeth convinced Safeway’s CEO, Steve Burd, to do a deal.  Safeway loaned Theranos $30 million.  Safeway also committed to a massive renovation project of its stores, creating new clinics where customers could have their blood tested on Theranos devices.  Burd saw Elizabeth as a genius.

In early 2011, Hunter was informed that Elizabeth and Sunny no longer wanted him on the calls or in meetings between Theranos and Walgreens.  Hunter asked: Why Walgreens was paying him $25,000 a month to look out for its interests if he couldn’t do his job, which includes asking tough questions? 

 

THE MINILAB  

Elizabeth had told Walgreens and Safeway that Theranos’s technology could perform hundreds of tests on small blood samples. 

The truth was that the Edison system could only do immunoassays, a type of test that uses antibodies to measure substances in the blood.  Immunoassays included some commonly ordered lab tests such as tests to measure vitamin D or to detect prostrate cancer.  But many other routine blood tests, ranging from cholesterol to blood sugar, required completely different laboratory techniques.

Elizabeth needed a new device, one that could perform more than just one class of test.  In November 2010, she hired a young engineer named Kent Frankovich and put him in charge of designing it.

Kent had just earned a master’s degree in mechanical engineering from Stanford.  Prior to that, he’d worked for two years at NASA’s Jet Propulsion Laboratory in Pasadena,where he’d helped construct Curiosity, the Mars rover.  Kent recruited a friend—Greg Baney—from NASA to Theranos.

Carreyrou notes that for several months, Kent and Greg were Elizabeth’s favorite employees.  She joined their brainstorming sessions and offered some suggestions about what robotic systems they should consider.  Elizabeth called the new system the “miniLab.” 

Because the miniLab would be in people’s homes, it had to be small.

This posed engineering challenges because, in order to run all the tests she wanted, the miniLab would need to have many more components than the Edison.  In addition to Edison’s photomultiplier tube, the new device would need to cram three other laboratory instruments in one small space: a spectrophotometer, a cytometer, and an isothermal amplifier.

None of these were new inventions…

Laboratories all over the world had been using these instruments for decades.  In other words, Theranos wasn’t pioneering any new ways to test blood.  Rather, the miniLab’s value would lie in the miniaturization of existing lab technology.  While that might not amount to groundbreaking science, it made sense in the context of Elizabeth’s vision of taking blood testing out of central laboratories and bringing it to drugstores, supermarkets, and, eventually, people’s homes.

To be sure, there were already portable blood analyzers on the market.  One of them, a device that looked like a small ATM called the Piccolo Express, could perform thirty-one different blood tests and produce results in as little as twelve minutes.  It required only three or four drops of blood for a panel of a half dozen commonly ordered tests.  However, neither the Piccolo nor other existing portable analyzers could do the entire range of laboratory tests.  In Elizabeth’s mind, that was going to be the miniLab’s selling point.

Greg thought they should take off-the-shelf components and get the overall system working first before miniaturizing it.  Trying to miniaturize before having a working prototype didn’t make sense.  But Elizabeth wouldn’t hear of it.

In the spring of 2011, Elizabeth hired her younger brother, Christian.  Although two years out of college—Duke University—and with no clear qualifications to work at a blood diagnostics company, what mattered to Elizabeth was that she could trust her brother.  Christian soon recruited five fraternity brothers: Jeff Blickman, Nick Menchel, Dan Edlin, Sani Hadziahmetovic, and MaxFosque.  The became known inside Theranosas “the Frat Pack.”

Like Christian, none of the other Duke boys had any experience or training relevant to blood testing or medical devices, but their friendship with Elizabeth’s brother vaulted them above most other employees in the company hierarchy.

Meanwhile, Greg had brought several of his own friends, Jordan Carr, Ted Pasco, and Trey Howard.

Jordan, Trey, and Ted were all assigned to the product management group with Christian and his friends, but they weren’t granted the same level of access to sensitive information.  Many of the hush-hush meetings Elizabeth and Sunny held to strategize about the Walgreens and Safeway partnerships were off limits to them, whereas Christian and his fraternity brothers were invited in.

At the holiday party in December 2011, Elizabeth gave a speech which included the following:

“The miniLab is the most important thing humanity has ever built.  If you don’t believe this is the case, you should leave now.  Everyone needs to work as hard as humanly possible to deliver it.”

By this point, Greg had decided to leave Theranos in two months.  He had become disillusioned:

The miniLab Greg was helping build with a prototype, nothing more.  It needed to be tested thoroughly and fine-tuned, which would require time.  A lot of time.  Most companies went through three cycles of prototyping before they went to market with a product.  But Sunny was already placing orders for components to build one hundred miniLabs, based on a first, untested prototype.  It was as if Boeing built one plane and, without doing a single flight test, told airline passengers, “Hop aboard.”

One problem that would require a great deal of testing was thermal.  Packing many instruments together in a small space led to unpredicted variations in temperature.

 

THE WELLNESS PLAY       

Safeway’s business was struggling.  On an earnings call, CEO Steve Burd was asked why the company was buying back stock in order to boost earnings per share.  Burd responded that the company was about to do well, so buying back shares was the right move.  Burd elaborated by saying that the company was planning a significant “wellness play.” Analysts inferred that Safeway had a secret plan to ignite growth.

Burd had high hopes for the venture.  He’d ordered the remodeling of more than half of Safeway’s seventeen hundred stores to make room for upscale clinics with deluxe carpeting, custom wood cabinetry, granite countertops, and flat-screen TVs.  Per Theranos’s instructions, they were to be called wellness centers and had to look “better than a spa.”  Although Safeway was shouldering the entire cost of the $350 million renovation on its own, Burd expected it to more than pay for itself once the new clinics started offering the startup’s novel blood tests.

…[Burd] was starry-eyed about the young Stanford dropout and her revolutionary technology, which fit so perfectly with his passion for preventative healthcare.

Elizabeth had a direct line to Burd and answered only to him… He usually held his deputies and the company’s business partners to firm deadlines, but he allowed Elizabeth to miss one after the other.

In early 2012, the companies had agreed that Theranos would be in charge of blood testing at a Safeway employee health clinic on its corporate campus in Pleasanton.

Safeway’s first chief medical officer was Kent Bradley.  Bradley attended West Point and then the armed forces’ medical school in Bethesda, Maryland.  Then he served the U.S. Army for seventeen years before Safeway hired him.  Bradley looked forward to seeing the Theranos system in action.

However, he was surprised to learn that Theranos wasn’t planning on putting any of its devices in the Pleasanton clinic.  Instead, it had stationed two phlebotomists there to draw blood, and the samples they collected were couriered across San Francisco Bay to Palo Alto for testing.  He also noticed that the phlebotomists were drawing blood from every employee twice, once with a lancet applied to the index finger and a second time the old-fashioned way with a hypodermic needle inserted in the arm.  Why the need for venipunctures—the medical term for needle draws—if the Theranos finger-stick technology was fully developed and ready to be rolled out to consumers, he wondered.

Bradley’s suspicions were further aroused by the amount of time it took to get results back.  His understanding had been that the tests were supposed to be quasi-instantaneous, but some Safeway employees were having to wait as long as two weeks to receive their results.  And not every test was performed by Theranos itself.  Even though the startup had not said anything about outsourcing some of the testing, Bradley discovered that it was farming out some tests to a big reference laboratory in Salt Lake City called ARUP.

What really set off Bradley’s alarm bells, though, was when some otherwise healthy employees started coming to him with concerns about abnormal test results.  As a precaution, he sent them to get retested at a Quest or LabCorp location.  Each time, the new set of tests came back normal, suggesting the Theranos results were off…

Bradley put together a detailed analysis of the discrepancies.  Some of the differences between the Theranos values and the values from the other labs were disturbingly large.  When the Theranos values did match those of the other labs, they tended to be for tests performed by ARUP.

Bradley ended up taking his concerns to Burd, but Burd assured the doctor that Theranos’s technology had been tested and was reliable.

Theranos had a temporary lab in East Meadow Circle in Palo Alto.  The lab had gotten a certificate saying it was in compliance with CLIA—the federal law that governed clinical laboratories.  But such certificates were easy to obtain.

Although the ultimate enforcer of CLIA was the Centers for Medicare and Medicaid Services, the federal agency delegated most routine lab inspections to states.  In California, they were handled by the state department of health’s Laboratory Field Services division, which an audit had shown to be badly underfunded and struggling to fulfill its oversight responsibilities.

The East Meadows Circle lab didn’t contain a single Theranos proprietary device.  The miniLab was still being developed and was a long way from being ready for patient testing.  Instead, the lab had more than a dozen commercial blood and body-fluid analyzers made by companies such as Chicago-based Abbott Laboratories, Germany’s Siemens, and Italy’s DiaSorin.  Arne Gelb, a pathologist, ran the lab.  A handful of clinical laboratory scientists (CLSs) helped Arne.

One CLS named Kosal Lim was poorly trained and sloppy.  An experienced colleague, Diana Dupuy, believed Lim was harming the accuracy of the test results.

To Dupuy, Lim’s blunders were inexcusable. They included ignoring manufacturers’ instructions for how to handle reagents; putting expired reagents in the same refrigerator as current ones; running patient tests on lab equipment that hadn’t been calibrated; improperly performing quality-control runs on an analyzer; doing tasks he hadn’t been trained to do; and contaminating a bottle of Wright’s stain, a mixture of dyes used to differentiate blood cell types.

Dupuy documented Lim’s mistakes in regular emails to Arne and to Sunny, often including photos.

Dupuy also had concerns about the competence of the two phlebotomists Theranos had stationed in Pleasanton.  Blood is typically spun down in a centrifuge before it’s tested to separate its plasma from the patient’s blood cells.  The phlebotomists hadn’t been trained to use the centrifuge they’d been given and they didn’t know how long or at what speed to spin down patients’ blood.  When they arrived in Palo Alto, the plasma samples were often polluted with particulate matter.  She also discovered that many of the blood-drawing tubes Theranos was using were expired, making the anticoagulant in them ineffective and compromising the integrity of the specimens.

Dupuy was sent to Delaware to train on a new Siemens analyzer Theranos bought.  When she got back to the lab, it was spotless.

Sunny, who appeared to have been waiting for her, summoned her into a meeting room.  In an intimidating tone, he informed her that he had taken a tour of the lab in her absence and found not a single one of her complaints to be justified.

Sunny promptly fired her.  He rehired her based on Arne’s recommendation.  Then Sunny fired Dupuy again several weeks later.  She was immediately escorted from the building without a chance to grab her personal belongings.  Dupuy sent an email to Sunny—and copied Elizabeth—which included the following:

“I was warned by more than 5 people that you are a loose cannon and it all depends on your mood as to what will trigger you to explode.  I was also told that anytime someone deals with you it’s never a good outcome for that person.

The CLIA lab is in trouble with Kosal running the show and no one watching him or Arne.  You have a mediocre Lab Director taking up for a sub-par CLS for whatever reason.  I fully guarantee that Kosal will certainly make a huge mistake one day in the lab that will adversely affect patient results. I actually think he has already done this on several accounts but has put the blame on the reagents.  Just as you stated everything he touches is a disaster!

I only hope that somehow I bring awareness to you that you have created a work environment where people hide things from you out of fear.  You cannot run a company through fear and intimidation… it will only work for a period of time before it collapses.”

As for the Safeway partnership, Theranos kept pushing back the date for the launch.  Burd had to keep telling analysts and investors on each quarterly earnings call that the new program was just about to launch, only to have it be delayed again.  Safeway’s finance department forecast revenues of $250 million, which was aggressive.  The revenues hadn’t materialized, however, and Safeway had spent $350 million just to build the wellness centers.  Safeway’s board was starting to get upset.  Although Burd had done an excellent job during his first decade as CEO, the second decade hadn’t been very good.  The costs and delays associated with the wellness centers prompted the board to ask Burd to retire.  He agreed.

Safeway then had to contact Sunny or the Frat Pack if they wanted to communicate with Theranos.  Sunny always acted upset as if his time was too valuable, as if Theranos’s technology was a massive innovation requiring a huge time commitment.  Safeway executives were very upset about Sunny’s attitude.  But they still worried that they might miss out, so they didn’t walk away from the partnership.

 

“WHO IS LTC SHOEMAKER?”

Lieutenant Colonel David Shoemaker was part of a small military delegation meeting in Palo Alto in November 2011 to bless Theranos’s deploying its devices in the Afghan war theatre.  Only, instead of blessing the proposal, LTC Shoemaker told Elizabeth that there were various regulations her approach would fail to meet.

The idea of using Theranos devices on the battlefield had germinated the previous August when Elizabeth had met James Mattis, head of the U.S. Central Command, at the Marines’ Memorial Club in San Francisco.  Elizabeth’s impromptu pitch about how her novel way of testing blood from just a finger prick could help diagnose and treat wounded soldiers faster, and potentially save lives, had found a receptive audience in the four-star general.  Jim “Mad Dog” Mattis was fiercely protective of his troops, which made him one of the most popular commanders in the U.S. military.  The hard-charging general was open to pursuing any technology that might keep his men safer as they fought the Taliban in the interminable, atrocity-marred war in Afghanistan.

This type of request had to go through the army’s medical department.  Shoemaker’s job was to makes sure the army followed all laws and regulations when it tested medical devices.  With regard to Theranos, the company would have to get approval from the FDA at a minimum.

Elizabeth disagreed forcefully, citing advice Theranos received from its lawyers.  She was so defensive and obstinate that Shoemaker quickly realized that prolonging the argument would be a waste of time.  She clearly didn’t want to hear anything that contradicted her point of view.  As he looked around the table, he noted that she had brought no regulatory affairs expert to the meeting.  He suspected the company didn’t even employ one.  If he was right about that, it was an incredibly naïve way of operating.  Health care was the most highly regulated industry in the country, and for good reason: the lives of patients were at stake.

Soon thereafter, in response to an email from Shoemaker complaining to the FDA, Gary Yamamoto, a veteran field inspector in CMS’s regional office in San Francisco, was sent to exam Theranos’s lab.

[Elizabeth] and Sunny professed not to know what Shoemaker had been talking about in his email.  Yes, Elizabeth had met with the army officer, but she had never told him Theranos intended to deploy its blood-testing machines far and wide under the cover of a single CLIA certificate.

Yamamoto asked why Theranos had applied for a CLIA certificate.

Sunny responded that the company wanted to learn about how labs worked and what better way to do that than to operate one itself?  Yamamoto found that answer fishy and borderline nonsensical.  He asked to see their lab.

Carreyrou continues:

It looked like any other lab.  No sign of any special or novel blood-testing technology.  When he pointed this out, Sunny said the Theranos devices were still under development and the company had no plans to deploy them without FDA clearance—flatly contradicting what Elizabeth had told Shoemaker on not one but two occasions.  Yamamoto wasn’t sure what to believe.  Why would the army officer have made all that stuff up?

…If Theranos intended to eventually roll its devices out to other locations, those places would need CLIA certificates too. Either that or, better yet, the devices themselves would need to be approved by the FDA.

Elizabeth immediately sent an email to General Mattis accusing Shoemaker of giving “blatantly false information” to the FDA and CMS about Theranos.  Mattis was furious and wanted to get to the bottom of things ASAP.  A colleague of Shoemaker’s forwarded the emails, including Mattis’s responses, to Shoemaker.  Shoemaker got worried about what Mattis would do.

Shoemaker met with Mattis to answer the general’s questions.  Once Mattis learned more about the rules and regulations governing the situation—the medical devices couldn’t be tested on human subjects without FDA approval except under very strict conditions—he was reasonable.  In the meantime, they could conduct a “limited objective experiment” using leftover de-identified blood samples from soldiers.

Although Theranos had the green light to run the “limited objective experiment,” for some reason it never proceeded to do so.

 

LIGHTING A FUISZ

On October 29, 2011, Richard Fuisz was served a set of papers.  It was a lawsuit filed by Theranos in federal court in San Francisco alleging that Fuisz had conspired with his sons from his first marriage, Joe and John Fuisz, to steal confidential patent information to develop a rival patent.  The suit alleged that the theft had been done by John Fuisz while he was employed at Theranos’s former patent counsel, McDermott Will & Emery.

Fuisz and his sons were angered by the suit, but they weren’t overly worried about it at first.  They were confident in the knowledge that its allegations were false.

Carreyrou writes:

John had no reason to wish Elizabeth or her family ill; on the contrary.  When he was in his early twenties, Chris Holmes had written him a letter of recommendation that helped him gain admission to Catholic University’s law school.  Later, John’s first wife had gotten to know Noel Holmes through Lorraine Fuisz and become friendly with her.  Noel had even dropped by their house when John’s first son was born to bring the baby a gift.

Moreover, Richard and John Fuisz weren’t close.  John thought his father was an overbearing megalomaniac and tried to keep their interactions to a bare minimum.  In 2004, he’d even dropped him as a McDermott client because he was being difficult and slow to pay his bills.  The notion that John had willingly jeopardized his legal career to steal information for his father betrayed a fundamental misunderstanding of their frosty relationship.

But Elizabeth was understandably furious at Richard Fuisz.  The patent application he had filed in April 2006 had matured into U.S. Patent 7,824,612 in November 2010 and now stood in the way of her vision of putting the Theranos device in people’s homes.  If that vision was someday realized, she would have to license the bar code mechanism Fuisz had thought up to alert doctors to patients’ abnormal blood-test results.  Fuisz had rubbed that fact in her face the day his patent was issued by sending a Fuisz pharma press release to info@theranos.com, the email address the company provided on its website for general queries.  Rather than give in to what she saw as blackmail, Elizabeth had decided to steamroll her old neighbor by hiring one of the country’s best and most feared attorneys to go after him.

The Justice Department had hired David Boies to handle its antitrust suit against Microsoft.  Boies won a resounding victory in that case, which helped him rise to national prominence.  Just before Theranos sued, all three Fuiszes—Richard, John, and Joe—could tell that they were under surveillance by private investigators.

Boies’s use of private investigators wasn’t an intimidation tactic, it was the product of a singular paranoia that shaped Elizabeth and Sunny’s view of the world.  That paranoia centered on the belief that the lab industry’s two dominant players, Quest Diagnostics and Laboratory Corporation of America, would stop at nothing to undermine Theranos and its technology.  When Boies had first been approached about representing Theranos by Larry Ellison and another investor, it was that overarching concern that had been communicated to him.  In other words, Boies’s assignment wasn’t just to sue Fuisz, it was to investigate whether he was in league with Quest and LabCorp.  The reality was that Theranos was on neither company’s radar at that stage and that, as colorful and filled with intrigue as Fuisz’s life had been, he had no connection to them whatsoever.

Boies didn’t have any evidence whatsoever that John Fuisz had done what Theranos alleged.  Nonetheless, Boies intended to use several things from John’s past to create doubt in a judge or jury.  Potentially the most damaging thing Boies wanted to use was that McDermott had made John resign in 2009 after he had an argument with the firm’s other partners.  John insisted the firm discontinue its reliance on a forged document in a case before the International Trade Commission in which McDermott was representing a Chinese state-owned company against the U.S. government’s Office of Unfair Import Investigations.  McDermott leaders agreed to withdraw the document, but that decision significantly weakened the Chinese client’s defense.  Senior partners got upset about it.  They argued that there had been several incidents when John didn’t behave as a partner should.  One incident was a complaint a client had made—this was Elizabeth’s September 2008 complaint about Richard Fuisz’s patent.

Eventually John was beyond furious.  He had launched his own practice after leaving McDermott.  The Theranos allegations had caused him to lose several clients.  Moreover, opposing counsel mentioned the allegations in order to tar John.  Finally, his wife had been diagnosed with vasa previa—a pregnancy complication where the fetus’s blood vessels are dangerously exposed.  This added to John’s stress.

John always had a short fuse.  During the deposition by Boies’s partners, John was combative and ornery.  He used foul language while threatening to harass Elizabeth “till she dies, absolutely.”

In the meantime, Richard and Joe Fuisz were worrying about how expensive the litigation was getting.  Also, they knew they were up against one of the most expensive lawyers in the world: David Boies, who was reported to make $10 million a year.  But they didn’t know that Boies had agreed to accept stock in Theranos in place of his usual fees.  Partly out of concern for his investment, Boies began attending all of the company’s board meetings in early 2013.

Richard Fuisz examined Theranos’s patents.  He noticed that the name Ian Gibbons often appeared.  Gibbons was British and had a Ph.D. in biochemistry from Cambridge.  Fuisz suspected that Gibbons and other Theranos employees with advanced degrees had done most of the technical work related to Theranos’s patents.

 

IAN GIBBONS

Elizabeth hired Ian Gibbons on the recommendation of her Stanford mentor, Channing Robertson.

Ian fit the stereotype of the nerdy scientists to a T.  He wore a beard and glasses and hiked his pants way above his waist.  He could spend hours on end analyzing data and took copious notes documenting everything he did at work.  This meticulousness carried over to his leisure time: he was an avid reader and kept a list of every single book he’d read.  It included Marcel Proust’s seven-volume opus, Remembrance of Things Past, which he reread more than once.

Ian met his wife Rochelle at Berkeley in the 1970s.  He was doing a postdoctorate fellowship in molecular biology, while Rochelle was doing graduate research.  They didn’t have children.  But they loved their dogs Chloe and Lucy, and their cat Livia, named after the wife of the Roman emperor Augustus.  Ian also enjoyed going to the opera and photography.  He altered photos for fun.

Ian’s specialty was immunoassays.  He was passionate about the science of bloodtesting.  He also enjoyed teaching it.  Early on at Theranos, he would give small lectures to the rest of the staff.

Ian insisted that the blood tests they designed be as accurate in Theranos devices as they did on the lab bench.  Because this was rarely the case, Ian was quite frustrated.

He and Tony Nugent butted heads over this issue during the development of the Edison. As admirable as Ian’s exacting standards were, Tony felt that all he did was complain and that he never offered any solutions.

Ian also had issues with Elizabeth’s management, especially the way she siloed the groups off from one another and discouraged them from communicating.  The reason she and Sunny invoked for this way of operating was that Theranos was “in stealth mode,” but it made no sense to Ian.  At the other diagnostics companies where he had worked, there had always been cross-functional teams with representatives from the chemistry, engineering, manufacturing, quality control, and regulatory departments working toward a common objective.  That was how you got everyone on the same page, solved problems, and met deadlines.

Elizabeth’s loose relationship with the truth was another point of contention.  Ian had heard her tell outright lies more than once and, after five years of working with her, he no longer trusted anything she said, especially when she made representations to employees or outsiders about the readiness of the company’s technology.

Ian complained confidentially to his friend Channing Robertson.  But Robertson turned around and told Elizabeth all that Ian said.  Elizabeth fired him.  Sunny called the next day because several colleagues urged Elizabeth to reconsider.  Ian was brought back but he was no longer head of general chemistry.  Instead, he was a technical consultant. 

Ian wasn’t the only employee being sidelined at that point.  It seemed that the old guard was being mothballed in favor of new recruits.  Nonetheless, Ian took it hard.

One day, Tony and Ian—who’d both been marginalized—got to talking.  Tony suggested that perhaps the company was merely a vehicle for Elizabeth and Sunny’s romance and that none of the work they didn’t actually mattered.  Ian agreed, saying, “It’s a folie a deux.”  Tony looked up the definition of that expression, which seemed accurate to him: “The presence of the same or similar delusional ideas in two persons closely associated with one another.”

Ian kept working closely with Paul Patel, who had replaced Ian.  Paul had enormous respect for Ian and continued treating him as an equal, consulting him on everything.  However, Paul avoided conflict and was more willing than Ian to compromise with the engineers while building the miniLab.  Ian wouldn’t compromise and got upset.  Paul frequently had to calm him down over the phone at night. Ian told Paul to abide by his convictions and never lose sight of concern for the patient.

Sunny put Samartha Anekal, who had a Ph.D. in chemical engineering, in charge of integrating the parts of the miniLab.  Sam struck some as a yes-man who simply did what Sunny told him to do.

As these things were unfolding, Ian had gotten clinically depressed—except he hadn’t been diagnosed as such.  He started drinking heavily in the evenings.  Rochelle was grieving for her mother, who had just passed away, and didn’t notice how depressed Ian was getting.

Theranos told Ian he’d been subpoenaed to testify in the Fuisz case.  Because Rochelle had done work as a patent attorney, Ian asked her to look the Theranos’s patents. 

While doing so, she noticed that Elizabreth’s name was on all the company’s patents, often in first place in the list of inventors.  When Ian told her that Elizabeth’s scientific contribution had been negligible, Rochelle warned him that the patents could be invalidated if this was ever exposed.  That only served to make him more agitated.

On May 15, he called to set up a meeting with Elizabeth.  After an appointment was set for the next day, Ian started worrying that Elizabeth would fire him.  The same day, the Theranos lawyer David Doyle told Ian that Fuizs’s lawyers—after trying for weeks to get the Boies Schiller attorneys to propose a date for Ian’s deposition—required Ian to appear at their offices in Campbell, California, on May 17.

The morning of May 16, Ian’s wife discovered that he’d taken enough acetaminophen to kill a horse.  He was pronounced dead on May 23.  Theranos had virtually no response. 

Although Tony Nugent and Ian had fought all the time, Tony felt bad about the lack of empathy for someone who had given a decade of his life to the company.  Tony downloaded a list of Ian’s patents and created an email, including a photo of Ian, which Tony sent to two dozen colleagues who’d worked with him.

 

CHIAT/DAY                                         

Chiat/Day was working on a secret marketing campaign for Theranos.  Patrick O’Neill, the creative director of the company’s Los Angeles office, was in charge.

Elizabeth had chosen Chiat/Day because it was the agency that represented Apple for many years, creating its iconic 1984 Macintosh ad and later its “Think Different” campaign in the late 1990s.  She’d even tried to convince Lee Clow, the creative genius behind those ads, to come out of retirement to work for her.  Clow politely referred her back to the agency, where she had immediately connected with Patrick.

Patrick was drawn in by Elizabeth’s extreme determination to do something great.  The Theranos mission to give people pain-free, low-cost health care was inspiring.  Advertisers don’t often get a chance to work on something that can make the world better, observes Carreyrou.

Part of the campaign included pictures of patients—played by models—of all different ages, genders, and ethnicities. 

The message was that Theranos’s blood-testing technology would help everyone.

Carreyrou again:

Real blood tended to turn purple after awhile when it was exposed to air, so they filled one of the nanotainters with fake Halloween blood and took pictures of it against a white background.  Patrick then made a photo montage showing it balancing on the tip of a finger.  As he’d anticipated, it made for an arresting visual.  Mike Yagi tried out different slogans to go with it, eventually settling on two that Elizabeth really liked: “One tiny drop changes everything” and “The lab test, reinvented.”…

Patrick also worked with Elizabeth on a new company logo.  Elizabeth believed in the Flower of Life, a geometric pattern of intersecting circles within a larger circle that pagans once considered the visual expression of the life that runs through all sentient beings.

Although Patrick was enthused, his colleague Stan Fiorito was more circumspect.  He thought something about Sunny was strange.  He kept using software engineering jargon in weekly meetings even though it had zero applicability to the marketing discussions.  Also, Theranos was paying Chiat/Day $6 million a year.  Where was it getting the money for this?  Elizabeth stated several times that the army was using Theranos technology on the battlefield in Afghanistan.  She claimed it was saving soldiers’ lives.  Perhaps Theranos was funded by the Pentagon, thought Stan.  At least that would help explain the extreme secrecy the company insisted upon.

Besides Mike Yagi, Stan supervised Kate Wolff and Mike Pedito.  Kate and Mike were no-nonsense people and they began to wonder about Theranos.

Elizabeth wanted the website and all the various marketing materials to feature bold, affirmative statements.  One was that Theranos could run “over 800 tests”on a drop of blood.  Another was that its technology was more accurate than traditional lab testing.  She also wanted to say that Theranos test results were ready in less than thirty minutes and that its tests were “approved by FDA” and “endorsed by key medical centers” such as the Mayo Clinic and the University of California, San Francisco’s medical school, using the FDA, Mayo Clinic, and UCSF logos.

When she inquired about the basis for the claim about Theranos’s superior accuracy, Kate learned that it was extrapolated from a study that had concluded that 93 percent of lab mistakes were due to human error.  Theranos argued that, since its testing process was fully automated inside its device, that was grounds enough to say that it was more accurate than other labs.  Kate thought that was a big leap in logic and said so.  After all, there were laws against misleading advertising.

Mike agreed with Kate.

Elizabeth had mentioned a report several hundred pages long supporting Theranos’s scientific claims.  Kate and Mike repeatedly asked to see it, but Theranos wouldn’t produce it.  Instead, the company sent them a password-protected file containing what it said were excerpts from the report.  It stated that the Johns Hopkins University School of Medicine had conducted due diligence on the Theranos technology and found it “novel and sound” and capable of “accurately” running “a wide range of routine and special assays.”

Those quotes weren’t from any lengthy report, however.  They were from the two-page summary of Elizabeth and Sunny’s meeting with five Hopkins officials in April 2010.  As it had done with Walgreens, Theranos was again using that meeting to claim that its system had been independently evaluated.  But that simply wasn’t true.  Bill Clarke, the director of clinical toxicology at the Johns Hopkins Hospital and one of three university scientists who attended the 2010 meeting, had asked Elizabeth to ship one of her devices to his lab so he could put it through its paces and compare its performance to the equipment he normally used.  She had indicated she would but had never followed through.  Kate and Mike didn’t know any of this, but the fact that Theranos refused to show them the full report made them suspicious.

To learn how to market to doctors, Chiat/Day suggested doing focus group interviews with a few physicians.  Theranos agreed as long as it was very secret.  Kate asked her wife, Tracy, chief resident at Los Angeles County General, to participate.  Tracy agreed.  During a phone interview, Tracy asked a few questions that no one at Theranos seemed to be able to answer.  Tracy told Kate that she doubted the company had any new technology.  She also doubted you could get enough blood from a finger to run tests accurately.

The evening before the marketing campaign was going to launch, Elizabeth set up an emergency conference call.  She systematically dialed back the language that would be used.  “Welcome to a revolution in lab testing” was changed to “Welcome to Theranos.”  “Faster results.  Faster answers.” became “Fast results.  Fast answers.”  “A tiny drop is all it takes” was now “A few drops is all it takes.”  “Goodbye, big bad needle” (which referred only to finger-stick draws) was replaced with “Instead of a huge needle, we can use a tiny finger stick or collect a micro-sample from a venous draw.”

Not everyone at Chiat/Day was skeptical, however.  Patrick thought Theranos could become his own big legacy, just as Apple had been for Lee Clow.

 

GOING LIVE

Alan Beam decided to become a doctor because his conservative Jewish parents thought that only law, medicine, or business was an appropriate career choice.  While attending Mount Sinai’s School of Medicine, he didn’t like the crazy hours or the sights and smells of the hospital ward.  Instead, he got interested in laboratory science.  He pursued postdoctoral studies in virology and a residency in clinical pathology at Brigham and Women’s Hospital in Boston.

In the summer of 2012, having recently read Walter Isaacson’s biography of Steve Jobs—which greatly inspired Alan—he wanted to move to the San Francisco Bay Area.  He ended up being hired as laboratory directory as Theranos.  He didn’t start until April 2013 because it took eight months before he got his California medical license.

After starting, Alan became concerned about low morale in the lab:

Its members were downright despondent.  During Alan’s first week on the job, Sunny summarily fired one of the CLSs.  The poor fellow was frog-marched out by security in front of everyone.  Alan got the distinct impression it wasn’t the first time something like that had happened.  No wonder people’s spirits were low, he thought.

The lab Alan inherited was divided into two parts: a room on the building’s second floor that was filled with commercial diagnostic equipment, and a second room beneath it where research was being conducted.  The upstairs room was the CLIA-certified part of the lab, the one Alan was responsible for.  Sunny and Elizabeth viewed its conventional machines as dinosaurs that would soon be rendered extinct by Theranos’s revolutionary technology, so they called it “Jurassic Park.”  They called the downstairs room “Normandy” in reference to the D-day landings during during World War II.  The proprietary Theranos devices it contained would take the lab industry by storm, like the Allied troops who braved hails of machine-gun fire on Normandy’s beaches to liberate Europe from Nazi occupation.

Alan liked the bravado at first.  But then he learned from Paul Patel—the biochemist leading the development of blood tests for Theranos’s new device (now called the “4S” instead of the miniLab)—that he and his team were still developing its assays on lab plates on the bench.  Alan asked Paul about it and Paul said the new Theranos box wasn’t working.

By the summer of 2013, the 4S had been under development for more than two and a half years.  But it still had a long list of problems.  Carreyrou writes:

The biggest problem of all was the dysfunctional corporate culture in which it was being developed.  Elizabeth and Sunny regarded anyone who raised a concern or an objection as a cynic and a naysayer.  Employees who persisted in doing so were usually marginalized or fired, while sycophants were promoted.  Sunny had elevated a group of ingratiating Indians to key positions…

For the dozens of Indians Theranos employed, the fear of being fired was more than just the dread of losing a paycheck.  Most were on H-1B visas and dependent on their continued employment at the company to remain in the country.  With a despotic boss like Sunny holding their fates in his hands, it was akin to indentured servitude.  Sunny, in fact, had the master-servant mentality common among an older generation of Indian businessmen.  Employees were his minions.  He expected them to be at his disposal at all hours of the day or night and on weekends. He checked the security logs every morning to see when they badged in and out…

With time, some employees grew less afraid of him and devised ways to manage him, as it dawned on them that they were dealing with an erratic man-child of limited intellect and an even more limited attention span.

Some of the problems were because Elizabeth was fixated on certain things.  For instance, she thought the 4S—aka the miniLab—was a consumer device like an iPhone, and therefore it had to be small and pretty.  She still hoped these devices would be in people’s homes someday.

Another difficulty stemmed from Elizabeth’s insistence that the miniLab be capable of performing the four major classes of blood tests: immunoassays, general chemistry assays, hematology assays, and assays that relied on the amplification of DNA.  The only known approach that would permit combining all of them in one desktop machine was to use robots wielding pipettes.  But this approach had an inherent flaw: overtime, a pipette’s accuracy drifts… While pipette drift was something that ailed all blood analyzers that relied on pipetting systems, the phenomenon was particularly pronounced on the miniLab. Its pipettes had to be recalibrated every two to three months, and the recalibration process put the device out of commission for five days.

Another serious weakness of the miniLab was that it could process only one blood sample at a time.  Commercial machines—which were bulky—could process hundreds of samples at the same time.

If the Theranos wellness centers attracted a lot of patients, the miniLab’s low throughput would cause long wait times, which was clearly inconsistent with the company’s promise of fast test results.

Someone suggested putting six miniLabs on top of one another—sharing one cytometer.  They adopted a computer term to name it: the“six-blade.”  But they overlooked a basic issue: temperature.  Some types of blood test require a very specific temperature. Because heat rises, the miniLabs near the top wouldn’t function.

There were other problems, too.  Many of them were fixable but would require a relatively long time.  Carreyrou explains:

Less than three years was not a lot of time to develop and perfect a complex medical device… The company was still several years away from having a viable product that could be used on patients.

However, as Elizabeth saw it, she didn’t have several years.  Twelve months earlier, on June 5, 2012, she’d designed a new contract with Walgreens that committed Theranos to launch its blood-testing services in some of the chain’s stores by February 1, 2013, in exchange for a $100 million “innovation fee” and an additional $40 million loan.

Theranos had missed that deadline—another postponement in what from Walgreens’s perspective had been three years of delays.  With Steve Burd’s retirement, the Safeway partnership was already falling apart, and if she waited much longer, Elizabeth risked losing Walgreens too. She was determined to launch in Walgreens stores by September, come hell or high water.

Since the miniLab was in no state to be deployed, Elizabeth and Sunny decided to dust off the Edison and launch with the older device.  That, in turn, led to another fateful decision—the decision to cheat.

Daniel Young, head of Theranos’s biomath team, and Xinwei Gong (who went by Sam), told Alan Beam that he and Sam were going to tinker with the ADVIA, one of the lab’s commercial analyzers.  It weighed 1,320 pounds and was made by Siemens Healthcare.  Since the Edison could only do immunoassays, Alan grasped why Daniel and Sam were going to try to use the ADVIA, which specialized in general chemistry assays.  As Carreyrou describes it:

One of the panels of blood tests most commonly ordered by physicians was known as the “chem 18” panel.  Its components, which ranged from tests to measure electrolytes sodium, potassium, and chloride to tests used to monitor patients’ kidney and liver function, were all general chemistry assays.  Launching in Walgreens stores with a menu of blood tests that didn’t include these tests would have been pointless.  They accounted for about two-thirds of doctors’ orders.

But the ADVIA was designed to handle a larger quantity of blood than you could obtain by pricking a finger.  So Daniel and Sam thought up a series of steps to adapt the Siemens analyzer to smaller samples.  Chief among these was the use of a big robotic liquid handler called the Tecan to dilute the little blood samples collected in the nanotainters with a saline solution.  Another was to transfer the diluted blood into custom-designed cups half the size of the ones that normally went into the ADVIA.

Because they were working with small blood samples, Daniel and Sam concluded that they would have to dilute the blood not once, but twice.  Alan knew this was a bad idea:

Any lab director worth his salt knew that the more you tampered with a blood sample, the more room you introduced for error.

Moreover, this double dilution lowered the concentration of the analytes in the blood samples to levels that were below the ADVIA’s FDA-sanctioned analytic measurement range. In other words, it meant using the machine in a way that neither the manufacturer nor its regulator approved of.  To get the final patient result, one had to multiply the diluted result by the same factor the blood had been diluted by, not knowing whether the diluted result was even reliable.  Daniel and Sam were nonetheless proud of what they’d accomplished.  At heart, both were engineers for whom patient care was an abstract concept.  If their tinkering turned out to have adverse consequences, they weren’t the ones who would be held personally responsible. It was Alan’s name, not theirs, that was on the CLIA certificate.

Anjali Laghari was in charge of the immunoassay group.  She’d worked with Ian Gibbons for a decade.  Anjali had spent years trying to get the Edison working, but the device still had a high error rate.

When Anjali started hearing that Theranos was “going live,” she grew very concerned.  She emailed Elizabeth and Daniel Young to remind them about the high error rates for some blood tests run on the Edison.

Neither Elizabeth nor Daniel acknowledged her email.  After eight years at the company, Anjali felt she was at an ethical crossroads.  To still be working out the kinks in the product was one thing when you were in R&D mode and testing blood volunteered by employees and their family members, but going live in Walgreens stores meant exposing the general population to what was essentially a big unauthorized research experiment.  That was something she couldn’t live with.  She decided to resign.

Elizabeth wanted to persuade Anjali to stay.  Anjali asked Elizabeth: Why they should rush to launch before their technology was ready?  

“Because when I promise something to a customer, I deliver.”

Anjali questioned this line of thought.  The customers who really mattered were the patients who ordered blood tests, believing that the tests were a reliable basis for medical decisions.

After Anjali resigned, her deputy Tina Noyes resigned.

The resignations infuriated Elizabeth and Sunny.  The following day they summoned the staff for an all-hands meeting in the cafeteria… Still visibly angry, Elizabeth told the gathered employees that she was building a religion.  If there were any among them who didn’t believe, they should leave.  Sunny put it more blatantly: anyone not prepared to show complete devotion and unmitigated loyalty to the company should “get the fuck out.”

 

UNICORN

Elizabeth had met the great statesman George Shultz a couple of years before 2013.  She impressed him and won his support.  Based on this connection, Elizabeth had been able to engineer a very favorable piece in the Wall Street Journal.  The article was published September 7, 2013, just as Theranos was going to launch its blood-testing services.  Carreyrou says of the article:

Drawing blood the traditional way with a needle in the arm was likened to vampirism… Theranos’s processes, by contrast,were described as requiring “only microscopic blood volumes” and as “faster, cheaper, and more accurate than the conventional methods.”  The brilliant young Stanford dropout behind the breakthrough invention was anointed “the next Steve Jobs or Bill Gates” by no less than former secretary of state George Shultz, the man many credited with winning the cold war, in a quote at the end of the article.

Elizabeth planned to use the misleading article and the Walgreens launch as a basis for a new fundraising campaign.

Donald A. Lucas, son of legendary venture capitalist Donald L. Lucas, called Mike Barsanti.  Don and Mike had been friendly since they attended Santa Clara University in the 1980s.  Don proceeded to pitch Mike on Theranos.

Mike had first heard about Elizabeth seven years earlier.  Mike had been interested then, but Don hadn’t been. 

[Back in 2006, Mike] asked Don why the firm wasn’t taking a flyer on [Elizabeth] like his father had.  Don had replied that after careful consideration he’s decided against it.  Elizabeth was all over the place, she wasn’t focused, his father couldn’t control her even though he chaired her board, and Don didn’t like or trust her, Mike recalled his friend telling him.

In 2013, Mike asked Don what had changed.

Don explained excitedly that Theranos had come a long way since then.  The company was about to announce the launch of its innovative finger-stick tests in one of the country’s largest retail chains.  And that wasn’t all, he said.  The Theranos devices were also being used by the U.S. military.

“Did you know they’re in the back of Humvees in Iraq?” he asked Mike.

[…]

If all this were true, they were impressive developments, Mike thought.

…Intent on seizing what he saw as a great opportunity, the Lucas Venture Group was raising money for two new funds, Don told Mike.  One of them was a traditional venture fund that would invest in several companies, including Theranos.  The second would be exclusively devoted to Theranos.  Did Mike want in?  If so, time was short.

Mike got an email on September 9, 2013, discussing the “Theranos-time sensitive” opportunity.  The Lucas Venture group would get a discounted price, which valued the firm at $6 billion.  Don mentioned that Theranos had “signed contracts and partnerships with very large retailers and drug stores as well as various pharmaceutical companies, HMO’s, insurance agencies, hospitals, clinics, and various government agencies.”  Don also said that the company had been “cash flow positive since 2006.”

Theranos seemed to be another “unicorn.”  Unicorns like Uber had been able to raise massive amounts of money while still remaining private companies, allowing them to avoid the pressures and scrutiny of going public.

Christopher James and Brian Grossman ran the hedge fund Partner Fund Management, which had $4 billion under management.  James and Grossman saw the Wall Street Journal article about Theranos and were interested.  They reached out to Elizabeth and went to meet with her on December 15, 2013.

During that first meeting, Elizabeth and Sunny told their guests that Theranos’s proprietary finger-stick technology could perform blood tests covering 1,000 of the 1,300 codes laboratories used to bill Medicare and private health insurers, according to a lawsuit Partner Fund later filed against the company.  (Many blood tests involve several billing codes, so the actual number of tests represented by those thousand codes was in the low hundreds.)

At a second meeting three weeks later, they showed them a Powerpoint presentation containing scatter plots purporting to compare test data from Theranos’s proprietary analyzers to data from conventional lab machines.  Each plot showed data points tightly clustered around a straight line that rose up diagonally from the horizontal x-axis.  This indicated that Theranos’s tests results were almost perfectly correlated with those of the conventional machines.  In other words, its technology was as accurate as traditional testing.  The rub was that much of the data in the charts wasn’t from the miniLab or even from the Edison.  It was from other commercial blood analyzers Theranos had purchased, including one manufactured by a company located an hour north of Palo Alto called Bio-Rad.

Sunny also told James and Grossman that Theranos had developed about three hundred different blood tests, ranging from commonly ordered tests to measure glucose, electrolytes, and kidney function to more esoteric cancer-detection tests.  He boasted that Theranos could perform 98 percent of them on tiny blood samples pricked from a finger and that, within six months, it would be able to do all of them that way.  These three hundred tests represented 99 to 99.9 percent of all laboratory requests, and Theranos had submitted every single one of them to the FDA for approval, he said.

Sunny and Elizabeth’s boldest claim was that the Theranos system was capable of running seventy different blood tests simultaneously on a single finger-stick sample and that it would soon be able to run even more.  The ability to perform so many tests on just a drop or two of blood was something of a Holy Grail in the field of microfluidics.

There were some basic problems with trying to run many tests on small samples of blood.  If you used a micro blood sample to do an immunoassay, then there usually wasn’t enough blood for the different set of lab techniques a general chemistry or hematology assay required.  Another fundamental problem was that in transferring a small sample to a microfluidic chip, some blood was lost.  This doesn’t matter for large blood samples, but it can be a crucial problem for small blood samples.  Yet Elizabeth and Sunny implied that they had solved these and other difficulties.

James and Grossman not only liked the presentations by Elizabeth and Sunny; they also were impressed by Theranos’s board of directors.  In addition to Shultz and General Mattis, the board now had Henry Kissinger, William Perry (former secretary of defense), Sam Nunn, and former navy admiral Gary Roughead.  Like Shultz, all of these board members were fellows at the Hoover Institution at Stanford.

Sunny sent the hedge fund managers a spreadsheet with financial projections.

It forecast gross profits of $165 million on revenues of $261 million in 2014 and gross profits of $1.08 billion on revenues of $1.68 billion in 2015.  Little did they know that Sunny had fabricated these numbers from whole cloth.  Theranos hadn’t had a real chief financial officer since Elizabeth had fired Henry Mosley in 2006.

Partner Fund invested $96 million.  This valued Theranos at $9 billion, which put Elizabeth’s net worth at almost $5 billion.

 

THE GRANDSON       

Carreyrou writes this chapter about Tyler Shultz, the grandon of George Shultz:

Tyler had first met Elizabeth in late 2011 when he’d dropped by his grandfather George’s house near the Stanford campus.  He was a junior then, majoring in mechanical engineering.  Elizabeth’s vision of instant and painless tests run on drops of blood collected from fingertips had struck an immediate chord with him.  After interning at Theranos that summer, he’d changed his major to biology and applied for a full-time position at the company.

Tyler became friends with Erika Cheung.

Their job on the immunoassay team was to help run experiments to verify the accuracy of blood tests on Theranos’s Edison devices before they were deployed in the lab for use on patients.  This verification process was known as “assay validation.”

[…]

One type of experiment he and Erika were tasked with doing involved retesting blood samples on the Edisons over and over to measure how much their results varied. The data collected were used to calculate each Edison’s blood test’s coefficient of variation, or CV.  A test is generally considered precise if its CV is less than 10 percent.  To Tyler’s dismay, data runs that didn’t achieve low enough CVs were simply discarded and the experiments repeated until the desired number was reached.  It was as if you flipped a coin enough times to get ten heads in a row and then declared that the coin always returned heads.  Even with the “good” data runs, Tyler and Erika noticed that some values were deemed outliers and deleted.  When Erika asked the group’s more senior scientists how they defined an outlier, no one could give her a straight answer.  Erika and Tyler might be young and inexperienced, but they both knew that cherry-picking data wasn’t good science.  Nor were they the only ones who had concerns about these practices.

Tyler and colleagues tested 247 blood samples on Edison for syphilis, 66 of which were known to be positive.  The devices correctly identified only 65 percent of the sample on the first run, and 80 percent on the second run.

Yet, in its validation report, Theranos stated that its syphilis test had a sensitivity of 95 percent.

There were other tests where Tyler and Erika thought Theranos was being misleading.  For instance, a blood sample would be tested for vitamin D on an analyzer made by the Italian company DiaSorin.  It might show a vitamin D concentration of 20 nanograms per milliliter—a normal result for a healthy patient.  When Erika tested the sample on the Edison,the result was 10 or 20 nanograms per milliliter—indicating a vitamin D deficiency.  Nonetheless, the Edison was cleared for use in the clinical lab on live patient samples, writes Carreyrou.

In November 2013, while working in the clinical lab, Erika received a patient order from the Walgreens store in Palo Alto.  As was standard practice, first she did a quality-control check.  That involves testing a sample where you already know the concentration of the analyte.

If the result obtained is two standard deviations higher or lower than the known value, the quality-control check is usually deemed to have failed.

Erik’a first quality-control check failed.  She ran it again and that one failed as well.  Because it was during Thanksgiving, no one Erika normally reported to was around.  Erika sent an email to the company’s emergency help line.

Sam Anekal, Suraj Saksena, and Daniel Young responded to her email with various suggestions, but nothing they proposed worked.  After awhile an employee named Uyen Do from the research-and-development side came down and took a look at the quality-control readings.

Twelve values had been generated, six during each quality-control test.

Without bothering to explain her rationale to Erika, Do deleted two of those twelve values, declaring them outliers.  She then went ahead and tested the patient sample and sent out a result.

This wasn’t how you were supposed to handle repeat quality-control failures.  Normally, two such failures in a row would have been cause to take the devices off-line and recalibrate them.  Moreover, Do wasn’t even authorized to be in the clinical lab.  Unlike Erika, she didn’t have a CLS license and had no standing to process patient samples.  The episode left Erika shaken.

Tyler Shultz moved to the production team in early 2014.  This put him back near Erika and other colleagues from the clinical lab.

Tyler learned from Erika and others that the Edisons were frequently flunking quality-control checks and that Sunny was pressuring lab personnel to ignore the failures and to test patient samples on the devices anyway.

Tyler asked Elizabeth about validation reports, and she suggested he speak with Daniel Young.  Tyler asked Daniel about CV values: Why were so many data runs discarded when the resulting CV was too high?   Daniel told him that he was making the mistake of taking into account all six values generating by the Edison during a test.  Young said that only the median value mattered.  It was obvious to Tyler that if the Edison’s results were accurate, such data contortions—and the associated dishonesty—wouldn’t be needed in the first place.

Furthermore, all clinical laboratories undergo “proficiency testing” three times a year.

During its first two years of operation, the Theranos lab had always tested proficiency-testing samples on commercial analyzers.  But since it was now using the Edisons for some patient tests, Alan Beam and his new lab codirector had been curious to see how the devices fared in the exercise.  Beam and the new codirector, Mark Pandori, had ordered Erika and other lab associates to split the proficiency-testing samples and run one part on the Edisons and the other part on the lab’s Siemens and DiaSorin analyzers for comparison.  The Edison results had differed markedly from the Siemens and DiaSorin ones, especially for vitamin D.

When Sunny had learned of their little experiment, he’d hit the roof.  Not only had he put an immediate end to it, he had made them report only the Siemens and DiaSorin results.  There was a lot of chatter in the lab that the Edison results should have been the ones reported.  Tyler had looked up the CLIA regulations and they seemed to bear that out…

Tyler told Daniel he didn’t see how what Theranos had done could be legal.  Daniel’s response followed a tortuous logic.  He said a laboratory’s proficiency-testing results were assessed by comparing them to its peers’ results, which wasn’t possible in Theranos’s case because its technology was unique and had no peer group.  As a result, the only way to do an apples-to-apples comparison was by using the same conventional methods as other laboratories.  Besides, proficiency-testing rules were extremely complicated, he argued.  Tyler could rest assured that no laws had been broken.  Tyler didn’t buy it.

In March 2014, using an alias, Tyler emailed the New York health department because it ran one of the proficiency-testing programs in which Theranos had participated.  Without revealing the name of the company in question, he asked about Theranos’s approach.  He got confirmation that Theranos’s practices were “a form of PT cheating” and were “in violation of the state and federal requirements.”  Tyler was given a choice: reveal the name of the company or file an anonymous complaint with New York State’s Laboratory Investigative Unit.  He chose the second option.

Tyler told his famous grandfather George about his concerns.  He said, moreover, that he was going to resign.  George asked him to give Elizabeth a chance to respond.  Tyler agreed.  Elizabeth was too busy to meet in person, so Tyler sent her a detailed email.  He didn’t hear anything for a few days.

When the response finally arrived, it didn’t come from Elizabeth.  It came from Sunny.  And it was withering.  In a point-by-point rebuttal that was longer than Tyler’s original email, Sunny belittled everything from his grasp of statistics to his knowledge of laboratory science.

On the topic of proficiency testing, Sunny wrote:

“That reckless comment and accusation about the integrity of our company, its leadership and its core team members based on absolute ignorance is so insulting to me that had any other person made these statements, we would have held them accountable in the strongest way.  The only reason I have taken so much time away from work to address this personally is because you are Mr. Shultz’s grandson…

I have now spent an extraordinary amount of time postponing critical business matters to investigate your assertions—the only email on this topic I want to see from you going forward is an apology that I’ll pass on to other people including Daniel here.”

Tyler replied to Sunny with a one-sentence email saying he was resigning.  Before he even got to his car, Tyler’s mother called and blurted, “Stop whatever you’re about to do!”  Tyler explained that he had already resigned.

“That’s not what I mean.  I just got off the phone with your grandfather.  He said Elizabeth called him and told him that if you insist on carrying out your vendetta against her, you will lose.”

Tyler was dumbfounded.  Elizabeth was threatening him through his family, using his grandfather to deliver the message.

Tyler went to the Hoover Institution to meet with his grandfather. George listened to what Tyler had to say.  Finally, George told his grandson that he thought he was wrong in this case.

In the meantime, a patient order for a hepatitis C test had reached the lab and Erika refused to run it on the Edisons, writes Carreyrou.  The reagents for the hepatitis C test were expired.  Also, the Edisons hadn’t been recalibrated in awhile.  Erika and a coworker decided to use commercially available hepatitis kits called OraQuick HCV.  That had worked until the lab had run out of them.  They tried to order more, but Sunny had gotten upset and tried to block it.  Sunny also learned that it was Erika who had given Tyler the proficiency-testing results.  Sunny asked Erika to meet with him and then told her, “You need to tell me if you want to work here or not.”

Erika went to meet Tyler, who suggested that she join him for dinner at his grandfather’s house.  Perhaps having two people with similar experiences would be more persuasive.  Unfortunately, while Charlotte, George’s wife, seemed receptive and incredulous, George wasn’t buying it.

Tyler had noticed how much he doted on Elizabeth.  His relationship with her seemed closer than their own.  Tyler also knew that his grandfather was passionate about science.  Scientific progress would make the world a better place and save it from such perils as pandemics and climate change, he often told his grandson.  This passion seemed to make him unable to let go of the promise of Theranos.

George said a top surgeon in New York had told him the company was gong to revolutionize the field of surgery and this was someone his good friend Henry Kissinger considered to be the smartest man alive.  And according to Elizabeth, Theranos’s devices were already being used in medevac helicopters and hospital operating rooms, so they must be working.

Tyler and Erika tried to tell him that couldn’t possibly be true given that the devices were barely working within the walls of Theranos.  But it was clear they weren’t making any headway.  George urged them to put the company behind them and to move on with their lives. 

The next morning Erika quit Theranos.

 

FAME

After Theranos sued Richard Fuisz, Richard and Joe Fuisz resolved to fight it to the very end.  However, after they’d spent more than $2 million on their defense and after they realized how outgunned they were by Theranos’s lawyers—led by David Boies—they decided it would be better to settle.

It amounted to a complete capitulation on the Fuiszes’ part.  Elizabeth had won.

At a meeting with Boies, the two sides drafted the settlement agreement. Then Richard and Joe signed.

…Richard Fuisz looked utterly defeated.  The proud and pugnacious former CIA agentbroke down and sobbed.

Roger Parloff, Fortune magazine’s legal correspondent, saw an article about the case involving Theranos and the Fuiszes.  Parloff called Dawn Schneider, Boies’s long-term public relations representative.  She offered to meet Parloff at his office.  On the walk across Midtown, Schneider thought that a better story to write about was Theranos and its brilliant young founder.  When she arrived at Parloff’s office, she told him about Theranos and said, “this is the greatest company you’ve never heard of.”

Parloff went to Palo Alto do meet with Elizabeth.

…what Elizabeth told Parloff she’d achieved seemed genuinely innovative and impressive.  As she and Sunny had stated to Partner fund, she told him the Theranos analyzer could perform as many as seventy different blood tests from one tiny finger-stick draw and she led him to believe that the more than two hundred tests on its menu were all finger-stick tests done with proprietary technology.  Since he didn’t have the expertise to vet her scientific claims, Parloff interviewed the prominent members of her board of directors and effectively relied on them as character witnesses… All of them vouched for Elizabeth emphatically. Shultz and Mattis were particularly effusive.

“Everywhere you look with this young lady, there’s a purity of motivation,” Shultz told him.  “I mean she is really trying to make the world better, and this is her way of doing it.”

Mattis went out his way to praise her integrity.  “She has probably one of the most mature and well-honed sense of ethics—personal ethics, managerial ethics, business ethics, medical ethics that I’ve ever heard articulated,” the retired general gushed.

Parloff’s cover story for Fortune magazine was published June 12, 2014.  Elizabeth instantly became a star.  Forbes then ran its own piece.

Two months later she graced one of the covers of the magazine’s annual Forbes 400 issue on the richest people in America.  More fawning stories followed in USA Today, Inc., Fast Company, and Glamour, along with segments on NPR, Fox Business, CNBC, CNN, and CBS News.  With the explosion of media coverage came invitations to numerous conferences and a cascade of accolades.  Elizabeth became the youngest person to win the Horatio Alger award.  Time magazine named her one of the one hundred most influential people in the world. President Obama appointed her a U.S. ambassador for global entrepreneurship, and Harvard Medical School invited her to join its prestigious board of fellows.

Carreyrou continues:

As much as she courted the attention, Elizabeth’s sudden fame wasn’t entirely her doing… In Elizabeth Holmes, the Valley had its first female billionaire tech founder.

Still, there was something unusual in the way Elizabeth embraced the limelight. She behaved more like a movie star than an entrepreneur, basking in the public adulation she was receiving.  Each week brought a new media interview or conference appearance.  Other well-known startup founders gave interviews and made public appearances too but with nowhere near the same frequency.  The image of the reclusive, ascetic young woman Parloff had been sold on had overnight given way to that of the ubiquitous celebrity.

Elizabeth excelled at delivering a heartwarming message that Theranos’s convenient blood tests could be used to catch diseases early so that no one would have to say goodbye to loved ones too soon, notes Carreyrou.  She soon started adding a new personal detail to her interviews and presentations: her uncle had died of cancer.

It was true that Elizabeth’s uncle, Ron Dietz, had died eighteen months earlier from skin cancer that had metastasized and spread to his brain.  But what she omitted to disclose was that she had never been close to him.  To family members who knew the reality of their relationship, using his death to promote her company felt phony and exploitative.

Of course, at that time, most people who heard Elizabeth in an interview or presentation didn’t know about the lies she was telling.  But she was a great salesperson.  Elizabeth told one story about a little girl who got stuck repeatedly because the nurse couldn’t find the vein.  Another story was about cancer patients depressed because of how much blood they had to give.

Patrick O’Neill, from TBWA/Chiat/Day, was Theranos’s chief creative officer.  He was raising Elizabeth’s profile and perfecting her image.

To Patrick, making Elizabeth the face of Theranos made perfect sense.  She was the company’s most powerful marketing tool.  Her story was intoxicating.  Everyone wanted to believe in it, including the numerous young girls who were sending her letters and emails.  It wasn’t a cynical calculus on his part: Patrick was one of her biggest believers.  He had no knowledge of the shenanigans in the lab and didn’t pretend to understand the science of blood testing.  As far as he was concerned, the fairy tale was real.

With over five hundred employees, Theranos had to move to a new location.  Patrick designed Elizabeth’s new office:

Elizabeth’s new corner office was designed to look like the Oval Office.  Patrick ordered a custom-made desk that was as deep as the president’s at its center but had rounded edges.  In front of it, he arranged two sofas and two armchairs around a table, replicating the White House layout.  At Elizabeth’s insistence, the office’s big windows were made of bulletproof glass.

 

THE HIPPOCRATIC OATH

Alan Beam had become disillusioned:

For his first few months as laboratory director, he’s clung to the belief that the company was going to transform with its technology.  But the past year’s events had shattered any illusion of that.  He now felt like a pawn in a dangerous played with patients, investors, and regulators.  At one point, he’d had to talk Sunny and Elizabeth out of running HIV tests on diluted finger-stick samples.  Unreliable potassium and cholesterol results were bad enough.  False HIV results would have been disastrous.

Two of Alan’s colleagues had recently resigned out of disagreement with what they viewed as blatantly dishonest company policies.

One day Alan was talking with Curtis Schneider, one of the smartest people at Theranos, with a Ph.D. in inorganic chemistry and having spent four years as a postdoctoral scholar at Caltech. 

He told Curtis about the lab’s quality-control data and how it was being kept from him.  And he confided something else: the company was cheating on its proficiency testing.  In case Curtis hadn’t registered the implication of what he’d just said, he spelled it out: Theranos was breaking the law.

A few weeks later, Christian Holmes contacted Alan.

Christian wanted Alan to handle yet another doctor’s complaint.  Alan had field dozens of them since the company had gone live with its tests the previous fall.  Time and time again, he’d been asked to convince physicians that blood-test results he had no confidence in were sound and accurate.  He decided he couldn’t do it anymore.  His conscience wouldn’t allow him to.

He told Christian no and emailed Sunny and Elizabeth to inform them that he was resigning and to ask them to immediately take his name off the lab’s CLIA license.

December 15, 2014, there another article about Theranos in the New Yorker.  Adam Clapper, a pathologist in Columbia Missouri, who writes a blog about the industry Pathology Blawg, noticed the article.  He was very skeptical about Theranos.  Joe Fuisz noticed the article and told his father about it.  Richard read the article and got in touch with Adam.  Adam felt initially that he would need more proof.

A few days later, Richard noticed that someone named Alan Beam had looked at his LinkedIn profile.  Richard saw that Alan had been laboratory director at Theranos.  So he sent him an InMail, thinking it was worth a shot.  Alan got back to him.

Alan called and said to Richard, “You and I took the Hippocratic Oath, which is to first do no harm.  Theranos is putting people in harm’s way.”  Alan filled him in on all the details. 

Richard told Adam about what he’d learned from Alan.  Adam agreed that the information changed everything. However, he was worried about the legal liability of going against a $9 billion Silicon Valley company with a litigious history and represented by David Boies.  That said, Adam knew an investigative reporter at the Wall Street Journal.  John Carreyrou.

 

THE TIP

Adam called John Carreyrou at the Wall Street Journal.  Carreyrou says that even though nine times out of ten, tips don’t workout, he always listened because you never knew.  Also, he happened to have just finished a year-long investigation in Medicare fraud and he was looking for his next story.

February 26, 2015, Carreyrou reached Alan Beam.  Alan agreed to talk as long as his identity was kept confidential.

…the Theranos devices didn’t work.  They were called Edisons, he said, and they were error-prone.  They constantly failed quality-control.  Furthermore, Theranos used them for only a small number of tests.  It performed most of its tests on commercially available instruments and diluted the blood samples.

…Theranos didn’t want people to know its technology was limited, so it had contrived a way of running small finger-stick samples on conventional machines.  This involved diluting the finger-stick samples to make them bigger.  The problem, he said, was that when you diluted the samples, you lowered the concentration of analytes in the blood to a level the conventional machines could no longer measure accurately.

He said he had tried to delay the launch of Theranos’s blood tests in Walgreens stores and had warned Holmes that the lab’s sodium and potassium results were completely unreliable… I was barely getting my head around these revelations when Alan mentioned something called proficiency testing.  He was adamant that Theranos was breaking federal proficiency-testing rules.

There was more:

Alan also said that Holmes was evangelical about revolutionizing blood testing but that her knowledge base on science and medicine was poor, confirming my instincts.  He said she wasn’t the onerunning Theranos day-to-day.  A man named Sunny Balwani was.  Alan didn’t mince his words about Balwani: he was a dishonest bully who managed through intimidation.  Then he dropped another bombshell: Holmes and Balwani were romantically involved.

It’s not that there were rules against such a romantic involvement in the Silicon Valley startup world. Rather, it’s that Elizabeth was hiding the relationship from her board.  What other information might she be keeping from her board?

Alan told Carreyrou how he had brought up his concerns with Holmes and Balwani a number of times, but Balwani would either rebuff him or put him off, writes Carreyrou. 

Alan was most worried about potential harm to patients:

He described the two nightmare scenarios false blood-test results could lead to.  A false positive might cause a patient to have an unnecessary medical procedure.  But a false negative was worse: a patient with a serious condition that went undiagnosed could die.

Carreyrou experienced the familiar rush of a big reporting breakthrough, but he knew that he needed to get corroboration.  He proceeded to speak with others who had been associated with Theranos and who were willing to talk—some on the condition of anonymity.  A good start.  However, getting documentary evidence was “the gold standard for these types of stories.”  This would be harder.

Carreyrou spoke with Alan again.

Our conversation shifted to proficiency testing. Alan explained how Theranos was gaming it and he told me which commercial analyzers it used fort he majority of its blood tests.  Both were made by Siemens… He revealed something else that hadn’t come up in our first call: Theranos’s lab was divided into two parts.  One contained the commercial analyzers and the other the Edison devices.  During her inspection of the lab, a state inspector had been shown only the part with the commercial analyzers.  Alan felt she’d been deceived.

He also mentioned that Theranos was working on a newer-generation device code-named 4S that was supposed to supplant the Edison and do a broader variety of blood tests, but it didn’t work at all and was never deployed in the lab.  Diluting finger-stick samples and running them on Siemens machines was supposed to be a temporary solution, but it had become a permanent one because the 4S had turned into a fiasco.

It was all beginning to make sense: Holmes and her company had overpromised and then cut corners when they couldn’t deliver. It was one thing to do that with software or a smartphone app, but doing it with a medical product that people relied on to make important health decisions was unconscionable.

Carreyrou reached out to twenty former and current Theranos employees.  Many didn’t respond.  Those Carreyrou got on the phone said they’d signed strict confidentiality agreements. They were worried about being sued.

Carreyrou’s initial conversations with Alan and two others had been “on deep background,” which meant Carreyrou could use what they said but had to keep their identities confidential. Subsequently, he spoke with a former high-ranking employee “off the record.”  This meant that Carreyrou couldn’t make use of any information from that conversation. But Carreyrou did learn corroborating information even though it was off the record.  This further bolstered his confidence.

Carreyrou knew he needed proof that Theranos was delivering inaccurate blood-test results.  He discovered a doctor, Nicole Sundene, who had much such a complaint on Yelp.  Carreyrou met with Dr. Sundene, who told him about the experience of one of her patients, Maureen Glunz.

The lab report she’d received from Theranos had shown abnormally elevated results for calcium, protein, glucose, and three liver enzymes… Dr. Sundene had worried she might be on the cusp of a stroke and sent her straight to the hospital.  Glunz had spent four hours in the emergency room on the eve of Thanksgiving while doctors ran a battery of tests on her,including a CT scan.  She’d been discharged after a new set of blood tests performed by the hospital’s lab came back normal.  That hadn’t been the end of it, however.  As a precaution, she’d undergone two MRIs during the ensuing week…

When I met with Dr. Sundene at her office, I learned that Glunz wasn’t the only patient whose results she found suspect.  She told me more than a dozen of her patients had tested suspiciously high for potassium and calcium and she doubted the accuracy of those results as well.  She had written Theranos a letter to complain but the company hadn’t even acknowledged it.

Carreyrou met a Dr. Adrienne Stewart who told him about two of her patients who’d gotten incorrect results from Theranos.  One patient had to delay a long-planned trip to Ireland because an incorrect result from Theranos suggested she could have deep vein thrombosis.  A second set of tests from another lab turned out to be normal. Also, ultrasound of the patient’s legs didn’t reveal anything.

Another of Dr. Stewart patients had gotten a test result from Theranos indicating a high TSH value.

The patient was already on thyroid medication and the result suggested that he dose needed to be raised.  Before she did anything, Dr. Stewart sent the patient to get retested at Sonora Quest, a joint venture of Quest and the hospital system Banner Health.  The Sonora Quest result came back normal.  Had she trusted the Theranos result and increased the patient’s medication dosage, the outcome could have been disastrous, Dr. Stewart said.  The patient was pregnant.  Increasing her dosage would have made her levels of thyroid hormone too high and put her pregnancy at risk.

Carreyrou also met with Dr. Gary Betz.  He had a patient on medication to reduce blood pressure.  High potassium was one potential side effect of the medication, so Dr. Betz monitored it.  A Theranos test showed that his patient had an almost critical level of potassium.  A nurse sent Dr. Bet’z patient back to get retested.  But the phlebotomist was unable to complete the test despite three attempts to draw blood. Dr. Betz was very upset because if the initial test was accurate, an immediate change in the patient’s treatment was crucial.  He sent his patient to get tested as SonoraQuest.  The result came back normal.

As an experiment, Carreyrou and Dr. Sundene had each gotten their blood tested by Theranos and by another lab.  Carreyrou:

Theranos had flagged three of my values as abnormally high and one as abnormally low.  Yet on LabCorp’s report, all four of those values showed up as normal. Meanwhile, LabCorp had flagged both my total cholesterol and LDL cholesterol as high, while the Theranos described the first as “desirable” and the second as “near optimal.”

Those differences were mild compared to a whopper Dr. Sundene had found in her results.  According to Theranos, the amount of cortisol in her blood was less than one microgram per deciliter.  A value that low was usually associated with Addison’s disease, a dangerous condition characterized by extreme fatigue and low blood pressure that could result in death if it went untreated.  Her LabCorp report, however, showed a cortisol level of 18.8, micrograms per deciliter, which was within the normal range for healthy patients.  Dr. Sundene had no doubt which of the two values was the correct one.

Carreyrou mentions a “No surprise” rule they have at the Wall Street Journal.

We never went to press with a story without informing the story subject of every single piece of information we had gathered in our reporting and giving them ample time and opportunity to address and rebut everything.

Carreyrou met with Erica Cheung.

She said Theranos should never have gone live testing patient samples.  The company routinely ignored quality-control failures and test errors and showed a complete disregard for the well-being of patients, she said.  In the end, she had resigned because she was sickened by what she had become a party to, she told me.

Carreyrou also met with Tyler Shultz, who gave him a detailed account of his experiences with Theranos. Finally, Carreyrou met with Rochelle Gibbons, the widow of Ian Gibbons.

I flew back to New York the next day confident that I’d reached a critical mass in my reporting and that it wouldn’t be too long before I could publish.  But that was underestimating whom I was up against.

 

THE AMBUSH

On May 27, 2015, Tyler went to his parents’ house for dinner,as he tried to do every two weeks.  His father, looking worried, asked Tyler if he’d spoken with an investigative journalist from the Wall Street Journal.  Yes, said Tyler.  His father: “Are you kidding me?  How stupid could you be?  Well, they know.”

His father told him that his grandfather George had called.  George said if Tyler wanted to get out of a “world of trouble,” he would have to meet with Theranos’s lawyers the next day and sign something.  Tyler called his grandfather and arranged to meet him later that night.

Carreyrou had sent a list of seven areas he wanted to discuss with Elizabeth to Matthew Traub, a representative of Theranos.  Included in one section was coefficient of variation for one of the blood tests.  It happened to be a number that Tyler had calculated.  It was because of that number that Elizabeth had been able to tie Tyler to the investigative reporter.

However, the number Elizabeth tied to Tyler could have come from anyone.  When Tyler met with his grandfather, he categorically denied speaking with any reporter.  George told Tyler:  “We’re doing this for you.  Elizabeth says your career will be over if the article is published.”

Tyler summarized all the issues he had raised earlier regarding Theranos.  But his grandfather still didn’t agree with Tyler’s views.  George told his grandson that there was a one-page document Theranos wanted him to sign swearing confidentiality going forward. Theranos argued that the Wall Street Journal article would include trade secrets of the company.  Tyler said he would consider signing the document if the company would stop bothering him. George then told Tyler that there were two Theranos lawyers upstairs.

Tyler felt betrayed because he had specifically asked to meet his grandfather with no lawyers.  His grandmother Charlotte told Tyler that she was questioning whether Theranos had a functioning product and that Henry Kissinger was also skeptical and wanted out.

The two lawyers, Mike Brill and Meredith Dearborn, were partners at Boies, Schiller & Flexner. Brille told Tyler he had identified him as a source for the Journal article.

He handed him three documents: a temporary restraining order, a notice to appear in court two days later, and a letter stating Theranos had reason to believe Tyler had violated his confidentiality obligations and was prepared to file suit against him.

Brille pressed Tyler to admit that he had spoken with a reporter.  Tyler kept denying it.  Brille kept pushing and pushing and pushing.  Finally, Tyler said the conversation needed to end.  His grandfather jumped in and defended Tyler and escorted the lawyers out of the house. 

[George] called Holmes and told her this was not what they had agreed upon.  She had sent over a prosecutor rather than someone who was willing to have a civilized conversation.  Tyler was ready to go to court the next day, he warned her.

George and Elizabeth reached a compromise.  They would meet again at George’s house the following morning.  Tyler would look at the one-page document.  George asked Elizabeth to send a different lawyer.

The next morning, Tyler wasn’t surprised to see Brille again.  Brille had new documents. 

One of them was an affidavit stating that Tyler had never spoken to any third parties about Theranos and that he pledged to give the names of every current and former employee who he knew had talked to the Journal. Brille asked Tyler to sign the affidavit.  Tyler refused.

George asked Tyler what it would take for him to sign it.  Tyler said Theranos would have to agree not to sue him.  George wrote the requirement on the affidavit.  Then he and Brille went into another room to talk.

In the interim, Tyler decided he wasn’t going to sign anything.  After speaking with two lawyers soon thereafter, Tyler stuck with his decision.  Brille had been threatening to sue immediately, but then told Tyler’s lawyer that they were going to delay the lawsuit in order to try to reach some agreement.

Tyler—through his lawyer—began exchanging drafts of the affidavit with Brille.  Tyler tried to make concessions in order to reach some agreement.  For instance, he agreed to be called a junior employee who couldn’t have known what he was talking about when it come to proficiency testing, assay validation, and lab operations. But Theranos kept pushing Tyler to name the Journal’s other sources.  He refused.

As the stalemate dragged on, Boies Schiller resorted to the bare-knuckle tactics it had become notorious for.  Brille let it be known that if Tyler didn’t sign the affidavit and name the Journal‘s sources, the firm would make sure to bankrupt his entire family when it took him to court.  Tyler also received a tip that he was being surveilled by private investigators.

Tyler got a lawyer for his parents.  That way Tyler and his parents could communicate through attorneys and those conversations would be protected by attorney-client privilege.

This led to an incident that rattled both Tyler and his parents.  Hours after his parents’ new lawyer met with them for the first time, her car was broken into and her briefcase containing her notes from the meeting was stolen.

 

TRADE SECRETS

A Theranos delegation met Carreyrou at the offices of the Journal. David Boies came with Mike Brille, Meredith Dearborn, and Heather King, who was now general counsel for Theranos. Matthew Traub was there.  The only Theranos executive was Daniel Young.

Carreyrou brought along Mike Siconolfi, head of the Journal’s investigations team, and Jay Conti, the deputy general counsel of the Journal’sparent company.

Carreyrou had sent eighty questions, at Traub’s request, as a basis for the discussion.  King began the meeting by saying they were going to refute the “false premises” assumed by the questions.  The lawyers tried to intimidate Carreyrou.  King warned: “We do not consent to your publication of our trade secrets.”

Carreyrou wasn’t going to be intimidated.  He retorted: “We do not consent to waiving our journalistic privileges.”

King became more conciliatory as they agreed to start going through the questions one at a time.  Daniel Young was the only there who could answer them.

After Young acknowledged that Theranos owned commercial blood analyzers, which he claimed the company used only for comparison purposes, rather than for delivering patient results, I asked if one of them was the Siemens ADVIA.  He declined to comment, citing trade secrets.  I then asked whether Theranos ran small finger-stick samples on the Siemens ADVIA with a special dilution protocol.  He again invoked trade secrets to avoid answering the question but argued that diluting blood samples was common in the lab industry.

Carreyrou pointed out that if they weren’t prepared to answer such basic questions that were at the heart of his story, what was the point ofmeeting?  Eventually Boies got angry and criticized Carreyrou’s reporting methods, saying he asked loaded questions to doctors.  Much more back-and-forth ensued between members of the Theranos delegation and Carreyrou, Siconolfi, and Conti.

How could anything involving a commercial analyzer manufactured by a third party possibly be deemed a Theranos trade secret? I asked.  Brille replied unconvincingly that the distinction wasn’t as possible as I made it out to be.

Turning to the Edison, Carreyrou asked how many blood tests it performs.  The answer was that it was a trade secret.

I felt like I was watching a live performance of the Theater of the Absurd.

…It was frustrating but also a sign that I was on the right track. They wouldn’t be stonewalling if they had nothing to hide.

For four more hours, the meeting went on like this.  Young did answer a few questions.

He acknowledged problems with Theranos’s potassium test but claimed they had quickly been solved and none of the faulty results had been released to any patients.  Alan Beam had told me otherwise, so I suspected Young was lying about that. Young also confirmed that Theranos conducted proficiency testing differently than most laboratories but argued this was justified by the uniqueness of its technology. 

A few days later, Theranos threatened Erika Cheung with a lawsuit and also started started threatening Alan Beam again.  However, Alan had consulted a lawyer and felt less vulnerable to Theranos’s intimidation tactics.

Boies sent a twenty-three page letter to the Journal threatening a lawsuit if the paper published a story that defamed Theranos or revealed any of its trade secrets.  Boies attacked Carreyrou’s journalistic integrity.

His main evidence to back up that argument was signed statements Theranos had obtained from two of the other doctors I had spoken two claiming I had mischaracterized what they had told me and hadn’t made clear to them that I might use the information in a published article.  The doctors were Lauren Beardsley and Saman Rezaie…

The truth was that I hadn’t planned on using the patient case Dr. Beardsley and Rezaie had told me about because it was a secondhand account.  The patient in question was being treated by another doctor in their practice who had declined to speak to me.  But, while their signed statements in no way weakened my story, the likelihood that they had caved to the company’s pressure worried me.

Meanwhile, Dr. Stewart reassured Carreyrou that she was standing up for patients and for the integrity of lab testing.  She wouldn’t be pressured.  Balwani later told her that if the Journal article was published with Dr.Stewart in the story, her name would be dragged through the mud.  When Carreyrou spoke with Dr. Stewart, she asked him please not to use her name in the story.

 

LA MATTANZA

Roger Parloff of Fortune still believed in Theranos.  During  interview with Elizabeth for a second article he was working on, he asked about an Ebola test Theranos had been developing.

Given that an Ebola epidemic had been raging in West Africa for more than a year, Parloff thought a rapid finger-stick test to detect the deadly virus could be of great use to public health authorities and had been interested in writing about it.  Holmes said she expected to obtain emergency-use authorization for the test shortly and invited him to come see a live demonstration of it at Boies Schiller’s Manhattan offices.

Parloff arrived at the offices, and they told him they wanted to do two tests, one for Ebola and the other to measure potassium.  They pricked his finger twice.

Parloff wondered fleetingly why one of the devices couldn’t simultaneously perform both tests from a single blood sample but decided not to press the issue.

For some reason, the results of the tests were delayed.  An indicator of the machine’s progress seemed to be moving very slowly.

Balwani had tasked a Theranos software engineer named Michael Craig to write an application for the miniLab’s software that masked test malfunctions.  When something went wrong insider the machine, the app kicked in and prevented an error message from appearing on the digital display.  Instead, the screen showed the test’s progress slowing to a crawl.

[…]

In the absence of real validation data, Holmes used these demos to convince board members, prospective investors, and journalists that the miniLab was a finished working product.  Michael Craig’s app wasn’t the only subterfuge used to maintain the illusion. During demos at headquarters, employees would make a show of placing the finger-stick sample of a visiting VIP in the miniLab, wait until the visitor had left the room, and then take the sample out and bring it to a lab associate, who would run it on one of the modified commercial analyzers.

Parloff had no idea he’d been duped.

Back in California, Holmes had invited Vice President Joe Biden to visit the company’s facilities.

Holmes and Balwani wanted to impress the vice president with a vision of a cutting-edge, completely automated laboratory. So instead of showing him the actual lab, they created a fake one.

Carreyrou writes:

A few days later, on July 28, I opened that morning’s edition of the Journal and nearly spit out my coffee: as I was leafing through the paper’s first section, I stumbled across an op-ed written by Elizabeth Holmes crowing about Theranos’s herpes-test approval and calling for all lab tests to be reviewed by the FDA. She’d been denying me an interview for months, her lawyers had been stonewalling and threatening my sources, and here she was using my own newspaper’s opinion pages to perpetuate the myth that she was regulators’ best friend.

Of course, because the firewall between the Journal’s news and editorial side, Paul Gigot and his staff had no idea what Carreyrou was working on.  Nonetheless, Carreyrou was annoyed because it seemed like Holmes was trying to make it more difficult for the paper to publish Carreyrou’s investigation.

Carreyrou went to speak with his editor, Mike Siconolfi, hoping they could speed up the publication of his Theranos article.  But Mike, who was Italian American, urged patience and then asked Carreyrou, “Did I ever tell you about la mattanza?”  La mattanza was an ancient Sicilian ritual in which fishermen waded into the Mediterranean Sea with clubs and spears. Then they stood perfectly still for hours until the fish no longer noticed them.  Someone would give the signal and the fishermen would strike.

 

DAMAGE CONTROL

Soon after Carreyrou started investigating Theranos, the company completed another round of fund-raising. They raised $430 million, $125 million of which came from Rupert Murdoch, who controlled News Corporation, the parent company of the Journal.

He was won over by Holmes’s charisma and vision but also by the financial projections she gave him.  The investment packet she sent forecast $330 million in profits on revenues of $1 billion in 2015 and $505 million in profits on revenues of $2 billion in 2016.  These numbers made what was now a $10 million valuation seem cheap.

Murdoch also derived comfort from some of the other reputable investors he heard Theranos had lined up.  They included Cox Enterprises, the Atlanta-based, family-owned conglomerate whose chairman, Jim Kennedy, he was friendly with, and the Waltons of Walmart fame.  Other big-name investors he didn’t know about ranged from Bob Kraft, owner of the New England Patriots, to Mexican billionaire Carlos Slim and John Elkann, the Italian industrialist who controlled Fiat Chrystler Automobiles.

On two separate occasions when Holmes met with Murdoch, she brought up Carreyrou’s story, saying it was false and would damage Theranos.  Both times, Murdoch maintained that he trusted the Journal’s editors to handle the matter fairly.

Meanwhile, Theranos continued to try to intimidate Carreyrou’ssources.  For instance, two patients who had appointments with Dr. Sundene fabricated negative stories and posted them on Yelp.  Dr. Sundene had to hire an attorney to get Yelp to remove the bad reviews.

The Journal finally published Carreyrou’s on the front page on Thursday, October 15, 2015.

The headline,“A Prized Startup Struggles,” was understated but the article itself was devastating.  In addition to revealing that Theranos ran all but a small fraction of its tests on conventional machines and laying bare its proficiency-testing shenanigans and its dilution of finger-stick samples, it raised serious questions about the accuracy of its own devices.  It ended with a quote from Maureen Glunz saying that “trial and error on people” was “not OK,” bringing home what I felt was the most important point: the medical danger to which the company had exposed patients.

Thestory sparked a firestorm…

Other news organization picked up the story and produced critical pieces.  In Silicon Valley,everyone was talking about the Theranos story. Some, including venture capitalist Marc Andreesen, defended Theranos.  Others revealed that they had had their doubts for some time:

Why had Holmes always been so secretive about her technology? Why had she never recruited a board member with even basic knowledge of blood science?  And why hadn’t a single venture capital firm with expertise in health care put money into the company?

Many others didn’t know what to believe.

Carreyrou writes:

We knew that the battle was far from over and that Theranos and Boies would be coming at us hard in the coming days and weeks. Whether my reporting stood up to their attacks would largely depend on what actions, if any, regulators took.

Carreyrou was trying to speak with his source at the FDA and finally reached him:

On deep background, he confirmed to me that the FDA had recently conducted a surprise inspection of Theranos’s facilities in Newark and Palo Alto. Dealing a severe blow to the company, the agency had declared its nanotainter an uncleared medical device and forbid it from continuing to use it, he said.

He explained that the FDA had targeted the little tube because, as a medical device, it clearly fell under its jurisdiction and gave it the most solid legal cover to take action against the company.  But the underlying reason for the inspection had been the poor clinical data Theranos had submitted to the agency in an effort to get it to approve its tests.  When the inspectors failed to find any better data on-site, the decision had been made to shut down the company’s finger-stick testing by taking away the nanotainter, he said.  That wasn’t all: he said the Centers for Medicare and Medicaid Services had also just launched its own inspection of Theranos.

Holmes tried to jump ahead of the story by stating that the nanotainter withdrawal was a voluntary decision.

We quickly published by follow-up piece online. Setting the record straight, it revealed that the FDA had forced the company to stop testing blood drawn from patients’ fingers and declared its nanotainter an “unapproved medical device.” The story made the front page of the paper’s print edition he next morning, providing more fuel to what was now a full-blown scandal.

Holmes called a meeting of all company employees.

Striking a defiant tone, she told the assembled staff that the two articles the Journal had published were filled with falsehoods seeded by disgruntled former employees and competitors.  This sort of thing was bound to happen when you were working to disrupt a huge industry with powerful incumbents who wanted to see you fail, she said.  Calling the Journal a “tabloid,” she vowed to take the fight to the paper.

A senior hardware engineer asked Balwani to lead them in a chant.  A few months earlier, they’d done a certain chant directed at Quest and LabCorp. Everyone remember this chant.

Balwani was glad to lead the chant again.  Several hundred employees chanted:

“Fuck you, Carrey-rou!  Fuck you, Carrey-rou!”

The following week, the Journal was hosting the WSJ D.Live conference at which Holmes was scheduled to be interviewed. 

Holmes came out swinging from the start.  That was no surprise: we had expected her to be combative.  What we hadn’t fully anticipated was her willingness to tell bald-faced lies in a public forum.  Not just once, but again and again during the half-hour interview.  In addition to continuing to insist that the nanotainter withdrawal had been voluntary, she said the Edison devices referred to in my stories were an old technology that Theranos hadn’t used in years.  She also denied that the company had ever used commercial lab equipment for finger-stick tests.  And she claimed that the way Theranos conducted proficiency-testing was not only perfectly legal, it has the express blessing of regulators.

The biggest lie, to my mind, was her categorical denial that Theranos diluted finger-stick samples before running them on commercial machines.

By this point, several prominent Silicon Valley figures were publicly criticizing the company.  John-Louis Gassee published a blog post in which he mentioned pointedly different blood-test results he received from Theranos and Stanford Hospital.  He wrote Holmes asking about the discrepancy, but never got a reply.

Shultz, Kissnger, Sam Nunn, and other ex-statesmen left the Theranos board and instead formed a board of counselors.  David Boies joined the Theranos board.

Within days, the Journal received a letter from Heather King demanding a retraction of the main points of the two articles, calling them “libelous assertions.”  David Boies stated that a defamation suit was likely.  The Journal received another letter demanding that it retain all documents concerning Theranos.

But if Theranos thought this saber rattling would make us stand down, it was mistaken.  Over the next three weeks, we published four more articles.  They revealed that Walgreens had halted a planned nationwide expansion of Theranos wellness centers, that Theranos had tried to sell more shares at a higher valuation days before my first story was published, that its lab was operating without a real director, and that Safeway had walked away from their previously undisclosed partnership over concerns about its testing.

In an interview with Bloomberg Businessweek, Holmes said she was the victim of sexism.

In the same story, her old Stanford professor, Channing Robertson, dismissed questions about he accuracy of Theranos’s testing as absurd, saying the company would have to be “certifiable” to go to market with a product that people’s lives depended on knowing that it was unreliable.  He also maintained that Holmes was a once-in-a-generation genius, comparing her to Newton, Einstein, Mozart, and Leonardo da Vinci.

Carreyrou comments:

There was only one way the charade would end and that was if CMS, the chief regulatory of clinical laboratories, too strong action against the company.  I needed to find out what had come of that second regulatory inspection.

 

THE EMPRESS HAS NO CLOTHES

Based on a complaint from Erika Cheung, a veteran CMS field inspector, Gary Yamamoto and his colleague Sarah Bennett made a surprise inspection of Theranos’s lab.  Yamamoto and Bennett planned to spend two days, but there were so many issues that they asked for more time.  Balwani asked if they could return in two months and they agreed.

In late 2015 and early 2016, Carreyrou tried to find out about the second inspection conducted by Yamamoto and Bennett.  Finally he learned that the CMS inspectors had found “serious deficiencies.”

How serious became clear a few days later when the agency released a letter it had sent the company saying they posed “immediate jeopardy to patient health and safety.”  The letter gave the company ten days to come up with a credible correction plan and warned that failing to come back into compliance quickly could cause the lab to lose its federal certification.

This was major.  The overseer of clinical laboratories in the United States had not only confirmed that there were significant problems with Theranos’s blood tests, it had deemed the problems grave enough to put patients in immediate danger.  Suddenly, Heather King’s written retraction demands, which had been arriving like clockwork after each story we published, stopped.

However, Theranos continued to minimize the seriousness of the situation.  In a statement, it claimed to have already addressed many of the deficiencies and that the inspection findings didn’t reflect the current state of the Newark lab.  It also claimed that the problems were confined to the way the lab was run and had no bearing on the soundness of its proprietary technology.  It was impossible to disprove these claims without access to the inspection report. CMS usually made such documents public a few weeks after sending them to the offending laboratory, but Theranos was invoking trade secrets to demand that it be kept confidential…

Carreyrou filed a Freedom of Information Act request to try to force CMS to release the inspection report.

But Heather King continued to urge the agency not to make the report public without extensive redactions, claiming that doing so would expose valuable trade secrets.  It was the first time the owner of a laboratory under the threat of sanctions had demanded redactions to an inspection report, and CMS seemed unsure how to proceed.

Carreyrou finally got his hands on a copy of the CMS report.

For one thing, it proved that Holmes had lied at the Journal’s tech conference the previous fall: the proprietary devices Theranos used in the lab were indeed called “Edison,” and the report showed it had used them for only twelve of the 250 tests on its menu.  Every other test had been run on commercial analyzers.

More important, the inspection report showed, citing the lab’s own data, that the Edisons produced wildly erratic results. During one month, they had failed quality-control checks nearly a third of the time.  One of the blood tests run on the Edisons, a test to measure a hormone that affects testosterone levels, had failed quality control an astounding 87 percent of the time.  And test, to help detect prostrate cancer, had failed 22 percent of its quality-control checks.  In comparison runs using the same blood samples, the Edisons had produced results that differed from those of conventional machines by as much as 146 percent.  And just as Tyler Shultz had contended, the devices couldn’t reproduce their own results. And Edison test to measure vitamin B12 had a coefficient of variation that ranged from 34 to 48 percent, far exceeding the 2 or 3 percent common for the test at most labs.

As for the lab itself, it was a mess: the company had allowed unqualified personnel to handle patient samples, it had stored blood at the wrong temperatures, it had let reagents expire, and it had failed to inform patients of flawed test results, among many other lapses.

[…]

The coup de grace came a few days later when we obtained a new letter CMS had sent to Theranos.  It said the company had failed to correct forty-three of the forty-five deficiencies the inspectors had cited it for and threatened to ban Holmes from the blood-testing business for two years.

Carreyrou met up with Tyler Shultz.  Carreyrou points out that Tyler never buckled even though he was under enormous pressure. Moreover, his parents spent over $400,000 on legal fees.  Were it not for Tyler’s courage, Carreyrou acknowledges that he might never have gotten his first Theranos article published.  In addition, Tyler continued to be estranged from his grandfather, who continued to believe Elizabeth and not Tyler.

Not long after this meeting between Tyler and Carreyrou, Theranos contacted Tyler’s lawyers and said they knew about the meeting.  Because neither one of them had told anyone about the meeting, they realized they were under surveillance and being followed.  (Alan Beam and Erika Cheung were probably also under surveillance.)  At this juncture, Tyler wasn’t too worried, joking that next time he might take a selfie of himself and Carreyrou and sent it to Holmes “to save her the trouble of hiring PIs.”

Soon thereafter, there was more bad news for Theranos.  Carreyrou:

…we reported that Theranos had voided tens of thousands of blood-test results, including two years’ worth of Edison tests, in an effort to come back into compliance and avoid the CMS ban.  In other words, it had effectively admitted to the agency that not a single one of the blood tests run on its proprietary devices could be relied upon.  Once again, Holmes had hoped to keep the voided tests secret, but I found out about them from my new source, the one who had leaked to me CMS’s letter threatening to ban Holmes from the lab industry.  In Chicago, executives at Walgreens were astonished to learn of the scale of the test voidings.  The pharmacy chain had been trying to get answers from Theranos about the impact on its customers for months.  On June 12, 2016, it terminated the companies’partnership and shut down all the wellness centers located in its stores.

In another crippling blow, CMS followed through on its threat to ban Holmes and her company from the lab business in early July.  More ominously, Theranos was now the subject of a criminal investigation by the U.S. Attorney’s Office in San Francisco and of a parallel civil probe by the Securities and Exchange Commission. 

Many investors in Theranos were fed up:

Partner Fund, the San Francisco hedge fund that had invested closet to $100 million in the company in early 2014, sued Holmes, Balwani, and the company in Delaware’s Court of Chancery, alleging that they had deceived it with “a series of lies,material misstatements, and omissions.” Another set of investors led by the retired banker Robert Coleman filed a separate lawsuit in federal court in San Francisco.  It also alleged securities fraud and sought class-action status.

Most of the other investors opted against litigation, settling instead for a grand of extra shares in exchange for a promise not to sue.  One notable exception was Rupert Murdoch.  The media mogul sold his stock back to Theranos for one dollar so he could claim a big tax write-off on his other earnings.  With a fortune estimated at $12 billion, Murdoch could afford to lose more than a $100 million on a bad investment.

[…]

Walgreens, which had sunk a total of $140 million into Theranos, filed its own lawsuit against the company, accusing it of failing to meet the “most basic quality standards and legal requirements” of the companies’ contract.  “The fundamental premise of the parties’contract—like any endeavor involving human health—was to help people, and not to harm them,” the drugstore chain wrote in its complaint.

Carreyrou concludes the chapter:

The number of test results Theranos voided or corrected in California and Arizona eventually reached nearly 1 million.  The harm done to patients from all those faulty tests is hard to determine.  Ten patients have filed lawsuits alleging consumer fraud and medical battery.  One of them alleges that Theranos’s blood tests failed to detect his heart disease,leading him to suffer a preventable heart attack.  The suits have been consolidated into a putative class action in federal court in Arizona.  Whether the plaintiffs are able to prove injury in court remains to be seen.

One thing is certain: the chances that people would have died from missed diagnoses or wrong medical treatments would have risen expontentially if the company had expanded its blood-testing services to Walgreen’s 8,134 other U.S. stores as it was on the cusp of doing when Pathology Blawg’s Adam Clapper reached out to me.

 

EPILOGUE

Theranos settled the Partners Fund case for $43 million, and it settled the Walgreens lawsuit for more than $25 million.  On March 14, 2018, the Securities and Exchange Commission charged Theranos, Holmes, and Balwani with conducting “an elaborate, years-long fraud.”

To resolve the agency’s civil charges, Holmes was forced to relinquish her voting control over the company, give back a big chunk of her stock, and pay a$500,000 penalty.  She also greed to be barred from being an officer or director in a public company for ten years.  Unable to reach a settlement with Balwani, the SEC sued him in federal court in California. In the meantime, the criminal investigation continued to gather steam.  As of this writing, criminal indictments of both Holmes and Balwani on charges of lying to investors and federal officials seem a distinct possibility.

It’s one thing for a software or hardware company to overhype the arrival of its technology years before the product was ready.  The term “vaporware” describes this kind of software or hardware.  Microsoft, Apple,and Oracle were all accused of this at one point, observes Carreyrou.

But it’s crucial to bear in mind that Theranos wasn’t a tech company in the traditional sense.  It was first and foremost a health-care company.  It’s product wasn’t software but a medical device that analyzed people’s blood.  As Holmes herself liked to point out in media interviews and public appearances at the height of her fame, doctors base 70 percent of their treatment decisions on lab results.  They rely on lab equipment to work as advertised.  Otherwise, patient health is jeopardized.

So howwas Holmes able to rationalize gambling with people’s lives?

Carreyrou ends the book:

A sociopath is often described as someone with little or no conscience.  I’ll leave it to the psychologists to decide whether Holmes fits the clinical profile, but there’s no question that her moral compass was badly askew.  I’m fairly certain she didn’t initially set out to defraud investors and put patients in harm’s way when she dropped out of Stanford fifteen years ago.  By all accounts, she had a vision that she genuinely believed in and threw herself into realizing.  But in her all-consuming quest to be the second coming of Steve Jobs amid the gold rush of the “unicorn” boom, there came a point when she stopped listening to sound advice and began to cut corners.  Her ambition was voracious and it brooked no interference.  If there was collateral damage on her way to riches and fame, so be it.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

This Time Is Different

(Image:  Zen Buddha Silence by Marilyn Barbone)

July 14, 2019

For a value investor who patiently searches for individual stocks that are cheap, predictions about the economy or the stock market are irrelevant.  In fact, most of the time, such predictions are worse than irrelevant because they could cause the value investor to miss some individual bargains.

Warren Buffett puts it best:

  • Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.
  • We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
  • Market forecasters will fill your ear but never fill your wallet.
  • Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.
  • Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
  • [On economic forecasts:] Why spend time talking about something you don’t know anything about?  People do it all the time, but why do it?
  • I don’t invest a dime based on macro forecasts.

(Illustration by Eti Swinford)

No one has ever been able to predict the stock market with any sort of reliability.  Ben Graham—with a 200 IQ—was as smart or smarter than any value investor who’s ever lived.  And here’s what Graham said near the end of his career:

If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

No one can predict the stock market, although anyone can get lucky once or twice in a row.  But if you’re patient, you can find individual stocks that are cheap.  Consider the career of Henry Singleton.

When he was managing Teledyne, Singleton built one of the best track records of all time as a capital allocator.  A dollar invested with Singleton would grow to $180.94 by the time of Singleton’s retirement 29 years later.  $10,000 invested with Singleton would have become $1.81 million.

Did Singleton ever worry about whether the stock market was too high when he was deciding how to allocate capital?  Not ever.  Not one single time.  Singleton:

I don’t believe all this nonsense about market timing.  Just buy very good value and when the market is ready that value will be recognized.

Had Singleton ever brooded over the level of the stock market, his phenomenal track record as a capital allocator would have suffered.

Top value investor Seth Klarman expresses the matter as follows:

In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

If you’re not convinced that focusing on individual bargains—regardless of the economy or the market—is the wise approach, then let’s consider whether “this time is different.”  Why is this phrase important?  Because if things are never different, then you can bet on historical trends—and mean reversion; you can bet that P/E ratio’s will return to normal, which (if true) implies that the stock market today will probably fall.

Quite a few leading value investors—who have excellent track records of ignoring the crowd and being right—agree that the U.S. stock market today is very overvalued, at least based on historical trends.  (This group includes Rob Arnott, Jeremy Grantham, John Hussman, Frank Martin, Russell Napier, and Andrew Smithers.)

However, this time the crowd appears to be right and leading value investors wrong.  This time really is different.  Grantham admits:

[It] can be very dangerous indeed to assume that things are never different.

Here Grantham presents his views: https://www.barrons.com/articles/grantham-dont-expect-p-e-ratios-to-collapse-1493745553

Leading value investor Howard Marks:

The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious—on which everyone agrees—turn out not to be true.

 

THIS TIME IS DIFFERENT

The main reason is not possible to predict the economy or the stock market is that both the economy and the stock market evolve over time.  As Howard Marks says:

Economics and markets aren’t governed by immutable laws like the physical sciences…

…sometimes things really are different…

Link: https://www.oaktreecapital.com/docs/default-source/memos/this-time-its-different.pdf

In 1963, Graham gave a lecture, “Securities in an Insecure World.”  Link: http://jasonzweig.com/wp-content/uploads/2015/03/BG-speech-SF-1963.pdf

In the lecture, Graham admits that the Graham P/E—based on ten-year average earnings of the Dow components—was much too conservative.  (The Graham P/E is now called the CAPE—cyclically adjusted P/E.)  Graham:

The action of the stock market since then would appear to demonstrate that these methods of valuations are ultra-conservative and much too low, although they did work out extremely well through the stock market fluctuations from 1871 to about 1954, which is an exceptionally long period of time for a test.  Unfortunately in this kind of work, where you are trying to determine relationships based upon past behavior, the almost invariable experience is that by the time you have had a long enough period to give you sufficient confidence in your form of measurement just then new conditions supersede and the measurement is no longer dependable for the future.

Because of the U.S. government’s more aggressive policy with respect to preventing a depression, Graham concluded that the U.S. stock market should have a fair value 50 percent higher.  (Graham explains this change in the 1962 edition of Security Analysis.)

Similar logic can be applied to the S&P 500 Index today—at just over 3,013.  Fed policy, moral hazard, lower interest rates, an aging population, slower growth, productivity, and higher profit margins (based in part on political and monopoly power) are all factors in the S&P 500 being quite high.

The great value investor John Templeton observed that when people say, “this time is different,” 20 percent of the time they’re right.

By traditional standards, the U.S. stock market looks high.  For instance, the CAPE is at 29+.  (The CAPE—formerly the Graham P/E—is the cyclically adjusted P/E ratio based on 10-year average earnings.)  The historical average CAPE is 16.6.

If the stock market followed the pattern of history, then there would be mean reversion in stock prices, i.e., there would probably be a large drop in stock prices, at least until the CAPE approached 16.6.  (Typically the CAPE would overshoot on the downside and so would go below 16.6.)

But that assumes that the CAPE will still average 16.6 going forward.  Since 1996, according to Rob Arnott, 96% of the time the CAPE has been above the 16.6; and two-thirds of the time the CAPE has been above 24.  See: https://www.researchaffiliates.com/en_us/publications/articles/645-cape-fear-why-cape-naysayers-are-wrong.html  

Here are some reasons why the average CAPE going forward could be 24 (or even higher) instead of 16.6.

  • Interest rates have gotten progressively lower over the past couple of decades, especially since 2009.  This may continue.  The longer interest rates stay low, the higher stock prices will be.
  • Perhaps the government has tamed the business cycle (at least to some extent).  Monetary and fiscal authorities may continue to be able to delay or avoid a recession.
  • Government deficits might not cause interest rates to rise, in part because the U.S. can print its own currency.
  • Government debt might not cause interest rates to rise.  (Again, the U.S. can print its own currency.)
  • Just because the rate of unemployment is low doesn’t mean that the rate of inflation will pick up.
  • Inflation may be structurally lower—and possibly also less volatile—than in the past.
  • Profit margins may be permanently higher than in the past.

Let’s consider each point in some detail.

 

LOWER INTEREST RATES

The longer rates stay low, the higher stock prices will be.

Warren Buffett pointed out recently that if 3% on 30-year bonds makes sense, then stocks are ridiculously cheap: https://www.cnbc.com/2019/05/06/warren-buffett-says-stocks-are-ridiculously-cheap-if-interest-rates-stay-at-these-levels.html

 

BUSINESS CYCLE TAMED

The current economic recovery is the longest recovery in U.S. history.  Does that imply that a recession is overdue?  Not necessarily.  GDP has been less volatile due in part to the actions of the government, including Fed policy.

Perhaps the government is finally learning how to tame the business cycle.  Perhaps a recession can be avoided for another 5-10 years or even longer.

 

GOVERNMENT DEFICITS MAY NOT CAUSE RATES TO RISE

Traditional economic theory says that perpetual government deficits will eventually cause interest rates to rise.  However, according to Modern Monetary Theory (MMT), a country that can print its own currency doesn’t need to worry about deficits.

Per MMT, the government first spends money and then later takes money back out in the form of taxes.  Importantly, every dollar the government spends ends up as a dollar of income for someone else.  So deficits are benign.  (Deficits can still be too big under MMT, particularly if they are not used to increase the nation’s productive capacity, or if there is a shortage of labor, raw materials, and factories.)

Interview with Stephanie Kelton, one of the most influential proponents of MMT: https://theglobepost.com/2019/03/28/stephanie-kelton-mmt/

 

MOUNTING GOVERNMENT DEBT MAY NOT CAUSE RATES TO RISE

Traditional economic theory says that government debt can get so high that people lose confidence in the country’s bonds and currency.  Stephanie Kelton:

The national debt is nothing more than a historical record of all of the dollars that were spent into the economy and not taxed back, and are currently being saved in the form of Treasury securities.

One key, again, is that the country in question must be able to print its own currency.

Kelton again:

MMT is advancing a different way of thinking about money and a different way of thinking about the role of taxes and deficits and debt in our economy.  I think it’s probably also safe to say that MMT has, I think, a superior understanding of monetary operations.  That means that we take banking and the Federal Reserve and Treasury operations and so forth very seriously, whereas more conventional approaches historically have rarely even found room in their models for things like money and finance and debt.

Let’s be clear.  MMT may be wrong, at least in part.  Many great economists—including Paul Krugman, Ken Rogoff, Larry Summers, and Janet Yellen—do not agree with MMT’s assertion that deficits and debt don’t matter for a country that can print its own currency.

 

UNEMPLOYMENT AND INFLATION

In traditional economic theory, the Phillips curve holds that there is an inverse relationship between the rate of unemployment and the rate of inflation.  As unemployment falls, wages increase which causes inflation.  But if you look at the non-employment rate (rather than the unemployment rate), the labor market isn’t really tight.  The labor force participation rate is at its lowest level in more than 40 years.  That explains in part why wages and inflation have not increased.

 

INFLATION STRUCTURALLY LOWER

As Howard Marks has noted, inflation may be structurally lower than in the past, due to automation, the shift of manufacturing to low-cost countries, and the abundace of free/cheap stuff in the digital age.

Link again: https://www.oaktreecapital.com/docs/default-source/memos/this-time-its-different.pdf

 

PROFIT MARGINS PERMANENTLY HIGHER

Proft margins on sales and corporate profits as a percentage of GDP have both been trending higher.  This is due partly to “increased monopoly, political, and brand power,” according to Jeremy Grantham.  Link again: https://www.barrons.com/articles/grantham-dont-expect-p-e-ratios-to-collapse-1493745553

Furthermore, lower interest rates and higher leverage (since 1997) have contributed to higher profit margins, asserts Grantham.

I would add that software and related technologies have become much more important in the U.S. and global economy.  Companies in these fields tend to have much higher profit margins—even after accounting for lower rates, higher leverage, and increased monopoly and political power.

 

IGNORE FORECASTS AND DON’T TRY TO TIME THE MARKET; INSTEAD FOCUS ON INDIVIDUAL BUSINESSES

The most important point is that it’s not possible to predict the stock market, but it is possible—if you’re patient—to find individual stocks that are undervalued.  This is especially true if your assets are small enough to invest in microcap stocks.  In 1999, when the overall U.S. stock market was close to its highest valuation in history, Warren Buffett said:

If I was running $1 million, or $10 million for that matter, I’d be fully invested.

No matter how high the S&P 500 Index gets, there are hundreds of microcap stocks that are almost completely ignored, with no analyst coverage and with no large investors paying attention.  That’s why Buffett said during the stock bubble in 1999 that he’d be fully invested if he were managing a small enough sum.

Microcap stocks offer the highest potential returns because there are thousands of them and they are largely ignored.  That’s not to say that there are no cheap small caps, mid caps, or large caps.  Even when the broad market is high, there are at least a few undervalued large caps.  But the number of undervalued micro caps is always much greater than the number of undervalued large caps.

So it’s best to focus on micro caps in order to maximize long-term returns.  But whether you invest in micro caps or in large caps, what matters is not the stock market or the economy, but the price of the individual business.

If and when you find a business selling at a cheap stock price, then it’s best to buy regardless of economic and market conditions—and regardless of economic and market forecasts.  As Seth Klarman puts it:

Investors must learn to assess value in order to know a bargain when they see one.  Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

For example, if you find a conservatively financed business whose stock is trading at 20 percent of liquidation value, it makes sense to buy it regardless of how high the overall stock market is and regardless of what’s happening—or what might happen—in the economy.  Seth Klarman again:

We don’t buy ‘the market’.  We invest in discrete situations, each individually compelling.

Ignore forecasts!

(Illustration by Maxim Popov)

Peter Lynch:

Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Now, every year there are “pundits” who make predictions about the stock market.  Therefore, as a matter of pure chance, there will always be people in any given year who are “right.”  But there’s zero evidence that any of those who were “right” at some point in the past have been correct with any sort of reliability.

Howard Marks has asked: of those who correctly predicted the bear market in 2008, how many of them predicted the recovery in 2009 and since then?  The answer: very few.  Marks points out that most of those who got 2008 right were already disposed to bearish views in general.  So when a bear market finally came, they were “right,” but the vast majority missed the recovery starting in 2009.

There are always naysayers making bearish predictions.  But anyone who owned an S&P 500 Index fund from 2007 to present (mid 2019) would have done dramatically better than most of those who listened to naysayers.  Buffett:

Ever-present naysayers may prosper by marketing their gloomy forecasts.  But heaven help them if they act on the nonsense they peddle.

Buffett himself made a 10-year wager against a group of talented hedge fund (and fund of hedge fund) managers.  Buffett’s investment in an S&P 500 Index fund trounced the super-smart hedge funds.  See: http://berkshirehathaway.com/letters/2017ltr.pdf

Some very able investors have stayed largely in cash since 2011.  Meanwhile, the S&P 500 Index has increased close to 140 percent.  Moreover, many smart investors have tried to short the U.S. stock market since 2011.  Not surprisingly, some of these short sellers are down 50 percent or more.

This group of short sellers includes the value investor John Hussman, whose Hussman Strategic Growth Fund (HSGFX) is down nearly 54 percent since the end of 2011.  Compare that to a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund Investor Shares (VFINX), which is up 140 percent since then end of 2011.

If you invested $10,000 in HSGFX at the end of 2011, you would have about $4,600 today.  If instead you invested $10,000 in VFINX at the end of 2011, you would have about $24,000 today.  In other words, if you invested with one of the “ever-present naysayers,” you would have 20 percent of the value you otherwise would have gotten from a simple index fund.   HSGFX will have to increase 400 percent more than VFINX just to get back to even.

Please don’t misunderstand.  John Hussman is a brilliant and patient investor.  (Also, I made a very similar mistake 2011-2013.)  But Hussman, along with many other highly intelligent value investors—including Rob Arnott, Frank Martin, Russell Napier, and Andrew Smithers—have missed the strong possibility that this time really may be different, i.e., the average CAPE (cyclically adjusted P/E) going forward may be 24 or higher instead of 16.6.

The truth—fair value—may be somewhere in-between a CAPE of 16.6 and a CAPE of 24.  But even in that case, HSGFX is unlikely to increase 400 percent relative to the S&P 500 Index.

Jeremy Grantham again:

[It] can be very dangerous indeed to assume that things are never different.

As John Maynard Keynes is (probably incorrectly) reported to have said:

When the information changes, I alter my conclusions.  What do you do, sir?

 

WARREN BUFFETT: U.S. STOCKS VS. GOLD

In his 2018 letter to Berkshire Hathaway shareholders, Warren Buffett writes about “The American Tailwind.”  See pages 13-14: http://www.berkshirehathaway.com/letters/2018ltr.pdf

Buffett begins this discussion by pointing out that he first invested in American business when he was 11 years old in 1942.  That was 77 years ago.  Buffett “went all in” and invested $114.75 in three shares of City Service preferred stock.

Buffett then asks the reader to travel back the two 77-year periods prior to his purchase.  The year is 1788.  George Washington had just been made the first president of the United States.

Buffett asks:

Could anyone then have imagined what their new country would accomplish in only three 77-year lifetimes?

Buffett continues:

During the two 77-year periods prior to 1942, the United States had grown from four million people – about 1⁄2 of 1% of the world’s population – into the most powerful country on earth.  In that spring of 1942, though, it faced a crisis: The U.S. and its allies were suffering heavy losses in a war that we had entered only three months earlier.  Bad news arrived daily.

Despite the alarming headlines, almost all Americans believed on that March 11th that the war would be won.  Nor was their optimism limited to that victory.  Leaving aside congenital pessimists, Americans believed that their children and generations beyond would live far better lives than they themselves had led.

The nation’s citizens understood, of course, that the road ahead would not be a smooth ride.  It never had been.  Early in its history our country was tested by a Civil War that killed 4% of all American males and led President Lincoln to openly ponder whether “a nation so conceived and so dedicated could long endure.”  In the 1930s, America suffered through the Great Depression, a punishing period of massive unemployment.

Nevertheless, in 1942, when I made my purchase, the nation expected post-war growth, a belief that proved to be well-founded.  In fact, the nation’s achievements can best be described as breathtaking.

Let’s put numbers to that claim: If my $114.75 had been invested in a no-fee S&P 500 index fund, and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019 (the latest data available before the printing of this letter).  That is a gain of 5,288 for 1.  Meanwhile, a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3 billion.

[…]

Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods.  That’s 40,000%!   Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency.  To “protect” yourself, you might have eschewed stocks and opted instead to buy 3 1⁄4 ounces of gold with your $114.75.

And what would that supposed protection have delivered?  You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business.  The magical metal was no match for the American mettle.

Our country’s almost unbelievable prosperity has been gained in a bipartisan manner.  Since 1942, we have had seven Republican presidents and seven Democrats.  In the years they served, the country contended at various times with a long period of viral inflation, a 21% prime rate, several controversial and costly wars, the resignation of a president, a pervasive collapse in home values, a paralyzing financial panic and a host of other problems.  All engendered scary headlines; all are now history.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Buffett’s Best: Microcap Cigar Butts

(Image:  Zen Buddha Silence by Marilyn Barbone)

June 16, 2019

Warren Buffett, the world’s greatest investor, earned the highest returns of his career from microcap cigar butts.  Buffett wrote in the 2014 Berkshire Letter:

My cigar-butt strategy worked very well while I was managing small sums.  Indeed, the many dozens of free puffs I obtained in the 1950’s made the decade by far the best of my life for both relative and absolute performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO.  Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares.  Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices.  Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent:  Cigar-butt investing was scalable only to a point.  With large sums, it would never work well…

Before Buffett led Berkshire Hathaway, he managed an investment partnership from 1957 to 1970 called Buffett Partnership Ltd. (BPL).  While running BPL, Buffett wrote letters to limited partners filled with insights (and humor) about investing and business.  Jeremy C. Miller has written a great book— Warren Buffett’s Ground Rules (Harper, 2016)—summarizing the lessons from Buffett’s partnership letters.

This blog post considers a few topics related to microcap cigar butts:

  • Net Nets
  • Dempster: The Asset Conversion Play
  • Liquidation Value or Earnings Power?
  • Mean Reversion for Cigar Butts
  • Focused vs. Statistical
  • The Rewards of Psychological Discomfort
  • Conclusion

 

NET NETS

Here Miller quotes the November 1966 letter, in which Buffett writes about valuing the partnership’s controlling ownership position in a cigar-butt stock:

…Wide changes in the market valuations accorded stocks at some point obviously find reflection in the valuation of businesses, although this factor is of much less importance when asset factors (particularly when current assets are significant) overshadow earnings power considerations in the valuation process…

Ben Graham’s primary cigar-butt method was net nets.  Take net current asset value minus ALL liabilities, and then only buy the stock at 2/3 (or less) of that level.  If you buy a basket (at least 20-30) of such stocks, then given enough time (at least a few years), you’re virtually certain to get good investment results, predominantly far in excess of the broad market.

A typical net-net stock might have $30 million in cash, with no debt, but have a market capitalization of $20 million.  Assume there are 10 million shares outstanding.  That means the company has $3/share in net cash, with no debt.  But you can buy part ownership of this business by paying only $2/share.  That’s ridiculously cheap.  If the price remained near those levels, you could effectively buy $1 million in cash for $667,000—and repeat the exercise many times.

Of course, a company that cheap almost certainly has problems and may be losing money.  But every business on the planet, at any given time, is in either one of two states:  it is having problems, or it will be having problems.  When problems come—whether company-specific, industry-driven, or macro-related—that often causes a stock to get very cheap.

The key question is whether the problems are temporary or permanent.  Statistically speaking, many of the problems are temporary when viewed over the subsequent 3 to 5 years.  The typical net-net stock is so extremely cheap relative to net tangible assets that usually something changes for the better—whether it’s a change by management, or a change from the outside (or both).  Most net nets are not liquidated, and even those that are still bring a profit in many cases.

The net-net approach is one of the highest-returning investment strategies ever devised.  That’s not a surprise because net nets, by definition, are absurdly cheap on the whole, often trading below net cash—cash in the bank minus ALL liabilities.

Buffett called Graham’s net-net method the cigar-butt approach:

…I call it the cigar-butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.

Link: http://intelligentinvestorclub.com/downloads/Warren-Buffett-Florida-Speech.pdf

(Photo by Sky Sirasitwattana)

When running BPL, Buffett would go through thousands of pages of Moody’s Manuals (and other such sources) to locate just one or a handful of microcap stocks trading at less than liquidation value.  Other leading value investors have also used this technique.  This includes Charlie Munger (early in his career), Walter Schloss, John Neff, Peter Cundill, and Marty Whitman, to name a few.

The cigar-butt approach is also called deep value investing.  This normally means finding a stock that is available below liquidation value, or at least below net tangible book value.

When applying the cigar-butt method, you can either do it as a statistical group approach, or you can do it in a focused manner.  Walter Schloss achieved one of the best long-term track records of all time—near 21% annually (gross) for 47 years—using a statistical group approach to cigar butts.  Schloss typically had a hundred stocks in his portfolio, most of which were trading below tangible book value.

At the other extreme, Warren Buffett—when running BPL—used a focused approach to cigar butts.  Dempster is a good example, which Miller explores in detail in his book.

 

DEMPSTER: THE ASSET CONVERSION PLAY

Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.  Buffett slowly bought shares in the company over the course of five years.

(Photo by Digikhmer)

Dempster had a market cap of $1.6 million, about $13.3 million in today’s dollars, says Miller.

  • Note:  A market cap of $13.3 million is in the $10 to $25 million range—among the tiniest micro caps—which is avoided by nearly all investors, including professional microcap investors.

Buffett’s average price paid for Dempster was $28/share.  Buffett’s estimate of liquidation value early on was near $35/share, which is intentionally conservative.  Miller quotes one of Buffett’s letters:

The estimated value should not be what we hope it would be worth, or what it might be worth to an eager buyer, etc., but what I would estimate our interest would bring if sold under current conditions in a reasonably short period of time.

To estimate liquidation value, Buffett followed Graham’s method, as Miller explains:

  • cash, being liquid, doesn’t need a haircut
  • accounts receivable are valued at 85 cents on the dollar
  • inventory, carried on the books at cost, is marked down to 65 cents on the dollar
  • prepaid expenses and “other” are valued at 25 cents on the dollar
  • long-term assets, generally less liquid, are valued using estimated auction values

Buffett’s conservative estimate of liquidation value for Dempster was $35/share, or $2.2 million for the whole company.  Recall that Buffett paid an average price of $28/share—quite a cheap price.

Even though the assets were clearly there, Dempster had problems.  Stocks generally don’t get that cheap unless there are major problems.  In Dempster’s case, inventories were far too high and rising fast.  Buffett tried to get existing management to make needed improvements.  But eventually Buffett had to throw them out.  Then the company’s bank was threatening to seize the collateral on the loan.  Fortunately, Charlie Munger—who later became Buffett’s business partner—recommended a turnaround specialist, Harry Bottle.  Miller:

Harry did such an outstanding job whipping the company into shape that Buffett, in the next year’s letter, named him “man of the year.”  Not only did he reduce inventories from $4 million to $1 million, alleviating the concerns of the bank (whose loan was quickly repaid), he also cut administrative and selling expenses in half and closed five unprofitable branches.  With the help of Buffett and Munger, Dempster also raised prices on their used equipment up to 500% with little impact to sales volume or resistance from customers, all of which worked in combination to restore a healthy economic return in the business.

Miller explains that Buffett rationally focused on maximizing the return on capital:

Buffett was wired differently, and he achieves better results in part because he invests using an absolute scale.  With Dempster he wasn’t at all bogged down with all the emotional baggage of being a veteran of the windmill business.  He was in it to produce the highest rate of return on the capital he had tied up in the assets of the business.  This absolute scale allowed him to see that the fix for Dempster would come by not reinvesting back into windmills.  He immediately stopped the company from putting more capital in and started taking the capital out.

With profits and proceeds raised from converting inventory and other assets to cash, Buffett started buying stocks he liked.  In essence, he was converting capital that was previously utilized in a bad (low-return) business, windmills, to capital that could be utilized in a good (high-return) business, securities.

Bottle, Buffett, and Munger maximized the value of Dempster’s assets.  Buffett took the further step of not reinvesting cash in a low-return business, but instead investing in high-return stocks.  In the end, on its investment of $28/share, BPL realized a net gain of $45 per share.  This is a gain of a bit more than 160% on what was a very large position for BPL—one-fifth of the portfolio.  Had the company been shut down by the bank, or simply burned through its assets, the return after paying $28/share could have been nothing or even negative.

Miller nicely summarizes the lessons of Buffett’s asset conversion play:

Buffett teaches investors to think of stocks as a conduit through which they can own their share of the assets that make up a business.  The value of that business will be determined by one of two methods: (1) what the assets are worth if sold, or (2) the level of profits in relation to the value of assets required in producing them.  This is true for each and every business and they are interrelated…

Operationally, a business can be improved in only three ways: (1) increase the level of sales; (2) reduce costs as a percent of sales; (3) reduce assets as a percentage of sales.  The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value.  These are the only ways a business can make itself more valuable.

Buffett “pulled all the levers” at Dempster…

 

LIQUIDATION VALUE OR EARNINGS POWER?

For most of the cigar butts that Buffett bought for BPL, he used Graham’s net-net method of buying at a discount to liquidation value, conservatively estimated.  However, you can find deep value stocks—cigar butts—on the basis of other low “price-to-a-fundamental” ratio’s, such as low P/E or low EV/EBITDA.  Even Buffett, when he was managing BPL, used a low P/E in some cases to identify cigar butts.  (See an example below: Western Insurance Securities.)

Tobias Carlisle and Wes Gray tested various measures of cheapness from 1964 to 2011.  Quantitative Value (Wiley, 2012)—an excellent book—summarizes their results.  James P. O’Shaughnessy has conducted one of the broadest arrays of statistical backtests.  See his results in What Works on Wall Street (McGraw-Hill, 4th edition, 2012), a terrific book.

(Illustration by Maxim Popov)

  • Carlisle and Gray found that low EV/EBIT was the best-performing measure of cheapness from 1964 to 2011.  It even outperformed composite measures.
  • O’Shaughnessy learned that low EV/EBITDA was the best-performing individual measure of cheapness from 1964 to 2009.
  • But O’Shaughnessy also discovered that a composite measure—combining low P/B, P/E, P/S, P/CF, and EV/EBITDA—outperformed low EV/EBITDA.

Assuming relatively similar levels of performance, a composite measure is arguably better because it tends to be more consistent over time.  There are periods when a given individual metric might not work well.  The composite measure will tend to smooth over such periods.  Besides, O’Shaughnessy found that a composite measure led to the best performance from 1964 to 2009.

Carlisle and Gray, as well as O’Shaughnessy, didn’t include Graham’s net-net method in their reported results.  Carlisle wrote another book, Deep Value (Wiley, 2014)—which is fascinating—in which he summarizes several tests of net nets:

  • Henry Oppenheimer found that net nets returned 29.4% per year versus 11.5% per year for the market from 1970 to 1983.
  • Carlisle—with Jeffrey Oxman and Sunil Mohanty—tested net nets from 1983 to 2008.  They discovered that the annual returns for net nets averaged 35.3% versus 12.9% for the market and 18.4% for a Small Firm Index.
  • A study of the Japanese market from 1975 to 1988 uncovered that net nets outperformed the market by about 13% per year.
  • An examination of the London Stock Exchange from 1981 to 2005 established that net nets outperformed the market by 19.7% per year.
  • Finally, James Montier analyzed all developed markets globally from 1985 to 2007.  He learned that net nets averaged 35% per year versus 17% for the developed markets on the whole.

Given these outstanding returns, why didn’t Carlisle and Gray, as well as O’Shaughnessy, consider net nets?  Primarily because many net nets are especially tiny microcap stocks.  For example, in his study, Montier found that the median market capitalization for net nets was $21 million.  Even the majority of professionally managed microcap funds do not consider stocks this tiny.

  • Recall that Dempster had a market cap of $1.6 million, or about $13.3 million in today’s dollars.
  • Unlike the majority of microcap funds, the Boole Microcap Fund does consider microcap stocks in the $10 to $25 million market cap range.

In 1999, Buffett commented that he could get 50% per year by investing in microcap cigar butts.  He was later asked about this comment in 2005, and he replied:

Yes, I would still say the same thing today.  In fact, we are still earning those types of returns on some of our smaller investments.  The best decade was the 1950s;  I was earning 50% plus returns with small amounts of capital.  I would do the same thing today with smaller amounts.  It would perhaps even be easier to make that much money in today’s environment because information is easier to access.  You have to turn over a lot of rocks to find those little anomalies.  You have to find the companies that are off the map—way off the map.  You may find local companies that have nothing wrong with them at all.  A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!!  I tried to buy up as much of it as possible.  No one will tell you about these businesses.  You have to find them.

Although the majority of microcap cigar butts Buffett invested in were cheap relative to liquidation value—cheap on the basis of net tangible assets—Buffett clearly found some cigar butts on the basis of a low P/E.  Western Insurance Securities is a good example.  It had a P/E of 0.15.

 

MEAN REVERSION FOR CIGAR BUTTS

Warren Buffett commented on high quality companies versus statistically cheap companies in his October 1967 letter to partners:

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors.  At the one extreme, the analyst exclusively oriented to qualitative factors would say, “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.”  On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.”  As is so often the pleasant result in the securities world, money can be made with either approach.  And, of course, any analyst combines the two to some extent—his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group.

Interestingly enough, although I consider myself to be primarily in the quantitative school… the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”.  This is what causes the cash register to really sing.  However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat.  So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Buffett and Munger acquired See’s Candies for Berkshire Hathaway in 1972.  See’s Candies is the quintessential high quality company because of its sustainably high ROIC (return on invested capital) of over 100%.

Truly high quality companies—like See’s—are very rare and difficult to find.  Cigar butts are much easier to find by comparison.

Furthermore, it’s important to understand that Buffett got around 50% annual returns from cigar butts because he took a focused approach, like BPL’s 20% position in Dempster.

The vast majority of investors, if using a cigar-butt approach like net nets, should implement a group—or statistical—approach, and regularly buy and hold a basket of cigar butts (at least 20-30).  This typically won’t produce 50% annual returns.  But net nets, as a group, clearly have produced very high returns, often 30%+ annually.  To do this today, you’d have to look globally.

As an alternative to net nets, you could implement a group approach using one of O’Shaughnessy’s composite measures—such as low P/B, P/E, P/S, P/CF, EV/EBITDA.  Applying this to micro caps can produce 15-20% annual returns.  Still excellent results.  And much easier to apply consistently.

You may think that you can find some high quality companies.  But that’s not enough.  You have to find a high quality company that can maintain its competitive position and high ROIC.  And it has to be available at a reasonable price.

Most high quality companies are trading at very high prices, to the extent that you can’t do better than the market by investing in them.  In fact, often the prices are so high that you’ll probably do worse than the market.

Consider this observation by Charlie Munger:

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market.  Everybody goes there and bets and the odds change based o­n what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2.  Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.  The prices have changed in such a way that it’s very hard to beat the system.

(Illustration by Nadoelopisat)

A horse with a great record (etc.) is much more likely to win than a horse with a terrible record.  But—whether betting on horses or betting on stocks—you don’t get paid for identifying winners.  You get paid for identifying mispricings.

The statistical evidence is overwhelming that if you systematically buy stocks at low multiples—P/B, P/E, P/S, P/CF, EV/EBITDA, etc.—you’ll almost certainly do better than the market over the long haul.

A deep value (cigar-butt) approach has always worked, given enough time.  Betting on “the losers” has always worked eventually, whereas betting on “the winners” hardly ever works.

Classic academic studies showing “the losers” doing far better than “the winners” over subsequent 3- to 5-year periods:

That’s not to say deep value investing is easy.  When you put together a basket of statistically cheap companies, you’re buying stocks that are widely hated or neglected.  You have to endure loneliness and looking foolish.  Some people can do it, but it’s important to know yourself before using a deep value strategy.

In general, we extrapolate the poor performance of cheap stocks and the good performance of expensive stocks too far into the future.  This is the mistake of ignoring mean reversion.

When you find a group of companies that have been doing poorly for at least several years, those conditions typically do not persist.  Instead, there tends to be mean reversion, or a return to “more normal” levels of revenues, earnings, or cash flows.

Similarly for a group of companies that have been doing exceedingly well.  Those conditions also do not continue in general.  There tends to be mean reversion, but in this case the mean—the average or “normal” conditions—is below recent activity levels.

Here’s Ben Graham explaining mean reversion:

It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided.  The converse would be assumed, of course, for those with superior records.  But this conclusion may often prove quite erroneous.  Abnormally good or abnormally bad conditions do not last forever.  This is true of general business but of particular industries as well.  Corrective forces are usually set in motion which tend to restore profits where they have disappeared or to reduce them where they are excessive in relation to capital.

With his taste for literature, Graham put the following quote from Horace’s Ars Poetica at the beginning of Security Analysis—the bible for value investors:

Many shall be restored that now are fallen and many shall fall than now are in honor.

Tobias Carlisle, while discussing mean reversion in Deep Value, smartly (and humorously) included this image of Albrecht Durer’s Wheel of Fortune:

(Albrecht Durer’s Wheel of Fortune from Sebastien Brant’s Ship of Fools (1494) via Wikimedia Commons)

 

FOCUSED vs. STATISTICAL

We’ve already seen that there are two basic ways to do cigar-butt investing: focused vs. statistical (group).

Ben Graham usually preferred the statistical (group) approach.  Near the beginning of the Great Depression, Graham’s managed accounts lost more than 80 percent.  Furthermore, the economy and the stock market took a long time to recover.  As a result, Graham had a strong tendency towards conservatism in investing.  This is likely part of why he preferred the statistical approach to net nets.  By buying a basket of net nets (at least 20-30), the investor is virtually certain to get the statistical results of the group over time, which are broadly excellent.

Graham also was a polymath of sorts.  He had wide-ranging intellectual interests.  Because he knew net nets as a group would do quite well over the long term, he wasn’t inclined to spend much time analyzing individual net nets.  Instead, he spent time on his other interests.

Warren Buffett was Graham’s best student.  Buffett was the only student ever to be awarded an A+ in Graham’s class at Columbia University.  Unlike Graham, Buffett has always had an extraordinary focus on business and investing.  After spending many years learning everything about virtually every public company, Buffett took a focused approach to net nets.  He found the ones that were the cheapest and that seemed the surest.

Buffett has asserted that returns can be improved—and risk lowered—if you focus your investments only on those companies that are within your circle of competence—those companies that you can truly understand.  Buffett also maintains, however, that the vast majority of investors should simply invest in index funds: http://boolefund.com/warren-buffett-jack-bogle/

Regarding individual net nets, Graham admitted a danger:

Corporate gold dollars are now available in quantity at 50 cents and less—but they do have strings attached.  Although they belong to the stockholder, he doesn’t control them.  He may have to sit back and watch them dwindle and disappear as operating losses take their toll.  For that reason the public refuses to accept even the cash holdings of corporations at their face value.

Graham explained that net nets are cheap because they “almost always have an unsatisfactory trend in earnings.”  Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors.  Ongoing business losses can, however, quickly erode net-net working capital.  Investors must therefore always consider the state of a company’s current operations before buying.

Even Buffett—nearly two decades after closing BPL—wrote the following in his 1989 letter to Berkshire shareholders:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the “cigar butt” approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original “bargain” price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.  For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.  But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost…

Based on these objections, you might think that Buffett’s focused approach is better than the statistical (group) method.  That way, the investor can figure out which net nets are more likely to recover instead of burn through their assets and leave the investor with a low or negative return.

However, Graham’s response was that the statistical or group approach to net nets is highly profitable over time.  There is a wide range of potential outcomes for net nets, and many of those scenarios are good for the investor.  Therefore, while there are always some individual net nets that don’t work out, a group or basket of net nets is nearly certain to work well eventually.

Indeed, Graham’s application of a statistical net-net approach produced 20% annual returns over many decades.  Most backtests of net nets have tended to show annual returns of close to 30%.  In practice, while around 5 percent of net nets may suffer a terminal decline in stock price, a statistical group of net nets has done far better than the market and has experienced fewer down years.  Moreover, as Carlisle notes in Deep Value, very few net nets are actually liquidated or merged.  In the vast majority of cases, there is a change by management, a change from the outside, or both, in order to restore earnings to a level more in line with net asset value.  Mean reversion.

 

THE REWARDS OF PSYCHOLOGICAL DISCOMFORT

We noted earlier that it’s far more difficult to find a company like See’s Candies, at a reasonable price, than it is to find statistically cheap stocks.  Moreover, if you buy a basket of statistically cheap stocks, you don’t have to possess an ability to analyze individual businesses in great depth.

That said, in order to use a deep value strategy, you do have to be able to handle the psychological discomfort of being lonely and looking foolish.

(Illustration by Sangoiri)

John Mihaljevic, author of The Manual of Ideas (Wiley, 2013), writes:

Comfort can be expensive in investing.  Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations….

…Misery loves company, so it makes sense that rewards may await those willing to be miserable in solitude…

Mihaljevic explains:

If we owned nothing but a portfolio of Ben Graham-style bargain equities, we may become quite uncomfortable at times, especially if the market value of the portfolio declined precipitously.  We might look at the portfolio and conclude that every investment could be worth zero.  After all, we could have a mediocre business run by mediocre management, with assets that could be squandered.  Investing in deep value equities therefore requires faith in the law of large numbers—that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time.  This conceptually sound view becomes seriously challenged in times of distress…

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

Deep value investors often find some of the best investments in cyclical areas.  A company at a cyclical low may have multi-bagger potential—the prospect of returning 300-500% (or more) to the investor.

A good current example is Ensco Rowan plc (NYSE: ESV), an offshore oil driller.  Ensco Rowan is one of the largest, safest, most reliable, and most technically advanced offshore oil drillers in the world.  It’s also one of the best capitalized drillers.  Moreover, Ensco Rowan has been rated #1 in customer satisfaction for nine consecutive years according to a leading independent survey.  As a result of its reliability, high-spec rigs, and well-capitalized position, Ensco Rowan has continued to win more new contracts than any other driller.

In April 2019, Ensco plc (ESV) and Rowan Companies plc (RDC) merged in an all-stock transaction.  The combination has brought together two world-class operators with common cultures.  Both companies have strong track records of safety and operational excellence.  And both companies have a strategic focus on innovative technologies that increase efficiencies and lower costs.

Ensco Rowan is the largest offshore driller and it has one of the highest quality fleets in the world.  It has a presence in six continents and nearly all major offshore markets.  The company has a large and diverse customer base including major, national, and independent E&P companies.

Ensco Rowan has $2.8 billion in contracted revenue backlog.  It has $1.6 billion in cash and short-term investments and $2.3 billion in credit available.  And it has only $1.1 billion in debt maturities to 2024, with no secured debt in the capital structure.

Also, Ensco Rowan expects to achieve cost savings of $165 million pre-tax per year.  The company may achieve additional savings through adoption of best-in-class operational processes and through economies of scale in capital purchasing.

You might wonder if Ensco is giving up something in the merger, given its ability to offer the highest specification drilling rigs—especially for ultra-deepwater.  However, Rowan’s groundbreaking partnership (ARO Drilling) with Saudi Aramco will create billions of dollars in value for shareholders.  Moreover, Rowan is a leading provider of ultra-harsh and modern harsh environment jackups.

Intrinsic value scenarios for Ensco Rowan:

    • Low case: If oil prices languish below $60 (WTI) for the next 3 to 5 years, Ensco Rowan will be a survivor, due to its large fleet, globally diverse customer base, industry leading performance, low cost structure, and well-capitalized position.  In this scenario, Ensco Rowan is likely worth at least one-half of current book value (which is depressed) of $72.27.  That’s $36.14, about 445% higher than today’s $6.62.
    • Mid case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years—which is likely based on long-term supply and demand—then Ensco Rowan is probably worth at least 125% current book value (which is depressed) of $72.27 a share.  That’s $90.34, over 1,260% higher than today’s $6.62.
    • High case: If oil prices average $85 or more over the next 3 to 5 years, then Ensco Rowan is worth at least 175% of current book value of $72.27.  That’s $126.47, over 1,800% higher than today’s $6.62.

Mihaljevic comments on a central challenge of deep value investing in cyclical companies:

The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation.  Even if a business has been cyclical in the past, analysts generally adopt a “this time is different” attitude.  As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.

Consider the following industries that have been pronounced permanently impaired in the past, only to rebound strongly in subsequent years:  Following the financial crisis of 2008-2009, many analysts argued that the banking industry would be permanently negatively affected, as higher capital requirements and regulatory oversight would compress returns on equity.  The credit rating agencies were seen as impaired because the regulators would surely alter the business model of the industry for the worse following the failings of the rating agencies during the subprime mortgage bubble.  The homebuilding industry would fail to rebound as strongly as in the past, as overcapacity became chronic and home prices remained tethered to building costs.  The refining industry would suffer permanently lower margins, as those businesses were capital-intensive and driven by volatile commodity prices.

Are offshore oil drillers in a cyclical or a secular decline?  It’s likely that oil will return to $65-85 in the next 3 to 5 years.  But no one knows for sure.

Ongoing improvements in technology allow oil producers to get more oil—more cheaply—out of existing fields.  Also, growth in transport demand for oil will slow significantly at some point, due to ongoing improvements in fuel efficiency.  See: https://www.spe.org/en/jpt/jpt-article-detail/?art=3286

Transport demand is responsible for over 50% of daily oil consumption, and it’s inelastic—typically people have to get where they’re going, so they’re not very sensitive to fuel price increases.

But even if oil never returns to $65+, oil will be needed for many decades.  At least some offshore drilling will still be needed.

What’s great about an investment in Ensco Rowan is that even in worst case, the company will survive and the stock would likely be worth at least half of current book value (which is depressed) of $72.27.  That’s $36.14 a share, about 445% higher than today’s 6.62.  Recall that the company has the largest and one of the most technically advanced fleets.  Also, Ensco Rowan has a globally diverse customer base, industry leading performance, a low cost structure, and a well-capitalized position.

If the worst-case scenario means that you’ll more than quintuple your money—over a 3- to 5-year holding period—that’s an interesting investment.  And if the base case scenario means that you’ll make over 12x your money, well…

Notes:

  • The Boole Fund had an investment in Atwood Oceanics.  Because Ensco acquired Atwood in 2017, the Boole Fund owns in Ensco.
  • Recently Ensco plc and Rowan Companies plc merged in an all-stock transaction.  As a result, the Boole Fund now owns shares in Ensco Rowan plc (ESV).
  • The Boole Fund holds positions for 3 to 5 years.  The fund doesn’t sell an investment that is still cheap, even if the stock in question is no longer a micro cap.

 

CONCLUSION

Buffett has made it clear, including in his 2014 letter to shareholders, that the best returns of his career came from investing in microcap cigar butts.  Most of these were mediocre businesses (or worse).  But they were ridiculously cheap.  And, in some cases like Dempster, Buffett was able to bring about needed improvements when required.

When Buffett wrote about buying wonderful businesses in his 1989 letter, that’s chiefly because investable assets at Berkshire Hathaway had grown far too large for microcap cigar butts.

Even in recent years, Buffett invested part of his personal portfolio in a group of cigar butts he found in South Korea.  So he’s never changed his view that an investor can get the highest returns from microcap cigar butts, either by using a statistical group approach or by using a more focused method.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Invest Like Sherlock Holmes

(Image:  Zen Buddha Silence by Marilyn Barbone.)

May 19, 2019

Robert G. Hagstrom has written a number of excellent books on investing.  One of his best is The Detective and the Investor  (Texere, 2002).

Many investors are too focused on the short term, are overwhelmed with information, take shortcuts, or fall prey to cognitive biases.  Hagstrom argues that investors can learn from the Great Detectives as well as from top investigative journalists.

Great detectives very patiently gather information from a wide variety of sources.  They discard facts that turn out to be irrelevant and keep looking for new facts that are relevant.  They painstakingly use logic to analyze the given information and reach the correct conclusion.  They’re quite willing to discard a hypothesis, no matter how well-supported, if new facts lead in a different direction.

(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)

Top investigative journalists follow a similar method.

Outline for this blog post:

  • The Detective and the Investor
  • Auguste Dupin
  • Jonathan Laing and Sunbeam
  • Top Investigative Journalists
  • Edna Buchanan—Pulitzer Prize Winner
  • Sherlock Holmes
  • Arthur Conan Doyle
  • Holmes on Wall Street
  • Father Brown
  • How to Become a Great Detective

The first Great Detective is Auguste Dupin, an invention of Edgar Allan Poe.  The financial journalist Jonathan Laing’s patient and logical analysis of the Sunbeam Corporation bears similarity to Dupin’s methods.

Top investigative journalists are great detectives.  The Pulitzer Prize-winning journalist Edna Buchanan is an excellent example.

Sherlock Holmes is the most famous Great Detective.  Holmes was invented by Dr. Arthur Conan Doyle.

Last but not least, Father Brown is the third Great Detective discussed by Hagstrom.  Father Brown was invented by G. K. Chesterton.

The last section—How To Become a Great Detective—sums up what you as an investor can learn from the three Great Detectives.

 

THE DETECTIVE AND THE INVESTOR

Hagstrom writes that many investors, both professional and amateur, have fallen into bad habits, including the following:

  • Short-term thinking: Many professional investors advertise their short-term track records, and many clients sign up on this basis.  But short-term performance is largely random, and usually cannot be maintained.  What matters (at a minimum) is performance over rolling five-year periods.
  • Infatuation with speculation: Speculation is guessing what other investors will do in the short term.  Investing, on the other hand, is figuring out the value of a given business and only buying when the price is well below that value.
  • Overload of information: The internet has led to an overabundance of information.  This makes it crucial that you, as an investor, know how to interpret and analyze the information.
  • Mental shortcuts: We know from Daniel Kahneman (see Thinking, Fast and Slow) that most people rely on System 1 (intuition) rather than System 2 (logic and math) when making decisions under uncertainty.  Most investors jump to conclusions based on easy explanations, and then—due to confirmation bias—only see evidence that supports their conclusions.
  • Emotional potholes: In addition to confirmation bias, investors suffer from overconfidence, hindsight bias, loss aversion, and several other cognitive biases.  These cognitive biases regularly cause investors to make mistakes in their investment decisions.  I wrote about cognitive biases here: http://boolefund.com/cognitive-biases/

How can investors develop better habits?  Hagstrom:

The core premise of this book is that the same mental skills that characterize a good detective also characterize a good investor… To say this another way, the analytical methods displayed by the best fictional detectives are in fact high-level decision-making tools that can be learned and applied to the investment world.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Hagstrom asks if it is possible to combine the methods of the three Great Detectives.  If so, what would the ideal detective’s approach to investing be?

First, our investor-detective would have to keep an open mind, be prepared to analyze each new opportunity without any preset opinions.  He or she would be well versed in the basic methods of inquiry, and so would avoid making any premature and possibly inaccurate assumptions.  Of course, our investor-detective would presume that the truth might be hidden below the surface and so would distrust the obvious.  The investor-detective would operate with cool calculation and not allow emotions to distract clear thinking.  The investor-detective would also be able to deconstruct the complex situation into its analyzable parts.  And perhaps most important, our investor-detective would have a passion for truth, and, driven by a nagging premonition that things are not what they seem to be, would keep digging away until all the evidence had been uncovered.

 

AUGUSTE DUPIN

(Illustration—by Frédéric Théodore Lix—to The Purloined Letter, via Wikimedia Commons)

The Murders in the Rue Morgue exemplifies Dupin’s skill as a detective.  The case involves Madame L’Espanaye and her daughter.  Madame L’Espanaye was found behind the house in the yard with multiple broken bones and her head almost severed.  The daughter was found strangled to death and stuffed upside down into a chimney.  The murders occurred in a fourth-floor room that was locked from the inside.  On the floor were a bloody straight razor, several bloody tufts of grey hair, and two bags of gold coins.

Several witnesses heard voices, but no one could say for sure which language it was.  After deliberation, Dupin concludes that they must not have been hearing a human voice at all.  He also dismisses the possibility of robbery, since the gold coins weren’t taken.  Moreover, the murderer would have to possess superhuman strength to stuff the daughter’s body up the chimney.  As for getting into a locked room, the murderer could have gotten in through a window.  Finally, Dupin demonstrates that the daughter could not have been strangled by a human hand.  Dupin concludes that Madame L’Espanaye and her daughter were killed by an orangutan.

Dupin places an advertisement in the local newspaper asking if anyone had lost an orangutan.  A sailor arrives looking for it.  The sailor explains that he had seen the orangutan with a razor, imitating the sailor shaving.  The orangutan had then fled.  Once it got into the room with Madame L’Espanaye and her daughter, the orangutan probably grabbed Madame’s hair and was waving the razor, imitating a barber.  When the woman screamed in fear, the orangutan grew furious and killed her and her daughter.

Thus Dupin solves what at first seemed like an impossible case.  The solution is completely unexpected but is the only logical possibility, given all the facts.

Hagstrom writes that investors can learn important lessons from the Great Detective Auguste Dupin:

First, look in all directions, observe carefully and thoughtfully everything you see, and do not make assumptions from inadequate information.  On the other hand, do not blindly accept what you find.  Whatever you read, hear, or overhear about a certain stock or company may not necessarily be true.  Keep on with your research;  give yourself time to dig beneath the surface.

If you’re a small investor, it’s often best to invest in microcap stocks.  (This presumes that you have access to a proven investment process.)  There are hundreds of tiny companies much too small for most professional investors even to consider.  Thus, there is much more mispricing among micro caps.  Moreover, many microcap companies are relatively easy to analyze and understand.  (The Boole Microcap Fund invests in microcap companies.)

 

JONATHAN LAING AND SUNBEAM

(Sunbeam logo, via Wikimedia Commons)

Hagstrom writes that, in the spring of 1997, Wall Street was in love with the self-proclaimed ‘turnaround genius’ Al Dunlap.  Dunlap was asked to take over the troubled Sunbeam Corporation, a maker of electric home appliances.  Dunlap would repeat the strategy he used on previous turnarounds:

[Drive] up the stock price by any means necessary, sell the company, and cash in his stock options at the inflated price.

Although Dunlap made massive cost cuts, some journalists were skeptical, viewing Sunbeam as being in a weak competitive position in a harsh industry.  Jonathan Laing of Barron’s, in particular, took a close look at Sunbeam.  Laing focused on accounting practices:

First, Laing pointed out that Sunbeam took a huge restructuring charge ($337 million) in the last quarter of 1996, resulting in a net loss for the year of $228.3 million.  The charges included moving reserves from 1996 to 1997 (where they could later be recharacterized as income);  prepaying advertising expenses to make the new year’s numbers look better;  a suspiciously high charge for bad-debt allowance;  a $90 million write-off for inventory that, if sold at a later date, could turn up in future profits;  and write-offs for plants, equipment, and trademarks used by business lines that were still operating.

To Laing, it looked very much like Sunbeam was trying to find every possible way to transfer 1997 projected losses to 1996 (and write 1996 off as a lost year, claiming it was ruined by previous management) while at the same time switching 1996 income into 1997…

(Photo by Evgeny Ivanov)

Hagstrom continues:

Even though Sunbeam’s first-quarter 1997 numbers did indeed show a strong increase in sales volume, Laing had collected evidence that the company was engaging in the practice known as ‘inventory stuffing’—getting retailers to place abnormally large orders either through high-pressure sales tactics or by offering them deep discounts (using the written-off inventory from 1996).  Looking closely at Sunbeam’s financial reports, Laing also found a hodgepodge of other maneuvers designed to boost sales numbers, such as delaying delivery of sales made in 1996 so they could go on the books as 1997 sales, shipping more units than the customer had actually ordered, and counting as sales orders that had already been canceled.

The bottom line was simply that much of 1997’s results would be artificial.  Hagstrom summarizes the lesson from Dupin and Laing:

The core lesson for investors here can be expressed simply:  Take nothing for granted, whether it comes from the prefect of police or the CEO of a major corporation.  This is, in fact, a key theme of this chapter.  If something doesn’t make sense to you—no matter who says it—that’s your cue to start digging.

By July 1998, Sunbeam stock had lost 80 percent of its value and was lower than when Dunlap took over.  The board of directors fired Dunlap and admitted that its 1997 financial statements were unreliable and were being audited by a new accounting firm.  In February 2001, Sunbeam filed for Chapter 11 bankruptcy protection.  On May 15, 2001, the Securities and Exchange Commission filed suit against Dunlap and four senior Sunbeam executives, along with their accounting firm, Arthur Andersen.  The SEC charged them with a fraudulent scheme to create the illusion of a successful restructuring.

Hagstrom points out what made Laing successful as an investigative journalist:

He read more background material, dissected more financial statements, talked to more people, and painstakingly pieced together what many others failed to see.

 

TOP INVESTIGATIVE JOURNALISTS

Hagstrom mentions Professor Linn B. Washington, Jr., a talented teacher and experienced investigative reporter.  (Washington was awarded the Robert F. Kennedy Prize for his series of articles on drug wars in the Richard Allen housing project.)  Hagstrom quotes Washington:

Investigative journalism is not a nine-to-five job.  All good investigative journalists are first and foremost hard workers.  They are diggers.  They don’t stop at the first thing they come to but rather they feel a need to persist.  They are often passionate about the story they are working on and this passion helps fuel the relentless pursuit of information.  You can’t teach that.  They either have it or they don’t.

…I think most reporters have a sense of morality.  They are outraged by corruption and they believe their investigations have a real purpose, an almost sacred duty to fulfill.  Good investigative reporters want to right the wrong, to fight for the underdog.  And they believe there is a real responsibility attached to the First Amendment.

(Photo by Robyn Mackenzie)

Hagstrom then refers to The Reporter’s Handbook, written by Steve Weinberg for investigative journalists.  Weinberg maintains that gathering information involves two categories: documents and people.  Hagstrom:

Weinberg asks readers to imagine three concentric circles.  The outmost one is ‘secondary sources,’ the middle one ‘primary sources.’  Both are composed primarily of documents.  The inner circle, ‘human sources,’ is made up of people—a wide range of individuals who hold some tidbit of information to add to the picture the reporter is building.

Ideally, the reporter starts with secondary sources and then primary sources:

At these two levels of the investigation, the best reporters rely on what has been called a ‘documents state of mind.’  This way of looking at the world has been articulated by James Steele and Donald Bartlett, an investigative team from the Philadephia Inquirer.  It means that the reporter starts from day one with the belief that a good record exists somewhere, just waiting to be found.

Once good background knowledge is accumulated from all the primary and secondary documents, the reporter is ready to turn to the human sources…

Photo by intheskies

Time equals truth:

As they start down this research track, reporters also need to remember another vital concept from the handbook:  ‘Time equals truth.’  Doing a complete job of research takes time, whether the researcher is a reporter following a story or an investor following a company—or for that matter, a detective following the evidence at a crime scene.  Journalists, investors, and detectives must always keep in mind that the degree of truth one finds is directly proportional to the amount of time one spends in the search.  The road to truth permits no shortcuts.

The Reporter’s Handbook also urges reporters to question conventional wisdom, to remember that whatever they learn in their investigation may be biased, superficial, self-serving for the source, or just plain wrong.  It’s another way of saying ‘Take nothing for granted.’  It is the journalist’s responsibility—and the investor’s—to penetrate the conventional wisdom and find what is on the other side.

The three concepts discussed above—‘adopt a documents state of mind,’ ‘time equals truth,’ and ‘question conventional wisdom;  take nothing for granted’—may be key operating principles for journalists, but I see them also as new watchwords for investors.

 

EDNA BUCHANAN—PULITZER PRIZE WINNER

Edna Buchanan, working for the Miami Herald and covering the police beat, won a Pulitzer Prize in 1986.  Hagstrom lists some of Buchanan’s principles:

  • Do a complete background check on all the key players.  Find out how a person treats employees, women, the environment, animals, and strangers who can do nothing for them.  Discover if they have a history of unethical and/or illegal behavior.
  • Cast a wide net.  Talk to as many people as you possibly can.  There is always more information.  You just have to find it.  Often that requires being creative.
  • Take the time.  Learning the truth is proportional to the time and effort you invest.  There is always more that you can do.  And you may uncover something crucial.  Never take shortcuts.
  • Use common sense.  Often official promises and pronouncements simply don’t fit the evidence.  Often people lie, whether due to conformity to the crowd, peer pressure, loyalty (like those trying to protect Nixon et al. during Watergate), trying to protect themselves, fear, or any number of reasons.  As for investing, some stories take a long time to figure out, while other stories (especially for tiny companies) are relatively simple.
  • Take no one’s word.  Find out for yourself.  Always be skeptical and read between the lines.  Very often official press releases have been vetted by lawyers and leave out critical information.  Take nothing for granted.
  • Double-check your facts, and then check them again.  For a good reporter, double-checking facts is like breathing.  Find multiples sources of information.  Again, there are no shortcuts.  If you’re an investor, you usually need the full range of good information in order to make a good decision.

In most situations, to get it right requires a great deal of work.  You must look for information from a broad range of sources.  Typically you will find differing opinions.  Not all information has the same value.  Always be skeptical of conventional wisdom, or what ‘everybody knows.’

 

SHERLOCK HOLMES

Image by snaptitude

Sherlock Holmes approaches every problem by following three steps:

  • First, he makes a calm, meticulous examination of the situation, taking care to remain objective and avoid the undue influence of emotion.  Nothing, not even the tiniest detail, escapes his keen eye.
  • Next, he takes what he observes and puts it in context by incorporating elements from his existing store of knowledge.  From his encyclopedic mind, he extracts information about the thing observed that enables him to understand its significance.
  • Finally, he evaluates what he observed in the light of this context and, using sound deductive reasoning, analyzes what it means to come up with the answer.

These steps occur and re-occur in an iterative search for all the facts and for the best hypothesis.

There was a case involving a young doctor, Percy Trevelyan.  Some time ago, an older gentleman named Blessington offered to set up a medical practice for Trevelyan in return for a share of the profits.  Trevelyan agreed.

A patient suffering from catalepsy—a specialty of the doctor—came to the doctor’s office one day.  The patient also had his son with him.  During the examination, the patient suffered a cataleptic attack.  The doctor ran from the room to grab the treatment medicine.  But when he got back, the patient and his son were gone.  The two men returned the following day, giving a reasonable explanation for the mix-up, and the exam continued.  (On both visits, the son had stayed in the waiting room.)

Shortly after the second visit, Blessington burst into the exam room, demanding to know who had been in his private rooms.  The doctor tried to assure him that no one had.  But upon going to Blessington’s room, he saw a strange set of footprints.  Only after Trevelyan promises to bring Sherlock Holmes to the case does Blessington calm down.

Holmes talks with Blessington.  Blessington claims not to know who is after him, but Holmes can tell that he is lying.  Holmes later tells his assistant Watson that the patient and his son were fakes and had some sinister reason for wanting to get Blessington.

Holmes is right.  The next morning, Holmes and Watson are called to the house again.  This time, Blessington is dead, apparently having hung himself.

But Holmes deduces that it wasn’t a suicide but a murder.  For one thing, there were four cigar butts found in the fireplace, which led the policeman to conclude that Blessington had stayed up late agonizing over his decision.  But Holmes recognizes that Blessington’s cigar is a Havana, but the other three cigars had been imported by the Dutch from East India.  Furthermore, two had been smoked from a holder and two without.  So there were at least two other people in the room with Blessington.

Holmes does his usual very methodical examination of the room and the house.  He finds three sets of footprints on the stairs, clearly showing that three men had crept up the stairs.  The men had forced the lock, as Holmes deduced from scratches on it.

Holmes also realized the three men had come to commit murder.  There was a screwdriver left behind.  And he could further deduce (by the ashes dropped) where each man sat as the three men deliberated over how to kill Blessington.  Eventually, they hung Blessington.  Two killers left the house and the third barred the door, implying that the third murderer must be a part of the doctor’s household.

All these signs were visible:  the three sets of footprints, the scratches on the lock, the cigars that were not Blessington’s type, the screwdriver, the fact that the front door was barred when the police arrived.  But it took Holmes to put them all together and deduce their meaning:  murder, not suicide.  As Holmes himself remarked in another context, ‘The world is full of obvious things which nobody by any chance ever observes.’

…He knows Blessington was killed by people well known to him.  He also knows, from Trevelyan’s description, what the fake patient and his son look like.  And he has found a photograph of Blessington in the apartment.  A quick stop at policy headquarters is all Holmes needs to pinpoint their identity.  The killers, no strangers to the police, were a gang of bank robbers who had gone to prison after being betrayed by their partner, who then took off with all the money—the very money he used to set Dr. Trevelyan up in practice.  Recently released from prison, the gang tracked Blessington down and finally executed him.

Spelled out thus, one logical point after another, it seems a simple solution.  Indeed, that is Holmes’s genius:  Everything IS simple, once he explains it.

Hagstrom then adds:

Holmes operates from the presumption that all things are explainable;  that the clues are always present, awaiting discovery. 

The first step—gathering all the facts—usually requires a great deal of careful effort and attention.  One single fact can be the key to deducing the true hypothesis.  The current hypothesis is revisable if there may be relevant facts not yet known.  Therefore, a heightened degree of awareness is always essential.  With practice, a heightened state of alertness becomes natural for the detective (or the investor).

“Details contain the vital essence of the whole matter.” — Sherlock Holmes

Moreover, it’s essential to keep emotion out of the process of discovery:

One reason Holmes is able to see fully what others miss is that he maintains a level of detached objectivity toward the people involved.  He is careful not to be unduly influenced by emotion, but to look at the facts with calm, dispassionate regard.  He sees everything that is there—and nothing that is not.  For Holmes knows that when emotion seeps in, one’s vision of what is true can become compromised.  As he once remarked to Dr. Watson, ‘Emotional qualities are antagonistic to clear reasoning… Detection is, or ought to be, an exact science and should be treated in the same cold and unemotional manner.  You have attempted to tinge it with romanticism, which produces much the same effect as if you worked a love story or an elopement into the fifth proposition of Euclid.’

Image by snaptitude

Holmes himself is rather aloof and even antisocial, which helps him to maintain objectivity when collecting and analyzing data.

‘I make a point of never having any prejudices and of following docilely wherever fact may lead me.’  He starts, that is, with no preformed idea, and merely collects data.  But it is part of Holmes’s brilliance that he does not settle for the easy answer.  Even when he has gathered together enough facts to suggest one logical possibility, he always knows that this answer may not be the correct one.  He keeps searching until he has found everything, even if subsequent facts point in another direction.  He does not reject the new facts simply because they’re antithetical to what he’s already found, as so many others might.

Hagstrom observes that many investors are susceptible to confirmation bias:

…Ironically, it is the investors eager to do their homework who may be the most susceptible.  At a certain point in their research, they have collected enough information that a pattern becomes clear, and they assume they have found the answer.  If subsequent information then contradicts that pattern, they cannot bring themselves to abandon the theory they worked so hard to develop, so they reject the new facts.

Gathering information about an investment you are considering means gather all the information, no matter where it ultimately leads you.  If you find something that does not fit your original thesis, don’t discard the new information—change the thesis.

 

ARTHUR CONAN DOYLE

Arthur Conan Doyle was a Scottish doctor.  One of his professors, Dr. Bell, challenged his students to hone their skills of observation.  Bell believed that a correct diagnosis required alert attention to all aspects of the patient, not just the stated problem.  Doyle later worked for Dr. Bell.  Doyle’s job was to note the patients’ problem along with all possibly relevant details.

Doyle had a very slow start as a doctor.  He had virtually no patients.  He spent his spare time writing, which he had loved doing since boarding school.  Doyle’s main interest was historical fiction.  But he didn’t get much money from what he wrote.

One day he wrote a short novel, A Study in Scarlet, which introduced a private detective, Sherlock Holmes.  Hagstrom quotes Doyle:

I thought I would try my hand at writing a story where the hero would treat crime as Dr. Bell treated disease, and where science would take the place of chance.

Doyle soon realized that he might be able to sell short stories about Sherlock Holmes as a way to get some extra income.  Doyle preferred historical novels, but his short stories about Sherlock Holmes started selling surprisingly well.  Because Doyle continued to emphasize historical novels and the practice of medicine, he demanded higher and higher fees for his short stories about Sherlock Holmes.  But the stories were so popular that magazine editors kept agreeing to the fee increases.

Photo by davehanlon

Soon thereafter, Doyle, having hardly a single patient, decided to abandon medicine and focus on writing.  Doyle still wanted to do other types of writing besides the short stories.  He asked for a very large sum for the Sherlock Holmes stories so that the editors would stop bothering him.  Instead, the editors immediately agreed to the huge fee.

Many years later, Doyle was quite tired of Holmes and Watson after having written fifty-six short stories and four novels about them.  But readers never could get enough.  And the stories are still highly popular to this day, which attests to Doyle’s genius.  Doyle has always been credited with launching the tradition of the scientific sleuth.

 

HOLMES ON WALL STREET

Sherlock Holmes is the most famous Great Detective for good reason.  He is exceptionally thorough, unemotional, and logical.

Holmes knows a great deal about many different things, which is essential in order for him to arrange and analyze all the facts:

The list of things Holmes knows about is staggering:  the typefaces used by different newspapers, what the shape of a skull reveals about race, the geography of London, the configuration of railway lines in cities versus suburbs, and the types of knots used by sailors, for a few examples.  He has authored numerous scientific monographs on such topics as tattoos, ciphers, tobacco ash, variations in human ears, what can be learned from typewriter keys, preserving footprints with plaster of Paris, how a man’s trade affects the shape of his hands, and what a dog’s manner can reveal about the character of its owner.

(Illustration of Sherlock Holmes with various tools, by Elena Kreys)

Consider what Holmes says about his monograph on the subject of tobacco:

“In it I enumerate 140 forms of cigar, cigarette, and pipe tobacco… It is sometimes of supreme importance as a clue.  If you can say definitely, for example, that some murder has been done by a man who was smoking an Indian lunkah, it obviously narrows your field of search.”

It’s very important to keep gathering and re-gathering facts to ensure that you haven’t missed anything.  Holmes:

“It is a capital mistake to theorize before you have all the evidence.  It biases the judgment.”

“The temptation to form premature theories upon insufficient data is the bane of our profession.”

Although gathering all facts is essential, at the same time, you must be organizing those facts since not all facts are relevant to the case at hand.  Of course, this is an iterative process. You may discard a fact as irrelevant and realize later that it is relevant.

Part of the sorting process involves a logical analysis of various combinations of facts.  You reject combinations that are logically impossible.  As Holmes famously said:

“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

Often there is more than one logical possibility that is consistent with the known facts.  Be careful not to be deceived by obvious hypotheses.  Often what is ‘obvious’ is completely wrong.

Sometimes finding the solution requires additional research.  Entertaining several possible hypotheses may also be required.  Holmes:

“When you follow two separate chains of thought you will find some point of intersection which should approximate to the truth.”

But be careful to keep facts and hypotheses separate, as Holmes asserts:

“The difficulty is to detach the frame of absolute undeniable facts from the embellishments of theorists.  Then, having established ourselves upon this sound basis, it is our duty to see what inferences may be drawn and what are the special points upon which the whole mystery turns.”

For example, there was a case involving the disappearance of a valuable racehorse.  The chief undeniable fact was that the dog did not bark, which meant that the intruder had to be familiar to the dog.

Sherlock Holmes As Investor

How would Holmes approach investing?  Hagstrom:

Here’s what we know of his methods:  He begins an examination with an objective mind, untainted by prejudice.  He observes acutely and catalogues all the information, down to the tiniest detail, and draws on his broad knowledge to put those details into context.  Then, armed with the facts, he walks logically, rationally, thoughtfully toward a conclusion, always on the lookout for new, sometimes contrary information that might alter the outcome.

It’s worth repeating that much of the process of gathering facts can be tedious and boring.  This is the price you must pay to ensure you get all the facts.  Similarly, analyzing all the facts often requires patience and can take a long time.  No shortcuts.

 

FATHER BROWN

Hagstrom opens the chapter with a scene in which Aristide Valentin—head of Paris police and the most famous investigator in Europe—is chasing Hercule Flambeau, a wealthy and famous French jewel thief.  Both Valentin and Flambeau are on the same train.  But Valentin gets distracted by the behavior of a very short Catholic priest with a round face.  The priest is carrying several brown paper parcels, and he keeps dropping one or the other, or dropping his umbrella.

When the train reaches London, Valentin isn’t exactly sure where Flambeau went.  So Valentin decides to go systematically to the ‘wrong places.’  Valentin ends up at a certain restaurant that caught his attention.  A sugar bowl has salt in it, while the saltcellar contains sugar.  He learns from a waiter that two clergymen had been there earlier, and that one had thrown a half-empty cup of soup against the wall.  Valentin inquires which way the priests went.

Valentin goes to Carstairs Street.  He passes a greengrocer’s stand where the signs for oranges and nuts have been switched.  The owner is still upset about a recent incident in which a parson knocked over his bin of apples.

Valentin keeps looking and notices a restaurant that has a broken window.  He questions the waiter, who explains to him that two foreign parsons had been there.  Apparently, they overpaid.  The waiter told the two parsons of their mistake, at which point one parson said, ‘Sorry for the confusion.  But the extra amount will pay for the window I’m about to break.’  Then the parson broke the window.

Valentin finally ends up in a public park, where he sees two men, one short and one tall, both wearing clerical garb.  Valentin approaches and recognizes that the short man is the same clumsy priest from the train.  The short priest suspected all along that the tall man was not a priest but a criminal.  The short priest, Father Brown, had left the trail of hints for the police.  At that moment, even without turning around, Father Brown knew the police were nearby ready to arrest Flambeau.

Father Brown was invented by G. K. Chesterton.  Father Brown is very compassionate and has deep insight into human psychology, which often helps him to solve crimes.

He knows, from hearing confessions and ministering in times of trouble, how people act when they have done something wrong.  From observing a person’s behavior—facial expressions, ways of walking and talking, general demeanor—he can tell much about that person.  In a word, he can see inside someone’s heart and mind, and form a clear impression about character…

His feats of detection have their roots in this knowledge of human nature, which comes from two sources:  his years in the confessional, and his own self-awareness.  What makes Father Brown truly exceptional is that he acknowledges the capacity for evildoing in himself.  In ‘The Hammer of God’ he says, ‘I am a man and therefore have all devils in my heart.’

Because of this compassionate understanding of human weakness, from both within and without, he can see into the darkest corners of the human heart.  The ability to identify with the criminal, to feel what he is feeling, is what leads him to find the identity of the criminal—even, sometimes, to predict the crime, for he knows the point at which human emotions such as fear or jealousy tip over from acceptable expression into crime.  Even then, he believes in the inherent goodness of mankind, and sets the redemption of the wrongdoer as his main goal.

While Father Brown excels in understanding human psychology, he also excels at logical analysis of the facts.  He is always open to alternative explanations.

(Frontispiece to G. K. Chesterton’s The Wisdom of Father Brown, Illustration by Sydney Semour Lucas, via Wikimedia Commons)

Later the great thief Flambeau is persuaded by Father Brown to give up a life of crime and become a private investigator.  Meanwhile, Valentin, the famous detective, turns to crime and nearly gets away with murder.  Chesterton loves such ironic twists.

Chesterton was a brilliant writer who wrote in an amazing number of different fields.  Chesterton was very compassionate, with a highly developed sense of social justice, notes Hagstrom.  The Father Brown stories are undoubtedly entertaining, but they also deal with questions of justice and morality.  Hagstrom quotes an admirer of Chesterton, who said:  ‘Sherlock Holmes fights criminals;  Father Brown fights the devil.’  Whenever possible, Father Brown wants the criminal to find redemption.

Hagstrom lists what could be Father Brown’s investment guidelines:

  • Look carefully at the circumstances;  do whatever it takes to gather all the clues.
  • Cultivate the understanding of intangibles.
  • Using both tangible and intangible evidence, develop such a full knowledge of potential investments that you can honestly say you know them inside out.
  • Trust your instincts.  Intuition is invaluable.
  • Remain open to the possibility that something else may be happening, something different from that which first appears; remember that the full truth may be hidden beneath the surface.

Hagstrom mentions that psychology can be useful for investing:

Just as Father Brown’s skill as an analytical detective was greatly improved by incorporating the study of psychology with the method of observations, so too can individuals improve their investment performance by combining the study of psychology with the physical evidence of financial statement analysis.

 

HOW TO BECOME A GREAT DETECTIVE

Hagstrom lists the habits of mind of the Great Detectives:

Auguste Dupin

  • Develop a skeptic’s mindset;  don’t automatically accept conventional wisdom.
  • Conduct a thorough investigation.

Sherlock Holmes

  • Begin an investigation with an objective and unemotional viewpoint.
  • Pay attention to the tiniest details.
  • Remain open-minded to new, even contrary, information.
  • Apply a process of logical reasoning to all you learn.

Father Brown

  • Become a student of psychology.
  • Have faith in your intuition.
  • Seek alternative explanations and re-descriptions.

Hagstrom argues that these habits of mind, if diligently and consistently applied, can help you to do better as an investor over time.

Furthermore, the true hero is reason, a lesson directly applicable to investing:

As I think back over all the mystery stories I have read, I realize there were many detectives but only one hero.  That hero is reason.  No matter who the detective was—Dupin, Holmes, Father Brown, Nero Wolfe, or any number of modern counterparts—it was reason that solved the crime and captured the criminal.  For the Great Detectives, reason is everything.  It controls their thinking, illuminates their investigation, and helps them solve the mystery.

Illustration by yadali

Hagstrom continues:

Now think of yourself as an investor.  Do you want greater insight about a perplexing market?  Reason will clarify your investment approach.

Do you want to escape the trap of irrational, emotion-based action and instead make decisions with calm deliberation?  Reason will steady your thinking.

Do you want to be in possession of all the relevant investment facts before making a purchase?  Reason will help you uncover the truth.

Do you want to improve your investment results by purchasing profitable stocks?  Reason will help you capture the market’s mispricing.

In sum, conduct a thorough investigation.  Painstakingly gather all the facts and keep your emotions entirely out of it.  Skeptically question conventional wisdom and ‘what is obvious.’  Carefully use logic to reason through possible hypotheses.  Eliminate hypotheses that cannot explain all the facts.  Stay open to new information and be willing to discard the best current hypothesis if new facts lead in a different direction.  Finally, be a student of psychology.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

A Few Lessons from Sherlock Holmes

(Image:  Zen Buddha Silence by Marilyn Barbone.)

April 14, 2019

Peter Bevelin is the author of the great book, Seeking Wisdom: From Darwin to Munger.  I wrote about this book here: http://boolefund.com/seeking-wisdom/

Bevelin also wrote a shorter book, A Few Lessons from Sherlock Holmes.  I’m a huge fan of Sherlock Holmes.  Robert Hagstrom has written an excellent book on Holmes called The Detective and the Investor.  Here’s my summary of Hagstrom’s book: http://boolefund.com/invest-like-sherlock-holmes/

I highly recommend Hagstrom’s book.  But if you’re pressed for time, Bevelin’s A Few Lessons from Sherlock Holmes is worth reading.

Belevin’s book is a collection of quotations.  Most of the quotes are from Holmes, but there are also quotes from others, including:

    • Joseph Bell, a Scottish professor of clinical surgery who was Arthur Conan Doyle’s inspiration for Sherlock Holmes
    • Dr. John Watson, Holmes’s assistant
    • Dr. John Evelyn Thorndike, a fictional detective and forensic scientist  in stories by R. Austin Freeman
    • Claude Bernard, a French physiologist
    • Charles Darwin, the English naturalist
    • Thomas McRae, an American professor of medicine and colleague of Sir William Osler
    • Michel de Montaigne, a French statesman and philosopher
    • William Osler, a Canadian physician
    • Oliver Wendell Holmes, Sr., an American physician and author

Sherlock Holmes:

Life is infinitely stranger than anything which the mind of man could invent.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Here’s an outline for this blog post:

    • Some Lessons
    • On Solving a Case—Observation and Inference
    • Observation—Start with collecting facts and follow them where they lead
    • Deduction—What inferences can we draw from our observations and facts?
    • Test Our Theory—If it disagrees with the facts it is wrong
    • Some Other Tools

 

SOME LESSONS

Bevelin quotes the science writer Martin Gardner on Sherlock Holmes:

Like the scientist trying to solve a mystery of nature, Holmes first gathered all the evidence he could that was relevant to his problem.  At times, he performed experiments to obtain fresh data.  He then surveyed the total evidence in the light of his vast knowledge of crime, and/or sciences relevant to crime, to arrive at the most probable hypothesis.  Deductions were made from the hypothesis; then the theory was further tested against new evidence, revised if need be, until finally the truth emerged with a probability approaching certainty.

Bevelin quotes Holmes on the qualities needed to be a good detective:

He has the power of observation and that of deduction.  He is only wanting in knowledge, and that may come in time.

It’s important to take a broad view.  Holmes:

One’s ideas must be as broad as Nature if they are to interpret Nature.

However, focus only on what is useful.  Bevelin quotes Dr. Joseph Bell:

He [Doyle] created a shrewd, quick-sighted, inquisitive man… with plenty of spare time, a retentive memory, and perhaps with the best gift of all—the power of unloading the mind of all burden of trying to remember unnecessary details.

Knowledge of human nature is obviously important.  Holmes:

Human nature is a strange mixture, Watson.  You see that even a villain and murderer can inspire such affection that his brother turns to suicide when he learns his neck is forfeited.

Holmes again:

Jealousy is a strange transformer of characters.

Bevelin writes that the most learned are not the wisest.  Knowledge doesn’t automatically make us wise.  Bevelin quotes Montaigne:

Judgment can do without knowledge but not knowledge without judgment.

Learning is lifelong.  Holmes:

Like all other arts, the Science of Deduction and Analysis is one which can only be acquired by long and patient study, nor is life long enough to allow any mortal to attain the highest possible perfection in it.

Interior view of the famous The Sherlock Holmes Museum on Nov. 14, 2015 in London

 

ON SOLVING A CASE—Observation and Inference

Bevelin quotes Dr. John Evelyn Thorndyke, a fictional detective in stories by R. Austin Freeman:

…I make it a rule, in all cases, to proceed on the strictly classical lines on inductive inquiry—collect facts, make hypotheses, test them and seek for verification.  And I always endeavour to keep a perfectly open mind.

Holmes:

We approached the case… with an absolutely blank mind, which is always an advantage.  We had formed no theories.  We were there simply to observe and to draw inferences from our observations.

Appearances can be deceiving.  If someone is likeable, that can cloud one’s judgment.  If someone is not likeable, that also can be misleading.  Holmes:

It is of the first importance… not to allow your judgment to be biased by personal qualities… The emotional qualities are antagonistic to clear reasoning.  I can assure you that the most winning woman I ever knew was hanged for poisoning three little children for their insurance-money, and the most repellant man of my acquaintence is a philanthropist who has spent nearly a quarter of a million on the London poor.

Holmes talking to Watson:

You remember that terrible murderer, Bert Stevens, who wanted us to get him off in ’87?  Was there ever a more mild-mannered, Sunday-school young man?

 

OBSERVATION—Start with collecting facts and follow them where they lead

Bevelin quotes Thomas McCrae, an American professor of medicine and colleague of Sir William Osler:

More is missed by not looking than not knowing.

That said, to conduct an investigation one must have a working hypothesis.  Bevelin quotes the French physiologist Claude Bernard:

A hypothesis is… the obligatory starting point of all experimental reasoning.  Without it no investigation would be possible, and one would learn nothing:  one could only pile up barren observations.  To experiment without a preconceived idea is to wander aimlessly.

(Charles Darwin, Photo by Maull and Polyblank (1855), via Wikimedia Commons)

Bevelin also quotes Charles Darwin:

About thirty years ago there was much talk that geologists ought only to observe and not theorise; and I well remember someone saying that at this rate a man might as well go into a gravel-pit and count the pebbles and describe the colors.  How odd it is that anyone should not see that all observation must be for or against some view if it is to be of any service!

Holmes:

Let us take that as  a working hypothesis and see what it leads us to.

It’s crucial to make sure one has the facts clearly in mind.  Bevelin quotes the French statesman and philosopher Montaigne:

I realize that if you ask people to account for “facts,” they usually spend more time finding reasons for them than finding out whether they are true…

Deception, writes Bevelin, has many faces.  Montaigne again:

If falsehood, like truth, had only one face, we would be in better shape.  For we would take as certain the opposite of what the liar said.  But the reverse of truth has a hundred thousand shapes and a limitless field.

Consider why someone might be lying.  Holmes:

Why are they lying, and what is the truth which they are trying so hard to conceal?  Let us try, Watson, you and I, if we can get behind the lie and reconstruct the truth.

It’s often not clear—especially near the beginning of an investigation—what’s relevant and what’s not.  Nonetheless, it’s vital to try to focus on what’s relevant because otherwise one can get bogged down by unnecessary detail.  Holmes:

The principal difficulty in your case… lay in the fact of their being too much evidence.  What was vital was overlaid and hidden by what was irrelevant.  Of all the facts which were presented to us we had to pick just those which we deemed to be essential, and then piece them together in order, so as to reconstruct this very remarkable chain of events.

Holmes again:

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital.  Otherwise your energy and attention must be dissipated instead of being concentrated.

Bevelin quotes the Canadian physician William Osler:

The value of experience is not in seeing much, but in seeing wisely.

Observation is a skill one must develop.  Most of us are not observant.  Holmes:

The world is full of obvious things which nobody by any chance ever observes.

(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)

Holmes again:

I see no more than you, but I have trained myself to notice what I see.

Small things can have the greatest importance.  Several quotes from Holmes:

    • The smallest point may be the most essential.
    • It has long been an axiom of mine that the little things are infinitely the most important.
    • What seems strange to you is only so because you do not follow my train of thought or observe the small facts upon which large inferences may depend.
    • It is just these very simple things which are extremely liable to be overlooked.
    • Never trust general impressions, my boy, but concentrate yourself upon details.

Belevin also quotes Dr. Joseph Bell:

I always impressed over and over again upon all my scholars—Conan Doyle among them—the vast importance of little distinctions, the endless significance of trifles.

Belevin points out that it’s easy to overlook relevant facts.  It’s important always to ask if one has overlooked something.

 

DEDUCTION—What inferences can we draw from our observations and facts?

Most people reason forward, predicting what will happen next.  But few people reason backward, inferring the causes of the effects one has observed.  Holmes:

Most people, if you describe a chain of events to them, will tell you what the result would be.  They can put those events together in their minds, and argue from them that something will come to pass.  There are few people, however, who, if you told them a result, would be able to evolve from their own inner consciousness what the steps were which led up to that result.  This power is what I mean when I talk of reasoning backward, or analytically.

Often the solution is simple.  Holmes:

The case has been an interesting one… because it serves to show very clearly how simple the explanation may be of an affair which at first sight seems to be almost inexplicable.

History frequently repeats.  Holmes:

They lay all the evidence before me, and I am generally able, by the help of my knowledge of the history of crime, to set them straight.  There is a strong family resemblance about misdeeds, and if you have all the details of a thousand at your finger ends, it is odd if you can’t unravel  the thousand and first.

Holmes:

There is nothing new under the sun.  It has all been done before.

That said, some cases are unique and different to an extent.  But bizarre cases tend to be easier to solve.  Holmes:

As a rule… the more bizarre a thing is the less mysterious it proves to be.  It is your commonplace, featureless crimes which are really puzzling, just as a commonplace face is the most difficult to identify.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Holmes again:

It is a mistake to confound strangeness with mystery.  The most commonplace crime is often the most mysterious, because it presents no new or special features from which deductions may be drawn.

If something we expect to see doesn’t happen, that in itself can be a clue.  There was one case of a race horse stolen during the night.  When Holmes gathered evidence, he learned that the dog didn’t bark.  This means the midnight visitor must have been someone the dog knew well.

Moreover, many seemingly isolated facts could provide a solution if they are taken together.  Holmes:

You see all these isolated facts, together with many minor ones, all pointed in the same direction.

After enough facts have been gathered, then one can consider each possible hypothesis one at a time.  In practice, there are many iterations:  new facts are discovered along the way, and new hypotheses are constructed.  By carefully excluding each hypothesis that is not possible, eventually one can deduce the hypothesis that is true.  Holmes:

That process… starts upon the supposition that when you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth.  It may well be that several explanations remain, in which case one tries test after test until one or other of them has a convincing amount of support.

 

TEST OUR THEORY—If it disagrees with the facts it is wrong

What seems obvious can be very misleading.  Holmes:

There is nothing more deceptive than an obvious fact.

“Truth is stranger than fiction,” said Mark Twain.  Holmes:

Life is infinitely stranger than anything which the mind of many could invent.

Holmes again:

One should always look for a possible alternative and provide against it.  It is the first rule of criminal investigation.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

It’s vital to take time to think things through.  Watson:

Sherlock Holmes was a man… who, when he had an unsolved problem upon his mind, would go for days, and even for a week, without rest, turning it over, rearranging his facts, looking at it from every point of view until he had either fathomed it or convinced himself that his data were insufficient.

Sometimes doing nothing—or something else—is best when one is waiting for more evidence.  Holmes:

I gave my mind a thorough rest by plunging into a chemical analysis.  One of our greatest statesmen has said that a change of work is the best rest.  So it is.

 

SOME OTHER TOOLS

Bevelin observes the importance of putting oneself in another’s shoes.  Holmes:

You’ll get results, Inspector, by always putting yourself in the other fellow’s place, and thinking what you would do yourself.  It takes some imagination, but it pays.

Others may be of help.  Holmes:

If you will find the facts, perhaps others may find the explanation.

Watson was a great help to Holmes.  Watson:

I was a whetstone for his mind.  I stimulated him.  He liked to think aloud in my presence.  His remarks could hardly be said to be made to me—many of them would have been as appropriately addressed to his bedstead—but nonetheless, having formed the habit, it had become in some way helpful that I should register and interject.  If I irritated him by a certain methodical slowness in my mentality, that irritation served only to make his own flame-like intuitions and impressions flash up the more vividly and swiftly.  Such was my humble role in our alliance.

(Illustration of Sherlock Holmes and John Watson by Sidney Paget, via Wikimedia Commons)

Different lines of thought can approximate the truth.  Bevelin quotes Dr. Joseph Bell:

There were two of us in the hunt, and when two men set out to find a golf ball in the rough, they expect to come across it where the straight lines marked in their minds’ eye to it, from their original positions, crossed.  In the same way, when two men set out to investigate a crime mystery, it is where their researches intersect that we have a result.

Holmes makes the same point:

Now we will take another line of reasoning.  When you follow two separate chains of thought, Watson, you will find some point of intersection which should approximate to the truth.

It’s essential to be open to contradictory evidence.  Bevelin quotes Charles Darwin:

I have steadily endeavoured to keep my mind free so as to give up any hypothesis, however much beloved… as soon as facts are shown to be opposed to it.

Mistakes are inevitable.  Holmes:

Because I made a blunder, my dear Watson—which is, I am afraid, a more common occurrence than anyone would think who only knew me through your memoirs.

Holmes remarks that every mortal makes mistakes.  But the best are able to recognize their mistakes and take corrective action:

Should you care to add the case to your annals, my dear Watson… it can only be as an example of that temporary eclipse to which even the best-balanced mind may be exposed.  Such slips are common to all mortals, and the greatest is he who can recognize and repair them.

Bevelin quotes the physician Oliver Wendell Holmes, Sr.:

The best part of our knowledge is that which teaches us where knowledge leaves off and ignorance begins.

(Oliver Wendell Holmes, Sr., via Wikimedia Commons)

In the investment world, the great investors Warren Buffett and Charlie Munger use the term circle of competence.  Here’s Buffett:

What an investor needs is the ability to correctly evaluate selected businesses.  Note that word “selected”:  You don’t have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.

Buffett again:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

Munger:

Knowing what you don’t know is more useful than being brilliant.

Finally, here’s Tom Watson, Sr., the founder of IBM:

I’m no genius.  I’m smart in spots—but I stay around those spots.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Ten Attributes of Great Investors

(Image:  Zen Buddha Silence by Marilyn Barbone.)

March 31, 2019

Michael Mauboussin is the author of several excellent books, including More Than You Know and Think Twice.  I wrote about these books here:

He has also written numerous papers, including Thirty Years: Reflections on the Ten Attributes of Great Investorshttps://bit.ly/2zlaljc

When it comes to value investing, Mauboussin is one of the best writers in the world.  Mauboussin highlights market efficiency, competitive strategy analysis, valuation, and decision making as chief areas of focus for him the past couple of decades.  Mauboussin:

What we know about each of these areas today is substantially greater than what we did in 1986, and yet we have an enormous amount to learn.  As I like to tell my students, this is an exciting time to be an investor because much of what we teach in business schools is a work-in-progress.

(Image by magele-picture)

Here are the Ten Attributes of Great Investors:

  • Be numerate (and understand accounting).
  • Understand value (the present value of free cash flow).
  • Properly assess strategy (or how a business makes money).
  • Compare effectively (expectations versus fundamentals).
  • Think probabilistically (there are few sure things).
  • Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected).
  • Beware of behavioral biases (minimizing constraints to good thinking).
  • Know the difference between information and influence.
  • Position sizing (maximizing the payoff from edge).
  • Read (and keep an open mind).

 

BE NUMERATE (AND UNDERSTAND ACCOUNTING)

Mauboussin notes that there are two goals when analyzing a company’s financial statements:

  • Translate the financial statements into free cash flow.
  • Determine how the competitive strategy of the company creates value.

The value of any business is the future free cash flow it will produce discounted back to the present.

(Photo by designer491)

Free cash flow is cash earnings minus investments that must be made to grow future earnings.  Free cash flow represents what owners of the business receive.  Warren Buffett refers to free cash flow as owner earnings.

Earnings alone cannot give you the value of a company.  You can grow earnings without growing value.  Whether earnings growth creates value depends on how much money the company invests to generate that growth.  If the ROIC (return on invested capital) of the company’s investment is below the cost of capital, then the resulting earnings growth destroys value rather than creates it.

After calculating free cash flow, the next goal in financial statement analysis is to figure out how the company’s strategy creates value.  For the company to create value, the ROIC must exceed the cost of capital.  Analyzing the company’s strategy means determining precisely how the company can get ROIC above the cost of capital.

Mauboussin writes that one way to analyze strategy is to compare two companies in the same business.  If you look at how the companies spend money, you can start to understand competitive positions.

Another way to grasp competitive position is by analyzing ROIC.

Photo by stanciuc

You can break ROIC into two parts:

  • profitability (net operating profit after tax / sales)
  • capital velocity (sales / invested capital)

Companies with high profitability but low capital velocity are using a differentiation strategy.  Their product is positioned in such a way that the business can earn high profit margins.  (For instance, a luxury jeweler.)

Companies with high capital velocity but low profitability have adopted a cost leadership strategy.  These businesses may have very thin profit margins, but they still generate high ROIC because their capital velocity is so high.  (Wal-Mart is a good example.)

Understanding how the company makes money can lead to insight about how long the company can maintain a high ROIC (if ROIC is high) or what the company must do to improve (if ROIC is low).

 

UNDERSTAND VALUE (THE PRESENT VALUE OF FREE CASH FLOW)

Mauboussin:

Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow.  Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.

It’s worth repeating: The value of any business (or any financial asset) is the future free cash flow it will produce discounted back to the present.  Successful investors understand the variables that impact free cash flow.

Illustration by OpturaDesign

 

PROPERLY ASSESS STRATEGY (OR HOW A COMPANY MAKES MONEY)

Mauboussin says this attribute has two elements:

  • How does the company make money?
  • Does the company have a sustainable competitive advantage, and if so, how durable is it?

To see how a business makes money, you have to figure out the basic unit of analysis.  Mauboussin points out that the basic unit of analysis for a retailer is store economics:  How much does it cost to build a store?  What revenues will it generate?  What are the profit margins?

Regarding sustainable competitive advantage, Warren Buffett famously said:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

If a company has a sustainable competitive advantage, then ROIC (return on invested capital) is above the cost of capital.  To assess the durability of that advantage, you have to analyze the industry and how the company fits in.  Looking at the five forces that determine industry attractiveness is a common step.  You should also examine potential threats from disruptive innovation.

Mauboussin:

Great investors can appreciate what differentiates a company that allows it to build an economic moat around its franchise that protects the business from competitors.  The size and longevity of the moat are significant inputs into any thoughtful valuation.

Bodiam Castle, Photo by valeryegorov

Buffett popularized the term economic moat to refer to a sustainable competitive advantage.  Here’s what Buffett said at the Berkshire annual meeting in 2000:

So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.  And we tell our managers we want the moat widened every year.  That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes.  However, if the moat is widened every year, the business will do very well.

 

COMPARE EFFECTIVELY (EXPECTATIONS VERSUS FUNDAMENTALS)

Mauboussin:

Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations.  Fundamentals capture a sense of a company’s future financial performance.  Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals.  Expectations reflect the financial performance implied by the stock price.

Mauboussin mentions pari-mutuel betting, specifically horse racing.

(Photo by Elshaneo)

Fundamentals are how fast the horse will run, while expectations are the odds.

  • If a company has good fundamentals, but the stock price already reflects that, then you can’t expect to beat the market by investing in the stock.
  • If a company has bad fundamentals, but the stock price is overly pessimistic, then you can expect to beat the market by investing in the stock.

The best business in the world will not bring excess returns if the stock price already fully reflects the high quality of the business.  Similarly, a terrible business can produce excess returns if the stock price indicates that investors have overreacted.

To make money by investing in a stock, you have to have what great investor Michael Steinhardt calls a variant perception—a view at odds with the consensus view (as reflected in the stock price).  And you have to be right.

Mauboussin observes that humans are quick to compare but aren’t good at it.  This includes reasoning by analogy, e.g., asking whether a particular turnaround is similar to some other turnaround.  However, it’s usually better to figure out the base rate:  What percentage of all turnarounds succeed?  (Not a very high number, which is why Buffett quipped, “Turnarounds seldom turn.”)

Another limitation of humans making comparisons is that people tend to see similarities when they’re looking for similarities, but they tend to see differences when they’re looking for differences.  For instance, Amos Tversky did an experiment in which the subjects were asked which countries are more similar, West Germany and East Germany, or Nepal and Ceylon?  Two-thirds answered West Germany and East Germany.  But then the subjects were asked which countries seemed more different.  Logic says that they would answer Nepal and Ceylon, but instead subjects again answered West Germany and East Germany.

 

THINK PROBABILISTICALLY (THERE ARE FEW SURE THINGS)

Great investors are always seeking an edge, where the price of an asset misrepresents the probabilities or the outcomes.  By similar logic, great investors evaluate each investment decision based on the process used rather than based on the outcome.

  • A good investment decision is one that if repeatedly made would be profitable over time.
  • A bad investment decision is one that if repeatedly made would lead to losses over time.

However, a good decision will sometimes lead to a bad outcome, while a bad decision will sometimes lead to a good outcome.  Investing is similar to other forms of betting in that way.

Photo by annebel146

Furthermore, what matters is not how often an investor is right, but rather how much the investor makes when he is right versus how much he loses when he is wrong.  In other words, what matters is not batting average but slugging percentage.  This is hard to put into practice due to loss aversion—the fact that as humans we feel a loss at least twice as much as an equivalent gain.

There are three ways of determining probabilities.  Subjective probability is a number that corresponds with your state of knowledge or belief.  Mauboussin gives an example:  You might come up with a probability that two countries will go to war.  Propensity is usually based on the physical properties of the system.  If a six-sided die is a perfect cube, then you know that the odds of a particular side coming up must be one out of six.  Frequency is the third approach.  Frequency—also called the base rate—is measured by looking at the outcomes of a proper reference class.  How often will a fair coin land on heads?  If you gather all the records you can of a fair coin being tossed, you’ll find that it lands on heads 50 percent of the time.  (You could run your own trials, too, by tossing a fair coin thousands or millions of times.)

Often subjective probabilities are useful as long as you remain open to new information and properly adjust your probabilities based on that information.  (The proper way to update such beliefs is using Bayes’s theorem.)  Subjective probabilities are useful when there’s no clear reference class—no relevant base rate.

When you’re looking at corporate performance—like sales or profit growth—it’s usually best to look at frequencies, i.e., base rates.

An investment decision doesn’t have to be complicated.  In fact, most good investment decisions are simple.  Mauboussin quotes Warren Buffett:

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.  That is what we’re trying to do.  It’s imperfect, but that’s what it’s all about.

Buffett again:

Investing is simple, but not easy.

 

UPDATE YOUR VIEWS EFFECTIVELY (BELIEFS ARE HYPOTHESES TO BE TESTED, NOT TREASURES TO BE PROTECTED)

We have a strong preference for consistency when it comes to our own beliefs.  And we expect others to be consistent.  The problem is compounded by confirmation bias, the tendency to look for and see only information that confirms our beliefs, and the tendency to interpret ambiguous information in a way that supports our beliefs.  As long as we feel like our beliefs are both consistent and correct—and, as a default psychological setting, most of us feel this way most of the time—we’ll feel comfortable and we won’t challenge our beliefs.

Illustration by intheskies

Great investors seek data and arguments that challenge their views.  Great investors also update their beliefs when they come across evidence that suggests they should.  The proper way to update beliefs is using Bayes’s theorem.  To see Bayes’s theorem and also a clear explanation and example, see: http://boolefund.com/the-signal-and-the-noise/

Mauboussin:

The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous.  They actively seek varied points of view and update their beliefs as new information dictates.  The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio.  Others, including your clients, may view this mental flexibility as unsettling.  But good thinking requires maintaining as accurate a view of the world as possible.

 

BEWARE OF BEHAVIORAL BIASES (MINIMIZING CONSTRAINTS TO GOOD THINKING)

Mauboussin:

Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions.  His claim is that the overlap between these abilities is much lower than most people think.  Importantly, you can cultivate your RQ.

Rationality is only partly genetic.  You can train yourself to be more rational.

Great investors relentlessly train themselves to be as rational as possible.  Typically they keep an investment journal in which they write down the reasoning for every investment decision.  Later they look back on their decisions to analyze what they got right and where they went wrong.

Great investors also undertake a comprehensive study of cognitive biases.  For a list of cognitive biases, see these two blog posts:

It’s rarely enough just to know about cognitive biases.  Great investors take steps—like using a checklist—designed to mitigate the impact that innate cognitive biases have on investment decision-making.

Photo by Kenishirotie

 

KNOW THE DIFFERENCE BETWEEN INFORMATION AND INFLUENCE

A stock price generally represents the collective wisdom of investors about how a given company will perform in the future.  Most of the time, the crowd is more accurate than virtually any individual investor.

(Illustration by Marrishuanna)

However, periodically a stock price can get irrational.  (If this weren’t the case, great value investors could not exist.)  People regularly get carried away with some idea.  For instance, as Mauboussin notes, many investors got rich on paper by investing in dot-com stocks in the late 1990’s.  Investors who didn’t own dot-com stocks felt compelled to jump on board when they saw their neighbor getting rich (on paper).

Mauboussin mentions the threshold model from Mark Granovetter, a professor of sociology at Stanford University.  Mauboussin:

Imagine 100 potential rioters milling around in a public square.  Each individual has a “riot threshold,” the number of rioters that person would have to see in order to join the riot.  Say one person has a threshold of 0 (the instigator), one has a threshold of 1, one has a threshold of 2, and so on up to 99.  This uniform distribution of thresholds creates a domino effect and ensures that a riot will happen.  The instigator breaks a window with a rock, person one joins in, and then each individual piles on once the size of the riot reaches his or her threshold.  Substitute “buy dotcom stocks” for “join the riot” and you get the idea.

The point is that very few of the individuals, save the instigator, think that rioting is a good idea.  Most would probably shun rioting.  But once the number of others rioting reaches a threshold, they will jump in.  This is how the informational value of stocks is set aside and the influential component takes over.

Great investors are not influenced much at all by the behavior of other investors.  Great investors know that the collective wisdom reflected in a stock price is usually right, but sometimes wrong.  These investors can identify the occasional mispricing and then make an investment while ignoring the crowd.

 

POSITION SIZING (MAXIMIZING THE PAYOFF FROM EDGE)

Great investors patiently wait for situations where they have an edge, i.e., where the odds are in their favor.  Many investors understand the need for an edge.  However, fewer investors pay much attention to position sizing.

If you know the odds, there’s a formula—the Kelly criterion—that tells you exactly how much to bet in order to maximize your long-term returns.  The Kelly criterion can be written as follows:

  • F = p – [q/o]

where

  • F = Kelly criterion fraction of current capital to bet
  • o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
  • p = probability of winning
  • q = probability of losing = 1 – p

The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital.  (This assumes that you’re going to make a long series of bets.)  Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.

Mauboussin adds:

Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage).   Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.

In brief, most investors are ineffective at position sizing, but great investors are good at it.

 

READ (AND KEEP AN OPEN MIND)

Great investors generally read a ton.  They also read widely across many disciplines.  Moreover, as noted earlier, great investors seek to learn about the arguments of people who disagree with them.  Mauboussin:

Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas.”  Reading is an activity that tends to foster all of those qualities.

(Photo by Lapandr)

Mauboussin continues:

Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time—none, zero.”  This may be hyperbolic, but seems to be true in the investment world as well.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Cheap, Solid Microcaps Far Outperform the S&P 500

(Image: Zen Buddha Silence, by Marilyn Barbone)

March 10, 2019

The wisest long-term investment for most investors is an S&P 500 index fund.  It’s just simple arithmetic, as Warren Buffett and Jack Bogle frequently observe: http://boolefund.com/warren-buffett-jack-bogle/

But you can do significantly better — roughly 7% per year (on average) — by systematically investing in cheap, solid microcap stocks.  The mission of the Boole Microcap Fund is to help you do just that.

Most professional investors never consider microcaps because their assets under management are too large.  Microcaps aren’t as profitable for them.  That’s why there continues to be a compelling opportunity for savvy investors.  Because microcaps are largely ignored, many get quite cheap on occasion.

Warren Buffett earned the highest returns of his career when he could invest in microcap stocks.  Buffett says he’d do the same today if he were managing small sums: http://boolefund.com/buffetts-best-microcap-cigar-butts/

Look at this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2015:

Decile Market Cap-Weighted Returns Equal Weighted Returns Number of Firms (year-end 2015) Mean Firm Size (in millions)
1 9.29% 9.20% 173 84,864
2 10.46% 10.42% 178 16,806
3 11.08% 10.87% 180 8,661
4 11.32% 11.10% 221 4,969
5 12.00% 11.92% 205 3,151
6 11.58% 11.40% 224 2,176
7 11.92% 11.87% 300 1,427
8 12.00% 12.27% 367 868
9 11.40% 12.39% 464 429
10 12.50% 17.48% 1,298 107
9+10 11.85% 16.14% 1,762 192

(CRSP is the Center for Research in Security Prices at the University of Chicago.  You can find the data for various deciles here:  http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html)

The smallest two deciles — 9+10 — comprise microcap stocks, which typically are stocks with market caps below $500 million.  What stands out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2015:

Microcap equal weighted returns = 16.14% per year

Large-cap equal weighted returns = ~11% per year

In practice, the annual returns from microcap stocks will be 1-2% lower because of the difficulty (due to illiquidity) of entering and exiting positions.  So we should say that an equal weighted microcap approach has returned 14% per year from 1927 to 2015, versus 11% per year for an equal weighted large-cap approach.

Still, if you can do 3% better per year than the S&P 500 index (on average) — even with only a part of your total portfolio — that really adds up after a couple of decades.

 

VALUE SCREEN: +2-3%

By systematically implementing a value screen — e.g., low EV/EBIT or low P/E — to a microcap strategy, you can add 2-3% per year.

 

IMPROVING FUNDAMENTALS: +2-3%

You can further boost performance by screening for improving fundamentals.  One excellent way to do this is using the Piotroski F_Score, which works best for cheap micro caps.  See:  http://boolefund.com/joseph-piotroski-value-investing/

 

BOTTOM LINE

In sum, over time, a quantitative value strategy — applied to cheap microcap stocks with improving fundamentals — has high odds of returning at least 7% (+/- 3%) more per year than an S&P 500 index fund.

If you’d like to learn more about how the Boole Fund can help you do roughly 7% better per year than the S&P 500, please call or e-mail me any time.

E-mail: jb@boolefund.com  (Jason Bond)

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Walter Schloss: Cigar-Butt Specialist

February 24, 2019

Walter Schloss generated one of the best investment track records of all time—close to 21% (gross) annually over 47 years—by investing exclusively in cigar butts (deep value stocks).  Cigar butt investing usually means buying stock at a discount to book value, i.e., a P/B < 1 (price-to-book ratio below 1).

The highest returning cigar butt strategy comes from Ben Graham, the father of value investing.  It’s called the net-net strategy whereby you take current assets minus all liabilities, and then invest at 2/3 of that level or less.

  • The main trouble with net nets today is that many of them are tiny microcap stocks—below $50 million in market cap—that are too small even for most microcap funds.
  • Also, many net nets exist in markets outside the United States.  Some of these markets have had problems periodically related to the rule of law.

Schloss used net nets in the early part of his career (1955 to 1960).  When net nets became too scarce (1960), Schloss started buying stocks at half of book value.  When those became too scarce, he went to buying stocks at two-thirds of book value.  Eventually he had to adjust again and buy stocks at book value.  Though his cigar-butt method evolved, Schloss was always using a low P/B to find cheap stocks.

(Photo by Sky Sirasitwattana)

One extraordinary aspect to Schloss’s track record is that he invested in roughly 1,000 stocks over the course of his career.  (At any given time, his portfolio had about 100 stocks.)  Warren Buffett commented:

Following a strategy that involved no real risk—defined as permanent loss of capital—Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500.  It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type.  A few big winners did not account for his success.  It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

Schloss was aware that a concentrated portfolio—e.g., 10 to 20 stocks—could generate better long-term returns.  However, this requires unusual insight on a repeated basis, which Schloss humbly admitted he didn’t have.

Most investors are best off investing in low-cost index funds or in quantitative value funds.  For investors who truly enjoy looking for undervalued stocks, Schloss offered this advice:

It is important to know what you like and what you are good at and not worry that someone else can do it better.  If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.

I found a few articles I hadn’t seen before on The Walter Schloss Archive, a great resource page created by Elevation Capital: https://www.walterschloss.com/

Here’s the outline for this blog post:

  • Stock is Part Ownership;  Keep It Simple
  • Have Patience;  Don’t Sell on Bad News
  • Have Courage
  • Buy Assets Not Earnings
  • Buy Based on Cheapness Now, Not Cheapness Later
  • Boeing:  Asset Play
  • Less Downside Means More Upside
  • Multiple Ways to Win
  • History;  Honesty;  Insider Ownership
  • You Must Be Willing to Make Mistakes
  • Don’t Try to Time the Market
  • When to Sell
  • The First 10 Years Are Probably the Worst
  • Stay Informed About Current Events
  • Control Your Emotions;  Be Careful of Leverage
  • Ride Coattails;  Diversify

 

STOCK IS PART OWNERSHIP;  KEEP IT SIMPLE

A share of stock represents part ownership of a business and is not just a piece of paper.

Try to establish the value of the company.  Use book value as a starting point.  There are many businesses, both public and private, for which book value is a reasonable estimate of intrinsic value.  Intrinsic value is what a company is worth—i.e., what a private buyer would pay for it.  Book value—assets minus liabilities—is also called “net worth.”

Follow Buffett’s advice: keep it simple and don’t use higher mathematics.

(Illustration by Ileezhun)

Some kinds of stocks are easier to analyze than others.  As Buffett has said, usually you don’t get paid for degree of difficulty in investing.  Therefore, stay focused on businesses that you can fully understand.

  • There are thousands of microcap companies that are completed neglected by most professional investors.  Many of these small businesses are simple and easy to understand.

 

HAVE PATIENCE;  DON’T SELL ON BAD NEWS

Hold for 3 to 5 years.  Schloss:

Have patience.  Stocks don’t go up immediately.

Schloss again:

Things usually take longer to work out but they work out better than you expect.

(Illustration by Marek)

Don’t sell on bad news unless intrinsic value has dropped materially.  When the stock drops significantly, buy more as long as the investment thesis is intact.

Schloss’s average holding period was 4 years.  It was less than 4 years in good markets when stocks went up more than usual.  It was greater than 4 years in bad markets when stocks stayed flat or went down more than usual.

 

HAVE COURAGE

Have the courage of your convictions once you have made a decision.

(Courage concept by Travelling-light)

Investors shun companies with depressed earnings and cash flows.  It’s painful to own stocks that are widely hated.  It can also be frightening.  As John Mihaljevic explains in The Manual of Ideas (Wiley, 2013):

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

A related worry is that if a company is burning through its cash, it will gradually destroy net asset value.  Ben Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

It’s true that an individual cigar butt (deep value stock) is more likely to underperform than an average stock.  But because the potential upside for a typical cigar butt is greater than the potential downside, a basket of cigar butts (portfolio of at least 30) does better than the market over time and also has less downside during bad states of the world—such as bear markets and recessions.

Schloss discussed an example: Cleveland Cliffs, an iron ore producer.  Buffett owned the stock at $18 but then sold at about that level.  The steel industry went into decline.  The largest shareholder sold out because he thought the industry wouldn’t recover.

Schloss bought a lot of stock at $6.  Nobody wanted it.  There was talk of bankruptcy.  Schloss noted that if he had lived in Cleveland, he probably wouldn’t have been able to buy the stock because all the bad news would have been too close.

Soon thereafter, the company sold some assets and bought back some stock.  After the stock increased a great deal from the lows, then it started getting attention from analysts.

In sum, often when an industry is doing terribly, that’s the best time to find cheap stocks.  Investors avoid stocks when they’re having problems, which is why they get so cheap.  Investors overreact to negative news.

 

BUY ASSETS NOT EARNINGS

(Illustration by Teguh Jati Prasetyo)

Schloss:

Try to buy assets at a discount [rather] than to buy earnings.  Earnings can change dramatically in a short time.  Usually assets change slowly.  One has to know much more about a company if one buys earnings.

Not only can earnings change dramatically; earnings can easily be manipulated—often legally.  Schloss:

Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore.

 

BUY BASED ON CHEAPNESS NOW, NOT CHEAPNESS LATER

Buy things based on cheapness now.  Don’t buy based on cheapness relative to future earnings, which are hard to predict.

Graham developed two ways of estimating intrinsic value that don’t depend on predicting the future:

  • Net asset value
  • Current and past earnings

Professor Bruce Greenwald, in Value Investing (Wiley, 2004), has expanded on these two approaches.

  • As Greenwald explains, book value is a good estimate of intrinsic value if book value is close to the replacement cost of the assets.  The true economic value of the assets is the cost of reproducing them at current prices.
  • Another way to determine intrinsic value is to figure out earnings power—also called normalized earnings—or how much the company should earn on average over the business cycle.  Earnings power typically corresponds to a market level return on the reproduction value of the assets.  In this case, your intrinsic value estimate based on normalized earnings should equal your intrinsic value estimate based on the reproduction value of the assets.

In some cases, earnings power may exceed a market level return on the reproduction value of the assets.  This means that the ROIC (return on invested capital) exceeds the cost of capital.  It can be exceedingly difficult, however, to determine by how much and for how long earnings power will exceed a market level return.  Often it’s a question of how long some competitive advantage can be maintained.  How long can a high ROIC be sustained?

As Buffett remarked:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

A moat is a sustainable competitive advantage.  Schloss readily admits he can’t determine which competitive advantages are sustainable.  That requires unusual insight.  Buffett can do it, but very few investors can.

As far as franchises or good businesses—companies worth more than adjusted book value—Schloss says he likes these companies, but rarely considers buying them unless the stock is close to book value.  As a result, Schloss usually buys mediocre and bad businesses at book value or below.  Schloss buys “difficult businesses” at clearly cheap prices.

Buying a high-growing company on the expectation that growth will continue can be quite dangerous.  First, growth only creates value if the ROIC exceeds the cost of capital.  Second, expectations for the typical growth stock are so high that even a small slowdown can cause the stock to drop noticeably.  Schloss:

If observers are expecting the earnings to grow from $1.00 to $1.50 to $2.00 and then $2.50, an earnings disappointment can knock a $40 stock down to $20.  You can lose half your money just because the earnings fell out of bed.

If you buy a debt-free stock with a $15 book selling at $10, it can go down to $8.  It’s not great, but it’s not terrible either.  On the other hand, if things turn around, that stock can sell at $25 if it develops its earnings.

Basically, we like protection on the downside.  A $10 stock with a $15 book can offer pretty good protection.  By using book value as a parameter, we can protect ourselves on the downside and not get hurt too badly.

Also, I think the person who buys earnings has got to follow it all the darn time.  They’re constantly driven by earnings, they’re driven by timing.  I’m amazed.

 

BOEING:  ASSET PLAY

(Boeing 377 Stratocruiser, San Diego Air & Space Museum Archives, via Wikimedia Commons)

Cigar butts—deep value stocks—are characterized by two things:

  • Poor past performance;
  • Low expectations for future performance, i.e., low multiples (low P/B, low P/E, etc.)

Schloss has pointed out that Graham would often compare two companies.  Here’s an example:

One was a very popular company with a book value of $10 selling at $45.  The second was exactly the reverse—it had a book value of $40 and was selling for $25.

In fact, it was exactly the same company, Boeing, in two very different periods of time.  In 1939, Boeing was selling at $45 with a book of $10 and earning very little.  But the outlook was great.  In 1947, after World War II, investors saw no future for Boeing, thinking no one was going to buy all these airplanes.

If you’d bought Boeing in 1939 at $45, you would have done rather badly.  But if you’d bought Boeing in 1947 when the outlook was bad, you would have done very well.

Because a cigar butt is defined by poor recent performance and low expectations, there can be a great deal of upside if performance improves.  For instance, if a stock is at a P/E (price-to-earnings ratio) of 5 and if earnings are 33% of normal, then if earnings return to normal and if the P/E moves to 15, you’ll make 900% on your investment.  If the initial purchase is below true book value—based on the replacement cost of the assets—then you have downside protection in case earnings don’t recover.

 

LESS DOWNSIDE MEANS MORE UPSIDE

If you buy stocks that are protected on the downside, the upside takes care of itself.

The main way to get protection on the downside is by paying a low price relative to book value.  If in addition to quantitative cheapness you focus on companies with low debt, that adds additional downside protection.

If the stock is well below probable intrinsic value, then you should buy more on the way down.  The lower the price relative to intrinsic value, the less downside and the more upside.  As risk decreases, potential return increases.  This is the opposite of what modern finance theory teaches.  According to theory, your expected return only increases if your risk also increases.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett discusses the relationship between risk and reward.  Sometimes risk and reward are positively correlated.  Buffett gives the example of Russian roulette.  Suppose a gun contains one cartridge and someone offers to pay you $1 million if you pull the trigger once and survive.  Say you decline the bet as too risky, but then the person offers to pay you $5 million if you pull the trigger twice and survive.  Clearly that would be a positive correlation between risk and reward.  Buffett continues:

The exact opposite is true with value investing.  If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.  The greater the potential for reward in the value portfolio, the less risk there is.

One quick example:  The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more.  The company owned the Post, Newsweek, plus several television stations in major markets.  Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater.  And to people that think beta measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.

Link: https://bit.ly/2jBezdv

Most brokers don’t recommend buying more on the way down because most people (including brokers’ clients) don’t like to buy when the price keeps falling.  In other words, most investors focus on price instead of intrinsic value.

 

MULTIPLE WAYS TO WIN

A stock trading at a low price relative to book value—a low P/B stock—is usually distressed and is experiencing problems.  But there are several ways for a cigar-butt investor to win, as Schloss explains:

The thing about buying depressed stocks is that you really have three strings to your bow:  1) Earnings will improve and the stocks will go up;  2) somebody will come in and buy control of the company;  or 3) the company will start buying its own stock and ask for tenders.

Schloss again:

But lots of times when you buy a cheap stock for one reason, that reason doesn’t pan out but another reason does—because it’s cheap.

 

HISTORY;  HONESTY;  INSIDER OWNERSHIP

Look at the history of the company.  Value line is helpful for looking at history 10-15 years back.  Also, read the annual reports.  Learn about the ownership, what the company has done, when business they’re in, and what’s happened with dividends, sales, earnings, etc.

It’s usually better not to talk with management because it’s easy to be blinded by their charisma or sales skill:

When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic.

That said, try to ensure that management is honest.  Honesty is more important than brilliance, says Schloss:

…we try to get in with people we feel are honest.  That doesn’t mean they’re necessarily smart—they may be dumb.

But in a choice between a smart guy with a bad reputation or a dumb guy, I think I’d go with the dumb guy who’s honest.

Finally, insider ownership is important.  Management should own a fair amount of stock, which helps to align their incentives with the interests of the stockholders.

Speaking of insider ownership, Walter and Edwin Schloss had a good chunk of their own money invested in the fund they managed.  You should prefer investment managers who, like the Schlosses, eat their own cooking.

 

YOU MUST BE WILLING TO MAKE MISTAKES

(Illustration by Lkeskinen0)

You have to be willing to make mistakes if you want to succeed as an investor.  Even the best value investors tend to be right about 60% of the time and wrong 40% of the time.  That’s the nature of the game.

You can’t do well unless you accept that you’ll make plenty of mistakes.  The key, again, is to try to limit your downside by buying well below probable intrinsic value.  The lower the price you pay (relative to estimated intrinsic value), the less you can lose when you’re wrong and the more you can make when you’re right.

 

DON’T TRY TO TIME THE MARKET

No one can predict the stock market.  Ben Graham observed:

If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

(Illustration by Maxim Popov)

Or as value investor Seth Klarman has put it:

In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

Perhaps the best quote comes from Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history:

I don’t believe all this nonsense about market timing.  Just buy very good value and when the market is ready that value will be recognized.

Singleton built Teledyne using extraordinary capital allocation skills over the course of more than three decades, from 1960 to the early 1990’s.  Fourteen of these years—1968 to 1982—were a secular bear market during which stocks were relatively flat and also experienced a few large downward moves (especially 1973-1974).  But this long flat period punctuated by bear markets didn’t slow down or change Singleton’s approach.  Because he consistently bought very good value, on the whole his acquisitions grew significantly in worth over time regardless of whether the broader market was down, flat, or up.

Of course, it’s true that if you buy an undervalued stock and then there’s a bear market, it may take longer for your investment to work.  However, bear markets create many bargains.  As long as you maintain a focus on the next 3 to 5 years, bear markets are wonderful times to buy cheap stocks (including more of what you already own).

In 1955, Buffett was advised by his two heroes, his father and Ben Graham, not to start a career in investing because the market was too high.  Similarly, Graham told Schloss in 1955 that it wasn’t a good time to start.

Both Buffett and Schloss ignored the advice.  In hindsight, both Buffett and Schloss made great decisions.  Of course, Singleton would have made the same decision as Buffett and Schloss.  Even if the market is high, there are invariably individual stocks hidden somewhere that are cheap.

Schloss always remained fully invested because he knew that virtually no one can time the market except by luck.

 

WHEN TO SELL

Don’t be in too much of a hurry to sell… Before selling try to reevaluate the company again and see where the stock sells in relation to its book value.

Selling is hard.  Schloss readily admits that many stocks he sold later increased a great deal.  But he doesn’t dwell on that.

The basic criterion for selling is whether the stock price is close to estimated intrinsic value.  For a cigar butt investor like Schloss, if he paid a price that was half book, then if the stock price approaches book value, it’s probably time to start selling.  (Unless it’s a rare stock that is clearly worth more than book value, assuming the investor was able to buy it low in the first place.)

If stock A is cheaper than stock B, some value investors will sell A and buy B.  Schloss doesn’t do that.  It often takes four years for one of Schloss’s investments to work.  If he already has been waiting for 1-3 years with stock A, he is not inclined to switch out of it because he might have to wait another 1-3 years before stock B starts to move.  Also, it’s very difficult to compare the relative cheapness of stocks in different industries.

Instead, Schloss makes an independent buy or sell decision for every stock.  If B is cheap, Schloss simply buys B without selling anything else.  If A is no longer cheap, Schloss sells A without buying anything else.

 

THE FIRST 10 YEARS ARE PROBABLY THE WORST

John Templeton’s worst ten years as an investor were his first ten years.  The same was true for Schloss, who commented that it takes about ten years to get the hang of value investing.

 

STAY INFORMED ABOUT CURRENT EVENTS

(Photo by Juan Moyano)

Walter Schloss and his son Edwin sometimes would spend a whole day discussing current events, social trends, etc.  Edwin Schloss said:

If you’re not in touch with what’s going on or you don’t see what’s going on around you, you can miss out on a lot of investment opportunities. So we try to be aware of everything around us—like John Templeton says in his book about being open to new ideas and new experiences.

 

CONTROL YOUR EMOTIONS;  BE CAREFUL OF LEVERAGE

Try not to let your emotions affect your judgment.  Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.

Quantitative investing is a good way to control emotion.  This is what Graham suggested and practiced.  Graham just looked at the numbers to make sure they were below some threshold—like 2/3 of current assets minus all liabilities (the net-net method).  Graham typically was not interested in what the business did.

On the topic of discipline and controlling your emotions, Schloss told a great story about when Warren Buffett was playing golf with some buddies:

One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks.  If you don’t shoot a hole-in-one, you owe us $10.”

Warren thought about it and said, “I’m not taking the bet.”

The others said, “Why don’t you?  The most you can lose is $10. You can make $10,000.”

Warren replied, If you’re not disciplined in the little things, you won’t be disciplined in the big things.”

Be careful of leverage.  It can go against you.  Schloss acknowledges that sometimes he has gotten too greedy by buying highly leveraged stocks because they seemed really cheap.  Companies with high leverage can occasionally become especially cheap compared to book value.  But often the risk of bankruptcy is too high.

Still, as conservative value investor Seth Klarman has remarked, there’s room in the portfolio occasionally for a super cheap, highly indebted company.  If the probability of success is high enough, it may not be a difficult decision.  If you pick the right one, you can make 10 times your money.

 

RIDE COATTAILS;  DIVERSIFY

Sometimes you can get good ideas from other investors you know or respect.  Even Buffett did this.  Buffett called it “coattail riding.”

Schloss, like Graham and Buffett, recommends a diversified approach if you’re doing cigar butt (deep value) investing.  Have at least 15-20 stocks in your portfolio.  A few investors can do better by being more concentrated.  But most investors will do better over time by using a quantitative, diversified approach.

Schloss tended to have about 100 stocks in his portfolio:

…And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work out.  Now I can’t tell you which ones, so I buy a hundred of them.  Of course, it doesn’t mean you own the same amount of each stock.  If we like a stock we put more money in it.  Positions we are less sure about we put less in… We then buy the stock on the way down and try to sell it on the way up.

Even though Schloss was quite diversified, he still took larger positions in the stocks he liked best and smaller positions in the stocks about which he was less sure.

Schloss emphasized that it’s important to know what you know and what you don’t know.  Warren Buffett and Charlie Munger call this a circle of competence.  Even if a value investor is far from being the smartest, there are hundreds of microcap companies that are easy to understand with enough work.

(Image by Wilma64)

The main trouble in investing is overconfidence: having more confidence than is warranted by the evidence.  Overconfidence is arguably the most widespread cognitive bias suffered by humans, as Nobel Laureate Daniel Kahneman details in Thinking, Fast and Slow.  By humbly defining your circle of competence, you can limit the impact of overconfidence.  Part of this humility comes from making mistakes.

The best choice for most investors is either an index fund or a quantitative value fund.  It’s the best bet for getting solid long-term returns, while minimizing or removing entirely the negative influence of overconfidence.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Common Stocks and Common Sense

(Image:  Zen Buddha Silence by Marilyn Barbone)

February 17, 2019

It’s crucial in investing to have the proper balance of confidence and humility.  Overconfidence is very deep-seated in human nature.  Nearly all of us tend to believe that we’re above average across a variety of dimensions, such as looks, smarts, academic ability, business aptitude, driving skill, and even luck (!).

Overconfidence is often harmless and it even helps in some areas.  But when it comes to investing, if we’re overconfident about what we know and can do, eventually our results will suffer.

(Image by Wilma64)

The simple truth is that the vast majority of us should invest in broad market low-cost index funds.  Buffett has maintained this argument for a long time: http://boolefund.com/warren-buffett-jack-bogle/

The great thing about investing in index funds is that you can outperform most investors, net of costs, over the course of several decades.  This is purely a function of costs.  A Vanguard S&P 500 index fund costs 2-3% less per year than the average actively managed fund.  This means that, after a few decades, you’ll be ahead of roughly 90% (or more) of all active investors.

You can do better than a broad market index fund if you invest in a solid quantitative value fund.  Such a fund can do at least 1-2% better per year, on average and net of costs, than a broad market index fund.

But you can do even better—at least 5% better per year than the S&P 500 index—by investing in a quantitative value fund focused on microcap stocks.

  • At the Boole Microcap Fund, our mission is to help you do at least 5% better per year, on average, than an S&P 500 index fund.  We achieve this by implementing a quantitative deep value approach focused on cheap micro caps with improving fundamentals.  See: http://boolefund.com/best-performers-microcap-stocks/

 

I recently re-read Common Stocks and Common Sense (Wiley, 2016), by Edgar Wachenheim III.  It’s a wonderful book.  Wachenheim is one of the best value investors.  He and his team at Greenhaven Associates have produced 19% annual returns for over 25 years.

Wachenheim emphasizes that, due to certain behavioral attributes, he has outperformed many other investors who are as smart or smarter.  As Warren Buffett has said:

Success in investing doesn’t correlate with IQ once you’re above the level of 125.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

That’s not to say IQ isn’t important.  Most of the finest investors are extremely smart.  Wachenheim was a Baker Scholar at Harvard Business School, meaning that he was in the top 5% of his class.

The point is that—due to behavioral factors such as patience, discipline, and rationality—top investors outperform many other investors who are as smart or smarter.  Buffett again:

We don’t have to be smarter than the rest; we have to be more disciplined than the rest.

Buffett himself has always been extraordinarily patient and disciplined.  There have been several times in Buffett’s career when he went for years on end without making a single investment.

Wachenheim highlights three behavioral factors that have helped him outperform others of equal or greater talent.

The bulk of Wachenheim’s book—chapters 3 through 13—is case studies of specific investments.  Wachenheim includes a good amount of fascinating business history, some of which is mentioned here.

Outline for this blog post:

  • Approach to Investing
  • Being a Contrarian
  • Probable Scenarios
  • Controlling Emotions
  • IBM
  • Interstate Bakeries
  • U.S. Home Corporation
  • Centex
  • Union Pacific
  • American International Group
  • Lowe’s
  • Whirlpool
  • Boeing
  • Southwest Airlines
  • Goldman Sachs

(Photo by Lsaloni)

 

APPROACH TO INVESTING

From 1960 through 2009 in the United States, common stocks have returned about 9 to 10 percent annually (on average).

The U.S. economy grew at roughly a 6 percent annual rate—3 percent from real growth (unit growth) and 3 percent from inflation (price increases).  Corporate revenues—and earnings—have increased at approximately the same 6 percent annual rate.  Share repurchases and acquisitions have added 1 percent a year, while dividends have averaged 2.5 percent a year.  That’s how, on the whole, U.S. stocks have returned 9 to 10 percent annually, notes Wachenheim.

Even if the economy grows more slowly in the future, Wachenheim argues that U.S. investors should still expect 9 to 10 percent per year.  In the case of slower growth, corporations will not need to reinvest as much of their cash flows.  That extra cash can be used for dividends, acquisitions, and share repurchases.

Following Warren Buffett and Charlie Munger, Wachenheim defines risk as the potential for permanent loss.  Risk is not volatility.

Stocks do fluctuate up and down.  But every time the market has declined, it has ultimately recovered and gone on to new highs.  The financial crisis in 2008-2009 is an excellent example of large—but temporary—downward volatility:

The financial crisis during the fall of 2008 and the winter of 2009 is an extreme (and outlier) example of volatility.  During the six months between the end of August 2008 and end of February 2009, the [S&P] 500 Index fell by 42 percent from 1,282.83 to 735.09.  Yet by early 2011 the S&P 500 had recovered to the 1,280 level, and by August 2014 it had appreciated to the 2000 level.  An investor who purchased the S&P 500 Index on August 31, 2008, and then sold the Index six years later, lived through the worst financial crisis and recession since the Great Depression, but still earned a 56 percent profit on his investment before including dividends—and 69 percent including the dividends that he would have received during the six-year period.  Earlier, I mentioned that over a 50-year period, the stock market provided an average annual return of 9 to 10 percent.  During the six-year period August 2008 through August 2014, the stock market provided an average annual return of 11.1 percent—above the range of normalcy in spite of the abnormal horrors and consequences of the financial crisis and resulting deep recession.

(Photo by Terry Mason)

Wachenheim notes that volatility is the friend of the long-term investor.  The more volatility there is, the more opportunity to buy at low prices and sell at high prices.

Because the stock market increases on average 9 to 10 percent per year and always recovers from declines, hedging is a waste of money over the long term:

While many investors believe that they should continually reduce their risks to a possible decline in the stock market, I disagree.  Every time the stock market has declined, it eventually has more than fully recovered.  Hedging the stock market by shorting stocks, or by buying puts on the S&P 500 Index, or any other method usually is expensive, and, in the long run, is a waste of money.

Wachenheim describes his investment strategy as buying deeply undervalued stocks of strong and growing companies that are likely to appreciate significantly due to positive developments not yet discounted by stock prices.

Positive developments can include:

  • a cyclical upturn in an industry
  • an exciting new product or service
  • the sale of a company to another company
  • the replacement of a poor management with a good one
  • a major cost reduction program
  • a substantial share repurchase program

If the positive developments do not occur, Wachenheim still expects the investment to earn a reasonable return, perhaps close to the average market return of 9 to 10 percent annually.  Also, Wachenheim and his associates view undervaluation, growth, and strength as providing a margin of safety—protection against permanent loss.

Wachenheim emphasizes that at Greenhaven, they are value investors not growth investors.  A growth stock investor focuses on the growth rate of a company.  If a company is growing at 15 percent a year and can maintain that rate for many years, then most of the returns for a growth stock investor will come from future growth.  Thus, a growth stock investor can pay a high P/E ratio today if growth persists long enough.

Wachenheim disagrees with growth investing as a strategy:

…I have a problem with growth-stock investing.  Companies tend not to grow at high rates forever.  Businesses change with time.  Markets mature.  Competition can increase.  Good managements can retire and be replaced with poor ones.  Indeed, the market is littered with once highly profitable growth stocks that have become less profitable cyclic stocks as a result of losing their competitive edge.  Kodak is one example.  Xerox is another.  IBM is a third.  And there are hundreds of others.  When growth stocks permanently falter, the price of their shares can fall sharply as their P/E ratios contract and, sometimes, as their earnings fall—and investors in the shares can suffer serious permanent loss.

Many investors claim that they will be able to sell before a growth stock seriously declines.  But very often it’s difficult to determine whether a company is suffering from a temporary or permanent decline.

Wachenheim observes that he’s known many highly intelligent investors—who have similar experiences to him and sensible strategies—but who, nonetheless, haven’t been able to generate results much in excess of the S&P 500 Index.  Wachenheim says that a key point of his book is that there are three behavioral attributes that a successful investor needs:

In particular, I believe that a successful investor must be adept at making contrarian decisions that are counter to the conventional wisdom, must be confident enough to reach conclusions based on probabilistic future developments as opposed to extrapolations of recent trends, and must be able to control his emotions during periods of stress and difficulties.  These three behavioral attributes are so important that they merit further analysis.

 

BEING A CONTRARIAN

(Photo by Marijus Auruskevicius)

Most investors are not contrarians because they nearly always follow the crowd:

Because at any one time the price of a stock is determined by the opinion of the majority of investors, a stock that appears undervalued to us appears appropriately valued to most other investors.  Therefore, by taking the position that the stock is undervalued, we are taking a contrarian position—a position that is unpopular and often is very lonely.  Our experience is that while many investors claim they are contrarians, in practice most find it difficult to buck the conventional wisdom and invest counter to the prevailing opinions and sentiments of other investors, Wall Street analysts, and the media.  Most individuals and most investors simply end up being followers, not leaders.

In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait.  I cannot prove this scientifically, but I have witnessed many intelligent and experienced investors who shunned undervalued stocks that were under clouds, favored fully valued stocks that were in vogue, and repeated this pattern year after year even though it must have become apparent to them that the pattern led to mediocre results at best.

Wachenheim mentions a fellow investor he knows—Danny.  He notes that Danny has a high IQ, attended an Ivy League university, and has 40 years of experience in the investment business.  Wachenheim often describes to Danny a particular stock that is depressed for reasons that are likely temporary.  Danny will express his agreement, but he never ends up buying before the problem is fixed.

In follow-up conversations, Danny frequently states that he’s waiting for the uncertainty to be resolved.  Value investor Seth Klarman explains why it’s usually better to invest before the uncertainty is resolved:

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.  Yet high uncertainty is frequently accompanied by low prices.  By the time the uncertainty is resolved, prices are likely to have risen.  Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.  The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

 

PROBABLE SCENARIOS

(Image by Alain Lacroix)

Many (if not most) investors tend to extrapolate recent trends into the future.  This usually leads to underperforming the market.  See:

The successful investor, by contrast, is a contrarian who can reasonably estimate future scenarios and their probabilities of occurrence:

Investment decisions seldom are clear.  The information an investor receives about the fundamentals of a company usually is incomplete and often is conflicting.  Every company has present or potential problems as well as present or future strengths.  One cannot be sure about the future demand for a company’s products or services, about the success of any new products or services introduced by competitors, about future inflationary cost increases, or about dozens of other relevant variables.  So investment outcomes are uncertain.  However, when making decisions, an investor often can assess the probabilities of certain outcomes occurring and then make his decisions based on the probabilities.  Investing is probabilistic.

Because investing is probabilitistic, mistakes are unavoidable.  A good value investor typically will have at least 33% of his or her ideas not work, whether due to an error, bad luck, or an unforeseeable event.  You have to maintain equanimity despite inevitable mistakes:

If I carefully analyze a security and if my analysis is based on sufficiently large quantities of accurate information, I always will be making a correct decision.  Granted, the outcome of the decision might not be as I had wanted, but I know that decisions always are probabilistic and that subsequent unpredictable changes or events can alter outcomes.  Thus, I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.  An analogy might be my putting game in golf.  Before putting, I carefully try to assess the contours and speed of the green.  I take a few practice strokes.  I aim the putter to the desired line.  I then putt and hope for the best.  Sometimes the ball goes in the hole…

 

CONTROLLING EMOTION

(Photo by Jacek Dudzinski)

Wachenheim:

I have observed that when the stock market or an individual stock is weak, there is a tendency for many investors to have an emotional response to the poor performance and to lose perspective and patience.  The loss of perspective and patience often is reinforced by negative reports from Wall Street and from the media, who tend to overemphasize the significance of the cause of the weakness.  We have an expression that aiplanes take off and land every day by the tens of thousands, but the only ones you read about in the newspapers are the ones that crash.  Bad news sells.  To the extent that negative news triggers further selling pressures on stocks and further emotional responses, the negativism tends to feed on itself.  Surrounded by negative news, investors tend to make irrational and expensive decisions that are based more on emotions than on fundamentals. This leads to the frequent sale of stocks when the news is bad and vice versa.  Of course, the investor usually sells stocks after they already have materially decreased in price.  Thus, trading the market based on emotional reactions to short-term news usually is expensive—and sometimes very expensive.

Wachenheim agrees with Seth Klarman that, to a large extent, many investors simply cannot help making emotional investment decisions.  It’s part of human nature.  People overreact to recent news.

I have continually seen intelligent and experienced investors repeatedly lose control of their emotions and repeatedly make ill-advised decisions during periods of stress.

That said, it’s possible (for some, at least) to learn to control your emotions.  Whenever there is news, you can learn to step back and look at your investment thesis.  Usually the investment thesis remains intact.

 

IBM

(IBM Watson by Clockready, Wikimedia Commons)

When Greenhaven purchases a stock, it focuses on what the company will be worth in two or three years.  The market is more inefficient over that time frame due to the shorter term focus of many investors.

In 1993, Wachenheim estimated that IBM would earn $1.65 in 1995.  Any estimate of earnings two or three years out is just a best guess based on incomplete information:

…having projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

The positive development Wachenheim expected was that IBM would announce a concrete plan to significantly reduce its costs.  On July 28, 1993, the CEO Lou Gerstner announced such a plan.  When IBM’s shares moved up from $11½ to $16, Wachenheim sold his firm’s shares since he thought the market price was now incorporating the expected positive development.

Selling IBM at $16 was a big mistake based on subsequent developments.  The company generated large amounts of cash, part of which it used to buy back shares.  By 1996, IBM was on track to earn $2.50 per share.  So Wachenheim decided to repurchase shares in IBM at $24½.  Although he was wrong to sell at $16, he was right to see his error and rebuy at $24½.  When IBM ended up doing better than expected, the shares moved to $48 in late 1997, at which point Wachenheim sold.

Over the years, I have learned that we can do well in the stock market if we do enough things right and if we avoid large permanent losses, but that it is impossible to do nearly everything right.  To err is human—and I make plenty of errors.  My judgment to sell IBM’s shares in 1993 at $16 was an expensive mistake.  I try not to fret over mistakes.  If I did fret, the investment process would be less enjoyable and more stressful.  In my opinion, investors do best when they are relaxed and are having fun.

Finding good ideas takes time.  Greenhaven rejects the vast majority of its potential ideas.  Good ideas are rare.

 

INTERSTATE BAKERIES

(Photo of a bakery by Mohylek, Wikimedia Commons)

Wachenheim discovered that Howard Berkowitz bought 12 percent of the outstanding shares of Interstate Bakeries, became chairman of the board, and named a new CEO.  Wachenheim believed that Howard Berkowitz was an experienced and astute investor.  In 1967, Berkowitz was a founding partner of Steinhardt, Fine, Berkowitz & Co., one of the earliest and most successful hedge funds.  Wachenheim started analyzing Interstate in 1985 when the stock was at about $15:

Because of my keen desire to survive by minimizing risks of permanent loss, the balance sheet then becomes a good place to start efforts to understand a company.  When studying a balance sheet, I look for signs of financial and accounting strengths.  Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and ‘hidden’ assets and liabilities all are among common considerations, with their relative importance depending on the situation.  If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.  

Wachenheim looks at management after he is done analyzing the balance sheet.  He admits that he is humble about his ability to assess management.  Also, good or bad results are sometimes due in part to chance.

Next Wachenheim examines the business fundamentals:

We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.  Because we believe that information reduces uncertainty, we try to gather as much information as possible.  We read and think—and we sometimes speak to customers, competitors, and suppliers.  While we do interview the managements of the companies we analyze, we are wary that their opinions and projections will be biased.

Wachenheim reveals that the actual process of analyzing a company is far messier than you might think based on the above descriptions:

We constantly are faced with incomplete information, conflicting information, negatives that have to be weighed against positives, and important variables (such as technological change or economic growth) that are difficult to assess and predict.  While some of our analysis is quantitative (such as a company’s debt-to-equity ratio or a product’s share of market), much of it is judgmental.  And we need to decide when to cease our analysis and make decisions.  In addition, we constantly need to be open to new information that may cause us to alter previous opinions or decisions.

Wachenheim indicates a couple of lessons learned.  First, it can often pay off when you follow a capable and highly incentivized business person into a situation.  Wachenheim made his bet on Interstate based on his confidence in Howard Berkowitz.  Interstate’s shares were not particularly cheap.

Years later, Interstate went bankrupt because they took on too much debt.  This is a very important lesson.  For any business, there will be problems.  Working through difficulties often takes much longer than expected.  Thus, having low or no debt is essential.

 

U.S. HOME CORPORATION

(Photo by Dwight Burdette, Wikimedia Commons)

Wachenheim describes his use of screens:

I frequently use Bloomberg’s data banks to run screens.  I screen for companies that are selling for low price-to-earnings (PE) ratios, low prices to revenues, low price-to-book values, or low prices relative to other relevant metrics.  Usually the screens produce a number of stocks that merit additional analyses, but almost always the additional analyses conclude that there are valid reasons for the apparent undervaluations. 

Wachenheim came across U.S. Home in mid-1994 based on a discount to book value screen.  The shares appeared cheap at 0.63 times book and 6.8 times earnings:

Very low multiples of book and earnings are adrenaline flows for value investors.  I eagerly decided to investigate further.

Later, although U.S. Home was cheap and produced good earnings, the stock price remained depressed.  But there was a bright side because U.S. Home led to another homebuilder idea…

 

CENTEX CORPORATION

(Photo by Steven Pavlov, Wikimedia Commons)

After doing research and constructing a financial model of Centex Corporation, Wachenheim had a startling realization:  the shares would be worth about $63 a few years in the future, and the current price was $12.  Finally, a good investment idea:

…my research efforts usually are tedious and frustrating.  I have hundreds of thoughts and I study hundreds of companies, but good investment ideas are few and far between.  Maybe only 1 percent or so of the companies we study ends up being part of our portfolios—making it much harder for a stock to enter our portfolio than for a student to enter Harvard.  However, when I do find an exciting idea, excitement fills the air—a blaze of light that more than compensates for the hours and hours of tedium and frustration.

Greenhaven typically aims for 30 percent annual returns on each investment:

Because we make mistakes, to achieve 15 to 20 percent average returns, we usually do not purchase a security unless we believe that it has the potential to provide a 30 percent or so annual return.  Thus, we have very high expectations for each investment.

In late 2005, Wachenheim grew concerned that home prices had gotten very high and might decline.  Many experts, including Ben Bernanke, argued that because home prices had never declined in U.S. history, they were unlikely to decline.  Wachenheim disagreed:

It is dangerous to project past trends into the future.  It is akin to steering a car by looking through the rearview mirror…

 

UNION PACIFIC

(Photo by Slambo, Wikimedia Commons)

After World War II, the construction of the interstate highway system gave trucks a competitive advantage over railroads for many types of cargo.  Furthermore, fewer passengers took trains, partly due to the interstate highway system and partly due to the commercialization of the jet airplane.  Excessive regulation of the railroadsin an effort to help farmersalso caused problems.  In the 1960s and 1970s, many railroads went bankrupt.  Finally, the government realized something had to be done and it passed the Staggers Act in 1980, deregulating the railroads:

The Staggers Act was a breath of fresh air.  Railroads immediately started adjusting their rates to make economic sense.  Unprofitable routes were dropped.  With increased profits and with confidence in their future, railroads started spending more to modernize.  New locomotives, freight cars, tracks, automated control systems, and computers reduced costs and increased reliability.  The efficiencies allowed the railroads to reduce their rates and become more competitive with trucks and barges….

In the 1980s and 1990s, the railroad industry also enjoyed increased efficiencies through consolidating mergers.  In the west, the Burlington Northern merged with the Santa Fe, and the Union Pacific merged with the Southern Pacific.  

Union Pacific reduced costs during the 2001-2002 recession, but later this led to congestion on many of its routes and to the need to hire and train new employees once the economy had picked up again.  Union Pacific experienced an earnings shortfall, leading the shares to decline to $14.86.

Wachenheim thought that Union Pacific’s problems were temporary, and that the company would earn about $1.55 in 2006.  With a conservative multiple of 14 times earnings, the shares would be worth over $22 in 2006.  Also, the company was paying a $0.30 annual dividend.  So the total return over a two-year period from buying the shares at $14½ would be 55 percent.

Wachenheim also thought Union Pacific stock had good downside protection because the book value was $12 a share.

Furthermore, even if Union Pacific stock just matched the expected return from the S&P 500 Index of 9½ percent a year, that would still be much better than cash.

The fact that the S&P 500 Index increases about 9½ percent a year is an important reason why shorting stocks is generally a bad business.  To do better than the market, the short seller has to find stocks that underperform the market by 19 percent a year.  Also, short sellers have limited potential gains and unlimited potential losses.  On the whole, shorting stocks is a terrible business and often even the smartest short sellers struggle.

Greenhaven sold its shares in Union Pacific at $31 in mid-2007, since other investors had recognized the stock’s value.  Including dividends, Greenhaven earned close to a 24 percent annualized return.

Wachenheim asks why most stock analysts are not good investors.  For one, most analysts specialize in one industry or in a few industries.  Moreover, analysts tend to extrapolate known information, rather than define future scenarios and their probabilities of occurrence:

…in my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes that will occur in the future.  Current fundamentals are based on known information.  Future fundamentals are based on unknowns.  Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one’s neck out—all efforts that human beings too often prefer to avoid.

Also, I believe it is difficult for securities analysts to embrace companies and industries that currently are suffering from poor results and impaired reputations.  Often, securities analysts want to see tangible proof of better results before recommending a stock.  My philosophy is that life is not about waiting for the storm to pass.  It is about dancing in the rain.  One usually can read a weather map and reasonably project when a storm will pass.  If one waits for the moment when the sun breaks out, there is a high probability others already will have reacted to the improved prospects and already will have driven up the price of the stock—and thus the opportunity to earn large profits will have been missed.

Wachenheim then quotes from a New York Times op-ed piece written on October 17, 2008, by Warren Buffett:

A simple rule dictates my buying:  Be fearful when others are greedy, and be greedy when others are fearful.  And most certainly, fear is now widespread, gripping even seasoned investors.  To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.  But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.  These businesses will indeed suffer earnings hiccups, as they always have.  But most major companies will be setting new profit records 5, 10, and 20 years from now.  Let me be clear on one point:  I can’t predict the short-term movements of the stock market.  I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now.  What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.  So if you wait for the robins, spring will be over.

 

AMERICAN INTERNATIONAL GROUP

(AIG Corporate, Photo by AIG, Wikimedia Commons)

Wachenheim is forthright in discussing Greenhaven’s investment in AIG, which turned out to be a huge mistake.  In late 2005, Wachenheim estimated that the intrinsic value of AIG would be about $105 per share in 2008, nearly twice the current price of $55.  Wachenheim also liked the first-class reputation of the company, so he bought shares.

In late April 2007, AIG’s shares had fallen materially below Greenhaven’s cost basis:

When shares of one of our holdings are weak, we usually revisit the company’s longer-term fundamentals.  If the longer-term fundamentals have not changed, we normally will continue to hold the shares, if not purchase more.  In the case of AIG, it appeared to us that the longer-term fundamentals remained intact.

When Lehman filed for Chapter 11 bankruptcy protection on September 15, 2008, all hell broke loose:

The decline in asset values caused financial institutions to mark down the carrying value of their assets, which, in turn, caused sharp reductions in their credit ratings.  Sharp reductions in credit ratings required financial institutions to raise capital and, in the case of AIG, to post collateral on its derivative contracts.  But the near freezing of the financial markets prevented the requisite raising of capital and cash and thus caused a further deterioration in creditworthiness, which further increased the need for new capital and cash, and so on… On Tuesday night, September 16, the U.S. government agreed to provide the requisite cash in return for a lion’s share of the ownership of AIG.  As soon as I read the agreement, it was clear to me that we had a large permanent loss in our holdings of AIG.

Wachenheim defends the U.S. government bailouts.  Much of the problem was liquidity, not solvency.  Also, the bailouts helped restore confidence in the financial system.

Wachenheim asked himself if he would make the same decision today to invest in AIG:

My answer was ‘yes’—and my conclusion was that, in the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments.  It comes with the territory.  So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks.  However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities.  One should not invest with the precept that the next 100-year storm is around the corner.

Wachenheim also points out that when Greenhaven learns of a flaw in its investment thesis, usually the firm is able to exit the position with only a modest loss.  If you’re right 2/3 of the time and if you limit losses as much as possible, the results should be good over time.

 

LOWE’S

(Photo by Miosotis Jade, Wikimedia Commons)

In 2011, Wachenheim carefully analyzed the housing market and reached an interesting conclusion:

I was excited that we had a concept about a probable strong upturn in the housing market that was not shared by most others.  I believed that the existing negativism about housing was due to the proclivity of human beings to uncritically project recent trends into the future and to overly dwell on existing problems.  When analyzing companies and industries, I tend to be an optimist by nature and a pragmatist through effort.  In terms of the proverbial glass of water, it is never half empty, but always half full—and, as a pragmatist, it is twice as large as it needs to be.

Next Wachenheim built a model to estimate normalized earnings for Lowe’s three years in the future (in 2014).  He came up with normal earnings of $3 per share.  He thought the appropriate price-to-earnings ratio was 16.  So the stock would be worth $48 in 2014 versus its current price (in 2011) of $24.  It looked like a bargain.

After gathering more information, Wachenheim revised his earnings model:

…I revise models frequently because my initial models rarely are close to being accurate.  Usually, they are no better than directional.  But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

Wachenheim now thought that Lowe’s could earn close to $4.10 in 2015, which would make the shares worth even more than $48.  In August 2013, the shares hit $45.

In late September 2013, after playing tennis, another money manager asked Wachenheim if he was worried that the stock market might decline sharply if the budget impasse in Congress led to a government shutdown:

I answered that I had no idea what the stock market would do in the near term.  I virtually never do.  I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good.  I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time.  Thus, one would do just as well by flipping a coin.

I feel the same way about predicting the short-term direction of the economy, interest rates, commodities, or currencies.  There are too many variables that need to be identified and weighed.

As for Lowe’s, the stock hit $67.50 at the end of 2014, up 160 percent from what Greenhaven paid.

 

WHIRLPOOL CORPORATION

(Photo by Steven Pavlov, Wikimedia Commons)

Wachenheim does not believe in the Efficient Market Hypothesis:

It seems to me that the boom-bust of growth stocks in 1968-1974 and the subsequent boom-bust of Internet technology stocks in 1998-2002 serve to disprove the efficient market hypothesis, which states that it is impossible for an investor to beat the stock market because stocks always are efficiently priced based on all the relevant and known information on the fundamentals of the stocks.  I believe that the efficient market hypothesis fails because it ignores human nature, particularly the nature of most individuals to be followers, not leaders.  As followers, humans are prone to embrace that which already has been faring well and to shun that which recently has been faring poorly.  Of course, the act of buying into what already is doing well and shunning what is doing poorly serves to perpetuate a trend.  Other trend followers then uncritically join the trend, causing the trend to feed on itself and causing excesses.

Many investors focus on the shorter term, which generally harms their long-term performance:

…so many investors are too focused on short-term fundamentals and investment returns at the expense of longer-term fundamentals and returns.  Hunter-gatherers needed to be greatly concerned about their immediate survival—about a pride of lions that might be lurking behind the next rock… They did not have the luxury of thinking about longer-term planning… Then and today, humans often flinch when they come upon a sudden apparent danger—and, by definition, a flinch is instinctive as opposed to cognitive.  Thus, over years, the selection process resulted in a subconscious proclivity for humans to be more concerned about the short term than the longer term.

By far the best thing for long-term investors is to do is absolutely nothing.  The investors who end up performing the best over the course of several decades are nearly always those investors who did virtually nothing.  They almost never checked prices.  They never reacted to bad news.

Regarding Whirlpool:

In the spring of 2011, Greenhaven studied Whirlpool’s fundamentals.  We immediately were impressed by management’s ability and willingness to slash costs.  In spite of a materially subnormal demand for appliances in 2010, the company was able to earn operating margins of 5.9 percent.  Often, when a company is suffering from particularly adverse industry conditions, it is unable to earn any profit at all.  But Whirlpool remained moderately profitable.  If the company could earn 5.9 percent margins under adverse circumstances, what could the company earn once the U.S. housing market and the appliance market returned to normal?

Not surprisingly, Wall Street analysts were focused on the short term:

…A report by J. P. Morgan dated April 27, 2011, stated that Whirlpool’s current share price properly reflected the company’s increased costs for raw materials, the company’s inability to increase its prices, and the current soft demand for appliances…

The J. P. Morgan report might have been correct about the near-term outlook for Whirlpool and its shares.  But Greenhaven invests with a two- to four-year time horizon and cares little about the near-term outlook for its holdings.

The bulk of Greenhaven’s returns has been generated by relatively few of its holdings:

If one in five of our holdings triples in value over a three-year period, then the other four holdings only have to achieve 12 percent average annual returns in order for our entire portfolio to achieve its stretch goal of 20 percent.  For this reason, Greenhaven works extra hard trying to identify potential multibaggers.  Whirlpool had the potential to be a multibagger because it was selling at a particularly low multiple of its potential earnings power.  Of course, most of our potential multibaggers do not turn out to be multibaggers.  But one cannot hit a multibagger unless one tries, and sometimes our holdings that initially appear to be less exciting eventually benefit from positive unforeseen events (handsome black swans) and unexpectedly turn out to be a complete winner.  For this reason, we like to remain fully invested as long as our holdings remain reasonably priced and free from large risks of permanent loss.

 

BOEING

(Photo by José A. Montes, Wikimedia Commons)

Wachenheim likes to read about the history of each company that he studies.

On July 4, 1914, a flight took place in Seattle, Washington, that had a major effect on the history of aviation.  On that day, a barnstormer named Terah Maroney was hired to perform a flying demonstration as part of Seattle’s Independence Day celebrations.  After displaying aerobatics in his Curtis floatplane, Maroney landed and offered to give free rides to spectators.  One spectator, William Edward Boeing, a wealthy owner of a lumber company, quickly accepted Maroney’s offer.  Boeing was so exhilarated by the flight that he completely caught the aviation bug—a bug that was to be with him for the rest of his life.

Boeing launched Pacific Aero Products (renamed the Boeing Airplane Company in 1917).  In late 1916, Boeing designed an improved floatplane, the Model C.  The Model C was ready by April 1917, the same month the United States entered the war.  Boeing thought the Navy might need training aircraft.  The Navy bought two.  They performed well, so the Navy ordered 50 more.

Boeing’s business naturally slowed down after the war.  Boeing sold a couple of small floatplanes (B-1’s), then 13 more after Charles Lindberg’s 1927 transatlantic flight.  Still, sales of commercial planes were virtually nonexistent until 1933, when the company started marketing its model 247.

The twin-engine 247 was revolutionary and generally is recognized as the world’s first modern airplane.  It had a capacity to carry 10 passengers and a crew of 3.  It had a cruising speed of 189 mph and could fly about 745 miles before needing to be refueled.

Boeing sold seventy-five 247’s before making the much larger 307 Stratoliner, which would have sold well were it not for the start of World War II.

Boeing helped the Allies defeat Germany.  The Boeing B-17 Flying Fortress bomber and the B-29 Superfortress bomber became legendary.  More than 12,500 B-17s and more than 3,500 B-29s were built (some by Boeing itself and some by other companies that had spare capacity).

Boeing prospered during the war, but business slowed down again after the war.  In mid-1949, the de Havilland Aircraft Company started testing its Comet jetliner, the first use of a jet engine.  The Comet started carrying passengers in 1952.  In response, Boeing started developing its 707 jet.  Commercial flights for the 707 began in 1958.

The 707 was a hit and soon became the leading commercial plane in the world.

Over the next 30 years, Boeing grew into a large and highly successful company.  It introduced many models of popular commercial planes that covered a wide range of capacities, and it became a leader in the production of high-technology military aircraft and systems.  Moreover, in 1996 and 1997, the company materially increased its size and capabilities by acquiring North American Aviation and McDonnell Douglas.

In late 2012, after several years of delays on its new, more fuel-efficient plane—the 787—Wall Street and the media were highly critical of Boeing.  Wachenheim thought that the company could earn at least $7 per share in 2015.  The stock in late 2012 was at $75, or 11 times the $7.  Wachenheim believed that this was way too low for such a strong company.

Wachenheim estimated that two-thirds of Boeing’s business in 2015 would come from commercial aviation.  He figured that this was an excellent business worth 20 times earnings (he used 19 times to be conservative).  He reckoned that defense, one-third of Boeing’s business, was worth 15 times earnings.  Therefore, Wachenheim used 17.7 as the multiple for the whole company, which meant that Boeing would be worth $145 by 2015.

Greenhaven established a position in Boeing at about $75 a share in late 2012 and early 2013.  By the end of 2013, Boeing was at $136.  Because Wall Street now had confidence that the 787 would be a commercial success and that Boeing’s earnings would rise, Wachenheim and his associates concluded that most of the company’s intermediate-term potential was now reflected in the stock price.  So Greenhaven started selling its position.

 

SOUTHWEST AIRLINES

(Photo by Eddie Maloney, Wikimedia Commons)

The airline industry has had terrible fundamentals for a long time.  But Wachenheim was able to be open-minded when, in August 2012, one of his fellow analysts suggested Southwest Airlines as a possible investment.  Over the years, Southwest had developed a low-cost strategy that gave the company a clear competitive advantage.

Greenhaven determined that the stock of Southwest was undervalued, so they took a position.

The price of Southwest’s shares started appreciating sharply soon after we started establishing our position.  Sometimes it takes years before one of our holdings starts to appreciate sharply—and sometimes we are lucky with our timing.

After the shares tripled, Greenhaven sold half its holdings since the expected return from that point forward was not great.  Also, other investors now recognized the positive fundamentals Greenhaven had expected.  Greenhaven sold the rest of its position as the shares continued to increase.

 

GOLDMAN SACHS

(Photo of Marcus Goldman, Wikimedia Commons)

Wachenheim echoes Warren Buffett when it comes to recognizing how much progress the United States has made:

My experience is that analysts and historians often dwell too much on a company’s recent problems and underplay its strengths, progress, and promise.  An analogy might be the progress of the United States during the twentieth century.  At the end of the century, U.S. citizens generally were far wealthier, healthier, safer, and better educated than at the start of the century.  In fact, the century was one of extraordinary progress.  Yet most history books tend to focus on the two tragic world wars, the highly unpopular Vietnam War, the Great Depression, the civil unrest during the Civil Rights movement, and the often poor leadership in Washington.  The century was littered with severe problems and mistakes.  If you only had read the newspapers and the history books, you likely would have concluded that the United States had suffered a century of relative and absolute decline.  But the United States actually exited the century strong and prosperous.  So did Goldman exit 2013 strong and prosperous.

In 2013, Wachenheim learned that Goldman had an opportunity to gain market share in investment banking because some competitors were scaling back in light of new regulations and higher capital requirements.  Moreover, Goldman had recently completed a $1.9 billion cost reduction program.  Compensation as a percentage of sales had declined significantly in the past few years.

Wachenheim discovered that Goldman is a technology company to a large extent, with a quarter of employees working in the technology division.  Furthermore, the company had strong competitive positions in its businesses, and had sold or shut down sub-par business lines.  Wachenheim checked his investment thesis with competitors and former employees.  They confirmed that Goldman is a powerhouse.

Wachenheim points out that it’s crucial for investors to avoid confirmation bias:

I believe that it is important for investors to avoid seeking out information that reinforces their original analyses.  Instead, investors must be prepared and willing to change their analyses and minds when presented with new developments that adversely alter the fundamentals of an industry or company.  Good investors should have open minds and be flexible.

Wachenheim also writes that it’s very important not to invent a new thesis when the original thesis has been invalidated:

We have a straightforward approach.  When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course.  We do not seek new theories that will justify our original decision.  We do not let errors fester and consume our attention.  We sell and move on.

Wachenheim loves his job:

I am almost always happy when working as an investment manager.  What a perfect job, spending my days studying the world, economies, industries, and companies;  thinking creatively;  interviewing CEOs of companies… How lucky I am.  How very, very lucky.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

The Education of a Value Investor

(Image:  Zen Buddha Silence by Marilyn Barbone.)

February 3, 2019

I have now read The Education of a Value Investor, by Guy Spier, several times.  It’s a very honest and insightful description of Guy Spier’s evolution from arrogant and envious youth to kind, ethical, humble, and successful value investor in the mold of his heroes—including the value investors Mohnish Pabrai, Warren Buffett, and Charlie Munger.

Spier recounts how, after graduating near the top of his class at Oxford and then getting an MBA at Harvard, he decided to take a job at D. H. Blair, an ethically challenged place.  Spier realized that part of his job was to dress up bad deals.  Being unable to admit that he had made a mistake, Spier ended up tarnishing his reputation badly by playing along instead of quitting.

Spier’s story is about the journey “from that dark place toward the Nirvana where I now live.”

Besides the lesson that one should never do anything unethical, Spier also learned just how important the environment is:

We like to think that we change our environment, but the truth is that it changes us.  So we have to be extraordinarily careful to choose the right environment….

 

THE PERILS OF AN ELITE EDUCATION

Spier observes that having an education from a top university often does not prevent one from making foolish and immoral decisions, especially when money or power is involved:

Our top universities mold all these brilliant minds.  But these people—including me—still make foolish and often immoral choices.  This also goes for my countless peers who, despite their elite training, failed to walk away from nefarious situations in other investment banks, brokerages, credit-rating agencies, bond insurance companies, and mortgage lenders.

Having stumbled quite badly, Spier felt sufficiently humbled and humiliated that he was willing to reexamine everything he believed.  Thus, in the wake of the worst set of decisions of his life, Spier learned important lessons about Wall Street and about himself that he never could have learned at Oxford or Harvard.

For one thing, Spier learned that quite a few people are willing to distort the truth in order to further their “own narrow self-interest.”  But having discovered Warren Buffett, who is both highly ethical and arguably the best investor ever, Spier began to see that there is another way to succeed.  “This discovery changed my life.”

 

WHAT WOULD WARREN BUFFETT DO?  WHAT WOULD CHARLIE MUNGER DO?  WHAT WOULD MARCUS AURELIUS DO?

Spier argues that choosing the right heroes to emulate is very powerful:

There is a wisdom here that goes far beyond the narrow world of investing.  What I’m about to tell you may be the single most important secret I’ve discovered in all my decades of studying and stumbling.  If you truly apply this lesson, I’m certain that you will have a much better life, even if you ignore everything else I write…

Having found the right heroes, one can become more like them gradually if one not only studies them relentlessly, but also tries to model their behavior.  For example, it is effective to ask oneself:  “What would Warren Buffett do if he were in my shoes right now?  What would Charlie Munger do?  What would Marcus Aurelius do?”

This is a surprisingly powerful principle: modeling the right heroes.  It can work just as well with eminent dead people, as Munger has pointed out.  One can relentlessly study and then model Socrates or Jesus, Epictetus or Seneca, Washington or Lincoln.  With enough studying and enough effort to copy / model, one’s behavior will gradually improve to be more like that of one’s chosen heroes.

 

ENVIRONMENT TRUMPS INTELLECT

Our minds are not strong enough on their own to overcome the environment:

… I felt that my mind was in Omaha, and I believed that I could use the force of my intellect to rise above my environment.  But I was wrong: as I gradually discovered, our environment is much stronger than our intellect.  Remarkably few investors—either amateur or professional—truly understand this critical point.  Great investors like Warren Buffett (who left New York and returned to Omaha) and Sir John Templeton (who settled in the Bahamas) clearly grasped this idea, which took me much longer to learn.

For long-term value investors, the farther away from Wall Street one is, the easier it is to master the skills of patience, rationality, and independent thinking.

 

CAUSES OF MISJUDGMENT

Charlie Munger gave a talk in 1995 at Harvard on 24 causes of misjudgment.  At the time, as Spier writes, this worldly wisdom—combining powerful psychology with economics and business—was not available anywhere else.  Munger’s talk provides deep insight into human behavior.  Link to speech: http://www.rbcpa.com/mungerspeech_june_95.pdf

Decades of experiments by Daniel Kahneman, Amos Tversky, and others have shown that humans have two mental systems: an intuitive system that operates automatically (and subconsciously) and a reasoning system that requires conscious effort.  Through years of focused training involving timely feedback, some people can train themselves to regularly overcome their subconscious and automatic biases through the correct use of logic, math, or statistics.

But the biases never disappear.  Even Kahneman admits that, despite his deep knowledge of biases, he is still automatically “wildly overconfident” unless he makes the conscious effort to slow down and to use his reasoning system.

 

LUNCH WITH WARREN

Guy Spier and Mohnish Pabrai had the winning bid for lunch with Warren Buffett—the proceeds go to GLIDE, a charity.

One thing Spier learned—directly and indirectly—from lunch with Warren is that the more one genuinely tries to help others, the happier life becomes.  Writes Spier:

As I hope you can see from my experience, when your consciousness or mental attitude shifts, remarkable things begin to happen.  That shift is the ultimate business tool and life tool.

At the lunch, Warren repeated a crucial lesson:

It’s very important always to live your life by an inner scorecard, not an outer scorecard.

In other words, it is essential to live in accord with what one knows at one’s core to be right, and never be swayed by external forces such as peer pressure.  Buffett pointed out that too often people justify misguided or wrong actions by reassuring themselves that ‘everyone else is doing it.’

Moreover, Buffett said:

People will always stop you from doing the right thing if it’s unconventional.

Spier asked Buffett if it gets easier to do the right thing.  After pausing for a moment, Buffett said: ‘A little.’

Buffett also stressed the virtue of patience when it comes to investing:

If you’re even a slightly above average investor who spends less than you earn, over a lifetime you cannot help but get very wealthy—if you’re patient.

Spier realized that he could learn to copy many of the successful behaviors of Warren Buffett, but that he could never be Warren Buffett.  Spier observes that what he learned from Warren was to become the best and most authentic version of Guy Spier.

 

HANDLING ADVERSITY

One effective way Spier learned to deal with adversity was by:

…studying heroes of mine who had successfully handled adversity, then imagining that they were by my side so that I could model their attitudes and behavior.  One historical figure I used in this way was the Roman emperor and Stoic philosopher Marcus Aurelius.  At night, I read excerpts from his Meditations.  He wrote of the need to welcome adversity with gratitude as an opportunity to prove one’s courage, fortitude, and resilience.  I found this particularly helpful at a time when I couldn’t allow myself to become fearful.

Moreover, Spier writes about heroes who have overcome serious mistakes:

I also tried to imagine how Sir Ernest Shackleton would have felt in my shoes.  He had made grievous mistakes on his great expedition to Antarctica—for example, failing to land his ship, Endurance, when he could and then abandoning his first camp too soon.  Yet he succeeded in putting these errors behind him, and he ultimately saved the lives of everyone on his team.  This helped me to realize that my own mistakes were an acceptable part of the process.  Indeed, how could I possibly pilot the wealth of my friends and family without making mistakes or encountering the occasional storm?  Like Shackleton, I needed to see that all was not lost and to retain my belief that I would make it through to the other side.

 

CREATING THE IDEAL ENVIRONMENT

Overcoming our cognitive biases and irrational tendencies is not a matter of simply deciding to use one’s rational system.  Rather, it requires many years of training along with specific tools or procedures that help reduce the number of mistakes:

Through painful experience… I discovered that it’s critical to banish the false assumption that I am truly capable of rational thought.  Instead, I’ve found that one of my only advantages as an investor is the humble realization of just how flawed my brain really is.  Once I accepted this, I could design an array of practical work-arounds based on my awareness of the minefield within my mind. 

No human being is perfectly rational.  Every human being has at one time or another made an irrational decision.  We all have mental shortcomings:

…The truth is, all of us have mental shortcomings, though yours may be dramatically different from mine.  With this in mind, I began to realize just how critical it is for investors to structure their environment to counter their mental weaknesses, idiosyncrasies, and irrational tendencies.

Spier describes how hard he worked to create an ideal environment with the absolute minimum of factors that could negatively impact his ability to think rationally:

Following my move to Zurich, I focused tremendous energy on this task of creating the ideal environment in which to invest—one in which I’d be able to act slightly more rationally.  The goal isn’t to be smarter.  It’s to construct an environment in which my brain isn’t subjected to quite such an extreme barrage of distractions and disturbing forces that can exacerbate my irrationality.  For me, this has been a life-changing idea.  I hope that I can do it justice here because it’s radically improved my approach to investing, while also bringing me a happier and calmer life.

As we shall see in a later chapter, I would also overhaul my basic habits and investment procedures to work around my irrationality.  My brain would still be hopelessly imperfect. But these changes would subtly tilt the playing field to my advantage.  To my mind, this is infinitely more helpful than focusing on things like analysts’ quarterly earnings reports, Tobin’s Q ratio, or pundits’ useless market predictions—the sort of noise that preoccupies most investors.

 

LEARNING TO TAP DANCE

Spier, like Pabrai, believes that mastering the game of bridge improves one’s ability to think probabilistically:

Indeed, as a preparation for investing, bridge is truly the ultimate game.  If I were putting together a curriculum on value investing, bridge would undoubtedly be a part of it…

For investors, the beauty of bridge lies in the fact that it involves elements of chance, probabilistic thinking, and asymmetric information.  When the cards are dealt, the only ones you can look at are your own.  But as the cards are played, the probabilistic and asymmetric nature of the game becomes exquisite…

With my bridge hat on, I’m always searching for the underlying truth, based on insufficient information.  The game has helped me to recognize that it’s simply not possible to have a complete understanding of anything.  We’re never truly going to get to the bottom of what’s going on inside a company, so we have to make probabilistic inferences.

Chess is another game that can improve one’s cognition in other areas.  Spier cites the lesson given by chess champion Edward Lasker:

When you see a good move, look for a better one.  

The lesson for investing:

When you see a good investment, look for a better investment.

Spier also learned, both from having fun at games such as bridge and chess, and from watching business people including Steve Jobs and Warren Buffett, that having a more playful attitude might help.  More importantly, whether via meditation or via other hobbies, if one could cultivate inner peace, that could make one a better investor.

The great investor Ray Dalio has often mentioned transcendental meditation as leading to a peaceful state of mind where rationality can be maximized and emotions minimized.  See: https://www.youtube.com/watch?v=zM-2hGA-k5E

Spier explains:

To give you an analogy, when you drop a stone in a calm pond, you see the ripples.  Likewise, in investing, if I want to see the big ideas, I need a peaceful and contented mind.

 

INVESTING TOOLS

Having written about various ways that he has made his environment as peaceful as possible—he also has a library full of great books (1/3 of which are unread), with no internet or phone—Spier next turns to ‘rules and routines that we can apply consistently.’

In the aftermath of the financial crisis, I worked hard to establish for myself this more structured approach to investing, thereby bringing more order and predictability to my behavior while also reducing the complexity of my decision-making process.  Simplifying everything makes sense, given the brain’s limited processing power…

Some of these rules are broadly applicable; others are more idiosyncratic and may work better for me than for you.  What’s more, this remains a work in progress—a game plan that I keep revising as I learn from experience what works best.  Still, I’m convinced that it will help you enormously if you start thinking about your own investment processes in this structured, systematic way.  Pilots internalize an explicit set of rules and procedures that guide their every action and ensure the safety of themselves and their passengers.  Investors who are serious about achieving good returns without undue risk should follow their example.

Here are Spier’s rules:

Rule #1—Stop Checking the Stock Price

A constantly moving stock price influences the brain—largely on a subconscious level—to want to take action.  But for the long-term value investor, the best thing is almost always to do nothing at all.  Thus, it is better only to check prices once per week, or even once per quarter or once per year:

Checking the stock price too frequently uses up my limited willpower since it requires me to expend unnecessary mental energy simply resisting these calls to action.  Given that my mental energy is a scarce resource, I want to direct it in more constructive ways.

We also know from behavioral finance research by Daniel Kahneman and Amos Tversky that investors feel the pain of loss twice as acutely as the pleasure from gain.  So I need to protect my brain from the emotional storm that occurs when I see that my stocks—or the market—are down.  If there’s average volatility, the market is typically up in most years over a 20-year period.  But if I check it frequently, there’s a much higher probability that it will be down at that particular moment…. Why, then, put myself in a position where I may have a negative emotional reaction to this short-term drop, which sends all the wrong signals to my brain?

… After all, Buffett didn’t make billions off companies like American Express and Coca-Cola by focusing on the meaningless movements of the stock ticker.

 

Rule #2—If Someone Tries to Sell You Something, Don’t Buy It

The brain will often make terrible decisions in response to detailed pitches from gifted salespeople.

Rule #3—Don’t Talk to Management

Beware of CEO’s and other top management, no matter how charismatic, persuasive, and amiable they seem.  Most managers have natural biases towards their own companies.

Rule #4—Gather Investment Research in the Right Order

We know from Munger’s speech on the causes of human misjudgment that the first idea to enter the brain tends to be the one that sticks.

Spier starts with corporate filings—‘meat and vegetables’—before consuming news and other types of information.

Rule #5—Discuss Your Investment Ideas Only with People Who Have No Axe to Grind

The idea is to try to find knowledgeable people who can communicate in an objective and logical way, minimizing the influence of various biases.

Rule #6—Never Buy or Sell Stocks When the Market is Open

This again relates to the fact that flashing stock prices push the brain subconsciously towards action:

When it comes to buying and selling stocks, I need to detach myself from the price action of the market, which can stir up my emotions, stimulate my desire to act, and cloud my judgment.  So I have a rule, inspired by Mohnish, that I don’t trade stocks while the market is open.  Instead, I prefer to wait until trading hours have ended.

Rule #7—If a Stock Tumbles after You Buy It, Don’t Sell It for Two Years

When you’ve lost a lot of money, many negative emotions occur.

Mohnish developed a rule to deal with the psychological forces aroused in these situations: if he buys a stock and it goes down, he won’t allow himself to sell it for two years.

…Once again, it acts as a circuit breaker, a way to slow me down and improve my odds of making rational decisions.  Even more important, it forces me to be more careful before buying a stock since I know that I’ll have to live with my mistake for at least two years.  That knowledge helps me to avoid a lot of bad investments.  In fact, before buying a stock, I consciously assume that the price will immediately fall by 50 percent, and I ask myself if I’ll be able to live through it.  I then buy only the amount that I could handle emotionally if this were to happen.

Mohnish’s rule is a variation on an important idea that Buffett has often shared with students:

I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it, so that you had 20 punches—representing investments that you got to make in a lifetime.  And once you’d punched through the card, you couldn’t make any more investments at all.  Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about.  So you’d do much better.

Rule #8—Don’t Talk about Your Current Investments

Once we’ve made a public statement, it’s psychologically difficult to back away from what we’ve said.  The automatic intuitive system in our brains tries to quickly remove doubt by jumping to conclusions.  This system also tries to eliminate any apparent inconsistencies in order to maintain a coherent—albeit highly simplified—story about the world.

But it’s not just our intuitive system that focuses on confirming evidence.  Even our logical system—the system that can do math and statistics—uses a positive test strategy:  When testing a given hypothesis, our logical system looks for confirming evidence rather than disconfirming evidence.  This is the opposite of what works best in science.

Thus, once we express a view, our brain tends to see all the reasons why the view must be correct and our brain tends to be blind to reasons why the view might be wrong.

 

AN INVESTOR’S CHECKLIST

Atul Gawande, a former Rhodes scholar, is a surgeon at Brigham and Women’s Hospital in Boston, a professor of surgery at Harvard Medical School, and a renowned author.  He’s ‘a remarkable blend of practitioner and thinker, and also an exceptionally nice guy.’  In December 2007, Gawande published a story in The New Yorker entitled “The Checklist”:  http://www.newyorker.com/magazine/2007/12/10/the-checklist

One of Gawande’s main points is that ‘intensive-care medicine has grown so far beyond ordinary complexity that avoiding daily mistakes is proving impossible even for our super-specialists.’

Gawande then described the work of Peter Pronovost, a critical-care specialist at Johns Hopkins Hospital.  Pronovost designed a checklist after a particular patient nearly died:

Pronovost took a single sheet of paper and listed all of the steps required to avoid the infection that had almost killed the man.  These steps were all ‘no-brainers,’ yet it turned out that doctors skipped at least one step with over a third of their patients.  When the hospital began to use checklists, numerous deaths were prevented.  This was partly because checklists helped with memory recall, ‘especially with mundane matters that are easily overlooked,’ and partly because they made explicit the importance of certain precautions.  Other hospitals followed suit, adopting checklists as a pragmatic way of coping with complexity.

Mohnish Pabrai and Guy Spier, following Charlie Munger, realized that they could develop a useful checklist for value investing.  The checklist makes sense as a way to overcome the subconscious biases of the human intuitive system.  Moreover, humans have what Spier calls “cocaine brain”:

the intoxicating prospect of making money can arouse the same reward circuits in the brain that are stimulated by drugs, making the rational mind ignore supposedly extraneous details that are actually very relevant.  Needless to say, this mental state is not the best condition in which to conduct a cool and dispassionate analysis of investment risk.

An effective investor’s checklist is based on a careful analysis of past mistakes, both by oneself and by others.

My own checklist, which borrows shamelessly from [Mohnish Pabrai’s], includes about 70 items, but it continues to evolve.  Before pulling the trigger on any investment, I pull out the checklist from my computer or the filing cabinet near my desk to see what I might be missing.  Sometimes, this takes me as little as 15 minutes, but it’s led me to abandon literally dozens of investments that I might otherwise have made…

As I’ve discovered from having ADD, the mind has a way of skipping over certain pieces of information—including rudimentary stuff like where I’ve left my keys.  This also happens during the investment process.  The checklist is invaluable because it redirects and challenges the investor’s wandering attention in a systematic manner…

That said, it’s important to recognize that my checklist should not be your checklist.  This isn’t something you can outsource since your checklist has to reflect your own unique experience, knowledge, and previous mistakes.  It’s critical to go through the arduous process of analyzing where things have gone wrong for you in the past so you can see if there are any recurring patterns or particular areas of vulnerability.

It is very important to note that there are at least four categories of investment mistakes, all of which must be identified, studied, and learned from:

  • A mistake where the investment does poorly because the intrinsic value of the business in question turns out to be lower than one thought;
  • A mistake of omission, where one fails to invest in a stock that one knows is cheap;
  • A mistake of selling the stock too soon.  Often a value investment will fail to move for years.  When it finally does move, many value investors will sell far too soon, sometimes missing out on an additional 300-500% return (or even more).  Value investors Peter Cundill and Robert Robotti have discussed this mistake.
  • A mistake where the investment does well, but one realizes that the good outcome was due to luck and that one’s analysis was incorrect.  It is often difficult to identify this type of mistake because the outcome of the investment is good, but it’s crucial to do so, otherwise one’s future results will be penalized.

Here is the value investor Chris Davis talking about how he and his colleagues frame their mistakes on the wall in order never to forget the lessons:  http://davisfunds.com/document/video/mistake_wall

Davis points out that, as an investor, one should always be improving with age.  As Buffett and Munger say, lifelong learning is a key to success, especially in investing, where all knowledge is cumulative.   Frequently one’s current decisions are better and more profitable as a result of having learned the right lessons from past mistakes.

 

DOING BUSINESS THE BUFFETT-PABRAI WAY

Buffett:

Hang out with people better than you, and you cannot help but improve.

Pabrai likes to quote Ronald Reagan:

There’s no limit to what you can do if you don’t mind who gets the credit.

Buffett also talks about the central importance of treating others as one wishes to be treated:

The more love you give, the more love you get.

Spier says that this may be the most important lesson of all.  The key is to value each person as an end rather than a means.  It helps to remember that one is a work in progress and also that one is mortal.  Pabrai:

I am but ashes and dust.

Spier explains that he tries to do things for people he meets.  Over time, he has learned to distinguish givers from takers.

The crazy thing is that, when you start to live this way, everything becomes so much more joyful.  There is a sense of flow and alignment with the universe that I never felt when everything was about what I could take for myself…

I’m not telling you this to be self-congratulatory as there are countless people who do so much more good than I do.  The point is simply that life has improved immeasurably since I began to live this way.  In truth, I’ve become increasingly addicted to the positive emotions awakened in me by these activities… One thing is for sure: I receive way more by giving than I ever did by taking.  So, paradoxically, my attempts at selflessness may actually be pretty selfish.

 

THE QUEST FOR TRUE VALUE

Buffett calls it the inner scorecard and Spier calls it the inner journey:

The inner journey is that path to becoming the best version of ourselves that we can be, and this strikes me as the only true path in life.  It involves asking questions such as:  What is my wealth for?  What give my life meaning?  And how can I use my gifts to help others?

Templeton also devoted much of his life to the inner journey.  Indeed, his greatest legacy is his charitable foundation, which explores ‘the Big Questions of human purpose and ultimate reality,’ including complexity, evolution, infinity, creativity, forgiveness, love, gratitude, and free will.  The foundation’s motto is ‘How little we know, how eager to learn.’

In my experience, the inner journey is not only more fulfilling but is also a key to becoming a better investor.  If I don’t understand my inner landscape—including my fears, insecurities, desires, biases, and attitude to money—I’m likely to be mugged by reality.  This happened early in my career, when my greed and arrogance led me to D. H. Blair…. [also later in New York with envy]

By embarking on the inner journey, I became more self-aware and began to see these flaws more clearly.  I could work to overcome them only once I acknowledged them.  But these traits were so deepseated that I also had to find practical ways to navigate around them.

The important thing is to understand not only human biases in general, but also one’s own unique brain.  Also, some lessons can only be learned through difficult experiences—including mistakes:

Adversity may, in fact, be the best teacher of all.  The only trouble is that it takes a long time to live through our mistakes and then learn from them, and it’s a painful process.

It doesn’t matter exactly how you do the inner journey, just that you do it.

[The] real reward of this inner transformation is not just enduring investment success.  It’s the gift of becoming the best person we can be.  That, surely, is the ultimate prize. 

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.